Subject Islamic Financial Systems

Course Code: MIB 2323

Specialization-ISLAMIC BANKING

s.no Syllabus&contents page

1 Overview of - qard-e-hasan, service charge, participatory modes of
financing (musharakah, diminishing musharakah, mudarabah,
mudarabah certificates),
2 debt creating modes (murabaha, salam, istisna, ijarah, diminishing
musharaka, musawamah, time multiple counter-loans, bay`
bithaman ajil, tawarruq)
3 sub-contracts (kafalah, hawalah, wakalah, jualah and bai-al-dayn);
Murabahah - related rules, applications, conditions,
4 AAOIFI Shariah standards; Musharakah - its mechanism,
termination, issues,
AAOIFI Shariah standards; Diminishing
5 Musharakah - mechanism, types, & applications;
Mudarabah - Profit distribution mechanism and AAOIFI Shariah
standards
6 Ijarah - principles, types, mechanism, documentation, issues and
Shariah standards
7 Salam & Parallel Salam - mechanism, applications and AAOIFI
Shariah standards
8 Istijrar - types, applications and conditions;
9 Istisna and Parallel Istisna - mechanism, applications and AAOIFI
Shariah standards;
10 Bay` Bithaman Ajil - its legality, applications; Bay’ al-Muajjal its
comparison, documentation and related issues;
11 Mechanism, applications and AAOIFI Shariah standards of
Tawarruq, Tenancy (muzarat), Kafalah, Hawala, Wakalah and
Ju‘alah
Chapter 1

Overview of - qard-e-hasan, - Also known as al-qard al-hasan, qardh hasan qard hasan,
or qard. An Islamic finance term, qard al-hasan refers to an interest free loan. In a qard al-
hasan transaction, the borrower repays the principal amount of the loan without interest, mark-
up, or a share in the business for which the loan was used. This product is consistent with
the Sharia prohibition against riba because the borrower is not compensating the lender for the
money advanced.
For more information on Islamic finance in the US, see Practice Notes, Islamic Finance: US Law
Overview and Islamic Finance Structures and Products.
For more information on Islamic finance in the UK, see Practice notes, Islamic finance: UK law
overview and A guide to key resources: Islamic finance.
Qardh al-hasan (Arabic: ‫قرض الحسن‬, transl. benevolent lending) is a form of interest-free loan
(fungible, marketable wealth) that is extended by a lender to a borrower on the basis of
benevolence (ihsan). Al-qardh, from a shari’a point of view, is a non commutative contract, as it
involves a facility granted only for the sake of tabarru’ (donation). Therefore, al-qardh al-hasan
is a gratuitous loan extended to people in need, for a specified period of time. At the end of that
period, the face value of the loan (asl al-qardh) is to be paid off. In other words, shari’a prohibits
the stipulation of an excess for the lender, as it amounts to riba, whether the excess is expressed
in terms of quality or quantity, or whether it is a tangible item or a benefit. However, it is
permitted that the repayment of qardh (loan extinguishing) is made with an excess (tangible item,
benefit, service, etc), provided that such an excess is neither expressly stipulated nor implicitly
pre-arranged (through collusion or tawatu’) in the contract of loan. The concept of Qardh al-
hasan is to assist the poor or needy by offering a loan without any interest. The Quran states that
such a loan is beautiful and admirable[7] because the borrower of such a loan is God; not the
person receiving the money.[8][9] According to the verses of Quran, God admires people who pay
their wealth for servants of God by using this statement "loan to God", while this wealth is
provided for people by God.[10]
A different and non-orthodox interpretation of the Quran's verses on qardh al-hasan (by M.O
Farooq) is that the context of the verses does not "seem to have anything to do with qardh in
general as business transactions in this world", but instead involves "the symbolic transaction
between Allah and the believers". In these sorts of transactions believers can only give Allah
loans, not gifts, because "Whatever we offer to Allah is ... treated as loan", since it is always
returned, "doubled or even more".[11] In contradiction to orthodox religious legal teachings that
the Quranic verses prohibit Muslims from charging interest on business loans, Farooq notes that
the verses "specify no detail whatsoever in regard to conditions or limitations, including
whether qardh or qardh al-hasan must be without excess. On the contrary, qardh al-hasan, as a
contract with God, consistently specifies an excess,"[5] (as the Quran talks of doubling the qardh
hasan).
Qardh al-hasan contracts between Islamic banks and borrowers state that the borrower only has
to pay back the amount borrowed, although the borrower can pay back extra money as thanks.
Loans such as this are used as an attempt to alleviate poverty and create economic growth. Also
the Quran has introduced it as an outstanding element such as sadaqah, zakat and waqf, that is a
necessary concept to provide the welfare of society.[1]
Qardh al-hasan supports the main principle of brotherhood. Also there are benefits such as the
aid of the poor, establishing a strengthened relationship between poor and rich, the just
distribution of national income between all citizens, removing caste differences and
unemployment, and being an act with great reward at resurrection da

service charge, - Islamic banking, also known as non-interest banking, is a banking system that
is based on the principles of Islamic or Sharia law and guided by Islamic economics. Two
fundamental principles of Islamic banking are the sharing of profit and loss, and the prohibition
of the collection and payment of interest by lenders and investors. Islamic law prohibits
collecting interest or "riba."
Understanding Islamic Banking
Islamic banking is grounded in Sharia, or Islamic, principles and all bank undertakings follow
those Islamic morals. Islamic rules on transactions are called Fiqh al-Muamalat. Typically,
financial transactions within Islamic banking are a culturally distinct form of ethical investing.
For example, investments involving alcohol, gambling, pork, and other forbidden items is
prohibited. There are over 300 Islamic banks in over 51 countries, including the United States.

Principles of Islamic Banking

The principles of Islamic banking follow Sharia law, which is based on the Quran and the
Hadith, the recorded sayings, and actions of the Prophet Muhammad. When more information or
guidance is necessary, Islamic bankers turn to learned scholars or use independent reasoning
based on scholarship and customs. The bankers also ensure their ideas do not deviate from the
fundamental principles of the Quran.

History of Islamic Banking

The origin of Islamic banking dates back to the beginning of Islam in the seventh century. The
Prophet Muhammad's first wife, Khadija, was a merchant. He acted as an agent for her business,
using many of the same principles used in contemporary Islamic banking.
In the Middle Ages, trade and business activity in the Muslim world relied on Islamic banking
principles. These banking principles spread throughout Spain, the Mediterranean, and the Baltic
states, arguably providing some of the basis for western banking principles. From the 1960s to
the 1970s, Islamic banking resurfaced in the modern world.
How Islamic Banks Make a Profit
To earn money without the use of charging interest, Islamic banks use equity participation
systems. Equity participation means if a bank loans money to a business, the business will pay
back the loan without interest, but instead gives the bank a share in its profits. If the business
defaults or does not earn a profit, then the bank also does not benefit.
For example, in 1963, Egyptians formed an Islamic bank in Mit Ghmar. When the bank loaned
money to businesses, it did so on a profit-sharing model. To reduce its risk, the bank only
approved about 40% of its business loan applications, but the default ratio was zero.
Islamic Banks Versus Islamic Windows
While an Islamic bank is one based on and managed with Islamic principles, an Islamic window
refers to the services provided by a conventional bank but based on Islamic principles. For
example, in Oman, there are two Islamic banks, Bank Nizwa and Al Izz Islamic Bank. Six of the
seven commercial banks in the country also offer Islamic banking services through dedicated
windows or sections.
Islamic finance strictly complies with Sharia law. Contemporary Islamic finance is based on a
number of prohibitions that are not always illegal in the countries where Islamic financial
institutions are operating:
1. Paying or charging an interest
Islam considers lending with interest paymentsInterest ExpenseInterest expense arises out of a
company that finances through debt or capital leases. Interest is found in the income statement,
but can also be calculated through the debt schedule. The schedule should outline all the major
pieces of debt a company has on its balance sheet, and calculate interest by multiplying the as an
exploitative practice that favors the lender at the expense of the borrower. According to Sharia
law, interest is usury (riba), which is strictly prohibited.

2. Investing in businesses involved in prohibited activities

Some activities, such as producing and selling alcohol or pork, are prohibited in Islam. The
activities are considered haram or forbidden. Therefore, investing in such activities is likewise
forbidden.

3. Speculation (maisir)
Sharia strictly prohibits any form of speculation or gambling, which is called maisir. Thus,
Islamic financial institutions cannot be involved in contracts where the ownership of good
depends on an uncertain event in the future.

4. Uncertainty and risk (gharar)

The rules of Islamic finance ban participation in contracts with the excessive risk and/or
uncertainty. The term gharar measures the legitimacy of risk or uncertain in nature
investments. Gharar is observed with derivative contractsFutures and ForwardsFuture and
forward contracts (more commonly referred to as futures and forwards) are contracts that are
used by businesses and investors to hedge against risks or speculate. Futures and forwards are
examples of derivative assets that derive their values from underlying assets. and short-selling,
which are forbidden in Islamic finance.

In addition to the above prohibitions, Islamic finance is based on two other crucial principles:

 Material finality of the transaction: Each transaction must be related to a real

underlying economic transaction.
 Profit/loss sharing: Parties entering into the contracts in Islamic finance share profit/loss
and risks associated with the transaction. No one can benefit from the transaction more
than the other party.

The financial sector performs various functions that facilitates the efficient functioning of the
economy and promotes economic growth. For the financial sector to contribute to growth and
mitigate risks, however, the industry itself has to be resilient and be able to reduce its own
vulnerabilities. Recognizing this, various international organizations such as the International
Monetary Fund, World Bank, Basel Committee for Banking Supervision, etc. are working on
developing various institutional standards, tools and policies necessary for the creation of a
sound framework for the development of the financial sector. Other than prudent financial
system supervision and regulation, the WB and IMF (2005) identify legal infrastructure,
systemic liquidity infrastructure, governance and information infrastructure, payments and
securities settlement systems, creditors’ rights, the provision of incentives for strong risk
management, credit reporting systems, etc. as being among the key architectural institutions
needed to promote the development and stability of the financial sector. The Islamic financial
sector has expanded globally in its short history with total global assets valued at USD 1.88
trillion in 2015 (IFSB 2016). Growing at a compound annual growth rate of 17% between 2009
and 2013 (IFSB 2015), the industry is expected to become systematically important in many
jurisdictions. The global role of Islamic finance has grown in many global financial centers such
as the UK, Luxembourg, Singapore, Hong Kong, Japan, etc. Given the above, a sound financial
architecture will be crucial for its future development as a robust and resilient industry. While
most of the elements of financial architecture that promote development in conventional finance
also apply to Islamic finance, there are certain specific issues that arise in the latter due to unique
features arising from Shariah compliance. However, being a relatively new industry in most
countries, the infrastructure institutions supporting the industry remain weak and are continuing
to evolve. Given the vital roles that architectural institutions play in promoting the growth and
stability of the financial sector, this study aims to identify the unique features of the financial
architecture governing Islamic finance, assess their statuses in selected OIC member countries
(MCs), and provide policy recommendations for improvement at both the domestic and
international levels. The study examines the status of seven categories of the Islamic financial
architecture (legal infrastructure; regulation and supervision framework; Shariah governance
framework; liquidity infrastructure; information infrastructure and transparency; consumer
protection architecture; and human capital and knowledge development framework) for 12 OIC
MCs. It also explores the status of Islamic finance in five countries with global financial centers
(the UK, Germany, Luxemburg Singapore, Hong Kong). After presenting the overall sizes of the
financial sectors, the approaches taken towards Islamic finance in these countries are discussed.
The study first examines the legal environment and the features of the financial sector of OIC
MCs. Most OIC MCs have adopted some variant of common law and civil law systems, with 16
countries having the former and 40 adopting the latter. The study shows that while the overall
average size of the banking sector in OIC MCs is similar to the world average on the liabilities
side, it is smaller for banking assets and the insurance sector. While the debt securities market is
underdeveloped in OIC MCs compared to the world average, stock market capitalization is
relatively higher. Information on the features of the financial sector shows that the average depth
and access of the financial institutions and financial markets in OIC MCs is lower than the world
average. However the average efficiency of both financial institutions and financial discussed in
Chapter 1, WB and IMF (2005:5) identify pillars of financial system architecture that can
promote the stability and development of the financial sector as being macro-prudential
surveillance and financial stability analysis, sound financial system supervision and regulation,
and financial system infrastructure. The latter includes legal infrastructure for finance, systemic
liquidity infrastructure and transparency, governance and information infrastructure, payments
and securities settlement systems, creditors’ rights, the provision of incentives for strong risk
management and good governance, credit reporting systems, etc. All the elements of the
financial architecture apply to the stability and development of the Islamic financial sector.
Some of the elements of financial architecture are neutral and apply to both Islamic and
conventional finance. These include sound and sustainable macroeconomic policies, effective
market discipline, well-regulated payment and clearing systems, etc. However, there are certain
unique features in the Islamic financial sector that may not be covered by conventional
architectural institutions and require specific attention. The elements of the Islamic financial
architecture that need special attention can be divided into seven categories: legal, regulations
and supervision, Shariah supervision, liquidity, information and transparency, consumer
protection and human capital. Specific infrastructure issues that arise due to unique features
arising from Shariah compliance in each of these categories are discussed below.

participatory modes of financing (musharakah, diminishing musharakah, mudarabah,

mudarabah certificates),-

As a participatory mode with profit-and-loss sharing Musharakah is considered to be the

most desired mode of Islamic financing. And Diminishing Musharakah is now being used
extensively in many areas for financing fixed assets such as houses and motor cars. It is
used mostly when one party who wants to own an asset cannot afford to pay the full pri ce
and takes the assistance of financing from another party which ends up with the complete
ownership of the asset by the first party who purchase the share of the other party over a
period of time while at the same time complying with the rules of the Shari’ah. When used
in home financing, Diminishing Musharakah can be viewed as a form of shared ownership
with a leasing sale-back arrangement, which makes it different from an interest-based
mortgage.

DM arrangements allow equity participation and sharing of profits on a pro-rata basis, they
also provide a method through which the bank keeps on reducing its equity in an asset
against periodical payments, ultimately transferring ownership of the asset to the client.The
procedure involved in Diminishing Musharakah is that the Islamic bank enters with a client
into a partnership in which they both invest in the equity capital required to finance a
project, and possibly also participate in the management; both share in the profits according
to a pre-determined basis or in losses according to their investment. The bank would be also
responsible for major maintenance, repair and insurance in respect of its share of a property.
The client makes rental payments based on the level of equity held by the bank, with each
payment, the bank’s equity reduces followed by a reduction in the rental calculated on the
reducing equity. The client purchases the bank’s equity by the capital repayments,
accordingly, its share is progressively increasing and the bank’s equity is dimini shing until
the bank has no equity and thus the client acquires complete ownership. Similarly, the rental
payments keep reducing with the bank’s diminishing equity in the asset until no further
rental payment has to be made.

A home financing transaction under DM involves the combined purchase of a house by the
Islamic bank and the client and the bank’s leasing its share to the client. The transaction
involves the creation of a joint ownership in the property and the rent of the Islamic bank’s
share to the client for an agreed period of time. For example, the Bank may contribute 90%
and the Buyer 10% of the purchase price. The client makes the promise to purchase the
bank’s share and purchases the units at different stages. Over a period of up to 20 years, t he
client will make monthly purchase instalments through which the Bank will sell its share of
the home to buyer. The bank leases out its share to the client for the use of the property with
the option to buy it, the bank receiving agreed rental payments for the use of the property.
Periodically, the client purchases a pre-agreed percentage of the bank’s share in the
property, thereby increasing the client’s ownership in the property and reducing the bank’s
share by a similar amount. The rental paid on the bank’s share is adjusted according to the
bank’s diminishing share; and the transaction ends with the transfer of ultimate ownership
of the entire property to the client upon successful completion of the lease term. if a client
wishes to purchase the bank’s remaining share in the property prior to the agreed date, the
Diminishing Musharakah agreement will be terminated upon payment.

Laws provide the framework for establishing appropriate institutions and markets in three key
financial sectors: banking, insurance and capital markets. The key laws necessary for each of
these financial sectors are not only those that enable the formation and operation of financial
institutions and markets but also those that enable the formation of a central bank to carry out
monetary policy and establish and give authority to certain public bodies to regulate and
supervise financial institutions and markets (WB and IMF 2005: 223). In many countries, the
central bank plays the regulatory and supervisory roles and the central banking law authorizes it
to perform these functions. The financial institutions' laws provide the legal basis to establish
specific financial institutions, define their scope of operations and governance, and include issues
related to the protection of different stakeholders. For example, the banking law specifies the
requirements to establish a bank and defines the banking activities that these institutions can
undertake. The law covers various operational issues such as governance Shariah Governance
Framework: The regulators play a key role in setting up the Shariah governance regime by
providing a framework for Shariah boards for financial institutions. A national Shariah board
would be responsible for issuing Shariah standards/parameters and promoting the harmonization
of practices by ensuring the Shariah compliance of the contracts used in the industry. Both
AAOIFI and IFSB have published Shariah governance standards for Islamic financial
institutions. However, there are no guidelines for national Shariah boards. Given that national
Shariah boards can contribute to the harmonization of practice and the reduction of costs of
Shariah governance in organizations and Shariah compliance risks within jurisdictions, there is a
need to come up with a framework for it. Furthermore, the work on developing Shariah
standards, parameters and templates for Islamic financial products by the AAOIFI, IsFA and
IIFM need to continue to enhance cross-border and international transactions by reducing legal
and Shariah compliance risks. Liquidity Infrastructure: A robust liquidity infrastructure consists
of appropriate instruments, efficient and liquid financial markets, and access to LOLR funds
from central banks. There is not only a scarcity of Shariah compliant liquid instruments, but most
jurisdictions also lack deep and efficient Islamic financial markets. While the central bank and
regulatory authorities can help develop the infrastructure for financial markets, the liquidity
instruments can be supplied by both public and private entities. Globally, the secondary markets
for sukuk in most countries are shallow, making them illiquid. IFSB and IIFM can develop
guidelines and templates to strengthen money markets, secondary markets for Islamic securities,
and LOLR facilities for Islamic banks. Information Infrastructure and Transparency: To properly
reflect the transactions and operations of Islamic financial institutions, countries can opt for
using either AAOIFI accounting standards or domestic accounting standards adapted by Islamic
finance. Other than the credit ratings provided by conventional rating agencies for debt based
transactions, other types of assessments such as Shariah compliance ratings and providing
assessments for equity modes of financing are also needed for Islamic finance. Globally, there is
significant progress being made towards developing accounting and auditing standards by
AAOIFI. Furthermore, AAOIFI and IFSB have also published disclosure guidelines for the
banking and takaful sectors. There is a need to develop detailed disclosure guidelines for Islamic
capital markets and Shariah compliance of products and securities. Ratings agencies that can
assess Shariah compliance and risks in equity based instruments can further strengthen the
information infrastructure for the industry. Consumer Protection Architecture: The study finds
the architectural element of consumer protection to be the weakest for the Islamic financial
sector in the countries that were examined. While instituting appropriate laws and regulations to
protect consumers and deposit insurance have to be implemented by the government and
regulators, improving financial literacy will require effort at different levels. Initiatives at the
global level to develop consumer protection guidelines that cater to the specific features of the
Islamic financial sector and also come up with a framework for financial literacy programs will
help their implementation at the national level. While the former can be done by IFSB, the latter
can be initiated by CIBAFI. To protect Islamic banking depositors during crises would also
require structure and requirements, information disclosure obligations, the protection of
depositors and other stakeholders, dealing with distressed banks, etc.
The capital market law covers various aspects to ensure the smooth functioning of the securities
markets. The law encompasses issues such as the conditions to issue securities to the public, their
registration and trading, and regulations related to organizations dealing with the securities
market such as brokers, dealers etc. Securities law reduces problems associated with raising
funds from markets by clearly specifying a contracting framework for issuing securities. These
laws also prevent self-dealing by instituting rules, incentives and penalties to prevent such
activities. An important aspect of protecting investors is the requirement by securities law to
disclose all relevant quantitative and non-quantitative information of listed companies.
Financial and real transactions may be identified differently under business law. The unique
nature of Islamic financial products and organizations that are not covered by conventional
financial laws necessitate the coming up with of laws that can support the activities of the
former. As products of Islamic banks involve dealings with real goods and services, the law has
to provide for these institutions to carry out trading and investment activities. It will be difficult
for Islamic banks to operate under conventional banking laws as these do not recognize the
special features of Islamic banking practices. As a result, specific laws may be required to enable
Islamic banks to use financial products that are based on sale, leasing and investments using risk-
sharing modes. Similarly, insurance law defines the activities of the insurance business that are
qualitatively different from takaful. One key feature of takaful is that the capital of the takaful
operator is separated from the participants risk fund and the participants have certain rights that
are not recognized by conventional insurance laws. While Shariah compliant stocks will fulfill
certain sector wise and financial ratios criteria, the nature of sukuk is very different compared to
bonds. Thus, securities laws should cater to the unique nature of Islamic securities and sukuk to
not only protect the investors and stakeholders but also for the sustainable growth of the Islamic
capital markets.
3.1.2. Tax regimes and impact on Islamic finance
Most economic and financial transactions have tax implications that affect costs and/or profits.
Tax laws relevant to banking are related to income (profit, withholding), transactions (capital
gains and stamp duties) and goods and services (value-added tax). For example, while interest
paid on debt can be deducted as costs, dividends paid are considered taxable income in most
jurisdictions. Similarly, withholding taxes on interest and other income such as dividends can be
different so that Islamic financial instruments are taxed differently compared to their
conventional counterpart.
As Islamic financial products are based on sale, leasing and partnership contracts, the tax
implications can make these products more costly compared to their conventional counterparts.
For example, home financing and ijarah sukuk may involve double stamp duties with the latter
also having capital gains tax due to sale and buy-back features. Thus, there is a need to change
the tax laws to level the playing field for Islamic finance with conventional finance. One way to
do this is to consider the economic substance of Islamic financial products as financing tools and
applying the rules of interest to profit generated in financial transactions. An example of this is in
the UK where tax laws treat profit in a mudarabah. Sustainable development of any financial
industry must have a suitable legal framework which includes an effective dispute resolution
mechanism (Grais, Iqbal, and El-Hawary, 2004). Courts and other dispute settlement institutions
ensure ex post implementation of contracts and enforcement of property rights in case of any
breach of contracts or exercise of rights (Pistor and Xu 2003). As the contracts used in Islamic
banking products are derived from the Shariah and the Islamic financial contracts' legitimacy
should be judged by the principles of Islamic law, the ideal situation would be to use Shariah as
the governing law to settle disputes. Thus, the dispute resolution issue becomes complicated due
to the duality of laws in play in Islamic finance transactions. While the contracts use Islamic law,
the courts in most jurisdictions use some variant of Western commercial law to adjudicate. This
would mean using non-Islamic legal system to resolve disputes involving Islamic financial
contracts. The outcome of these disputes will partly depend on the legal system and whether
supporting Islamic banking law exists or not.
One way to resolve the problem of adjudicating disputes in courts using non-Islamic civil laws is
to include choice-of-law and dispute settlement clauses (Vogel and Hayes, 1998). If Islamic law
is chosen as the law of choice to settle disputes, the contracts can opt for commercial arbitration
and be shielded from the national legal environment. While some Islamic arbitration centers
exist, parties are reluctant to take disputes to these institutions due to the lack of precedence that
creates legal risks. There is uncertainty regarding outcomes due to the differences of opinion
among different scholars and schools and the absence of a standardized codified Islamic law. As
such, partners in transactions avoid using Islamic law as they want to avoid the "impracticalities
or the uncertainty of applying classical Islamic law" (Vogel and Hayes, 1998: 51).
Diversification of financing methods
Bankruptcy law addresses defaults and restructuring by enforcing property rights of different
stakeholders in an appropriate way when firms become bankrupt (Moskow 2002). Bankruptcy
law along with insolvency systems entail the rules and regulations that govern access, protection,
risk management, and recovery of dues by providers of debt. Insolvency systems include
elements such as requiring creditor consent to file for reorganization, imposing an automatic stay
on the assets of the firm on filing reorganizing, requiring secured creditors to be ranked first
among distribution of proceeds resulting from the disposition of assets of the firm, and requiring
the appointment of an official by the court or by the creditors to operate the firm during
reorganization (La Porta et al. 1998). An important factor determining the rights of investors in
bankruptcies is to have a sound insolvency system that has an efficient enforcement process of
the claims arising from bankruptcy proceedings (World Bank 2005: 230). Inefficient bankruptcy
regimes create uncertainty about creditor rights and can adversely affect the growth of the
financial sector.
Certain specific issues arise in bankruptcies related to financial sector. A key factor is the quality
of the collateral and the rights of the creditor on it after a bankruptcy. This is relevant in financial
securities where their structure will determine the nature of risks the investors. appropriate
models for deposit insurance. IFSB can collaborate with IADI to initiate this project. Human
Capital and Knowledge Development Framework: Human capital and knowledge development
appear to be the strongest element of the Islamic financial architecture. However, as the industry
is expected to grow, there will be increasing demand for personnel with the appropriate
knowledge and skills, particularly in countries where the industry is relatively new. In this
regard, the public and private sector entities, along with academic institutions and universities,
can contribute to providing training and building a knowledge base for the future growth of the
industry. Various multilateral organizations such as IRTI, IDB and World Bank GIFDC are
involved in research that can promote the development of the Islamic financial sector. There is
also need to invest in research and provide training in different areas related to Islamic
architectural institutions. One key gap that needs to be filled is creating knowledge related to
infrastructure institutions and providing training to staff in public bodies that work in the
industry. While IFSB organizes workshops to familiarize its published standards and guidelines,
multilateral organizations such as IDB and WB can take initiatives to enhance such knowledge
and skills to develop other elements of infrastructure institutions though their technical assistance
programs. The development of standards and guidelines by international multilateral institutions
is one of the key instruments for developing sound architectural institutions. Specifically,
countries with underdeveloped infrastructures can benefit by using the framework provided by
international benchmarks to develop institutions that can support the Islamic financial industry.
The study suggests strengthening the existing international infrastructure institutions and
establishing some new ones. Developing legal documents and templates can help the
development of the legal infrastructure for Islamic finance in OIC MCs. This initiative is similar
to the Law and Policy Reform Program of the Asian Development Bank and can be best
performed by IDB. While IFSB has developed many regulatory standards for the Islamic
financial industry, the published standards and guidelines for different sectors have not been
even. As the Islamic financial industry is expected to grow in the future, there may be a need to
strengthen the institutional capacity of IFSB. One way to do this is have separate divisions within
IFSB dealing with issues related to Islamic banking, takaful and Islamic capital market segments.
Both AAOIFI and IFSB have published Shariah governance standards for Islamic financial
institutions. However, as there are no guidelines for national Shariah boards, there is a need to
come up with a framework for it. Furthermore, the work on developing Shariah standards,
parameters and templates for Islamic financial products by AAOIFI, IsFA and IIFM need to
continue to enhance cross-border and international transactions by reducing legal and Shariah
compliance risks. There is a need to develop detailed disclosure guidelines for all segments of
Islamic finance and improve Shariah compliance of products and securities. Ratings agencies
that can assess Shariah compliance and risks in equity based instruments would further
strengthen the information infrastructure for the industry. IFSB and IIFM can develop guidelines
and templates to strengthen money markets, secondary markets for Islamic securities, and LOLR
facilities for Islamic banks. Furthermore, there is a need to establish an Islamic Monetary Fund
(IsMF) that can either provide Shariah compliant liquidity at the global level or coordinate
arranging liquidity from other central banks by using swap arrangements As the Islamic financial
industry is expected to grow in the future and become systematically important in some
countries, the study suggests establishing a Stability Board for Islamic Finance (SBIF) to
enhance the global stability and development of a sound Islamic financial sector. Among others,
SBIF can come up with a framework for establishing an Islamic Financial Sector Assessment
Program (IFSAP) and also the relevant Standards and Codes applicable to the Islamic financial
sector, coordinate the implementation of existing standards from IFSB and AAOIFI, and
contribute to filling the gaps in other architectural elements such as the legal and Shariah
governance frameworks for the Islamic financial sector globally. As the body would engage key
policy holders from different countries, the suggested organization, SBIF, can be initiated by
either OIC under the realm of COMCEC or by D-8 countries The financial sector performs
various functions that facilitate the efficient functioning of the economy and promote economic
growth. Levine (1997: 689) identifies the functions of a financial system as “the trading of risk,
allocating capital, monitoring managers, mobilizing savings, and easing the trading of goods”. 1
For the financial sector to contribute to growth and mitigate risks, however, the industry itself
has to be resilient and be able to reduce its own vulnerabilities. The global financial crisis (GFC)
highlights the vulnerability of the financial sector and its detrimental impact on output and
welfare with the monetary cost of the crisis estimated to be as high as USD 15 trillion (Yoon
2012).2 Given the complexity and dynamism of modern financial products and markets,
appropriate institutions are needed to reduce the risks and vulnerabilities that can potentially lead
to harmful and costly economic downturns. This would require certain architectural institutions
and policies that foster a stable and efficient financial sector that effectively promote economic
development. Financial transactions are legal constructs with contracts that usually have the
realization of their outcomes in the future. The theoretical basis of the need for a sound
institutional environment facilitating economic and financial development lies in New
Institutional Economics which asserts that institutions such as laws, the executive, legislature,
judiciary, etc. provide the formal rules that enforce property rights and promote economic
activities (Williamson 2000). An institutional framework introduces first order economizing in
the economy by providing supporting rules of the game that enables the production and exchange
of goods and services in an orderly manner. For example, organization, financial institution, tax,
and contract laws are relevant to the construction of financial transactions. Specifically,
organizational law determines the types of organizations that can be formed and banking law
specifies the legal requirements to establish and operate banks. Tax laws relevant to the financial
sector are related to income (profit), transactions (capital gains and stamp duties) and goods and
services (value-added tax). Contract law provides the principles and basis of conducting
transactions. While ‘law and finance’ literature assert that legal institutions have an influence on
financial development, the ‘political institutions and finance’ strand maintains that ‘political
institutions’ that protect property rights are also important determinants of financial and
economic development.3 Recognizing this, various international organizations such as
International Monetary Fund, World Bank, Basel Committee for Banking Supervision, etc. are
developing various institutional standards, tools, and policies necessary for a sound framework
for the development of the financial sector. The role of the financial sector in promoting
development depends on both demand and supply side factors. On the supply side, the financial
sector has to be inclusive and provide various financial services to all segments of the population
including the poor. On the demand side, two broad types of markets can be identified: domestic
and international. An issue on the demand side in Muslim countries relates to voluntary
exclusion whereby a large segment of the population does not deal with the interest-based
financial sector due to religious convictions.4 Inclusive financial systems in many OIC member
countries (MCs), therefore, require providing Shariah compliant financial services so that all
segments of the population can benefit from the financial system and contribute to the
development process. Although Islamic finance predominantly serves the financial needs of
Muslims who do not want to engage with conventional finance for religious reasons, it can also
be an alternative source for ethical and social finance for much wider markets. With USD 1.88
trillion worth of assets in 2015, the Islamic financial sector has expanded globally in its short
history (IFSB 2016). While the conventional financial sector stalled after the global financial
crisis, the Islamic financial industry grew at a compound annual growth rate of 17% between
2009 and 2013 (IFSB 2015). It is expected that by 2020, a significant part of the banking and
finance in the Gulf and in some South-east Asian countries such as Malaysia and Indonesia will
be Islamic. The global role of Islamic finance is also expected to expand as many global
financial centers such as the UK, Luxembourg, Singapore, Hong Kong, Japan, etc. have taken
initiatives to introduce Islamic finance. With its growth, the Islamic financial sector is expected
to become systematically important in many jurisdictions. A sound financial architecture will be
crucial for its development as a robust and resilient industry. However, being a relatively new
industry in most countries, the infrastructural institutions supporting the industry remain weak
and are still evolving. This is reflected in a survey conducted by MEGA (2016: 50) which
reveals that 38% of the respondents identify regulatory costs and 18% point out Shariah
compliance costs as factors that limit the growth of Islamic banks. Meanwhile, 29% of the
respondents identify regulatory issues and 17% identify the lack of liquid markets as being
among the biggest external threats. Furthermore, the internal threats identified were a shortage of
qualified personnel, identified by 28% of the respondents, and Shariah compliance issues,
identified by 21% of the respondents (MEGA 2016: 51). While most of the elements of financial
architecture that bring about stability and promote development in conventional finance also
apply to the Islamic financial sector, there are certain specific issues that arise in the latter due to
some unique features arising from Shariah compliance. Compliance with Shariah introduces
some unique risks in Islamic financial institutions and also restricts the use of certain risk-
mitigating tools that are available to their conventional counterparts. Furthermore, Islamic
finance operates in countries that have legal and regulatory systems that are not Islamic. Given
the above, specific architectural institutions are needed for the future development of Islamic
finance. This study attempts to identify these institutions, examines their statuses in selected
countries, and suggests ways in which these can be developed. The remainder of the chapter is
organized as follows. The next section presents a brief overview of the evolution of the notion of
financial architecture in conventional finance followed by a section that outlines the aim and
scope of the study. The concluding section provides the outline of the key architectural
institutions that will be examined in this study. increased is by the use of standardized contracts
and documents among the financial sector stakeholders. In this regard, the regulatory authorities
can facilitate coming up with standardized documents and contracts that can be used by both the
financial institutions and financial markets.
3.4. Liquidity Infrastructure
To meet liquidity needs from private sources a bank must hold assets that can be sold or used as
collateral to obtain credit from other financial intermediaries (Holmstrom and Tirole 1998).
However, market failures may constrain access to liquidity from private sources. Opaque bank
assets create information related problems where financial institutions may not be able to screen
and monitor the prospective borrowers adequately (Rochet 2008). Failure of markets to provide
liquidity can be resolved in two ways. Private arrangements can be used between banks to create
liquidity pools. However, this is difficult to implement, particularly when the financial sector
experiences economy-wide negative shocks. In such cases, public bodies such as the central bank
need to provide the liquidity to prevent serious interruptions in operations that can lead to bank
failures. One of the tools used by central banks is to provide emergency funding to banks as the
lender of the last resort (LOLR). b) Salam: The Salam sale is an advance purchase or product-
deferred sale of a generic good. In a salam contract, the buyer of a product pays in advance for a
good that is produced and delivered later. The contract applies mainly to agricultural goods. c)
Istisna: The Istisna contract is similar to the salam contract with the difference that the goods are
produced according to the specifications given by the buyer. This applies mainly to
manufactured goods and real estate. In istisna, the client asks the financier to provide an asset
(like real estate) and the payments are made over a period of time in the future. In this case, the
financier may need to have a parallel istisna and sub-contract the project to a third party for its
completion. In istisna the payments can be made in installments over time with the progression
of the production. d) Ijarah: Ijarah is a lease contract in which the lessee pays rent to the lessor
for use of usufruct. In ijarah the ownership and right to use an asset (usufruct) are separated. It
falls under a sale-based contract as it involves the sale of usufructs. A lease contract that results
in the transfer of an asset to the lessee at the end of the contract is called ijarah wa iqtina or ijarah
muntahia bittamleek. Ijarah wa iqtina combines sale and leasing contracts and uses hirepurchase
or rent-sharing principles. The ownership of the asset is transferred to the lessee as payments for
the asset are also made along with the rent. After the contract period is over, the lessee assumes
the ownership of the asset. Note that in a simple ijarah, the rental payments made are captured in
the current liabilities in the balance sheet. In case of ijarah wa iqtinah, however, the leased item
would be in the form of a debt during the period of lease. e) Musharakah: Sharikah is a
partnership between parties in which financial capital and/or labor act as shared inputs and profit
is distributed according to the capital share of the partners or in some agreed upon ratio. The
loss, however, is distributed according to the share of the capital. Though there can be different
kinds of partnerships based on money, labor, and reputation, one case of sharikah is participation
financing or musharakah in which partners share both in capital and management of the business
enterprise. Thus partners in musharakah have both control rights and claims to the profit. f)
Mudarabah (or qirad or muqadarah): Mudarabah is similar to the concept of silent partnership in
which financial capital is provided by one or more partner(s) (rab ul mal) and the work is carried
out by the other partner(s) mudarib. The financiers and the managers of the project share the
profit in an agreed upon ratio. The loss, however, is borne by the financiers according to their
share in the capital. The manager’s loss is not getting any reward for his services. As the rab ul
mal is the sleeping partner, he/she has a claim on profit without any say in the management of
the firm. 2.4. Islamic The first experiments of contemporary Islamic finance began in the
countryside of Mit Ghamar in Lower Egypt in 1963. Under the leadership of Ahmed al-Najjar,
savings/investment houses operated in small towns in Northern Egypt, providing financing on a
profit-loss sharing basis to small entrepreneurs and poor farmers. In the same year, the Pilgrims’
Management and Fund Board (Tabung Haji) was established in Malaysia to help people save
money to go for the hajj (pilgrimage). The funds were used to invest in industrial and agricultural
projects. Islamic finance has diversified and has grown rapidly to become a significant global
sector. The evolution of different Islamic financial institutions over time is shown in Table 2.2
and key milestones are discussed below. Table 2.2: Evolution of Islamic Financial Institutions
and Markets 1970s: After the formation of the Organization of Islamic Conference (OIC) in
1973, the Islamic Development Bank (IDB) was established in 1975 in Jeddah, Saudi Arabia. In
the same year, the first Islamic commercial bank, Dubai Islamic Bank, was established in UAE.
Realizing that conventional insurance had objections from a Shariah point of view, two Islamic
insurance companies were launched in 1979, the Islamic Arab Insurance Co. (IAIC) in UAE and
the Islamic Insurance Co. in Sudan. 1980s: The 1980s witnessed the launch of a number of non-
bank financial institutions. Modaraba companies were established in Pakistan after the
promulgation of the Modaraba Ordinance 1980. One of the earlier Islamic microfinance
institutions was Al-Fallah Aam Unnayan Sangstha in Bangladesh, established in 1989. In non-
Muslim countries where banking laws did not allow the establishment of Islamic banks, Islamic
cooperatives were introduced. The first Islamic cooperative in the Western world, Ansar and
Islamic Co-operative Housing Corporation Ltd. was established in Toronto, Canada in 1981 to
provide Shariah compliant home financing to Muslims of the country. The Muslim Credit Union
was established in Trinidad and Tobago in 1983 and Pattani Islamic Saving Cooperative started
operations in 1987. Bank ABC, an investment bank based in Bahrain launched its Islamic
services in 1987, thus starting Islamic investment banking. With the expansion of takaful
companies, retakaful companies emerged in the 1980s (NuHtay et. al. 2014). Furthermore, larger
Islamic financial institutions also emerged during the 1980s that established other financial
institutions such as banks, takaful companies and investment banks in different parts of the
world. One the first of these institutions was the Dar al Maal Islami Trust that was established in
Switzerland in 1981.
Chapter 2

debt creating modes (murabaha,- Murabaha, also referred to as cost-plus financing, is an

Islamic financing structure in which the seller provides the cost and profit margin of an asset.
Murabaha is not an interest-bearing loan (qardh ribawi) but is an acceptable form of credit sale
under Islamic law. As with a rent-to-own arrangement, the purchaser does not become the true
owner until the loan is fully paid.
Understanding Murabaha
In a murabaha contract of sale, the client petitions the bank to purchase an item for him/her.
Complying with the client's request, the bank establishes a contract setting the cost and profit for
the item, with repayment typically in installments. Because a set fee is charged rather
than riba (interest), this type of loan is legal in Islamic countries. Islamic banks are prohibited
from charging interest on loans according to the religious tenet that money is only a medium of
exchange and has no inherent value; so banks must charge a flat fee for continuing daily
operations.

Many argue that this is simply another method of charging interest. However, the difference lies
in the structure of the contract. In a murabaha contract for sale, the bank buys an asset and then
sells the asset back to the client with a profit charge. This type of transaction is halal or valid,
according to Islamic Sharia/Sharīʿah.

Issuing conventional loans and charging interest are interest-based activities, which are haram
(prohibited) according to Islamic Sharīʿah.
Murabaha and Default
Additional charges may not be imposed after a murabaha due date, which makes murabaha
default an increasing concern for Islamic banks. Many banks believe defaulters should be
blacklisted and not allowed future loans from any Islamic bank as a method of decreasing
murabaha default. Even if it is not expressly mentioned in the loan agreement, this arrangement
is permissible in Sharia. If a debtor is facing a genuine hardship and cannot repay a loan on time,
respite may be given as described in the Quran. However, the government may take action in
cases of willful default.

Examples of Murabaha
The murabaha form of financing is typically used in place of loans in diverse sectors. For
example, consumers use murabaha when purchasing household appliances, cars, or real estate.
Businesses use this type of financing when purchasing machinery, equipment, or raw materials.
Murabaha is also commonly used for a short-term trade, such as issuing letters of credit for
importers.

A murabaha letter of credit is issued on behalf of an applicant (importer). The bank issuing the
letter of credit agrees to pay an amount of money in compliance with the terms described in the
letter of credit. Because the bank’s creditworthiness replaces that of the applicant, the beneficiary
(exporter) is guaranteed payment. This benefits the exporter because the bank assumes the
payment risk. Following the murabaha contract provisions, the importer is required to repay the
bank for the cost of goods plus a profit markup amount.

KEY TAKEAWAYS

 Interest-bearing loans are prohibited under Islam’s Sharia law.

 In Islamic finance, murabaha financing is used in place of loans.
 Murabaha is also referred to as cost-plus financing because it includes a profit markup in
the transaction rather than interest.
salam, Bai Salami (Arabic ‫بيع سلم‬, more accurately transliterated as Bai us Salami) is
an Islamic contract in which full payment is made in advance for specific goods (often
agricultural products) to be delivered at a future date. It is necessary that the quality of the
commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute.
Bai salami covers almost every thing which is capable of being definitely described as to quality,
quantity and workmanship. For Islamic banks this product is an ideal for Agriculture financing
but can also be used to finance the working capital needs to the business customer. It is one of
the most popular Islamic Modes of finance used by banks in Islamic countries to promote riba-
free transactions.[1]

1. Early and contemporary jurists agree on the legitimacy of Salami.[2] In general under
Shariah law, no sale is lawful unless the goods being sold are in existence at the time of
the agreement. Salami sale is an exception found in the hadith of the prophet of Islam
Muhammad (collections of his sayings and teachings) provided the goods are defined
and the date of delivery is fixed.[3] Upon migration from Makkah, Mohammed came to
Madinah, where the people used to pay in advance the price of fruit or dates to be
delivered over one, two or three years.[4] However, such sale was carried out without
specifying the quality, measure or weight of the commodity or the time of delivery.
 Mohammed ordained: “Whoever pays money in advance for fruit to be delivered later
should pay it for a known quality, specified measure and weight (of dates or fruit) of
course along with the price and time of delivery”.[ It is necessary for the validity of
Salam that the buyer pays the price in full to the seller at the time of affecting the sale. In
the absence of full payment, it will be tantamount to sale of a debt against a debt, which
is expressly prohibited by Mohammed. Moreover, the basic rationale for allowing Salam
is to facilitate the "instant need" of the seller. If it is not paid in full, the basic purpose
will not be achieved.
2. Only those goods can be sold through a Salam contract in which the quantity and quality
can be exactly specified e.g. precious stones cannot be sold on the basis of Salam
because each stone differ in quality, size, weight and their exact specification is not
possible.
3. Salam cannot be affected on a particular commodity or on a product of a particular field
or farm e.g. Supply of wheat of a particular field or the fruit of a particular tree 24 The
hadith reported by Imam Bukhari, Muslim and others.[6]
4. All details in respect to quality of goods sold must be expressly specified leaving no
ambiguity, which may lead to a dispute.
5. It is necessary that the quantity of the commodity is agreed upon in absolute terms. It
should be measured or weighed in its usual measure only, meaning what is normally
weighed cannot be quantified and vice versa.
6. The exact date and place of delivery must be specified in the contract.
7. Salam cannot be affected in respect of things, which must be delivered at spot.

istisna,-

Istisna is widely used by Islamic banks and financial institutions to finance the construction of
real estate such as buildings, warehouses, showrooms, shopping malls, residential towers and
villas, as well as manufacturing activities involved in the construction of like aircrafts, ships,
machines and equipment, etc. Istisna is generally a long-term sales contract between a customer
and the bank, whereby Dubai Islamic Bank agrees to construct and deliver an asset at a pre-
determined future time, at an agreed price. The bank takes care of paying the contracted
developer or builder in full or at specific stages of project completion. The client then pays the
bank as per agreed payment plan. The customer then pays the bank either in installments, at
delivery or after project completion.

In a well-functioning financial system, the supervisors and regulators act on behalf of the society
at large and protect the interests of the different stakeholders and ensure stability in the financial
system as a whole (Pistor and Xu 2003). A proactive enabling regulatory and supervision
framework will ensure the application of rules and laws, protection of property rights, the
stability of the financial sector, consumer protection, and the fairness and efficiency of markets
(see Llewellyn 2006 and GOT 2008). The complexity and dynamism of modern financial
products and markets make regulation itself complex and multi-dimensional (Black 2012). If not
approached correctly, inappropriate regulations can create risks and vulnerabilities that can
potentially lead to harmful and costly economic downturns.
Regulatory perimeters determine the boundaries of the regulated and unregulated activities and
institutions. Determining the regulatory perimeters will depend on various factors. Among
others, the degree of systemic risks and customer sophistication will determine the level of
regulatory intervention. The tools and goals of regulation include micro-prudential regulation to
promote the safety of individual financial institutions, macro-prudential regulation and
supervision for the stability of the financial sector, conduct of business regulation to establish
rules for appropriate business behavior and practices, product regulation to limit specific harmful
products, consumer protection regulation to protect consumers, and indirect regulation to limit
exposures of institutions to certain activities and to enhance the fairness and efficiency of
markets (BOE 2012; GOT 2008; Llewellyn 2006). Other regulatory functions relate to providing
safety net arrangements (deposit insurance and lender of last resort) and ensuring the integrity of
the payments system and markets. The regulators must also have measures in place to handle
emergency situations such as handling insolvent institutions and resolving crises.
There are various models of regulatory frameworks for the financial sector. While in some
countries separate bodies regulate the banking, insurance and the securities markets, in others
these sectors are regulated by a single body. The GFC showed that, if legal and regulatory
regimes fail to adjust to the changing situations, they become ineffective in mitigating the new
risks that can lead to costly systemic problems. Furthermore, there can also be a separation of the
prudential regulation and supervision from a conduct of business and consumer protection
regulation under the ‘twin peaks’ approach (Crockett 2009: 19).
Various international bodies have come up with the various principles and standards of
regulations and supervision of different segments of the financial sector. The Basel Committee
for Banking Supervision (BCBS) is responsible for developing international regulatory standards
for the banking sector. It came up with the Basel III standards to strengthen the regulatory
regimes for the banking sector after the GFC. The new standards bolster Basel II by enhancing
the quality and quantity of capital and introducing risk coverage of the systematically important
financial institutions. It also enhances the supervisory review process The notion of a financial
architecture was first discussed after the Asian financial crisis of the late 1990s. As the crisis
revealed several weaknesses in the financial systems of afflicted countries, a group of Finance
Ministers and Central Bank Governors met in Washington DC in 1998 to discuss ways in which
financial systems could be strengthened nationally and globally to bring about stability and avoid
the recurrence of such crises (BIS 1998). The need for sound structural, social and
macroeconomic policies to bring about not only financial stability but also promote economic
development and poverty eradication were underscored (World Bank 2005). The initiatives that
would promote financial stability by preventing and managing crises were discussed under the
framework of the development of International Financial Architecture (IFA). IFA would include
arrangements and actions that would not only strengthen country level financial systems but also
the global level institutions to ensure stability and facilitate financial integration (World Bank
2005). There were two key components of the IFA initiative: crisis prevention and crisis
mitigation and resolution. Policies to prevent crises included the ‘development and
implementation of international standards and good practice’ on the one hand and ‘deepening
and broadening surveillance, and intensifying capacity building’ on the other hand (World Bank
2005: 4). The World Bank and IMF used two key tools to accomplish these goals: first, the
Financial Sector Assessment Program (FSAP) identified the strengths and weaknesses of the
national level financial sectors, and, second, the Reports on Standards and Codes (ROSC)
initiative strengthened the soundness and transparency of institutions, markets and polices related
to the financial system. The ROSC assesses the compliance of national architectural institutions
with international standards in 12 areas including corporate governance, accounting and auditing,
insolvency and creditors’ rights, regulation of banks, insurance and securities markets, payments
and settlements systems, anti-money laundering and financing terrorism, and transparency of
data, fiscal, monetary and financial policies (World Bank 2001 and 2005). After the global
financial crisis of 2007-2008, the FSAP program was reviewed and changes were introduced
(IMF 2014). Changes included adding focus on systemic risks, improving analytical capabilities
to assess vulnerabilities and resilience and improving the quality of the country level Financial
Sector Stability Assessment (FSSA) reports. For developing and emerging economies, the FSAP
would have two broad components, one assessing the financial stability and the other assessing
the financial development. Indicators of financial stability include not only the soundness of
banks and other financial institutions but also the quality of the supervision of banks, insurance
and capital markets against international standards and the ability of policy makers and financial
safety-nets to respond to negative shocks. Financial development indicators include the quality
of the legal framework and the financial infrastructure in promoting the financial sector that
serve all segments of the population (IMF 2015). WB and IMF (2005:5) identify three pillars of
the financial system architecture that can promote the stability and development of the financial
sector. Whereas Pillar I relates to macro-prudential surveillance and financial stability analysis,
Pillar II deals with sound financial system supervision and regulation. Pillar III involves financial
system infrastructure that include legal infrastructure for finance; systemic liquidity
infrastructure; and transparency, governance and information infrastructure. Some other financial
infrastructure institutions include payments and securities settlement systems; creditors’ rights;
the provision of incentives for strong risk management; and good governance, credit reporting
systems, etc. For Islamic finance, IFSB (2015a) identifies several preconditions that must be
fulfilled for effective regulation and supervision that can ensure the stability of Islamic financial
institutions. These include "sound and sustainable macroeconomic policies; well established
framework for financial stability policy formulation; well-developed public infrastructure; a clear
framework for crisis management, recovery and resolution; appropriate level of systemic
protection (or public safety); and effective market discipline" (IFSB 2015a: 9). A welldeveloped
public infrastructure would entail key architectural elements such as a system of business laws;
well-defined internationally accepted accounting principles and rules; an efficient and
independent judiciary; competent and experienced professionals; well-regulated payment
systems; credit bureaus; and the availability of basic economic, financial and social data and
information (IFSB 2015a: 10). In this study, ‘financial architecture’ and ‘infrastructural
institutions’ are used interchangeably. financial sector that may not be covered by the
conventional architectural institutions and require specific attention. The elements of the Islamic
financial architecture that need special attention and are discussed in this study can be classified
into seven categories as identified below: Legal Infrastructure: Existence of supporting Islamic
finance laws, tax regimes impacting Islamic finance, dispute settlement/conflict resolution
framework and institutions, and resolution of banks. Regulation and Supervision Framework:
Appropriate regulatory and supervisory frameworks for Islamic banks, takaful and Islamic
capital markets including the presence of separate regulatory departments/units dealing with
Islamic financial sectors. Rules related to the nature of the Islamic financial industry and the
existence of Islamic windows/subsidiaries in conventional banks. Shariah Governance
Framework: Existence of regulatory standards for Shariah governance and whether Islamic
financial institutions are required to use IFSB/AAOIFI Shariah governance guidelines of
AAOIFI Shariah standards. Determine the role of central national Shariah board (if it exists) and
its responsibilities and scope. Liquidity Infrastructure: Status of liquidity management
framework (markets and arrangements) and liquidity management instruments and products for
Islamic financial institutions. Need for Shariah compliant LLOR facilities and instruments that
Islamic banks can use. Information Infrastructure and Transparency: Requirements to use either
AAOIFI accounting/auditing standards or domestic standards adapted to Islamic finance. The
legal and regulatory framework of the country related to transparency and disclosure for IFIs.
Existence of organizations providing credit ratings for sukuk issuance and Shariah ratings of
Islamic financial institutions. Consumer Protection Architecture: Laws/regulations related to the
protection of consumers of the financial sector in general and Islamic financial institutions in
particular and institutional mechanisms/arrangements to address the unfair treatment of
consumers. Deposit insurance scheme for depositors of Islamic banks in the country. Scheme for
financial literacy in the country and if there are any specific schemes for Islamic financial
consumers. Human Capital & Knowledge Development Framework: Adequate personnel to cater
to the needs of the Islamic financial sector at different levels (such as regulatory bodies, IFIs, law
firms, etc.). Existence of public and private educational/academic institutions to enhance the
knowledge and skill levels for the Islamic financial sector. Islamic law (Shariah) is
comprehensive and covers various aspects of life including economic dealings. Other than
providing legal rules, Shariah also provides moral principles relating to economic activities and
transactions. It defines the founding concepts of an economic system such as property rights,
rationality, and the objectives of economic activities and principles that govern economic
behavior and activities of individuals, markets, and the economy. Al-Ghazali identifies the
essential goals of Shariah (maqasid al Shariah) to constitute safeguarding the faith (din), self
(nafs), intellect (‘aql), posterity (nasl), and wealth (mal) (Chapra 2006). The objective of Islamic
commercial law and an Islamic economy would strive to protect and enhance one or several of
the maqasid. Specifically, commercial transactions are sanctified and encouraged as they
preserve and support property and progeny (Hallaq 2004). The implications of maqasid in an
economy and the financial sector can be viewed in different ways. One categorization of maqasid
would be to classify them at the macro/general level (maqasid ammah) and micro/specific level
(maqasid khassah) (Abozaid 2010, Dusuki 2009, Dusuki and Bouheraoua 2011). While
macro/general maqasid relates to the benefits and wellbeing of the overall society, micro/specific
maqasid deals with issues relating to individual transactions. A brief overview of maqasid from
these perspectives for the financial sector is presented below. Maqasid at the macro level is
similar to the broader goals of Shariah and involve realizing human wellbeing by enhancing
maslahah (benefit) on the one hand and preventing mafsadah (harm) on the other hand (Laldin
and Furqani 2012). Different scholars suggest the macro implications of maqasid in a variety of
ways. At the broadest level, Abozaid (2010: 67) views it as a vision that protects and preserves
public interests in all aspects and segments of life. Fulfilling the maqasid at this level would
imply that an economy should ensure growth and stability with equitable distribution of income,
where all households earn a respectable income to satisfy basic needs (Chapra 1992). Achieving
the objectives of optimal growth and social justice in an Islamic economy would require
universal education and employment generation (Naqvi 1981: 85). The micro-maqasid relates to
specific issues arising in the operations and transactions of the Islamic financial sector. Using
various legal maxims, Dusuki and Abdullah (2007) and Dusuki and Bouheraoua (2011) conclude
that prevention and minimizing harm should be a key objective of an Islamic firm. These would
include not engaging in harmful activities such as selling products that harm the consumer,
dumping toxic waste harmful to the environment or residential areas, engaging in speculative
ventures, etc. Maqasid at the micro or product level also implies Shariah compliance and
fulfilling the objectives of contracts. Kahf (2006) views maqasid in transactions as fulfilling the
objectives stipulated in contacts. These include upholding property rights, respecting consistency
of entitlements with the rights of ownership, linking transactions to real life activity, transfer of
property rights in sales, prohibiting debt sale, etc. Two key principles governing Islamic financial
transactions are that financing is closely linked to the real economy and returns are associated
with risks in real transactions. The legal maxims of ‘benefit of a thing is a return for the liability
for loss from that thing’ (al-kharaj bi aldaman) and ‘the detriment is as a return for the benefit
(al-ghurm bi al-ghunm) (Majallah Articles 85 and 87) link ‘entitlement of gain’ to the
‘responsibility of loss’ (Kahf and Khan 1988: 30). The implications of these maxims is a
preference for profit-loss sharing instruments and also that the party enjoying the full benefit of
an asset or object should bear risks of the ownership (Vogel and Hayes 1998). for risk
management and capital planning at the bank level and requires higher levels of risk disclosure
to improve market discipline.
IOSCO is a global multilateral organization dealing with regulatory issues related to capital
markets. It published the Objectives and Principles of Securities Regulation, also known as the
IOSCO Principles, in 1998 which were then updated in 2010 after the GFC. The document
consists of 38 core principles for the regulation of the securities markets and entails three key
elements: investor protection; ensuring fair, efficient and transparent markets; and the reduction
of systematic risks. The key focus of the IOSCO's core objectives of securities regulation is on
disclosure and transparency (Singh 2013). Similarly, IAIS (2015), an association of national
level insurance regulators, has published various regulatory documents that include the
Insurance Core Principles. Updated in 2015, the document has 28 core principles for the
development of a sound and stable insurance industry.
Although the Basel regulatory principles and guidelines should apply to all banks, there are some
additional regulatory requirements for Islamic financial institutions.11 This stems from the use
of Islamic financial contracts on both the liability and asset sides. The unique feature of Shariah
compliance not only introduces risks to Islamic finance that are different from those of its
conventional counterpart but also limits the use of certain risk mitigation instruments and
products from which conventional financial institutions are able to benefit. Thus, governance and
regulation of Islamic financial institutions requires a clear understanding of the risks arising in
Islamic finance and then proposing appropriate measures to mitigate them. The Islamic Financial
Services Board (IFSB), an international standard-setting body for the Islamic financial industry,
has specified standards for Islamic financial institutions that are compatible with Basel
standards.12 IFSB is responsible for coming up with regulatory standards for all three segments
of the financial sector and has published various principles, standards, disclosure requirements
and guidance notes for Islamic banking, takaful and Islamic capital markets.

ijarah,- Leasing is an agreement that permits one party (the lessee) to use an asset or
property owned by another party (the lessor) for an agreed-upon price over a fixed period of
time. It is a form of asset finance which has the benefit of using assets without the
requirements of ownership. The lessee acquires the asset he needs without borr owing on
interest and receives the benefits of use while the lessor receives the value of regular rental
payments for a specified period plus the residual value of the asset. The lease may be
written either for a short-term or for a long-term and its rules are similar to those governing
sale because in both cases there is a transfer of one thing between two parties for valuable
consideration. However, leasing differs from sale as its mechanism allows the separation
between ownership and use; in fact, it does not involve transferring the corpus or ownership
of an asset which remains with the lessor.

There are generally two types of leases: a finance lease and an operating lease. A finance
lease is mainly a method of raising long-term finance to pay for assets. It provides the lessor
with full recovery of its investment and a reasonable profit over the initial non -cancelable
lease term. This mode enables enterprises, especially SMEs, to acquire assets, such as
capital goods and high cost equipment, for which they do not have the funds to make a large
up-front payment that would otherwise be involved in a direct purchase. In this type of
lease, the lessor retains ownership of the equipment but transfers to the lessee substantially
all of the risks and rewards of ownership of the asset. The lessee is responsible for the
insurance, registration and maintenance of the equipment.

Financial leases have some similar feature to secured loans. Both allow a business to use an
asset, such as equipment, over a fixed period, in return for regular payments. The business
client chooses the equipment it requires and the bank buys it on behalf of the business. After
all the payments have been made, the business client becomes the owner of the equipment.
The lessor's rate of return is fixed and is not dependent upon the asset-value, performance,
or any other extraneous costs. The fixed lease rentals give rise to an ascertainable rate of
return on investment. Therefore, by spreading payments out over the lifecycle of the asset,
the business is able to align the cost with the benefit derived from the use of the leased
asset. The lessor generally would not provide any services relating to operation of the asset.
In addition, financial leases are non-cancellable; in fact, the lessee cannot return the asset
and not pay the whole of the lessor's investment.

On the other hand, when a risk is involving other than a plain financial risk in a lease, it is
an operating lease. In fact, an operating lease is similar to a rental agreement, and i s not a
finance lease for the purpose of acquiring assets; operating leases take innumerable forms
based on the risks the lessor takes or avoids, and the involvement of the lessor in operation
of the asset. Operating leases are also referred to as a “non-full payout” leases, because the
amount of the rental does not cover the lessor’s full capital outlay for the expected
economic life of an asset, the minimum lease payments over the lease term are such as to
secure for the lessor the recovery of his capital outlay plus a market return on funds invested
and the lease period is always less than the working life of the asset.
The basic features that differentiate an operating lease from a financial lease are related to
whether the lessor or the lessee takes on the risks of ownership of the leased assets. In fact
operating leases do not put the lessee in the position of a virtual owner; the lessee is simply
using the asset for an agreed period. Also, there is always a dependence on the lessee's
commitment to pay, as a result, the lessor also takes is asset-based. Its rate of return in an
operating lease is dependent upon the asset value, performance, or costs relating to the
asset; and is always a matter of probabilities and uncertainty.

Therefore, in an operating lease, the lessor normally holds a stock of assets with high degree
of marketability to provide to other entities. He may also provide any services relating to
these assets, such as maintenance or operations. The assets remain property of the lessor
who has the option to re-lease them every time the lease period terminates. Accordingly, the
lessor bears the risk of obsolescence, recession or diminishing demand. In contrast, a
financial lease provider operates like a lender except that the lessor has the additional
collateral of legal ownership of the assets without any of the risks associated with
ownership.

Since leasing is a variety of sale, it is lawful in everything that can lawfully be bought and
sold, and the rules of Shari´ah pertaining to sale are also generally applicable to leasing. In
fact, any Islamic financing mode should be asset-based there has to be an element of risk
taking. In fact, the profit is generated when an asset having intrinsic utility is sold or offered
for use; and one cannot claim a profit without bearing the risk connected to the transaction.
Therefore, most of the rules relating to the contract of sale come into existence also apply to
Ijarah or Islamic leasing. Muslim jurists have, however, singled out some conditions the
validity of an Ijarah contract with respect to the asset or service hired and the rental.

The first conditions required in a valid Ijarah are that the two sides of the exchange must
both be known and specified in such a way that eliminates the possibility of disagreement
and dispute; that the usufruct in question has a financial or market value; The assets from
which it is almost impossible to derive any benefit from its use, cannot become the subject
of Ijarah; and also the agreement does not involve unlawful activities and substances. The
contracted usufruct and the rent should be ascertained clearly and agreed in advance, either
for the full period of the lease or for a specified period in absolute terms.

Since leasing transfers the ownership of usufruct from the lessor to the lessee, the former
must not only own the assets involved but also be able to transfer the ownership of its
benefits to the lessee. If a particular asset is specified for Ijarah, the lease contract cannot
be executed before getting of the asset or its usufruct. It is also a requirement of a valid
Ijarah that the lease period must be specified and that the lessor retains ownership of the
leased asset during the entire period of the lease. Liabilities arising from ownership will be
borne by the lessor, while the liabilities relating to the use of the property leased asset will
be borne by the lessee. The lessee is liable for any loss to the leased asset due to negligence,
but he cannot be made liable for loss caused by factors beyond its control.

The rental can be determined, with the mutual consent of the contracting parties, on the
basis of aggregate of the cost incurred by the lessor for the acquisition of the assets to be
leased and based on a reasonable rate of return by reference to an agreed benchmark. If the
lease is based on a floating rental rate, it is recommended to use a well known benchmark or
index to determine rentals of subsequent periods in a long-term lease to avoid any dispute or
injustice due to possible fluctuations in the market rate structure and binding nature of the
lease contract. The floating rate, however, should be subjected to an upper limit in order to
avoid the element of Gharar.

Furthermore, a stipulation may be inserted in the Ijarah contract making late payment by the
lessee over a period of time liable to a certain amount of charity. This may provide
prevention from late payment even though it does not compensate the lessor for his
opportunity cost over the period of default. The lessor may also approach a competent court
to award damages for any shortfall. The lessor can also demand payment of an earnest
money amount as advance payment of rentals to ensure that the prospective lessee fulfils the
commitment to take possession of the asset on lease when purchased by the lessor. If the
Ijarah contract is not executed for any reason attributable to the lessee, the lessor can
recover from the earnest money the amount of the actual losses suffered loss incurred in this
agreement. And unlike normal sale which cannot be effected for a future date, Ijarah for a
future date is permissible. The lease period and the lessor’s entitlement to rent, however,
begin form the date on which the leased asset has been delivered to the lessee. The rent
thereof may be payable in advance before delivery of the asset to the lessee. Any advance
rentals must be adjusted against future rentals

Finally, either the lessor or the lessee can make a unilateral promise to buy or sell the leased
asset at the end of the lease period, or earlier, at an agreed price, provided that the lease
agreement shall not be conditional upon such sale. On the other hand, the lessor may make a
promise to gift the asset to the lessee upon termination of the lease, provided the lessee has
fulfilled all the obligations under the contract. There must also not be any stipulation in the
contract purporting to transfer of ownership of the leased assets at a future date. In the
Islamic jurisprudence, one transaction cannot be conditioned by another transactio n. Ijarah
and sale/purchase transactions are two different contracts and the transfer of ownership in
the leased property cannot be made by a sale contract on a future date along with the Ijarah
contract. Therefore a ‘Hire-Purchase’ agreement which combines both lease and sale at the
time of contract, it is not suitable for Islamic banks.

The method acceptable to Shari´ah is that the ownership remains with the lessor along with
all liabilities emerging from ownership. As a result, Islamic banks take the asset risk, bear
the ownership related expenses and give or take responsibility for transfer of the asset to the
lessee upon termination of the lease. This is done under Ijarah Muntahia-bi-tamleek which
includes a promise by the lesser to transfer the ownership of the leased property to the
lessee. The transaction basically remains that of Ijarah and the transfer of ownership is kept
separate from the main Ijarah contract. Under this arrangement, the bank purchases the asset
for the client who then leases the asset from the bank; at the end of the lease term, the
transfer of the asset ownership to the lessee is kept separate.

Ijarah shares many common features with financial lease and hire-purchase arrangements. It
involves a lessor purchasing an asset and renting it to a lessee for a specific time period at
an agreed rental and at the end of the lease period transferring the ownership of the asset to
the lessee. However, Ijarah Muntahia-bi-tamleek is different from the conventional leases
where the rentals start accruing as soon as the payment for purchase of the asset being
leased is made by the lessor; while in Ijarah Muntahia-bi-tamleek, rentals start at the time
when the asset is supplied to the lessee in useable form. Also, if the price of the asset is p aid
to the lessee instead of the supplier, there must be an agency (Wakalah) agreement between
the parties prior to the lease agreement that gives authority to the lessee to purchase the
asset on behalf of the bank. If the asset is destroyed before its delivery to the lessee in
useable form, the loss will be that of the bank and not of the agent. Therefore, the risk of the
asset will be that of the bank as long as the client serves as its agent for purchase of the
asset while in conventional lease all risks are borne by the lessee.

In addition, is different from a hire purchase and finance lease in the sense that it is an
arrangement that does not comprise two contracts in one bargain; in fact, leasing is the real
and the major contract; therefore, it is subject to all Shari´ah rules of an ordinary operating
Ijarah contract. The transfer of ownership is processed through a separate sale or gift
contract. This other part of the deal is only a unilateral promise not binding on the
promissee and as such it is not a transaction until actually entered into by the parties. In
addition, Ijarah Muntahia-bi-tamleek is a fair arrangement based on justice for both the
parties; the lessor recovers cost of the leased asset and also the profit in the form of rentals
while the lessee can get ownership title of the asset at the end of the lease period. The lessee
is also protected from the loss by the lessor would bear all responsibility for loss of the
leased asset, in case of absence of negligence on the part of the lessee.
There are many Islamic finance structures where Ijarah can be used. Islamic banks use this
mode of financing with the purpose of enabling customers to use durable goods and
equipment such as ships, housing, heavy machines and plants in productive enterprises who
may be unable to buy them for their production purposes. Ijarah has also huge potential as a
financing mode for retail, corporate and the public sectors and can also play a crucial role in
promoting Islamic finance industry. It can be used as incentive to economic development as
it is usually long term and offers potential for stimulating productive industries.

Leasing is an attractive mode of investment for Islamic banks because assets acquired under
these contracts are usually of high quality, marketable and maintain their market value well
above book value; therefore, the bank does not have to depend so much on the
creditworthiness of the lessee, given that as a recourse, it can sell the asset to dispose for
cash in case of default. And since the Islamic bank acquires the desired asset only when a
client requests it and commits himself to enter into a lease contract with the bank, the
possibility of misuse of funds and assets is minimized and the bank can make a profit by
setting the rent at a level that covers, over the lease period, the purchase price as well as a
return in line with the current rate of mark-up. In fact, Islamic banks can get variable and
floating return on long term investments. And although Ijarah is a longer-term financing
instrument, a leasing contract can be reviewed periodically. The financing party thus not
tied down to a fixed return that may not be in its investment goals.

Furthermore, Ijarah offers the advantage of not requiring collateral and thus of simpler
repossession procedures since ownership of the asset lies with the lessor. It also means that
it has greater in-built stability to contain inflationary pressures in the economy. The lessor is
only exposed to a low level credit risk from the lessee as the lease transaction is, by
definition, asset-backed. Ijarah has also become popular due to a tax advantages as the
rental can be offset against corporate tax by the lessee.

Finally, Ijarah can be used indirectly for Sukuk issues by the corporate and the gove rnment
sectors. Ijarah Sukuk represent leased assets without actually relating the holders to any
corporate body or institution. Securitisation on the basis of Ijarah is an alternative tool to
interest based borrowing provided it uses durable and useable assets. For example, an
aircraft leased to an airline can be represented in bonds and owned by a number of Sukuk
holders, each of them individually and independently collecting their periodic rent from the
airline company. The Sukuk holders are not owners of a share in a company that owns the
leased asset, but simply a sharing owner of a part of the aircraft itself. Islamic banks are
also able to offer leasing certificates to their depositor clients as specific investment
certificates as a form of declining equity. These mechanisms facilitate the formation of fixed
assets and can contribute to long term economically beneficial investment.
musawamah,- Musawamah is an Islamic finance term that describes a sale in which the seller is
not obligated to disclose to a buyer the price paid by the seller to create or obtain the good or
service. There are rules regarding the good or service that must be met in order for Musawamah
to be used as a method of negotiation. The rules must be satisfied in order for the transaction to
be Shariah compliant. Banking or other transactions undertaken under Islamic rules must be
Shari'ah compliant.
BREAKING DOWN Musawamah
Musawamah describes a transaction where the price acquisition price of an underlying good or
service is not disclosed to the buyer. This differs from murabaha, where a buyer knows the cost
of the underlying asset. Since the seller is not obligated to disclose the cost of obtaining or
producing the merchandise for sale to the buyer, the agreed selling price is left to the bargaining
powers of both the seller and buyer. In order to comply with Shari'ah, there are many restrictions
to a musawamah, including:

 The underlying asset must be in existence and in the sellers' possession at the time of the
sale.
 The sale must occur instantaneously, future sale dates are void.
 The asset must be of value and usable

time multiple counter-loans, bay` bithaman ajil, - Another possible method of financing
considered by the Council is the system of “time multiple counter-loans”. The concept of
counter-loans, in essence, is quite simple and can best be explained with the help of an example:
Suppose a small trader A wishes to borrow Rs. 100 from a bank B for three months free of
interest. B may provide the required loan to A if the latter, simultaneously with receiving the
loan, deposits a fraction of the loan for a proportionately longer period, say Rs. 10 for 30 months.
After three months, A repays Rs. 100 to B but B would pay back to A his deposit of Rs. 10 after
the expiry of 30 months from the date of the deposit. During this period B can use this deposit or
“counter-loan” for profit-earning investment. However, just as A would not be required to share
the income earned by him by deploying the loan provided by B, the latter would also not pay any
additional amount when A’s deposit (counterloan) matures.
The Council is of the view that it would not be correct to use this method by way of a permanent
alternative system to the interest-based system. However, if it is desired that provision may be
made for providing personal loans to people of small means, then instead of the above
stipulations the banks may adopt it as a principle that they would provide loans for personal and
non-productive purposes only to those persons who already hold accounts with them. In laying
down the repayment schedule and the amount of the loan, however, the banks may keep in view
the amount of the deposit of the applicant for the loan and the period over which he has
maintained his deposit with the bank. The Pakistan Banking Council may evolve the appropriate
procedure and rules in this regard.
tawarruq)- awarruq is a financial instrument in which a buyer purchases a commodity from a
seller on a deferred payment basis, and the buyer sells the same commodity to a third party on
a spot payment basis (meaning that payment is made on the spot). The buyer basically borrows
the cash needed to make the initial purchase.

Later, when he secures the cash from the second transaction, the buyer pays the original seller
the installment or lump sum payment he owes (which is cost plus markup, or murabaha).

Because the buyer has a contract for a murabaha transaction, and later the same transaction is
reversed, this scenario is called a reverse murabaha. Both transactions involved must be sharia-
compliant.

Tawarruq is a somewhat controversial product. Because the intention of the commodity

purchases isn’t for the buyer’s use or ownership, certain scholars believe that the transactions
aren’t sharia-compliant. Their argument is that the absence of any real economic activities
creates interest, which is prohibited in sharia.

Scholars who accept this contract as valid note that it is based on two valid legal contracts,
murabaha and sales. Despite the controversy, however, many Islamic banks, including the United
Arab Bank, QNB Al Islamic, Standard Chartered of United Arab Emirates, and Bank Muaamalat
of Malaysia, use tawarruq products.

Generally, commodities such as gold, silver, barley, salt, wheat, and dates aren’t allowed in
tawarruq. However, the London Metal Exchange (LME) has been used by many Islamic banks as
a platform for tawarruq because metal is not part of its commodities transactions.

How does tawarruq work in matters of personal finance? First, the customer purchases a
commodity (other than a medium of exchange) from the bank on a cost plus profit basis. Then
the customer sells that commodity to a third party. (In reality, the customer simply authorizes the
bank to sell the commodity to the third party on his behalf.)
The proceeds from the sale are credited to the customer’s account, and the customer pays back
the bank (the cost plus profit).
Chapter 3
sub-contracts - For Islamic banks to a make profit and to satisfy the borrowers’ needs of cash,
they have to conduct transactions that do not violate Islamic rules by looking for allowed
contracts that can achieve the required goal. Mostly, they are based on sale and purchase
transactions, accompanied by a degree of risk.
There are five main contracts in Islamic finance: Mudarabah, Musharakah, Murabahah, Ijarah
and Salam:
Profit and loss sharing (Mudarabah): is a contract between two parties; one provides the
capital and the other provides the labor to form a partnership to share the profits by certain
agreed proportions.
ii. Joint venture (Musharakah): is a financial contract between two or many parties to establish
a commercial enterprise based on capital and labor. The profit and loss are shared at an agreed
proportion according to the amount of contribution.
iii. Cost plus (Murabahah): refers to a sale of a good or property with an agreed profit against a
deferred or a lump sum payment. There are two contracts in Murabahah: the first contract is
between the client and the bank, whereas the second contract is between the bank and supplier.
The client (purchaser) orders a certain commodity through the bank, the bank then buys the
commodity from the supplier and sells it to the client with specified profit whereby the client can
make a lump sum or a deferred payment to the bank.
iv. Leasing (Ijarah): in which two parties are involved therein: the lessee and leaser. The leaser
(bank) is the real owner of the asset or property and it is rented out to the lessee until full
payment is received. The lessee has the option to keep the asset at contract maturity or give it
back to the bank. If all payments are received, the lessee can keep the asset but at a higher price
than the usual asset price.
v. Salam: is another contract where full payment for a good is paid in advance but the delivery
of the good is made at an agreed future date.

(kafalah, - The concept can be explained by using a simple example involving three parties.
Party A purchases an asset from Party B on a deferred payment basis. Party B requires some
assurances that Party A will make the required payments. Party C provides Party B such
assurances that in the event Party A defaults on payments to Party B, Party C will make good all
losses.

This arrangement can also be modified to where Party A commits to deliver certain goods in the
future to Party B, for which Party A has already taken the sale price, like
in salaam and istisna contracts. Party C stands in on Party A's behalf that in the event Party A
does not fulfill his or her obligations, Party C will do so by providing the required goods or
making good the losses incurred by Party B.
Let's assume Party A owes Party B a deferred payment of $150,000, to be made in lump sum in
90 days. Party A arranges for Party C to be a guarantor for $150,000. Now Party B has recourse
to Party C in the event that Party A defaults. Party A does default on the payments due to Party B
in 90 days, and Party C makes good the payment of $150,000 owed to Party B.

hawalah, - Hawalah (also spelled hawala) is the transfer of debt from one party (the
transferor or in Arabic al-muheel) to another party (the payer or in Arabic al-muhal alaihi).
Hawalah could also refer to the transfer of right where a creditor is replaced with another
creditor. The former form of hawalah (debt transfer or in Arabic hawalat-ul dayn) differs
from the latter (right transfer or in Arabic hawalat-ul haqq) in that in the former a debtor is
replaced with another debtor, while the latter involves the replacement of a creditor with
another creditor. The contract of hawalah is not a contract of sale (ba’i), as it is used to
facilitate payments and debt recovery.
 Hawalat-ul dayn (debt transfer): according to Hanafi jurists, it is the transfer of the
liability for a debt from the legal personality of the debtor to the legal personality of the
liable person named in the contract. In this sense, a transfer of debt is different from a
guarantee contract in that the latter entails the conjoining of liabilities rather than the
transfer of liabilities. Therefore, once a transfer is legally made, the original debtor is
relieved from repayment requests. In general, the transferor is a debtor to the transferee,
where the debt gets transferred to a third party (al-muhal elaihi or the payer) who
becomes the new debtor. In this type of hawalah, the debtor is the initiator of transfer.
The following figure illustrates the relationship between the three parties involved in
hawalat-ul dayn:

wakalah, - Literally Wakalah means protection or remedying on behalf of others. Legally

Wakalah refers to a contract where a person authorizes another to do a certain well -defined
legal action on his behalf. It is a contract of agency which means doing any work or
providing any service on behalf of any other. An agent is someone who establishes
contractual and commercial relations between a principal and a third party, usually against a
fixed fee. An action performed by an agent on behalf of the principal will be deemed as
action by the principal. Agency is necessitated by the fact that an agent has to perform
certain tasks which the principal has neither the time, knowledge nor the expertise to
perform himself. The need for agency arises where a person has no ability or expertise to
perform a certain action due, for example, to distance or size. The main features of agency
are service, representation and the authority to act for the principal. An agent may obtain a
certain wage for services rendered within the incentive structure of the principal The
contract of Wakalah is about the provision of service. Some of these services include sale
and purchase, letting and hiring, borrowing and lending, assignment of debt, guarantee,
pledge, gifts, bailment, taking and making payments, litigation and relinquishment,
admission and acknowledgment of rights. Islamic banks use the concept of Wakalah in
various Islamic products such as Musharakah, Mudarabah, Murabaha, Salam, Istisna´a and
Ijarah. It is also used in payment and collection of trade bills, fund management and
securitisation. Banks normally charge fee for agency services rendered by them on behalf of
their clients. An agency contract could be specific or general; it could be both commutative
and non-commutative; the nature of activity to be undertaken should be clearly defined to
avoid any disputes. For example, if Wakalah is for the sale or purchase of specific goods,
the kind, quality and other necessary attributes of the commodity should be clearly
mentioned.

The principal should have the power and competence to deal and own the property. For
example, an insane or a minor cannot appoint agents to act on their behalf. However, it is
not necessary for the person appointing an agent to have attained a minimum age. Also, a
principal may appoint an agent to conduct any business transaction activity that the person
would be able to undertake. However, Agency is not permissible in activities prohibited in
the Shari´ah or acts of dishonesty such as theft and usurpation of property or conduc ting
Riba-based business. It is also prohibited to appoint an agent for acts such as prayer, fasting,
giving evidence, or for taking an oath. The agent must act in accordance with the
instructions of the principal and exercise due care and skill. If he is appointed to sell goods
on behalf of the principal, he cannot purchase these goods as a buyer. Similarly, if the
principal restricts the agent to certain limits, the agent is bound to observe them.

An agent appointed to engage in buying and selling activities or to pay and receive a debt is
considered to be a custodian of the principal’s property and in the fiduciary position of a
trustee. And in the absence of any instructions to the contrary, an agent appointed to sell
goods can sell them for cash or on credit; the agent can take a pledge of a security for
payment in the case of goods sold on credit. Besides, an agent is not allowed to appoint
another agent unless he himself is not capable to do it; in that case, he may appoint another
agent with the consent of the principal. He must also avoid any conflict of interest such as
selling goods to the principal without disclosing that such goods are owned by the agent.

In the case of Wakalah of sales, the principal appoints an agent to sell a certain propert y for
him; the agent is responsible for making payment and receiving goods on behalf of the
principal. He has the authority for claiming the price, exercising the right of option of
voiding a sale on account of defective goods or inspection and returning goods as well as
similar rights and liabilities associated with sale transactions
.

Finally, Wakalah is a non-binding contract; the principal or the agent may withdraw at any
time by mutual agreement, unilateral termination, discharging the obligation, des truction of
the subject matter and the death or loss of legal capacity of the contracting parties. If the
agent concludes a contract that contravenes the terms and conditions of the agency, the
contract is not binding on the principal and its validity depends on his approval. In case
where an agent concludes a contract that apparently contravenes the conditions, but the
contract is beneficial to the principal, it is binding on him.

jualah and bai-al-dayn- ai al dayn is essentially a contract of the sale of debt. Being a contract
of sale, there must be all the elements or pillars of a sales contract such as legitimacy of
contracting parties, and offer and acceptance. Between the contracting parties there must be a
subject matter of sale, a price, and delivery of the asset. The asset in this case, however, is a
financial asset or a debt.

The Majelle defined dayn as a matter that is due, that is, the money owed by a certain
debtor.1 Shariah scholars have defined debt to include any moneys owed in a contract of qard,
murabahah, ijara, bai bithman ajil, and many others.2 Any basket of receivables owed by one
party to another, whether they are generated by a deferred credit sale, a contract of rent, or a
contract of loan, is considered to be debt.
Shariah allows the transfer of debt though what it is called the assignment of debt or hawalah.
This trading of debt at par is allowed unanimously by all Islamic jurists as it does not give any
benefit to the purchaser and is free of elements such as riba, gharar, and maiser.3 It is considered
that the bai al dayn purpose is genuine and it is in the benefit of the parties involved
(maslahah).4 The issue here is to sell the debt to a third party that is a nondebtor and on a
discounted value. Depending on the underlying essence inside the debt, most shariah scholars
are of the opinion that selling a money-based debt to a third party on a discounted basis is not
accepted ...

Murabahah – Murabaha is one of the most common modes used by Islamic Banks. It refers to a
sale where the seller discloses the cost of the commodity and amount of profit charged.
Therefore, Murabaha is not a loan given on interest rather it is a sale of a commodity at profit.
The mechanism of Murabaha is that the bank purchases the commodity as per requisition of the
client and sells him on cost-plus-profit basis.

Under this arrangement, the bank is bound to disclose cost and profit margin to the client.
Therefore, the bank, rather than advancing money to a borrower, buys the goods from a third
party and sell those goods to the customer on profit. A question may be raised that selling goods
on profit (under Murabaha) and charging interest on the loan (as per the practice of conventional
banks) appears to be one of the same things and also produces the same results. The answer to
this query is that there is a clear difference between the mechanism/structure of the product.

The basic difference lies in the contract being used. Murabaha is a sale contract whereas the
conventional finance overdraft facility is an interest based lending agreement and transaction. In
case of Murabaha, the bank sells an asset and charges profit which is a trade activity declared
halal (valid) in the Islamic Shariah. Whereas giving loan and charging interest thereupon is pure
interest-based transaction declared haram(prohibited) by Islamic Shariah Trading in currencies;
Usury is of course completely prohibited in Islam, and is defined very widely. This implies that
any kind of deal or contract which involves an element of interest (riba) is not permissible
according to Islamic law. For a long time, retail Forex brokers reflected the market practice of
paying or charging to the trader the interest differential between the two components of any
currency pair whose position remains open overnight. Eventually, most Forex brokers responded
to market forces (and pressure from Islamic traders) by becoming “Islamic Forex Brokers” and
offering “Muslim Forex Accounts” which operate without standard interest payments. You might
ask how they did so and maintained the profitability of their operations. This was achieved by
charging increased commissions in spot Forex trades, and this practice has become the hallmark
of nearly all Islamic Forex brokers. Arguably, this in itself is just a camouflaged interest
component, and if this view is taken, it makes Forex trading problematic according to Islamic
law.

The interest problem also eliminates any possibility of trading Forex forwards, as there is always
an interest element involved in these transactions.

However, “regular” spot Forex trading offered by Forex brokers, with no overnight interest
payments or charges, could clear the hurdle of riba.
What Islam Says on Online Forex Trading

Having reduced the issue to one of trading spot Forex and assuming there is no interest element
deemed to be involved, we move onto the next issue. It would seem to be permissible only “so
long as it [the exchange] is hand to hand”. So clearly, the Prophet Mohammed (peace be upon
him) had in mind exchanges of different types of commodities that would be made between two
parties, recognizing that this was a natural and just aspect of commerce. The question here lies in
what is considered to be “hand to hand”. In the olden days, there were of course no computers or
telephones, so the aspect of making a deal face to face (or hand to hand) wasn’t much of a
question. In fact, one could extrapolate that it was natural and accepted for a deal to made
between two different parties. In modern times, it can be argued that in regards to Forex trading,
the deal is made between a Forex broker and a trader, so this would qualify under such a
definition of two different parties, which would be permissible according to Islamic law. A
further widely recognized stipulation is that the actual exchange must take place during the same
“sitting” in which the contract is made- in other words, trades must be concluded more or less
immediately. We would seem to be on solid ground here, as when a trade is made with a Forex
broker, it takes effect immediately. Interestingly, this could suggest that all non-market trades
(i.e. stop or limit orders) are haram!

It is here that we arrive at the biggest hurdle in attempting to answer the question “Is Forex halal
or haram?” Generally, Forex traders do not expect to take actual delivery of the currency they are
“buying”, and never actually own the currency that they are “selling”. They are simply
speculating that the value of one with go up and the value of another will go down. Is such
speculation permissible according to Islamic law?

This is an extremely difficult question to answer and it may be one that should be discussed with
your own religious leader rather than being decided base on an internet article. Nevertheless,
we’ve researched the issue thoroughly and will be outlining some points of thought below.

We can start by saying that Islam recognizes that nearly all adult human beings strive to improve
their financial positions, and that life involves a large element of uncertainty. In life we are
confronted with many choices, the outcome of which is unclear, and we strive to use intelligence
and skill in choosing the available option that will produce the superior outcome. However, we
then must go on to say that gambling is strictly forbidden by Islamic law, even as a form of
recreation or entertainment when undertaken with small monies which the gambler might be said
to be able to afford to lose.

In measuring these two competing elements, it can be said that it is the method of speculation
that makes the difference. One author has examined the subject and stated that speculation on the
basis of fundamental analysis is permissible, but technical analysis is not, and an interesting
reasoning is given: placing trades based on technical analysis is essentially tantamount to betting
on the bets of others, and relying upon the behavior of the crowd to influence your speculation is
drenched with the essence of gambling, which is forbidden by Islamic law.

However, this argument can certainly be criticized as spurious as related to market realities. For
example, is a speculator who believes that the U.S. Dollar will rise against his Euros due to
economic fundamentals bound to simply make the trade immediately, and forbidden to take any
action to time the trade entry to a psychologically opportune moment?
Once you’ve done your research thoroughly, you can decide whether Islamic Forex is right for
you.

A stronger argument could be made that a Muslim has no business speculating on the currency
markets unless he or she has a firm basis upon which to anticipate success. This would mean that
trades must involve either some element of fundamental analysis or technical analysis which the
trader actually has a firm reason to believe in. One example might be trend following trends that
have an academically established track record as a profitable trading method in liquid financial
markets, and trading these trends using Islamic FX Brokers. A trader could argue that a strong
technical trend is easier to establish – and is also likely to have an underlying (if invisible)
“fundamental” reason behind it - than a classical fundamental economic outlook which might be
disputed by professional economists!
Creating a Muslim Forex Account

There is no question that currency exchange is permissible in Islam, provided that there is no
interest element, that it is made hand to hand (though this phrase can be translated in multiple
ways), and that the exchanger has a valid reason to anticipate a probable profit based upon an
analysis that does not rely upon the psychology of gambling. On a minimal basis, Islamic Forex
brokers can be used to trade, which should at least remove arguably all of the riba challenges. As
we have seen, there are certain grey areas within this qualification that must be investigated
deeply in good faith and conscience by anyone wishing to begin halal Forex trading with a
Muslim Forex account.
Conclusion

It should be stressed that though we’ve researched the issue of Islamic Forex and its validity
within Islamic law at length, we are in no way attempting to provide religious guidance for
readers of this article or their acquaintances. As evidenced in the research presented here, there
are certainly many people who believe that in the right circumstances, Islamic Forex trading is
permissible. However, there may be some that aren’t comfortable using these workarounds, and
this is a completely valid approach as well. If you are interested in researching more on the issue
or considering how each Forex broker implements their Islamic Forex system, we recommend
that you evaluate our top Islamic Forex brokers and speak to their teams if you have any
questions or concerns about how their practices relate to Islamic law. A solid and respectable
Forex broker will have concrete answers and will make you feel at ease, not uncomfortable.

default in payment, - An overview of AAOIFI Standard Number Three is presented. It should

be noted only a summary and overview of the standard is presented, the full standard is available
from AAOIFI.
The purpose of this standard is to explain the Shari’a rulings applicable to the transactions of
Islamic Financial Institutions relating to delay on the part of solvent debtors in settling their
debts, delay on the part of guarantors and contractors in fulfilling their obligations, and the ruling
on the matter of penalty clauses.
This standard is applicable to cases of default on the part of a solvent debtor or a solvent
guarantor, and the case of a contractor or concessionaire who is late in completing work and thus
becomes a debtor by virtue of a penalty clause.
The standard is not applicable to debtors who are insolvent or bankrupt, or to debtors who delay
payment for an established Shari’a reason.
The standard is issued on 27 Safar 1421 H, corresponding to 31 May 2000.

Shari’a ruling

Default in payment by a debtor

1. Default in payment by a debtor who is capable of paying the debt is haram (prohibited).
2. It is not permitted to stipulate any financial compensation, either in cash or in other
consideration, as a penalty clause in respect of a delay by a debtor in settling his debt,
whether or not the amount of such compensation is pre-determined; this applies both to
compensation in respect of loss of income (opportunity loss) and in respect of a loss due
to a change in the value of the currency of the debt.
3. It is not permitted to make a judicial demand on a debtor in default to pay financial
compensation, in the form either of cash or of other consideration, for a delay in settling
his debt.
4. The debtor in default bears all legal and other expenses incurred by the creditor in order
to recover his debt.
5. The creditor is entitled to apply for the sale of any asset pledged as collateral for the debt,
for the liquidation of the debt. He is equally entitled to stipulate that the debtor must give
a mandate to the creditor in sell the pledged asset without recourse to the courts.
6. It is permitted to stipulate that all outstanding installments become due once the solvent
debtor fails to pay an installment. It is preferable that this clause should be implemented
only after notifying the debtor and after the lapse of a reasonable period of time, not less
than two weeks.
7. In the case of a Murabaha sale, if the asset that was sold is still available in the condition,
in which it was sold and the buyer has defaulted in the settlement of the price and has
later become bankrupt, then the seller (the institution) is entitled to repossess the asset
instead of initiating procedures to obtain a bankruptcy order.
8. It is permitted to prescribe in contracts involving indebtedness (such as Murabaha) an
obligation on the debtor, in the case of default in payment, to donate an amount or a
percentage of the payment due on condition that this be donated to charitable courses
under the supervision of the bank’s Shar’a supervisory board.

Guarantor

1. It is permitted for a creditor to demand that a debt be settled by a guarantor according to

established Shari’a principles. The institution is entitled to demand payment from either
the debtor or the guarantor, provided that there is no condition in the contract to the effect
that payment must be sought first from the debtor.
2. All rulings applicable to debtors in default are equally applicable to guarantors in default.

Contractor or concessionaire
It is permitted to include penalty clauses in contracts for construction, Istisna’a and supply
contracts. In case of a refusal to pay the amount due under a penalty clause, the rulings
relating to default by a debtor would be applicable. It is permitted to deduct the amount from
outstanding amounts due to the contractor.

Non-material punishments for default in payment

The institution is entitled to include the name of a debtor in default in a list of undesirable
customers (black list) and to send a warning admonition to other companies about the
defaulting debtor, either when there is an inquiry from other companies about the debtor or when
such ‘black lists’ are exchanged between companies directly.

General rulings

1. The institution is entitled to follow the affairs of a defaulting debtor and his financial
dealings; this is considered a kind of pursuit of the debtor.
2. The institution may accept a payment from a debtor who is in default that is in excess of
the amount of the debt, provided there is no contractual condition whether written or,
verbal or custom or mutual agreement relating to this additional amount.
3. It is permissible for the institution to include a condition in a contract dealing with
indebtedness to the effect that, if the debtor is late in making payment, the institution is
entitled to recoup the amount due from any of the accounts of the customer with the
institution.

settlement of debts,- There are different ways through which funds could be raised to meet
individuals and organisations needs and funding requirements. Raising loans is one of the
various ways these requirements can be fulfilled. In the terminology of Islamic framework,
Qard and Dayn relate to the giving or taking of loans. However, the word Dayn has a
broader connotation then the word Qard. Dayn incurs in any way which leaves a debt as a
liability to another party to be paid later without any profit over the principal amounts.
Whereas, Qard could be defined as an interest-free loan for needy borrowers extended on a
goodwill basis; in particular Qard al Hasan provides funds for humanitarian and welfare
purposes without any profit accruing to the lender.

In fact, Qard consists on giving ownership of anything having value for the benefit of
another by way of virtue. The ownership of the loaned objects is transferred to the borrower
who can use, buy, sell, or donate them as the borrower wishes. Qard is only applied when
one gets obliged to return the equivalent of the thing taken and repayment is for the same
amount as the amount lent. Goods of the same kind will be paid back on demand or at the
settled time. Qard should not bring any return or addition to the lender because that woul d
be equivalent to taking Riba. However, a borrower can pay more than the amount borrowed,
but it must not be stipulated in the contract. Further, the date of payment of the loan may or
may not be included in the Qard contract as the lender can demand repa yment at any time.
And the loan should not be conditional upon any other contract, such as Bai´ and vice -versa.

Ariyya is another structure of borrowing goods in a virtuous act. However, in the case of
Ariyya, the exact borrowed commodity has to be returned to its owner, not any replacement.
While in Qard, the same kind of the loaned commodity with essentially the same nature or
character could be paid back.

On the other hand, a Dayn is the result of any contract or credit transaction. The created
debts ought to be returned without any profit over their principal amounts. Salaf is a form of
Dayn that is similar to Salam. It is used for a loan of fixed tenure and in that sense it is
closer to Dayn; Salaf includes loans for short, intermediate and long term loans and the
price of the commodity is paid in advance, while it is delivered at a future date. The amount
given as Salaf cannot be called back before its due date. Therefore, this creates a liability
for the seller to supply the commodity in the future.

In addition, in all credit transactions, Islam recommends witnesses and documentation. This
provides safeguards against disputes and allows credit transactions for a fixed or known
time period. And since Islamic banks can neither pay interest nor charge any return on
loans, they have the right to ask for collateral to ensure recovery of the loan amount. In fact,
the client cannot refuse to repay the loan or debt in case he has incurred loss in the business
conducted with the bank’s loan. Also, The Shari´ah puts a great deal of emphasis on
repayment of loans/debts and the borrower also has a moral obligation to repay a loan. For
that reason, banks can include, with mutual consent of the clients, a penalty clause in the
credit contract to mitigate the risk of default, but the penalty charged on any default has to
go to charity

With regard to a possible rebate that could be given to the debtor for repaying the loan
earlier than the due date, the Shari´ah considers that as a reduction of interest in the
financing costs arising from prepayment of the amount that would be stipulated in a
contract. And, there is unanimity about the illegality of remitting a part of the debt payable
by anyone and getting the remaining part. However, Muslim jurists have differentiated
between loans or debts that have become due or can be called back at any time (Duyoon
Haalah), and loans where time of payment settled between the creditor and the debtor and
the debt is not yet due (Duyun Mu’ajjalah). Duyoon Haalah are allowed b y almost all
Muslim jurists on the rationale that in such loans, delay is not the right of the debtor. In fact,
rebate should neither be provided in the agreement nor be made a condition in the loan
contract. In opposition, remission of a part of a debt not yet due involves Riba. The
fulfilment of one's obligation under all contracts is a religious duty in Islam. Therefore, the
Shari’ah defines specific rights and responsibilities of debtors and creditors. The most
important duty of the debtor is to repay the loan in fulfilment of the promise or contract
made with the creditor. God’s punishment will be severe to the borrower whose intention is
to blemish or to usurp the loan. And the main duty of the creditor is not charge interest on
the principal amount of the loan because those who charge Riba are compared in Quran to
those controlled by the devil's influence.

In fact, Islamic teachings stress that a borrower, when accepting loans, must be firmly
determined to make repayment. The debtor should not only pay the debt in time, but also
express gratitude to the creditor while repaying the borrowed amount. And if the debtor
refuses to pay even though he has the means, he would be a perpetrator of injustice who
exposes himself to possible punishment. In fact, in Shari´ah, if a debtor default wilfully, he
can be arrested, punished and dealt with harshly.

In addition, Islam condemns the person who delays the payment of his dues without a valid
cause. He could be admonished, disgraced or even jailed and if necessar y could be disposed
of his asset to pay the debt. A monetary fine, on the other hand, wouldn’t be a lawful option,
since this would amount to a monetary penalty for delayed payment, which is Riba.
However, Islam makes a distinction between debtors who default by Procrastination and
those who default by necessity. The Qur'an recommends that the latter deserves compassion
and is to be given be given respite until he is able to pay. In extreme circumstances,
creditors are exhorted to forgive the debt, which can be counted towards obligatory Zakat or
as a donation.

However, Islamic jurists see no harm if it is agreed between the parties that some indirect
benefits do not involve any cost for the borrower. For example, debt could be paid in the
form of cheques and drafts or in some other currencies if it is in the interest of both the
parties.

In the case of a debt with a settlement date, the creditor is not entitled to ask for earlier
repayment, so long as the debtor does not transgress the terms and conditions . But, if the
creditor is not disposed to give more time for repayment, he cannot be compelled to do so
and the debtor would then be liable to repay the debt at the falling due from whatever he has
beyond his basic needs.

In addition, Shari´ah allows creditors to ask for collateral to ensure recovery of the amount
in the case of failure by borrowers to fulfil their obligation for the repayment of the debt.
The subject of the sale could be the subject of a pledge made to the extent of the debt. In
fact, a pledge is permissible in the Shari´ah, whether a person is on a journey or at home and
even between a Muslim and a non-Muslim. The ownership of the pledged goods remains
with the pledger, who takes on the risk of losing the pledged commodity while the pledg ee
holds the goods on trust. Hence, if the pledged goods are lost without any fault of the
pledgee, the loss would be that of the debtor. And if the due debt is not paid, the pledgee
can apply to the court to have the pledged good sold and the debt recovered out of the sale.

documentary credit, - There are different ways through which funds could be raised to
meet individuals and organisations needs and funding requirements. Raising loans is one of
the various ways these requirements can be fulfilled. In the terminology of Islamic
framework, Qard and Dayn relate to the giving or taking of loans. However, the word Dayn
has a broader connotation then the word Qard. Dayn incurs in any way which leaves a debt
as a liability to another party to be paid later without any profit over the principal amounts.
Whereas, Qard could be defined as an interest-free loan for needy borrowers extended on a
goodwill basis; in particular Qard al Hasan provides funds for humanitarian and welfare
purposes without any profit accruing to the lender.

In fact, Qard consists on giving ownership of anything having value for the benefit of
another by way of virtue. The ownership of the loaned objects is transferred to the borrower
who can use, buy, sell, or donate them as the borrower wishes. Qard is only applied when
one gets obliged to return the equivalent of the thing taken and repayment is for the same
amount as the amount lent. Goods of the same kind will be paid back on demand or at the
settled time. Qard should not bring any return or addition to the lender because that would
be equivalent to taking Riba. However, a borrower can pay more than the amount borrowed,
but it must not be stipulated in the contract. Further, the date of payment of the loan may or
may not be included in the Qard contract as the lender can demand repayment at any time.
And the loan should not be conditional upon any other contract, such as Bai´ and vice -versa.

Ariyya is another structure of borrowing goods in a virtuous act. However, in the case of
Ariyya, the exact borrowed commodity has to be returned to its owner, not any replacement.
While in Qard, the same kind of the loaned commodity with essentially the same nature or
character could be paid back.

On the other hand, a Dayn is the result of any contract or credit transaction. The created
debts ought to be returned without any profit over their principal amounts. Salaf is a form of
Dayn that is similar to Salam. It is used for a loan of fixed tenure and in that sense it is
closer to Dayn; Salaf includes loans for short, intermediate and long term loans and the
price of the commodity is paid in advance, while it is delivered at a future date. The amount
given as Salaf cannot be called back before its due date. Therefore, this creates a liability
for the seller to supply the commodity in the future.

In addition, in all credit transactions, Islam recommends witnesses and documentation. This
provides safeguards against disputes and allows credit transactions for a fixed or known
time period. And since Islamic banks can neither pay interest nor charge any return on
loans, they have the right to ask for collateral to ensure recovery of the loan amount. In fact,
the client cannot refuse to repay the loan or debt in case he has incurred loss in the business
conducted with the bank’s loan. Also, The Shari´ah puts a great deal of emphasis on
repayment of loans/debts and the borrower also has a moral obligation to repay a loan. For
that reason, banks can include, with mutual consent of the clients, a penalty clause i n the
credit contract to mitigate the risk of default, but the penalty charged on any default has to
go to charity

.
Chapter 4

AAOIFI Shariah standards; Accounting and Auditing Organisation for Islamic Financial
Institutions (AAOIFI) is an independent industry body dedicated to the development of
international standards applicable for Islamic financial institutions. The Bahrain-based
organisation started producing standards as early as 1993.
AAOIFI standards have been developed in consultation with leading Sharia scholars, with
several counties adopting them. Although AAOIFI standards are not binding on members, over
the last few years the organisation has made significant progress in encouraging the widespread
adoption of the standards.
Countries where AAOIFI standards are either mandatory or recommended include: Bahrain,
Malaysia, UAE, Saudi Arabia, Lebanon, Syria, Sudan and Jordan. Prior to implementation of
AAOIFI standards many financial institutions in these countries were operating under a “semi-
regulated market” (Al Baluchi, 2006), where accounting policies were determined with the
assistance of the bank’s Sharia Supervisory Board (SSB). In addition, over this period,
International Accounting Standards (IAS) or respective national accounting standards were
followed by Islamic banks. Hence, the unique requirements of Islamic financial institutions were
not being met. To give two examples:

a. Fiduciary risk: the Mudaraba contract places liability of the loss on the mudarib.
b. Displaced commercial risk: where Islamic banks “smooth” the returns Investment
Account Holders (IAH) by varying the percentage of profit taken as Mudarib share.

As a result, with the support of banking authorities, AAOIFI standards were created. In an
industry that is often quite fragmented, it is hoped that the development of AAOIFI standards
will go a long way in promoting convergence in Sharia standards and leading to further growth
in this nascent market.
AAOIFI Standards – The following standards have been developed by AAOIFI:
Accounting Standards:
1. Objective of financial accounting for Islamic banks and financial institution (IFIs).
2. Concept of financial accounting for IFIs.
3. General presentation and disclosure in the financial statements of IFIs.
4. Murabaha and Murabaha to the purchase orderer.
5. Mudaraba financing.
6. Musharaka financing.
7. Disclosure of bases for profit allocation between owners’ equity and investment account
holders.
8. Equity of investment account holders and their equivalent.
9. Salam and Parallel Salam.
10. Ijarah and Ijarah Muntahia Bittamleek.
11. Zakah.
12. Istisna’a and Parallel Istisna’a.
13. Provisions and Reserves.
14. General Presentation and Disclosure in the Financial Statements of Islamic Insurance
Companies.
15. Disclosure of Bases for Determining and Allocating Surplus or Deficit in Islamic Insurance
Companies.
16. Investment Funds.
17. Provisions and Reserves in Islamic Insurance Companies.
18. Foreign Currency Transactions and Foreign Operation.
19. Investments.
20. Islamic Financial Services Offered by Conventional Financial Institutions.
21. Contributions in Islamic Insurance Companies.
22. Deferred Payment Sale .
23. Disclosure on Transfer of Assets.
24. Segment Reporting.
25. Consolidation.
26. Investment in Associates.

Auditing Standards:
1. Objective and principles of auditing.
2. The Auditor’s Report.
3. Terms of Audit Engagement.
4. Testing for Compliance with Shariaa Rules and Principles by an External Auditor.
5. The Auditor’s Responsibility to Consider Fraud and Error in an Audit of Financial Statements.

Governance Standards:
1. Sharia Supervisory Board: Appointment, Composition and Report.
2. Sharia Review.
3. Internal Sharia Review.
4. Audit and Governance Committee for IFIs.
5. Independence of Sharia Supervisory Board.
6. Statement on Governance Principles for IFIs.
7. Corporate Social Responsibility.
Ethics Standards:
1. Code of ethics for accountants and auditors of IFIs.
2. Code of ethics for employees of IFIs.
Sharia Standards:
1. Trading in currencies.
2. Debit Card, Charge Card and Credit Card
3. Default in Payment by a Debtor.
4. Settlement of Debt by Set-Off.
5. Guarantees.
6. Conversion of a Conventional Bank to an Islamic Bank.
7. Hawala.
8. Murabaha to the Purchase Orderer.
9. Ijarah and Ijarah Muntahia Bittamleek.
10. Salam and Parallel Salam.
11. Istisna’a and Parallel Istisna’a.
12. Sharika (Musharaka) and Modern Corporations.
13. Mudaraba.
14. Documentary Credit.
15. Jua’la.
16. Commercial Papers.
17. Investment Sukuk.
18. Possession (Qabd).
19. Loan (Qard).
20. Commodities in Organised Markets.
21. Financial Papers (Shares and Bonds).
22. Concession Contracts.
23. Agency.
24. Syndicated Financing.
25. Combination of Contracts.
26. Islamic Insurance.
27. Indices.
28. Banking Services.
29. Ethics and stipulations for Fatwa.
30. Monetization (Tawarruq)
31. Gharar Stipulations in Financial Transactions
32. Arbitration
33. Waqf
34. Ijarah on Labour (Individuals)
35. Zakah
36. Impact of Contingent Incidents on Commitments.
37. Credit Agreement
38. Online Financial Dealings
39. Mortgage and its Contemporary Applications.
40. Distribution of Profit in Mudarabah-based Investments Accounts.
41. Islamic Reinsurance
42. Financial Rights and Its Disposal Management
43. Liquidity and Its Instruments
44. Bankruptcy
45. Capital and Investment Protection
To purchase Accounting, Auditing & Governance Standards (for Islamic Financial Institutions),
English version, please visit: http://www.aaoifi.com
AAOIFI Standard on Gold
Dr. Mohd Daud Bakar:
AAOIFI has been issuing more than 50 Shariah Standards already. This Shariah standard on gold
wouldn’t be the first and the last. As such, what is so special about this standard? Allow me to
share some of the insights that I am able to discover while working on this Shariah standard from
day one.
First things first. It is essentially meant to be a stand-alone standard in the sense that you can find
as many relevant principles of Shariah on gold as possible in one standard. It seems that the
initial drafters and the AAOIFI sub-committee of the standard have the motivation to compile
almost all relevant rulings dealing with gold under this standard. It will be easier for the readers
then to know the overall Shariah prescriptions without referring to many other Shariah Standards
of AAOIFI found elsewhere. In other Shariah Standards, many of the Shariah issues, if already
covered by other Shariah Standards, will be straight-away referred to that Shariah Standard so
that the reader may need to flip through relevant Shariah Standards to get what they need to
know

Musharakah – Musharakah is a joint enterprise or partnership structure in Islamic finance in

which partners share in the profits and losses of an enterprise. Since Islamic law (or Sharia) does
not permit profiting from interest in lending, musharakah allows for the financier of a project or
company to achieve a return in the form of a portion of the actual profits earned according to a
predetermined ratio. However, unlike a traditional creditor, the financier also will share in any
losses should they occur, also on a pro rata basis. Musharakah is a type of shirkah al-amwal (or
partnership), which in Arabic means "sharing."
KEY TAKEAWAYS

 Musharakah is a joint partnership arrangement in Islamic finance in which profits and

losses are shared.
 Profits from interest are not permitted in Islamic practice, necessitating the need for a
musharakah.
 A permanent musharakah is often used for long-term financing needs since it has no
specific end date and continues until the partners decide to dissolve it.
Understanding Musharakah
Musharakah plays a vital role in financing business operations based on Islamic principles. For
example, suppose that individual A wants to start a business but has limited funds. Individual B
has excess funds and wishes to be the financier in musharakah with A. The two people would
come to an agreement to the terms and begin a business in which both share a portion of the
profits and losses. This negates the need for A to receive a loan from B.

Musharakah is frequently used in the purchase of property and real estate, in providing credit, for
investment projects, and to finance large purchases. In real estate deals, the partners request from
a bank an assessment of the property's value via imputed rent (the sum a partner might pay to
live in the property in question). Profits are divided between partners in predetermined ratios
based on the value that was assigned and the sum of their different stakes. Every party that puts
up capital is entitled to a say in the property's management. When musharakah is employed to
finance large purchases, banks tend to lend by using floating-rate interest loans pegged to a
company's rate of return. That peg serves as a lending partner's profit. Within musharakah, there
are differing partnership arrangements. In a shirkah al-‘inan partnership, the partners are simply
the agent and do not serve as guarantors of other partners. shirkah al-mufawadah is an equal,
unlimited, and unrestricted partnership in which all partners put in the same sum, share the same
profit, and have the same rights.
A permanent musharakah has no specific end date and continues until the partners decide to
dissolve it. As such, it often used for long-term financing needs. A diminishing musharakah can
have a few different structures. The first is a consecutive partnership, in which the share of each
partner stays the same until the joint venture comes to an end. It often is used in project finance
and especially home-buying.
In a diminishing partnership (also known as a declining balance partnership or declining
musharakah), one partner's share is drawn down while it is transferred to another partner until the
entire sum is passed over. Such a structure is common in home-buying where the lender
(generally a bank) buys a property and receives payment from a buyer (via monthly rent
payments) until the whole balance is paid off.

In the case of a default, both the buyer and lender get a share of the proceeds from the sale of the
property on a pro rata basis. This differs from more traditional lending structures which have the
lender alone benefiting from any property sale following a foreclosure.

A commercial paper (CP) is a tradable certificate representing pecuniary rights whereby the
issuer is under obligation to pay at sight or after a short notice. Basically, it is an instrument
of payment (means of exchange) and serves as a substitute for cash in commercial
transactions. These papers, being debts receivable, cannot be sold or purchased below or
above par. Any commercial paper entitles the holder to receive a specified amount of money
from the issuer, but it cannot be negotiated from a shari'a perspective. The only way it can
be traded is to transfer it at face value (i.e., without discounting). At a corporate level,
commercial papers are issued by corporations to finance their working capital requirements
on a short-term, rollover basis. Shari’a permits using commercial papers in transactions on
the condition that they don’t end up with any contravention of shari’a principles and
precepts.
The above point of view is mainly held by Islamic finance practitioners and fuqaha in the
Arabian region. In East Asian countries, some institutions are already in the business of
trading commercial papers. A product dubbed “Islamic commercial paper” (ICP) is issued
(for maturities ranging from 1 month to 12 months) and traded in the interbank market and
may either be sold or purchased at a discount, at par or premium to the face value. Prices
depend mainly on the credit-worthiness of the issuer. ICPs have their own credit rating
assigned by rating agencies.
Notwithstanding, shari’a doesn’t permit trading in debts on the basis that it amounts to ba’i
al-dayn and as such it is feared it would fling the door open to the explicit payment or
receipt of riba. In essence, discounting commercial papers is, per se, not permissible because
it involves the sale of debt to a third party for a price lower than its face value. Likewise, a
commercial paper can’t be sold on a murabaha basis.

possession (qabd), -

An Arabic term that means taking possession of an object of sale or exchange, an amount of
money, a financial instrument, etc. In the context of a contract of sarf (currency exchange), qabd
refers to taking possession, by the two parties, of the amounts of the two underlying currencies.
In general, qabd depends on shari'a rules as to a particular type of transaction, urf, or the
common business practices prevalent in a specific market. In some markets, the possession of a
good is recognized as having taken place either through actual or constructive delivery of that
good. Basically, qabd can be classified as qabd haqiqi and qabd hukmi.
qard (loan)- Qard means giving a property to a party who will benefit from it and who will
subsequently return an equivalent replacement.43 In the early stages of Islamic finance in
Malaysia, several products based on qard were introduced, for example, Government
Investment Certificates (currently known as Government Investment Issue) and benevolent
loans. Nowadays, its application has been expanded to other products such as rahn loans,
credit cards, charge cards and others. It has also become the underlying concept for liquidity
management instruments for Islamic financial institutions. 32. Qard Principles in Islamic
Finance The application of qard hasan concept in a correct manner which fulfills the Shariah
requirements would definitely benefit the contracting parties. However, if it is inappropriately
applied, it would potentially tarnish the image of the Islamic financial system. Among the
issues that may arise in Islamic finance relating to the application of qard hasan are: i.
Whether qard hasan in its true sense implies a gift that does not require repayment or
otherwise. This refers to the situation where the Islamic financial institution decides to bring a
case of a defaulted customer in a financing based on qard hasan to court; and ii. Since
Islamic financial institutions provide financing by utilising the deposits of customers who
expect returns, financing based on qard hasan does not effectively serve such purpose because
qard hasan is not meant to generate profits, rather it is benevolent or tabarru` by nature. In
this regard, the SAC was referred to on the issue as to whether a financing product based on
qard principles is allowed since the application of this concept in a financing product may
contradict the original meaning of qard according to Shariah. The SAC was also referred to
on the issue as to whether the word “hasan” may be taken out from the term “qard hasan”
that has generally been acceptable in the Islamic financial system. The SAC, in its 51st
meeting dated 28 July 2005, has resolved that financing products based on qard principle are
permissible. However, the word “hasan” shall be taken out from the term “qard hasan” to
imply that it is an obligation for the borrower to repay his qard to the lender or financier and
such obligation shall be borne by the heirs of the borrower in the case of his death before the
total settlement of his loan obligation. Basis of the Ruling The scholars define qard as
affectionately giving a property to a party who will benefit from it and who will subsequently
replace it.44 The scholars have unanimously agreed that qard is permissible based on al-
Quran, Sunnah and ijma`. 45 The following Quranic verse is regarded as a basis for
permissibility of qard “Who is that will grant Allah a goodly (sincere) loan so that He will
repay him many times over? And (remember) it is Allah who decreases and increases
(sustenance), and to Him you shall all return.” 46 According to scholars of tafsir, the term
qard hasan in the context of the above verse refers to acts of contributing for the sake of Allah
SWT (infaq). The term qard literally means loan and not infaq. Nevertheless, the scholars of
tafsir stated that the term qard used in this verse is intended to dignify the status of mankind
since Allah SWT had chosen to communicate using common and understandable vocabulary
with mankind.47 The permissibility of qard in the context of loans is based on the literal
meaning of the above verse since Allah SWT will not probably mention and equate
commendable matter like infaq with forbidden matters. This indicates that qard is permissible.
In relation to the recommendation that Islamic financial institutions shall not use the word
“hasan” in the term qard hasan, the SAC justified its decision based on the following
arguments: i. The fiqh scholars had never elaborated the term qard hasan specifically but only
discussed the concept of qard and its permissibility in Shariah. Generally, qard hasan relates
to matters pertaining to contribution for the sake of Allah SWT (infaq); and ii. The word
“hasan” as used in al-Quran refers to an infaq that is given sincerely for rewards from Allah
SWT.48 Based on this fact, it is concluded that the use of the term qard hasan to refer to a
loan especially in the mu`amalah context in Islamic finance is inaccurate. This is because
qard as defined by fiqh scholars is a loan (qard) that must be settled. Thus, the term qard is
seen more appropriate for an interest free loan as practised in the current Islamic finance
industry. 33. Liquidity Management Instrument Based on Qard Liquidity management
instrument is an instrument used to ensure that the liquidity of financial institutions is at an
optimum level. It is specifically used to absorb the liquidity surplus in the market. Islamic
financial institutions with liquidity surplus will be able to channel the surplus to Bank Negara
Malaysia via this instrument. Previously, most of the Islamic liquidity management
instruments were based on mudarabah and wadi`ah. Thus, there was a proposal to introduce
liquidity management instruments based on qard as an additional instrument for managing
liquidity in the Islamic financial system. The proposed mechanism of liquidity management
instruments based on qard is as follows: 1. Paying or charging an interest
Islam considers lending with interest paymentsInterest ExpenseInterest expense arises out of a
company that finances through debt or capital leases. Interest is found in the income statement,
but can also be calculated through the debt schedule. The schedule should outline all the major
pieces of debt a company has on its balance sheet, and calculate interest by multiplying the as an
exploitative practice that favors the lender at the expense of the borrower. According to Sharia
law, interest is usury (riba), which is strictly prohibited.

2. Investing in businesses involved in prohibited activities

Some activities, such as producing and selling alcohol or pork, are prohibited in Islam. The
activities are considered haram or forbidden. Therefore, investing in such activities is likewise
forbidden.

3. Speculation (maisir)
Sharia strictly prohibits any form of speculation or gambling, which is called maisir. Thus,
Islamic financial institutions cannot be involved in contracts where the ownership of good
depends on an uncertain event in the future.

4. Uncertainty and risk (gharar)

The rules of Islamic finance ban participation in contracts with the excessive risk and/or
uncertainty. The term gharar measures the legitimacy of risk or uncertain in nature
investments. Gharar is observed with derivative contractsFutures and ForwardsFuture and
forward contracts (more commonly referred to as futures and forwards) are contracts that are
used by businesses and investors to hedge against risks or speculate. Futures and forwards are
examples of derivative assets that derive their values from underlying assets. and short-selling,
which are forbidden in Islamic finance.

In addition to the above prohibitions, Islamic finance is based on two other crucial principles:

 Material finality of the transaction: Each transaction must be related to a real

underlying economic transaction.
 Profit/loss sharing: Parties entering into the contracts in Islamic finance share profit/loss
and risks associated with the transaction. No one can benefit from the transaction more
than the other party.

The financial sector performs various functions that facilitates the efficient functioning of the
economy and promotes economic growth. For the financial sector to contribute to growth and
mitigate risks, however, the industry itself has to be resilient and be able to reduce its own
vulnerabilities. Recognizing this, various international organizations such as the International
Monetary Fund, World Bank, Basel Committee for Banking Supervision, etc. are working on
developing various institutional standards, tools and policies necessary for the creation of a
sound framework for the development of the financial sector. Other than prudent financial
system supervision and regulation, the WB and IMF (2005) identify legal infrastructure,
systemic liquidity infrastructure, governance and information infrastructure, payments and
securities settlement systems, creditors’ rights, the provision of incentives for strong risk
management, credit reporting systems, etc. as being among the key architectural institutions
needed to promote the development and stability of the financial sector. The Islamic financial
sector has expanded globally in its short history with total global assets valued at USD 1.88
trillion in 2015 (IFSB 2016). Growing at a compound annual growth rate of 17% between 2009
and 2013 (IFSB 2015), the industry is expected to become systematically important in many
jurisdictions. The global role of Islamic finance has grown in many global financial centers such
as the UK, Luxembourg, Singapore, Hong Kong, Japan, etc. Given the above, a sound financial
architecture will be crucial for its future development as a robust and resilient industry. While
most of the elements of financial architecture that promote development in conventional finance
also apply to Islamic finance, there are certain specific issues that arise in the latter due to unique
features arising from Shariah compliance. However, being a relatively new industry in most
countries, the infrastructure institutions supporting the industry remain weak and are continuing
to evolve. Given the vital roles that architectural institutions play in promoting the growth and
stability of the financial sector, this study aims to identify the unique features of the financial
architecture governing Islamic finance, assess their statuses in selected OIC member countries
(MCs), and provide policy recommendations for improvement at both the domestic and
international levels. The study examines the status of seven categories of the Islamic financial
architecture (legal infrastructure; regulation and supervision framework; Shariah governance
framework; liquidity infrastructure; information infrastructure and transparency; consumer
protection architecture; and human capital and knowledge development framework) for 12 OIC
MCs. It also explores the status of Islamic finance in five countries with global financial centers
(the UK, Germany, Luxemburg Singapore, Hong Kong). After presenting the overall sizes of the
financial sectors, the approaches taken towards Islamic finance in these countries are discussed.
The study first examines the legal environment and the features of the financial sector of OIC
MCs. Most OIC MCs have adopted some variant of common law and civil law systems, with 16
countries having the former and 40 adopting the latter. The study shows that while the overall
average size of the banking sector in OIC MCs is similar to the world average on the liabilities
side, it is smaller for banking assets and the insurance sector. While the debt securities market is
underdeveloped in OIC MCs compared to the world average, stock market capitalization is
relatively higher. Information on the features of the financial sector shows that the average depth
and access of the financial institutions and financial markets in OIC MCs is lower than the world
average. However the average efficiency of both financial institutions and financial discussed in
Chapter 1, WB and IMF (2005:5) identify pillars of financial system architecture that can
promote the stability and development of the financial sector as being macro-prudential
surveillance and financial stability analysis, sound financial system supervision and regulation,
and financial system infrastructure. The latter includes legal infrastructure for finance, systemic
liquidity infrastructure and transparency, governance and information infrastructure, payments
and securities settlement systems, creditors’ rights, the provision of incentives for strong risk
management and good governance, credit reporting systems, etc. All the elements of the
financial architecture apply to the stability and development of the Islamic financial sector.
Some of the elements of financial architecture are neutral and apply to both Islamic and
conventional finance. These include sound and sustainable macroeconomic policies, effective
market discipline, well-regulated payment and clearing systems, etc. However, there are certain
unique features in the Islamic financial sector that may not be covered by conventional
architectural institutions and require specific attention. The elements of the Islamic financial
architecture that need special attention can be divided into seven categories: legal, regulations
and supervision, Shariah supervision, liquidity, information and transparency, consumer
protection and human capital. Specific infrastructure issues that arise due to unique features
arising from Shariah compliance in each of these categories are discussed below.

Traditional Islamic financing; Laws provide the framework for establishing appropriate
institutions and markets in three key financial sectors: banking, insurance and capital markets.
The key laws necessary for each of these financial sectors are not only those that enable the
formation and operation of financial institutions and markets but also those that enable the
formation of a central bank to carry out monetary policy and establish and give authority to
certain public bodies to regulate and supervise financial institutions and markets (WB and IMF
2005: 223). In many countries, the central bank plays the regulatory and supervisory roles and
the central banking law authorizes it to perform these functions. The financial institutions' laws
provide the legal basis to establish specific financial institutions, define their scope of operations
and governance, and include issues related to the protection of different stakeholders. For
example, the banking law specifies the requirements to establish a bank and defines the banking
activities that these institutions can undertake. The law covers various operational issues such as
governance Shariah Governance Framework: The regulators play a key role in setting up the
Shariah governance regime by providing a framework for Shariah boards for financial
institutions. A national Shariah board would be responsible for issuing Shariah
standards/parameters and promoting the harmonization of practices by ensuring the Shariah
compliance of the contracts used in the industry. Both AAOIFI and IFSB have published Shariah
governance standards for Islamic financial institutions. However, there are no guidelines for
national Shariah boards. Given that national Shariah boards can contribute to the harmonization
of practice and the reduction of costs of Shariah governance in organizations and Shariah
compliance risks within jurisdictions, there is a need to come up with a framework for it.
Furthermore, the work on developing Shariah standards, parameters and templates for Islamic
financial products by the AAOIFI, IsFA and IIFM need to continue to enhance cross-border and
international transactions by reducing legal and Shariah compliance risks. Liquidity
Infrastructure: A robust liquidity infrastructure consists of appropriate instruments, efficient and
liquid financial markets, and access to LOLR funds from central banks. There is not only a
scarcity of Shariah compliant liquid instruments, but most jurisdictions also lack deep and
efficient Islamic financial markets. While the central bank and regulatory authorities can help
develop the infrastructure for financial markets, the liquidity instruments can be supplied by both
public and private entities. Globally, the secondary markets for sukuk in most countries are
shallow, making them illiquid. IFSB and IIFM can develop guidelines and templates to
strengthen money markets, secondary markets for Islamic securities, and LOLR facilities for
Islamic banks. Information Infrastructure and Transparency: To properly reflect the transactions
and operations of Islamic financial institutions, countries can opt for using either AAOIFI
accounting standards or domestic accounting standards adapted by Islamic finance. Other than
the credit ratings provided by conventional rating agencies for debt based transactions, other
types of assessments such as Shariah compliance ratings and providing assessments for equity
modes of financing are also needed for Islamic finance. Globally, there is significant progress
being made towards developing accounting and auditing standards by AAOIFI. Furthermore,
AAOIFI and IFSB have also published disclosure guidelines for the banking and takaful sectors.
There is a need to develop detailed disclosure guidelines for Islamic capital markets and Shariah
compliance of products and securities. Ratings agencies that can assess Shariah compliance and
risks in equity based instruments can further strengthen the information infrastructure for the
industry. Consumer Protection Architecture: The study finds the architectural element of
consumer protection to be the weakest for the Islamic financial sector in the countries that were
examined. While instituting appropriate laws and regulations to protect consumers and deposit
insurance have to be implemented by the government and regulators, improving financial
literacy will require effort at different levels. Initiatives at the global level to develop consumer
protection guidelines that cater to the specific features of the Islamic financial sector and also
come up with a framework for financial literacy programs will help their implementation at the
national level. While the former can be done by IFSB, the latter can be initiated by CIBAFI. To
protect Islamic banking depositors during crises would also require structure and requirements,
information disclosure obligations, the protection of depositors and other stakeholders, dealing
with distressed banks, etc.
The capital market law covers various aspects to ensure the smooth functioning of the securities
markets. The law encompasses issues such as the conditions to issue securities to the public, their
registration and trading, and regulations related to organizations dealing with the securities
market such as brokers, dealers etc. Securities law reduces problems associated with raising
funds from markets by clearly specifying a contracting framework for issuing securities. These
laws also prevent self-dealing by instituting rules, incentives and penalties to prevent such
activities. An important aspect of protecting investors is the requirement by securities law to
disclose all relevant quantitative and non-quantitative information of listed companies.
Financial and real transactions may be identified differently under business law. The unique
nature of Islamic financial products and organizations that are not covered by conventional
financial laws necessitate the coming up with of laws that can support the activities of the
former. As products of Islamic banks involve dealings with real goods and services, the law has
to provide for these institutions to carry out trading and investment activities. It will be difficult
for Islamic banks to operate under conventional banking laws as these do not recognize the
special features of Islamic banking practices. As a result, specific laws may be required to enable
Islamic banks to use financial products that are based on sale, leasing and investments using risk-
sharing modes. Similarly, insurance law defines the activities of the insurance business that are
qualitatively different from takaful. One key feature of takaful is that the capital of the takaful
operator is separated from the participants risk fund and the participants have certain rights that
are not recognized by conventional insurance laws. While Shariah compliant stocks will fulfill
certain sector wise and financial ratios criteria, the nature of sukuk is very different compared to
bonds. Thus, securities laws should cater to the unique nature of Islamic securities and sukuk to
not only protect the investors and stakeholders but also for the sustainable growth of the Islamic
capital markets.
3.1.2. Tax regimes and impact on Islamic finance
Most economic and financial transactions have tax implications that affect costs and/or profits.
Tax laws relevant to banking are related to income (profit, withholding), transactions (capital
gains and stamp duties) and goods and services (value-added tax). For example, while interest
paid on debt can be deducted as costs, dividends paid are considered taxable income in most
jurisdictions. Similarly, withholding taxes on interest and other income such as dividends can be
different so that Islamic financial instruments are taxed differently compared to their
conventional counterpart.
As Islamic financial products are based on sale, leasing and partnership contracts, the tax
implications can make these products more costly compared to their conventional counterparts.
For example, home financing and ijarah sukuk may involve double stamp duties with the latter
also having capital gains tax due to sale and buy-back features. Thus, there is a need to change
the tax laws to level the playing field for Islamic finance with conventional finance. One way to
do this is to consider the economic substance of Islamic financial products as financing tools and
applying the rules of interest to profit generated in financial transactions. An example of this is in
the UK where tax laws treat profit in a mudarabah. Sustainable development of any financial
industry must have a suitable legal framework which includes an effective dispute resolution
mechanism (Grais, Iqbal, and El-Hawary, 2004). Courts and other dispute settlement institutions
ensure ex post implementation of contracts and enforcement of property rights in case of any
breach of contracts or exercise of rights (Pistor and Xu 2003). As the contracts used in Islamic
banking products are derived from the Shariah and the Islamic financial contracts' legitimacy
should be judged by the principles of Islamic law, the ideal situation would be to use Shariah as
the governing law to settle disputes. Thus, the dispute resolution issue becomes complicated due
to the duality of laws in play in Islamic finance transactions. While the contracts use Islamic law,
the courts in most jurisdictions use some variant of Western commercial law to adjudicate. This
would mean using non-Islamic legal system to resolve disputes involving Islamic financial
contracts. The outcome of these disputes will partly depend on the legal system and whether
supporting Islamic banking law exists or not.
One way to resolve the problem of adjudicating disputes in courts using non-Islamic civil laws is
to include choice-of-law and dispute settlement clauses (Vogel and Hayes, 1998). If Islamic law
is chosen as the law of choice to settle disputes, the contracts can opt for commercial arbitration
and be shielded from the national legal environment. While some Islamic arbitration centers
exist, parties are reluctant to take disputes to these institutions due to the lack of precedence that
creates legal risks. There is uncertainty regarding outcomes due to the differences of opinion
among different scholars and schools and the absence of a standardized codified Islamic law. As
such, partners in transactions avoid using Islamic law as they want to avoid the "impracticalities
or the uncertainty of applying classical Islamic law" (Vogel and Hayes, 1998: 51).

Diversification of financing methods

Bankruptcy law addresses defaults and restructuring by enforcing property rights of different
stakeholders in an appropriate way when firms become bankrupt (Moskow 2002). Bankruptcy
law along with insolvency systems entail the rules and regulations that govern access, protection,
risk management, and recovery of dues by providers of debt. Insolvency systems include
elements such as requiring creditor consent to file for reorganization, imposing an automatic stay
on the assets of the firm on filing reorganizing, requiring secured creditors to be ranked first
among distribution of proceeds resulting from the disposition of assets of the firm, and requiring
the appointment of an official by the court or by the creditors to operate the firm during
reorganization (La Porta et al. 1998). An important factor determining the rights of investors in
bankruptcies is to have a sound insolvency system that has an efficient enforcement process of
the claims arising from bankruptcy proceedings (World Bank 2005: 230). Inefficient bankruptcy
regimes create uncertainty about creditor rights and can adversely affect the growth of the
financial sector.
Certain specific issues arise in bankruptcies related to financial sector. A key factor is the quality
of the collateral and the rights of the creditor on it after a bankruptcy. This is relevant in financial
securities where their structure will determine the nature of risks the investors. appropriate
models for deposit insurance. IFSB can collaborate with IADI to initiate this project. Human
Capital and Knowledge Development Framework: Human capital and knowledge development
appear to be the strongest element of the Islamic financial architecture. However, as the industry
is expected to grow, there will be increasing demand for personnel with the appropriate
knowledge and skills, particularly in countries where the industry is relatively new. In this
regard, the public and private sector entities, along with academic institutions and universities,
can contribute to providing training and building a knowledge base for the future growth of the
industry. Various multilateral organizations such as IRTI, IDB and World Bank GIFDC are
involved in research that can promote the development of the Islamic financial sector. There is
also need to invest in research and provide training in different areas related to Islamic
architectural institutions. One key gap that needs to be filled is creating knowledge related to
infrastructure institutions and providing training to staff in public bodies that work in the
industry. While IFSB organizes workshops to familiarize its published standards and guidelines,
multilateral organizations such as IDB and WB can take initiatives to enhance such knowledge
and skills to develop other elements of infrastructure institutions though their technical assistance
programs. The development of standards and guidelines by international multilateral institutions
is one of the key instruments for developing sound architectural institutions. Specifically,
countries with underdeveloped infrastructures can benefit by using the framework provided by
international benchmarks to develop institutions that can support the Islamic financial industry.
The study suggests strengthening the existing international infrastructure institutions and
establishing some new ones. Developing legal documents and templates can help the
development of the legal infrastructure for Islamic finance in OIC MCs. This initiative is similar
to the Law and Policy Reform Program of the Asian Development Bank and can be best
performed by IDB. While IFSB has developed many regulatory standards for the Islamic
financial industry, the published standards and guidelines for different sectors have not been
even. As the Islamic financial industry is expected to grow in the future, there may be a need to
strengthen the institutional capacity of IFSB. One way to do this is have separate divisions within
IFSB dealing with issues related to Islamic banking, takaful and Islamic capital market segments.
Both AAOIFI and IFSB have published Shariah governance standards for Islamic financial
institutions. However, as there are no guidelines for national Shariah boards, there is a need to
come up with a framework for it. Furthermore, the work on developing Shariah standards,
parameters and templates for Islamic financial products by AAOIFI, IsFA and IIFM need to
continue to enhance cross-border and international transactions by reducing legal and Shariah
compliance risks. There is a need to develop detailed disclosure guidelines for all segments of
Islamic finance and improve Shariah compliance of products and securities. Ratings agencies
that can assess Shariah compliance and risks in equity based instruments would further
strengthen the information infrastructure for the industry. IFSB and IIFM can develop guidelines
and templates to strengthen money markets, secondary markets for Islamic securities, and LOLR
facilities for Islamic banks. Furthermore, there is a need to establish an Islamic Monetary Fund
(IsMF) that can either provide Shariah compliant liquidity at the global level or coordinate
arranging liquidity from other central banks by using swap arrangements As the Islamic financial
industry is expected to grow in the future and become systematically important in some
countries, the study suggests establishing a Stability Board for Islamic Finance (SBIF) to
enhance the global stability and development of a sound Islamic financial sector. Among others,
SBIF can come up with a framework for establishing an Islamic Financial Sector Assessment
Program (IFSAP) and also the relevant Standards and Codes applicable to the Islamic financial
sector, coordinate the implementation of existing standards from IFSB and AAOIFI, and
contribute to filling the gaps in other architectural elements such as the legal and Shariah
governance frameworks for the Islamic financial sector globally. As the body would engage key
policy holders from different countries, the suggested organization, SBIF, can be initiated by
either OIC under the realm of COMCEC or by D-8 countries The financial sector performs
various functions that facilitate the efficient functioning of the economy and promote economic
growth. Levine (1997: 689) identifies the functions of a financial system as “the trading of risk,
allocating capital, monitoring managers, mobilizing savings, and easing the trading of goods”. 1
For the financial sector to contribute to growth and mitigate risks, however, the industry itself
has to be resilient and be able to reduce its own vulnerabilities. The global financial crisis (GFC)
highlights the vulnerability of the financial sector and its detrimental impact on output and
welfare with the monetary cost of the crisis estimated to be as high as USD 15 trillion (Yoon
2012).2 Given the complexity and dynamism of modern financial products and markets,
appropriate institutions are needed to reduce the risks and vulnerabilities that can potentially lead
to harmful and costly economic downturns. This would require certain architectural institutions
and policies that foster a stable and efficient financial sector that effectively promote economic
development. Financial transactions are legal constructs with contracts that usually have the
realization of their outcomes in the future. The theoretical basis of the need for a sound
institutional environment facilitating economic and financial development lies in New
Institutional Economics which asserts that institutions such as laws, the executive, legislature,
judiciary, etc. provide the formal rules that enforce property rights and promote economic
activities (Williamson 2000). An institutional framework introduces first order economizing in
the economy by providing supporting rules of the game that enables the production and exchange
of goods and services in an orderly manner. For example, organization, financial institution, tax,
and contract laws are relevant to the construction of financial transactions. Specifically,
organizational law determines the types of organizations that can be formed and banking law
specifies the legal requirements to establish and operate banks. Tax laws relevant to the financial
sector are related to income (profit), transactions (capital gains and stamp duties) and goods and
services (value-added tax). Contract law provides the principles and basis of conducting
transactions. While ‘law and finance’ literature assert that legal institutions have an influence on
financial development, the ‘political institutions and finance’ strand maintains that ‘political
institutions’ that protect property rights are also important determinants of financial and
economic development.3 Recognizing this, various international organizations such as
International Monetary Fund, World Bank, Basel Committee for Banking Supervision, etc. are
developing various institutional standards, tools, and policies necessary for a sound framework
for the development of the financial sector. The role of the financial sector in promoting
development depends on both demand and supply side factors. On the supply side, the financial
sector has to be inclusive and provide various financial services to all segments of the population
including the poor. On the demand side, two broad types of markets can be identified: domestic
and international. An issue on the demand side in Muslim countries relates to voluntary
exclusion whereby a large segment of the population does not deal with the interest-based
financial sector due to religious convictions.4 Inclusive financial systems in many OIC member
countries (MCs), therefore, require providing Shariah compliant financial services so that all
segments of the population can benefit from the financial system and contribute to the
development process. Although Islamic finance predominantly serves the financial needs of
Muslims who do not want to engage with conventional finance for religious reasons, it can also
be an alternative source for ethical and social finance for much wider markets. With USD 1.88
trillion worth of assets in 2015, the Islamic financial sector has expanded globally in its short
history (IFSB 2016). While the conventional financial sector stalled after the global financial
crisis, the Islamic financial industry grew at a compound annual growth rate of 17% between
2009 and 2013 (IFSB 2015). It is expected that by 2020, a significant part of the banking and
finance in the Gulf and in some South-east Asian countries such as Malaysia and Indonesia will
be Islamic. The global role of Islamic finance is also expected to expand as many global
financial centers such as the UK, Luxembourg, Singapore, Hong Kong, Japan, etc. have taken
initiatives to introduce Islamic finance. With its growth, the Islamic financial sector is expected
to become systematically important in many jurisdictions. A sound financial architecture will be
crucial for its development as a robust and resilient industry. However, being a relatively new
industry in most countries, the infrastructural institutions supporting the industry remain weak
and are still evolving. This is reflected in a survey conducted by MEGA (2016: 50) which
reveals that 38% of the respondents identify regulatory costs and 18% point out Shariah
compliance costs as factors that limit the growth of Islamic banks. Meanwhile, 29% of the
respondents identify regulatory issues and 17% identify the lack of liquid markets as being
among the biggest external threats. Furthermore, the internal threats identified were a shortage of
qualified personnel, identified by 28% of the respondents, and Shariah compliance issues,
identified by 21% of the respondents (MEGA 2016: 51). While most of the elements of financial
architecture that bring about stability and promote development in conventional finance also
apply to the Islamic financial sector, there are certain specific issues that arise in the latter due to
some unique features arising from Shariah compliance. Compliance with Shariah introduces
some unique risks in Islamic financial institutions and also restricts the use of certain risk-
mitigating tools that are available to their conventional counterparts. Furthermore, Islamic
finance operates in countries that have legal and regulatory systems that are not Islamic. Given
the above, specific architectural institutions are needed for the future development of Islamic
finance. This study attempts to identify these institutions, examines their statuses in selected
countries, and suggests ways in which these can be developed. The remainder of the chapter is
organized as follows. The next section presents a brief overview of the evolution of the notion of
financial architecture in conventional finance followed by a section that outlines the aim and
scope of the study. The concluding section provides the outline of the key architectural
institutions that will be examined in this study. increased is by the use of standardized contracts
and documents among the financial sector stakeholders. In this regard, the regulatory authorities
can facilitate coming up with standardized documents and contracts that can be used by both the
financial institutions and financial markets.
Chapter 5
Musharakah – Musharakah is a joint enterprise or partnership structure in Islamic finance in
which partners share in the profits and losses of an enterprise. Since Islamic law (or Sharia) does
not permit profiting from interest in lending, musharakah allows for the financier of a project or
company to achieve a return in the form of a portion of the actual profits earned according to a
predetermined ratio. However, unlike a traditional creditor, the financier also will share in any
losses should they occur, also on a pro rata basis. Musharakah is a type of shirkah al-amwal (or
partnership), which in Arabic means "sharing."
KEY TAKEAWAYS

 Musharakah is a joint partnership arrangement in Islamic finance in which profits and

losses are shared.
 Profits from interest are not permitted in Islamic practice, necessitating the need for a
musharakah.
 A permanent musharakah is often used for long-term financing needs since it has no
specific end date and continues until the partners decide to dissolve it.
Understanding Musharakah
Musharakah plays a vital role in financing business operations based on Islamic principles. For
example, suppose that individual A wants to start a business but has limited funds. Individual B
has excess funds and wishes to be the financier in musharakah with A. The two people would
come to an agreement to the terms and begin a business in which both share a portion of the
profits and losses. This negates the need for A to receive a loan from B.

Musharakah is frequently used in the purchase of property and real estate, in providing credit, for
investment projects, and to finance large purchases. In real estate deals, the partners request from
a bank an assessment of the property's value via imputed rent (the sum a partner might pay to
live in the property in question). Profits are divided between partners in predetermined ratios
based on the value that was assigned and the sum of their different stakes. Every party that puts
up capital is entitled to a say in the property's management. When musharakah is employed to
finance large purchases, banks tend to lend by using floating-rate interest loans pegged to a
company's rate of return. That peg serves as a lending partner's profit.

Musharakah are not binding contracts in that either party can terminate the agreement
unilaterally.
Types of Musharakah
Within musharakah, there are differing partnership arrangements. In a shirkah al-‘inan
partnership, the partners are simply the agent and do not serve as guarantors of other partners.
shirkah al-mufawadah is an equal, unlimited, and unrestricted partnership in which all partners
put in the same sum, share the same profit, and have the same rights.

A permanent musharakah has no specific end date and continues until the partners decide to
dissolve it. As such, it often used for long-term financing needs. A diminishing musharakah can
have a few different structures. The first is a consecutive partnership, in which the share of each
partner stays the same until the joint venture comes to an end. It often is used in project finance
and especially home-buying.

In a diminishing partnership (also known as a declining balance partnership or declining

musharakah), one partner's share is drawn down while it is transferred to another partner until the
entire sum is passed over. Such a structure is common in home-buying where the lender
(generally a bank) buys a property and receives payment from a buyer (via monthly rent
payments) until the whole balance is paid off.

In the case of a default, both the buyer and lender get a share of the proceeds from the sale of the
property on a pro rata basis. This differs from more traditional lending structures which have the
lender alone benefiting from any property sale following a foreclosure.

Mudarabah – he term refers to a form of business contract in which one party brings capital and
the other personal effort. The proportionate share in profit is determined by mutual agreement.
But the loss, if any, is borne only by the owner of the capital, in which case the entrepreneur gets
nothing for his labour. The financier is known as ‘rabal-maal’ and the entrepreneur
as ‘mudarib’. As a financing technique adopted by Islamic banks, it is a contract in which all the
capital is provided by the Islamic bank while the business is managed by the other party. The
profit is shared in pre-agreed ratios, and loss, if any, unless caused by negligence or violation of
terms of the contract by the ‘mudarib’ is borne by the Islamic bank. The bank passes on this loss
to the depositors.

2. Mudarabah:

We may act as managing trustee (‘Modareb’) while you are the beneficial owner (Rab El-Maal).
It is our responsibility to invest the funds that you provide. Alternatively, our roles may be
reversed, when you, as managing trustee, are responsible for investing our funds. In each case,
we shall agree on our relative share of any profits.

3. Mudarabah:

In the theoretical model of Islamic banking Mudaraba has been suggested a technique which
shall provide the basis for the Islamic re-organisation of commercial banking sector. In actual
practice of Islamic banking, Mudaraba has not made much progress on t he asset side of the
balance sheet, although on the liability side the Islamic banks on Mudaraba accept the funds in
investment accounts. Mudaraba is mostly translated in English as profit and loss sharing.

There is no loss sharing in a Mudaraba contract. Profit and loss sharing is more accurate
description of the Musharaka contract. The Mudaraba contract may better be represented by the
expression profit sharing Mudaraba is an Islamic contract in which one party supplies the money
and the other provides management in order to do a specific trade. The party supplying the
capital is called owner of the capital. The other party is referred to as worker or agent who
actually runs the business. In the Islamic Jurisprudence, different duties and responsibilities have
been assigned to each of these two.

As a matter of principle the owner of the capital does not have a right to interfere in to the
management of the business enterprise which is the sole responsibility of the Agent x. However,
he has every right to specify such conditions that would ensure better management of his money.
That is why sometime Mudaraba is referred as sleeping partnership. An important characteristic
of Mudaraba is the arrangement of profit sharing. The profits in a Mudaraba agreement may be
shared in any proportion agreed between the parties before hand. However, the loss is to be
completely borne by the owner of the capital. In case of loss, the capital owner shall bear the
monetary loss and agent shall lose the reward of his effort. Mudaraba could be individual or
joint.

Islamic banks practice Mudaraba in its both forms. In case of individual Mudaraba an Islamic
bank provides finance to a commercial venture run by a person or a company on the basis of
profit sharing. The joint Mudaraba may be between the investors and the bank on a continuing
basis. The investors keep their funds in a special fund and share the profits without even the
liquidation of those financing operations that have not reached the stage of final settlement.
Many Islamic Investment Funds operate on the basis of joint Mudaraba.

4. Mudarabah:

This is an agreement made between two parties: one which provides ‘100 percent of the capital’
for the project and another party known as a ‘Mudarib’ who using his entrepreneurial skills,
manages the project. Profits arising from the project are distributed according to a predetermined
ratio. Any losses accruing are borne by the provider of capital. The provider of capital has no
control over the management of the project.
Q - Is it lawful for the investor to seek from the contractor (agent-manager) payment of a specific
percentage of the contract (for the deal the agent-manager is to undertake as his/her part of the
mudarabah operation) in addition to (the agreed upon return from) the capital invested?
Regardless of the amount financed, and regardless of whether the operation is profitable or not?

A - Such a contract will not be valid because it includes the agent-manager's liability for the
capital investment; when the agent-manager is no more than a trustee of the capital and cannot be
made liable for it unless he/she has been negligent or incompetent in its use. Secondly, the
investor's stipulating that the agent-manager pay a certain amount; when such a condition
invalidates the contract because it means that the two partners will not share in the profits.

Q - Where an Islamic Bank owing to its position in the international banking community,
undertakes mudarabah operations in partnership with several other banks and financial
institutions, some of which are Islamic and some of which are not. And that the bank serves as
agent-manager for the group, using the funds they invest to purchase goods and then sells them
by means of murabahah, such that the bank authorizes an international firm, as its agent, to
purchase goods on behalf of the bank by means of a murabahah sales contract with that
company. Is this permitted under the Shariah?

A - The jurists of all the major legal schools are agreed on the legitimacy of mudarabah
transactions. In this regard they cite texts from the Qur'an and the Sunnah. In the Qur'an, the root
for the word mudarabah, d-r-b, is used in a verse that clearly indicates the lawfulness of trade:
And others who go forth in the earth, seeking the bounty of the Almighty (73:20). In the Sunnah,
it is related that Ibn 'Abbas said, "Our tribal leader, al 'Abbas ibn 'Abd al Muttalib, whenever he
paid money out in mudarabah, would stipulate to his partner that he must not cross over water
with his money, or make camp in a dry riverbed, or buy a fractious mount with it. If his partner
did any of those things, he would be held personally responsible. When news of these conditions
reached the Prophet of Allah, upon him be peace, he endorsed them."

Given the lawfulness of mudarabah from a Shari'ah perspective, the Board sees no impediment
to the bank's purchasing goods on the international market with funds gathered from other
Islamic banks and financial institutions in partnership, and then its assuming the responsibility of
managing the operation (as agent-manager) as a mudarabah in which it also participates as an
investor, regardless of whether its dealings are undertaken on a short or a long-term basis, or take
the form of either a sale of trust, such as murabahah, or an ordinary bargained sale. Is it lawful
for the bank to charge its client for consultative services ordered by the bank for the study of a
project's feasibility before investing in it with, or for, its client by means of mudarabah?

M.A
Jordan
A - There is no legal impediment to taking payment from a client in return for actual consultation
presented to the bank in regard to the study and evaluation of projects for mudarabah,
musharakah, ijarah, etc. Services performed after a contract has been signed, however, will be
shared equally by the client and the bank; except in regard to interest-free loans in which case all
fees will be paid by the client alone after the contract has been signed.

Back to the top

Q - What is the Shari'ah ruling in regard to the bank's paying zakah on the profits earned by
investors in mudarabah operations?

P.Z
Egypt

A - There is no legal impediment to the bank's paying zakah from the accounts of its investors so
long as it does so with the approval of investors who have authorized it in writing to deduct their
zakah portions from their investment accounts; either from their profits or, if no profits are
realized, then from the capital investment itself.

Back to Top

Q - It is a well-established fact in international economics that the greater the amount of capital
invested, the greater the profits that may be expected. Will it be lawful, therefore, to combine the
capital from two or more mudarabah operations in a single investment vehicle, especially when
the mudarabah operations are managed by a single firm?

A.M
Cayman Islands

A - The Board sees no legal impediment to combining the capital from two or more mudarabah
operations in a single account that is maintained in accordance with the Shari'ah of Islam, so long
as the profits and losses are distributed in proportion to the percentage of each shareholder's
investment in the mudarabah.

Back to Top
Q - To what extent will it be lawful to include the following condition in a contract for an
investment savings account: The minimum daily balance acceptable for participation in
investment schemes will be one hundred Dinars. If the balance falls below that amount, the
account will become a regular current account, and will no longer be subject to the rules for a
mudarabah investment.

R.H
France

A - There is no legal impediment to placing a minimum on the daily balance in the conditions of
the contract. If the balance falls below one hundred, the account will be treated like an ordinary
current account because a musharakah may be dissolved by means of such a condition.

Back to Top

Q - Is it lawful to transfer mudarabah contracts from one agent manager to another, when there is
an express or implicit approval for the same, and/or the transfer is agreed to either, individually
or collectively by the investing partners in their capacity as the benefiting owners.

M.J
India

A - It is lawful to transfer mudarabah contracts in the light of the legal principle which states that
the agent-partner in mudarabah transactions may be engaged under the following conditions:

1. The investors will not have to pay for the second agent-partner brought in by the first. Rather
the two will share in the percentage of the profit specified for the first agent-partner and
agreed to by the investor(s).
2. Since the mudarabah contract is not legally binding, it may be dissolved at will by either of
the contracting parties.
Back to Top

Q - Is it lawful for the bank in a mudharabah sale transaction, to invest in one of its accounts, a
deposit (representing 5% of the value of the sale transaction) paid in by the purchase pledger as a
guarantee of payment.

M.S
USA
A - Such an investment is not lawful, regardless of whether the deposit is kept in a current
account or in an investment account. This is because the deposit is a (the client's) guarantee
against payment and, if it is to be invested, it should be invested to the benefit of the client.

Back to Top

Q - Is the practice of the bank lawful, in coming to an agreement with its clients on an amount
that will serve as a ceiling for their transactions over a specified period of time. And within the
framework of that agreement, dealings are undertaken with the client by means of murabahah in
which the amount of profit is specified in advance of purchases, and on a deal to deal basis. Is
this practice in accordance with the Shariah?

S.A.O
Switzerland

A - There is no legal impediment of setting limits on the extent the bank is willing to Finance a
client in their original agreement, or to specify the percentages of profit for each and every
murabahah deal when the bank receives the client's order, in the understanding that the order
represents the clients pledge to purchase. A pledge to buy, however, is not the same as a sale, but
rather a binding agreement to but at the time the sale is ready to be completed.

Q - Will it be lawful to distribute monthly or periodical profits to investors in long- term

mudarabah operations that will not yield returns until after the passing of several years?

A - There is no legal impediment to an agent-manager's distribution of profits from long term

mudarabah operations to investors, by periodically paying investors in the for of interest free
loans guaranteed by their capital investments. The periods for such payments may be determined
by the agent manager. Furthermore the loans will be debited at the final accounting of the profits.

Q - How is the share of profits for each of the parties in a mudarabah operation to be
determined?

A - It is legally required that whatever is specified as profit for both the bank (the agent-
manager) and the investor (the bank's client) be for-mulaled precisely from the joint share, that it
be known to both parties, and that it remain intact throughout the mudarabah operation period.
Such a determination, moreover, must be included in the mudarabah contract either at the time it
is entered into or when it is renewed. If the profit percentage is to be changed in the future, prior
notification of such a change must be made, and a period of time must be set, the passing of
which will be taken to indicate the investors agreement to the change if he/she has not objected
(to it by that lime).
Q - Is it lawful for the working partner in a mudharabah operation to sell the possessions of the
financing partner without seeking the permission of the partner?

A - It is not lawful for the working partner in mudarabah to sell his own possessions in exchange
for mudarabah money (that he is administering), regardless of whether those possessions are lar
removed from the wealth of the (mudarabah financed) company (operation), or actually
considered a part of it. It is likewise unlawful for the partner to buy merchandise from the
mudarabah operation for himself. In both cases, however, if the financing partner gives special
permission, the sale will be lawful.

Profit distribution mechanism and AAOIFI Shariah standards- Accounting and Auditing
Organisation for Islamic Financial Institutions (AAOIFI) is an independent industry body
dedicated to the development of international standards applicable for Islamic financial
institutions. The Bahrain-based organisation started producing standards as early as 1993.
AAOIFI standards have been developed in consultation with leading Sharia scholars, with
several counties adopting them. Although AAOIFI standards are not binding on members, over
the last few years the organisation has made significant progress in encouraging the widespread
adoption of the standards.
Countries where AAOIFI standards are either mandatory or recommended include: Bahrain,
Malaysia, UAE, Saudi Arabia, Lebanon, Syria, Sudan and Jordan. Prior to implementation of
AAOIFI standards many financial institutions in these countries were operating under a “semi-
regulated market” (Al Baluchi, 2006), where accounting policies were determined with the
assistance of the bank’s Sharia Supervisory Board (SSB). In addition, over this period,
International Accounting Standards (IAS) or respective national accounting standards were
followed by Islamic banks. Hence, the unique requirements of Islamic financial institutions were
not being met. To give two examples:

a. Fiduciary risk: the Mudaraba contract places liability of the loss on the mudarib.
b. Displaced commercial risk: where Islamic banks “smooth” the returns Investment
Account Holders (IAH) by varying the percentage of profit taken as Mudarib share.

As a result, with the support of banking authorities, AAOIFI standards were created. In an
industry that is often quite fragmented, it is hoped that the development of AAOIFI standards
will go a long way in promoting convergence in Sharia standards and leading to further growth
in this nascent market.
AAOIFI Standards – The following standards have been developed by AAOIFI:
Accounting Standards:
1. Objective of financial accounting for Islamic banks and financial institution (IFIs).
2. Concept of financial accounting for IFIs.
3. General presentation and disclosure in the financial statements of IFIs.
4. Murabaha and Murabaha to the purchase orderer.
5. Mudaraba financing.
6. Musharaka financing.
7. Disclosure of bases for profit allocation between owners’ equity and investment account
holders.
8. Equity of investment account holders and their equivalent.
9. Salam and Parallel Salam.
10. Ijarah and Ijarah Muntahia Bittamleek.
11. Zakah.
12. Istisna’a and Parallel Istisna’a.
13. Provisions and Reserves.
14. General Presentation and Disclosure in the Financial Statements of Islamic Insurance
Companies.
15. Disclosure of Bases for Determining and Allocating Surplus or Deficit in Islamic Insurance
Companies.
16. Investment Funds.
17. Provisions and Reserves in Islamic Insurance Companies.
18. Foreign Currency Transactions and Foreign Operation.
19. Investments.
20. Islamic Financial Services Offered by Conventional Financial Institutions.
21. Contributions in Islamic Insurance Companies.
22. Deferred Payment Sale .
23. Disclosure on Transfer of Assets.
24. Segment Reporting.
25. Consolidation.
26. Investment in Associates.

Auditing Standards:
1. Objective and principles of auditing.
2. The Auditor’s Report.
3. Terms of Audit Engagement.
4. Testing for Compliance with Shariaa Rules and Principles by an External Auditor.
5. The Auditor’s Responsibility to Consider Fraud and Error in an Audit of Financial Statements.

Governance Standards:
1. Sharia Supervisory Board: Appointment, Composition and Report.
2. Sharia Review.
3. Internal Sharia Review.
4. Audit and Governance Committee for IFIs.
5. Independence of Sharia Supervisory Board.
6. Statement on Governance Principles for IFIs.
7. Corporate Social Responsibility.
Ethics Standards:
1. Code of ethics for accountants and auditors of IFIs.
2. Code of ethics for employees of IFIs.
Sharia Standards:
1. Trading in currencies.
2. Debit Card, Charge Card and Credit Card
3. Default in Payment by a Debtor.
4. Settlement of Debt by Set-Off.
5. Guarantees.
6. Conversion of a Conventional Bank to an Islamic Bank.
7. Hawala.
8. Murabaha to the Purchase Orderer.
9. Ijarah and Ijarah Muntahia Bittamleek.
10. Salam and Parallel Salam.
11. Istisna’a and Parallel Istisna’a.
12. Sharika (Musharaka) and Modern Corporations.
13. Mudaraba.
14. Documentary Credit.
15. Jua’la.
16. Commercial Papers.
17. Investment Sukuk.
18. Possession (Qabd).
19. Loan (Qard).
20. Commodities in Organised Markets.
21. Financial Papers (Shares and Bonds).
22. Concession Contracts.
23. Agency.
24. Syndicated Financing.
25. Combination of Contracts.
26. Islamic Insurance.
27. Indices.
28. Banking Services.
29. Ethics and stipulations for Fatwa.
30. Monetization (Tawarruq)
31. Gharar Stipulations in Financial Transactions
32. Arbitration
33. Waqf
34. Ijarah on Labour (Individuals)
35. Zakah
36. Impact of Contingent Incidents on Commitments.
37. Credit Agreement
38. Online Financial Dealings
39. Mortgage and its Contemporary Applications.
40. Distribution of Profit in Mudarabah-based Investments Accounts.
41. Islamic Reinsurance
42. Financial Rights and Its Disposal Management
43. Liquidity and Its Instruments
44. Bankruptcy
45. Capital and Investment Protection
To purchase Accounting, Auditing & Governance Standards (for Islamic Financial Institutions),
English version, please visit: http://www.aaoifi.com
AAOIFI Standard on Gold
Dr. Mohd Daud Bakar:
AAOIFI has been issuing more than 50 Shariah Standards already. This Shariah standard on gold
wouldn’t be the first and the last. As such, what is so special about this standard? Allow me to
share some of the insights that I am able to discover while working on this Shariah standard from
day one.
First things first. It is essentially meant to be a stand-alone standard in the sense that you can find
as many relevant principles of Shariah on gold as possible in one standard. It seems that the
initial drafters and the AAOIFI sub-committee of the standard have the motivation to compile
almost all relevant rulings dealing with gold under this standard. It will be easier for the readers
then to know the overall Shariah prescriptions without referring to many other Shariah Standards
of AAOIFI found elsewhere. In other Shariah Standards, many of the Shariah issues, if already
covered by other Shariah Standards, will be straight-away referred to that Shariah Standard so
that the reader may need to flip through relevant Shariah Standards to get what they need to
know.
Shariah Standards Committee

Board
Full Name Bank Position
Position

Sheikh Dr. Abdul Sattar Abu Shari’a Consultant, Dallah Al Baraka Group, Saudi
Chairman
Ghuddah Arabia.

Sheikh Dr. Ali MohiEldinne Head of Islamic Jurisprudence Department, Qatar

Member
Alqoradaghi University, Qatar

Member of the Shari'a Board, Bahrain Islamic Bank,

Shaikh Nizam Yaquby Member
Kingdom of Bahrain

Sheikh Waleed Bin Hadi Shari’a Board, Qatar Islamic Bank, Qatar. Chairman

Sheikh Aflah Alkahalili Head of studies and research – Grand Mufti Office- Oman Member

To meet liquidity needs from private sources a bank must hold assets that can be sold or used as
collateral to obtain credit from other financial intermediaries (Holmstrom and Tirole 1998).
However, market failures may constrain access to liquidity from private sources. Opaque bank
assets create information related problems where financial institutions may not be able to screen
and monitor the prospective borrowers adequately (Rochet 2008). Failure of markets to provide
liquidity can be resolved in two ways. Private arrangements can be used between banks to create
liquidity pools. However, this is difficult to implement, particularly when the financial sector
experiences economy-wide negative shocks. In such cases, public bodies such as the central bank
need to provide the liquidity to prevent serious interruptions in operations that can lead to bank
failures. One of the tools used by central banks is to provide emergency funding to banks as the
lender of the last resort (LOLR). b) Salam: The Salam sale is an advance purchase or product-
deferred sale of a generic good. In a salam contract, the buyer of a product pays in advance for a
good that is produced and delivered later. The contract applies mainly to agricultural goods. c)
Istisna: The Istisna contract is similar to the salam contract with the difference that the goods are
produced according to the specifications given by the buyer. This applies mainly to
manufactured goods and real estate. In istisna, the client asks the financier to provide an asset
(like real estate) and the payments are made over a period of time in the future. In this case, the
financier may need to have a parallel istisna and sub-contract the project to a third party for its
completion. In istisna the payments can be made in installments over time with the progression
of the production. d) Ijarah: Ijarah is a lease contract in which the lessee pays rent to the lessor
for use of usufruct. In ijarah the ownership and right to use an asset (usufruct) are separated. It
falls under a sale-based contract as it involves the sale of usufructs. A lease contract that results
in the transfer of an asset to the lessee at the end of the contract is called ijarah wa iqtina or ijarah
muntahia bittamleek. Ijarah wa iqtina combines sale and leasing contracts and uses hirepurchase
or rent-sharing principles. The ownership of the asset is transferred to the lessee as payments for
the asset are also made along with the rent. After the contract period is over, the lessee assumes
the ownership of the asset. Note that in a simple ijarah, the rental payments made are captured in
the current liabilities in the balance sheet. In case of ijarah wa iqtinah, however, the leased item
would be in the form of a debt during the period of lease. e) Musharakah: Sharikah is a
partnership between parties in which financial capital and/or labor act as shared inputs and profit
is distributed according to the capital share of the partners or in some agreed upon ratio. The
loss, however, is distributed according to the share of the capital. Though there can be different
kinds of partnerships based on money, labor, and reputation, one case of sharikah is participation
financing or musharakah in which partners share both in capital and management of the business
enterprise. Thus partners in musharakah have both control rights and claims to the profit. f)
Mudarabah (or qirad or muqadarah): Mudarabah is similar to the concept of silent partnership in
which financial capital is provided by one or more partner(s) (rab ul mal) and the work is carried
out by the other partner(s) mudarib. The financiers and the managers of the project share the
profit in an agreed upon ratio. The loss, however, is borne by the financiers according to their
share in the capital. The manager’s loss is not getting any reward for his services. As the rab ul
mal is the sleeping partner, he/she has a claim on profit without any say in the management of
the firm. 2.4. Islamic The first experiments of contemporary Islamic finance began in the
countryside of Mit Ghamar in Lower Egypt in 1963. Under the leadership of Ahmed al-Najjar,
savings/investment houses operated in small towns in Northern Egypt, providing financing on a
profit-loss sharing basis to small entrepreneurs and poor farmers. In the same year, the Pilgrims’
Management and Fund Board (Tabung Haji) was established in Malaysia to help people save
money to go for the hajj (pilgrimage). The funds were used to invest in industrial and agricultural
projects. Islamic finance has diversified and has grown rapidly to become a significant global
sector. The evolution of different Islamic financial institutions over time is shown in Table 2.2
and key milestones are discussed below. Table 2.2: Evolution of Islamic Financial Institutions
and Markets 1970s: After the formation of the Organization of Islamic Conference (OIC) in
1973, the Islamic Development Bank (IDB) was established in 1975 in Jeddah, Saudi Arabia. In
the same year, the first Islamic commercial bank, Dubai Islamic Bank, was established in UAE.
Realizing that conventional insurance had objections from a Shariah point of view, two Islamic
insurance companies were launched in 1979, the Islamic Arab Insurance Co. (IAIC) in UAE and
the Islamic Insurance Co. in Sudan. 1980s: The 1980s witnessed the launch of a number of non-
bank financial institutions. Modaraba companies were established in Pakistan after the
promulgation of the Modaraba Ordinance 1980. One of the earlier Islamic microfinance
institutions was Al-Fallah Aam Unnayan Sangstha in Bangladesh, established in 1989. In non-
Muslim countries where banking laws did not allow the establishment of Islamic banks, Islamic
cooperatives were introduced. The first Islamic cooperative in the Western world, Ansar and
Islamic Co-operative Housing Corporation Ltd. was established in Toronto, Canada in 1981 to
provide Shariah compliant home financing to Muslims of the country. The Muslim Credit Union
was established in Trinidad and Tobago in 1983 and Pattani Islamic Saving Cooperative started
operations in 1987. Bank ABC, an investment bank based in Bahrain launched its Islamic
services in 1987, thus starting Islamic investment banking. With the expansion of takaful
companies, retakaful companies emerged in the 1980s (NuHtay et. al. 2014). Furthermore, larger
Islamic financial institutions also emerged during the 1980s that established other financial
institutions such as banks, takaful companies and investment banks in different parts of the
world. One the first of these institutions was the Dar al Maal Islami Trust that was established in
Switzerland in 1981.
Chapter 6
Ijarah - principles, types, mechanism, documentation, issues and Shariah standards- Leasing is
an agreement that permits one party (the lessee) to use an asset or property owned by
another party (the lessor) for an agreed-upon price over a fixed period of time. It is a form
of asset finance which has the benefit of using assets without the requirements of
ownership. The lessee acquires the asset he needs without borrowing on interest and
receives the benefits of use while the lessor receives the value of regular rental payments for
a specified period plus the residual value of the asset. The lease may be written either for a
short-term or for a long-term and its rules are similar to those governing sale because in
both cases there is a transfer of one thing between two parties for valuable consideration.
However, leasing differs from sale as its mechanism allows the separation between
ownership and use; in fact, it does not involve transferring the corpus or ownership of an
asset which remains with the lessor.

There are generally two types of leases: a finance lease and an operating lease. A finance
lease is mainly a method of raising long-term finance to pay for assets. It provides the lessor
with full recovery of its investment and a reasonable profit over the initial non-cancelable
lease term. This mode enables enterprises, especially SMEs, to acquire assets, such as
capital goods and high cost equipment, for which they do not have the funds to make a large
up-front payment that would otherwise be involved in a direct purchase. In this type of
lease, the lessor retains ownership of the equipment but transfers to the lessee substantially
all of the risks and rewards of ownership of the asset. The lessee is responsible for the
insurance, registration and maintenance of the equipment.

Financial leases have some similar feature to secured loans. Both allow a business to use an
asset, such as equipment, over a fixed period, in return for regular payments. The business
client chooses the equipment it requires and the bank buys it on behalf of the business. After
all the payments have been made, the business client becomes the owner of the equipment.
The lessor's rate of return is fixed and is not dependent upon the asset -value, performance,
or any other extraneous costs. The fixed lease rentals give rise to an ascertainable rate of
return on investment. Therefore, by spreading payments out over the lifecycle of the asset,
the business is able to align the cost with the benefit derived from the use of the leased
asset. The lessor generally would not provide any services relating to operation of the asset.
In addition, financial leases are non-cancellable; in fact, the lessee cannot return the asset
and not pay the whole of the lessor's investment

On the other hand, when a risk is involving other than a plain financial risk in a lease, it is
an operating lease. In fact, an operating lease is similar to a rental agreement, and is not a
finance lease for the purpose of acquiring assets; operating leases take innumerable forms
based on the risks the lessor takes or avoids, and the involvement of the lessor in operation
of the asset. Operating leases are also referred to as a “non-full payout” leases, because the
amount of the rental does not cover the lessor’s full capital outlay for the expected
economic life of an asset, the minimum lease payments over the lease term are such as to
secure for the lessor the recovery of his capital outlay plus a market return on funds invested
and the lease period is always less than the working life of the asset.

The basic features that differentiate an operating lease from a financial lease are related to
whether the lessor or the lessee takes on the risks of ownership of the leased assets. In fact
operating leases do not put the lessee in the position of a virtual owner; the lessee is simply
using the asset for an agreed period. Also, there is always a dependence on the lessee's
commitment to pay, as a result, the lessor also takes is asset-based. Its rate of return in an
operating lease is dependent upon the asset value, performance, or costs relating to the
asset; and is always a matter of probabilities and uncertainty.

Therefore, in an operating lease, the lessor normally holds a stock of assets with high degree
of marketability to provide to other entities. He may also provide any services relating to
these assets, such as maintenance or operations. The assets remain property of the lessor
who has the option to re-lease them every time the lease period terminates. Accordingly, the
lessor bears the risk of obsolescence, recession or diminishing demand. In contrast, a
financial lease provider operates like a lender except that the lessor has the additional
collateral of legal ownership of the assets without any of the risks associated wi th
ownership. Since leasing is a variety of sale, it is lawful in everything that can lawfully be
bought and sold, and the rules of Shari´ah pertaining to sale are also generally applicable to
leasing. In fact, any Islamic financing mode should be asset-based there has to be an
element of risk taking. In fact, the profit is generated when an asset having intrinsic utility is
sold or offered for use; and one cannot claim a profit without bearing the risk connected to
the transaction. Therefore, most of the rules relating to the contract of sale come into
existence also apply to Ijarah or Islamic leasing. Muslim jurists have, however, singled out
some conditions the validity of an Ijarah contract with respect to the asset or service hired
and the rental.

The first conditions required in a valid Ijarah are that the two sides of the exchange must
both be known and specified in such a way that eliminates the possibility of disagreement
and dispute; that the usufruct in question has a financial or market value; The assets from
which it is almost impossible to derive any benefit from its use, cannot become the subject
of Ijarah; and also the agreement does not involve unlawful activities and substances. The
contracted usufruct and the rent should be ascertained clearly and agreed in advance, either
for the full period of the lease or for a specified period in absolute terms.

Since leasing transfers the ownership of usufruct from the lessor to the lessee, the former
must not only own the assets involved but also be able to transfer the ownership of its
benefits to the lessee. If a particular asset is specified for Ijarah, the lease contract cannot
be executed before getting of the asset or its usufruct. It is also a requirement of a valid
Ijarah that the lease period must be specified and that the lessor retains ownership of the
leased asset during the entire period of the lease. Liabilities arising from ownership will be
borne by the lessor, while the liabilities relating to the use of the property leased asset wil l
be borne by the lessee. The lessee is liable for any loss to the leased asset due to negligence,
but he cannot be made liable for loss caused by factors beyond its control.

The rental can be determined, with the mutual consent of the contracting parties , on the
basis of aggregate of the cost incurred by the lessor for the acquisition of the assets to be
leased and based on a reasonable rate of return by reference to an agreed benchmark. If the
lease is based on a floating rental rate, it is recommended to use a well known benchmark or
index to determine rentals of subsequent periods in a long-term lease to avoid any dispute or
injustice due to possible fluctuations in the market rate structure and binding nature of the
lease contract. The floating rate, however, should be subjected to an upper limit in order to
avoid the element of Gharar.

Furthermore, a stipulation may be inserted in the Ijarah contract making late payment by the
lessee over a period of time liable to a certain amount of charity. This may provide
prevention from late payment even though it does not compensate the lessor for his
opportunity cost over the period of default. The lessor may also approach a competent court
to award damages for any shortfall. The lessor can also demand payment of an earnest
money amount as advance payment of rentals to ensure that the prospective lessee fulfils the
commitment to take possession of the asset on lease when purchased by the lessor. If the
Ijarah contract is not executed for any reason attributable to the lessee, the lessor can
recover from the earnest money the amount of the actual losses suffered loss incurred in this
agreement. And unlike normal sale which cannot be effected for a future date, Ijarah for a
future date is permissible. The lease period and the lessor’s entitlement to rent, however,
begin form the date on which the leased asset has been delivered to the lessee. The rent
thereof may be payable in advance before delivery of the asset to the lessee. Any advance
rentals must be adjusted against future rentals.

Finally, either the lessor or the lessee can make a unilateral promise to buy or sell the leased
asset at the end of the lease period, or earlier, at an agreed price, provided that the lease
agreement shall not be conditional upon such sale. On the other hand, the lessor may make a
promise to gift the asset to the lessee upon termination of the lease, provided the lessee has
fulfilled all the obligations under the contract. There must also not be any stipulation in the
contract purporting to transfer of ownership of the leased assets at a future date. In the
Islamic jurisprudence, one transaction cannot be conditioned by another transaction. Ijarah
and sale/purchase transactions are two different contracts and the transfer of ownersh ip in
the leased property cannot be made by a sale contract on a future date along with the Ijarah
contract. Therefore a ‘Hire-Purchase’ agreement which combines both lease and sale at the
time of contract, it is not suitable for Islamic banks.

The method acceptable to Shari´ah is that the ownership remains with the lessor along with
all liabilities emerging from ownership. As a result, Islamic banks take the asset risk, bear
the ownership related expenses and give or take responsibility for transfer of th e asset to the
lessee upon termination of the lease. This is done under Ijarah Muntahia-bi-tamleek which
includes a promise by the lesser to transfer the ownership of the leased property to the
lessee. The transaction basically remains that of Ijarah and the transfer of ownership is kept
separate from the main Ijarah contract. Under this arrangement, the bank purchases the asset
for the client who then leases the asset from the bank; at the end of the lease term, the
transfer of the asset ownership to the lessee is kept separate.

Ijarah shares many common features with financial lease and hire-purchase arrangements. It
involves a lessor purchasing an asset and renting it to a lessee for a specific time period at
an agreed rental and at the end of the lease period transferring the ownership of the asset to
the lessee. However, Ijarah Muntahia-bi-tamleek is different from the conventional leases
where the rentals start accruing as soon as the payment for purchase of the asset being
leased is made by the lessor; while in Ijarah Muntahia-bi-tamleek, rentals start at the time
when the asset is supplied to the lessee in useable form. Also, if the price of the asset is paid
to the lessee instead of the supplier, there must be an agency (Wakalah) agreement between
the parties prior to the lease agreement that gives authority to the lessee to purchase the
asset on behalf of the bank. If the asset is destroyed before its delivery to the lessee in
useable form, the loss will be that of the bank and not of the agent. Therefore, the risk of the
asset will be that of the bank as long as the client serves as its agent for purchase of the
asset while in conventional lease all risks are borne by the lessee.

In addition, is different from a hire purchase and finance lease in th e sense that it is an
arrangement that does not comprise two contracts in one bargain; in fact, leasing is the real
and the major contract; therefore, it is subject to all Shari´ah rules of an ordinary operating
Ijarah contract. The transfer of ownership is processed through a separate sale or gift
contract. This other part of the deal is only a unilateral promise not binding on the
promissee and as such it is not a transaction until actually entered into by the parties. In
addition, Ijarah Muntahia-bi-tamleek is a fair arrangement based on justice for both the
parties; the lessor recovers cost of the leased asset and also the profit in the form of rentals
while the lessee can get ownership title of the asset at the end of the lease period. The lessee
is also protected from the loss by the lessor would bear all responsibility for loss of the
leased asset, in case of absence of negligence on the part of the lessee. There are many
Islamic finance structures where Ijarah can be used. Islamic banks use this mode of
financing with the purpose of enabling customers to use durable goods and equipment such
as ships, housing, heavy machines and plants in productive enterprises who may be unable
to buy them for their production purposes. Ijarah has also huge potential as a financing
mode for retail, corporate and the public sectors and can also play a crucial role in
promoting Islamic finance industry. It can be used as incentive to economic development as
it is usually long term and offers potential for stimulating productive industries.

Leasing is an attractive mode of investment for Islamic banks because assets acquired under
these contracts are usually of high quality, marketable and maintain their market value well
above book value; therefore, the bank does not have to depend so much on the
creditworthiness of the lessee, given that as a recourse, it can sell the asset to dispose for
cash in case of default. And since the Islamic bank acquires the desired asset only when a
client requests it and commits himself to enter into a lease contract with the bank, the
possibility of misuse of funds and assets is minimized and the bank can make a profit by
setting the rent at a level that covers, over the lease period, the purchase price as well as a
return in line with the current rate of mark-up. In fact, Islamic banks can get variable and
floating return on long term investments. And although Ijarah is a longer-term financing
instrument, a leasing contract can be reviewed periodically. The financing party thus not
tied down to a fixed return that may not be in its investment goals.

Furthermore, Ijarah offers the advantage of not requiring collateral and thus of simpler
repossession procedures since ownership of the asset lies with the lessor. It also means that
it has greater in-built stability to contain inflationary pressures in the economy. The lessor is
only exposed to a low level credit risk from the lessee as the lease transaction is, by
definition, asset-backed. Ijarah has also become popular due to a tax advantages as the
rental can be offset against corporate tax by the lessee.

Finally, Ijarah can be used indirectly for Sukuk issues by the corporate and the government
sectors. Ijarah Sukuk represent leased assets without actually relating the holders to any
corporate body or institution. Securitisation on the basis of Ijarah is an alternative tool to
interest based borrowing provided it uses durable and useable assets. For example, an
aircraft leased to an airline can be represented in bonds and owned by a number of Sukuk
holders, each of them individually and independently collecting their periodic rent from the
airline company. The Sukuk holders are not owners of a share in a company that owns the
leased asset, but simply a sharing owner of a part of the aircraft itself. Islamic banks are
also able to offer leasing certificates to their depositor clients as specific investment
certificates as a form of declining equity. These mechanisms facilitate the formation of fixed
assets and can contribute to long term economically beneficial investment. In a well-
functioning financial system, the supervisors and regulators act on behalf of the society at large
and protect the interests of the different stakeholders and ensure stability in the financial system
as a whole (Pistor and Xu 2003). A proactive enabling regulatory and supervision framework
will ensure the application of rules and laws, protection of property rights, the stability of the
financial sector, consumer protection, and the fairness and efficiency of markets (see Llewellyn
2006 and GOT 2008). The complexity and dynamism of modern financial products and markets
make regulation itself complex and multi-dimensional (Black 2012). If not approached correctly,
inappropriate regulations can create risks and vulnerabilities that can potentially lead to harmful
and costly economic downturns.
Regulatory perimeters determine the boundaries of the regulated and unregulated activities and
institutions. Determining the regulatory perimeters will depend on various factors. Among
others, the degree of systemic risks and customer sophistication will determine the level of
regulatory intervention. The tools and goals of regulation include micro-prudential regulation to
promote the safety of individual financial institutions, macro-prudential regulation and
supervision for the stability of the financial sector, conduct of business regulation to establish
rules for appropriate business behavior and practices, product regulation to limit specific harmful
products, consumer protection regulation to protect consumers, and indirect regulation to limit
exposures of institutions to certain activities and to enhance the fairness and efficiency of
markets (BOE 2012; GOT 2008; Llewellyn 2006). Other regulatory functions relate to providing
safety net arrangements (deposit insurance and lender of last resort) and ensuring the integrity of
the payments system and markets. The regulators must also have measures in place to handle
emergency situations such as handling insolvent institutions and resolving crises.
There are various models of regulatory frameworks for the financial sector. While in some
countries separate bodies regulate the banking, insurance and the securities markets, in others
these sectors are regulated by a single body. The GFC showed that, if legal and regulatory
regimes fail to adjust to the changing situations, they become ineffective in mitigating the new
risks that can lead to costly systemic problems. Furthermore, there can also be a separation of the
prudential regulation and supervision from a conduct of business and consumer protection
regulation under the ‘twin peaks’ approach (Crockett 2009: 19).
Various international bodies have come up with the various principles and standards of
regulations and supervision of different segments of the financial sector. The Basel Committee
for Banking Supervision (BCBS) is responsible for developing international regulatory standards
for the banking sector. It came up with the Basel III standards to strengthen the regulatory
regimes for the banking sector after the GFC. The new standards bolster Basel II by enhancing
the quality and quantity of capital and introducing risk coverage of the systematically important
financial institutions. It also enhances the supervisory review process The notion of a financial
architecture was first discussed after the Asian financial crisis of the late 1990s. As the crisis
revealed several weaknesses in the financial systems of afflicted countries, a group of Finance
Ministers and Central Bank Governors met in Washington DC in 1998 to discuss ways in which
financial systems could be strengthened nationally and globally to bring about stability and avoid
the recurrence of such crises (BIS 1998). The need for sound structural, social and
macroeconomic policies to bring about not only financial stability but also promote economic
development and poverty eradication were underscored (World Bank 2005). The initiatives that
would promote financial stability by preventing and managing crises were discussed under the
framework of the development of International Financial Architecture (IFA). IFA would include
arrangements and actions that would not only strengthen country level financial systems but also
the global level institutions to ensure stability and facilitate financial integration (World Bank
2005). There were two key components of the IFA initiative: crisis prevention and crisis
mitigation and resolution. Policies to prevent crises included the ‘development and
implementation of international standards and good practice’ on the one hand and ‘deepening
and broadening surveillance, and intensifying capacity building’ on the other hand (World Bank
2005: 4). The World Bank and IMF used two key tools to accomplish these goals: first, the
Financial Sector Assessment Program (FSAP) identified the strengths and weaknesses of the
national level financial sectors, and, second, the Reports on Standards and Codes (ROSC)
initiative strengthened the soundness and transparency of institutions, markets and polices related
to the financial system. The ROSC assesses the compliance of national architectural institutions
with international standards in 12 areas including corporate governance, accounting and auditing,
insolvency and creditors’ rights, regulation of banks, insurance and securities markets, payments
and settlements systems, anti-money laundering and financing terrorism, and transparency of
data, fiscal, monetary and financial policies (World Bank 2001 and 2005). After the global
financial crisis of 2007-2008, the FSAP program was reviewed and changes were introduced
(IMF 2014). Changes included adding focus on systemic risks, improving analytical capabilities
to assess vulnerabilities and resilience and improving the quality of the country level Financial
Sector Stability Assessment (FSSA) reports. For developing and emerging economies, the FSAP
would have two broad components, one assessing the financial stability and the other assessing
the financial development. Indicators of financial stability include not only the soundness of
banks and other financial institutions but also the quality of the supervision of banks, insurance
and capital markets against international standards and the ability of policy makers and financial
safety-nets to respond to negative shocks. Financial development indicators include the quality
of the legal framework and the financial infrastructure in promoting the financial sector that
serve all segments of the population (IMF 2015). WB and IMF (2005:5) identify three pillars of
the financial system architecture that can promote the stability and development of the financial
sector. Whereas Pillar I relates to macro-prudential surveillance and financial stability analysis,
Pillar II deals with sound financial system supervision and regulation. Pillar III involves financial
system infrastructure that include legal infrastructure for finance; systemic liquidity
infrastructure; and transparency, governance and information infrastructure. Some other financial
infrastructure institutions include payments and securities settlement systems; creditors’ rights;
the provision of incentives for strong risk management; and good governance, credit reporting
systems, etc. For Islamic finance, IFSB (2015a) identifies several preconditions that must be
fulfilled for effective regulation and supervision that can ensure the stability of Islamic financial
institutions. These include "sound and sustainable macroeconomic policies; well established
framework for financial stability policy formulation; well-developed public infrastructure; a clear
framework for crisis management, recovery and resolution; appropriate level of systemic
protection (or public safety); and effective market discipline" (IFSB 2015a: 9). A welldeveloped
public infrastructure would entail key architectural elements such as a system of business laws;
well-defined internationally accepted accounting principles and rules; an efficient and
independent judiciary; competent and experienced professionals; well-regulated payment
systems; credit bureaus; and the availability of basic economic, financial and social data and
information (IFSB 2015a: 10). In this study, ‘financial architecture’ and ‘infrastructural
institutions’ are used interchangeably. financial sector that may not be covered by the
conventional architectural institutions and require specific attention. The elements of the Islamic
financial architecture that need special attention and are discussed in this study can be classified
into seven categories as identified below: Legal Infrastructure: Existence of supporting Islamic
finance laws, tax regimes impacting Islamic finance, dispute settlement/conflict resolution
framework and institutions, and resolution of banks. Regulation and Supervision Framework:
Appropriate regulatory and supervisory frameworks for Islamic banks, takaful and Islamic
capital markets including the presence of separate regulatory departments/units dealing with
Islamic financial sectors. Rules related to the nature of the Islamic financial industry and the
existence of Islamic windows/subsidiaries in conventional banks. Shariah Governance
Framework: Existence of regulatory standards for Shariah governance and whether Islamic
financial institutions are required to use IFSB/AAOIFI Shariah governance guidelines of
AAOIFI Shariah standards. Determine the role of central national Shariah board (if it exists) and
its responsibilities and scope. Liquidity Infrastructure: Status of liquidity management
framework (markets and arrangements) and liquidity management instruments and products for
Islamic financial institutions. Need for Shariah compliant LLOR facilities and instruments that
Islamic banks can use. Information Infrastructure and Transparency: Requirements to use either
AAOIFI accounting/auditing standards or domestic standards adapted to Islamic finance. The
legal and regulatory framework of the country related to transparency and disclosure for IFIs.
Existence of organizations providing credit ratings for sukuk issuance and Shariah ratings of
Islamic financial institutions. Consumer Protection Architecture: Laws/regulations related to the
protection of consumers of the financial sector in general and Islamic financial institutions in
particular and institutional mechanisms/arrangements to address the unfair treatment of
consumers. Deposit insurance scheme for depositors of Islamic banks in the country. Scheme for
financial literacy in the country and if there are any specific schemes for Islamic financial
consumers. Human Capital & Knowledge Development Framework: Adequate personnel to cater
to the needs of the Islamic financial sector at different levels (such as regulatory bodies, IFIs, law
firms, etc.). Existence of public and private educational/academic institutions to enhance the
knowledge and skill levels for the Islamic financial sector. Islamic law (Shariah) is
comprehensive and covers various aspects of life including economic dealings. Other than
providing legal rules, Shariah also provides moral principles relating to economic activities and
transactions. It defines the founding concepts of an economic system such as property rights,
rationality, and the objectives of economic activities and principles that govern economic
behavior and activities of individuals, markets, and the economy. Al-Ghazali identifies the
essential goals of Shariah (maqasid al Shariah) to constitute safeguarding the faith (din), self
(nafs), intellect (‘aql), posterity (nasl), and wealth (mal) (Chapra 2006). The objective of Islamic
commercial law and an Islamic economy would strive to protect and enhance one or several of
the maqasid. Specifically, commercial transactions are sanctified and encouraged as they
preserve and support property and progeny (Hallaq 2004). The implications of maqasid in an
economy and the financial sector can be viewed in different ways. One categorization of maqasid
would be to classify them at the macro/general level (maqasid ammah) and micro/specific level
(maqasid khassah) (Abozaid 2010, Dusuki 2009, Dusuki and Bouheraoua 2011). While
macro/general maqasid relates to the benefits and wellbeing of the overall society, micro/specific
maqasid deals with issues relating to individual transactions. A brief overview of maqasid from
these perspectives for the financial sector is presented below. Maqasid at the macro level is
similar to the broader goals of Shariah and involve realizing human wellbeing by enhancing
maslahah (benefit) on the one hand and preventing mafsadah (harm) on the other hand (Laldin
and Furqani 2012). Different scholars suggest the macro implications of maqasid in a variety of
ways. At the broadest level, Abozaid (2010: 67) views it as a vision that protects and preserves
public interests in all aspects and segments of life. Fulfilling the maqasid at this level would
imply that an economy should ensure growth and stability with equitable distribution of income,
where all households earn a respectable income to satisfy basic needs (Chapra 1992). Achieving
the objectives of optimal growth and social justice in an Islamic economy would require
universal education and employment generation (Naqvi 1981: 85). The micro-maqasid relates to
specific issues arising in the operations and transactions of the Islamic financial sector. Using
various legal maxims, Dusuki and Abdullah (2007) and Dusuki and Bouheraoua (2011) conclude
that prevention and minimizing harm should be a key objective of an Islamic firm. These would
include not engaging in harmful activities such as selling products that harm the consumer,
dumping toxic waste harmful to the environment or residential areas, engaging in speculative
ventures, etc. Maqasid at the micro or product level also implies Shariah compliance and
fulfilling the objectives of contracts. Kahf (2006) views maqasid in transactions as fulfilling the
objectives stipulated in contacts. These include upholding property rights, respecting consistency
of entitlements with the rights of ownership, linking transactions to real life activity, transfer of
property rights in sales, prohibiting debt sale, etc. Two key principles governing Islamic financial
transactions are that financing is closely linked to the real economy and returns are associated
with risks in real transactions. The legal maxims of ‘benefit of a thing is a return for the liability
for loss from that thing’ (al-kharaj bi aldaman) and ‘the detriment is as a return for the benefit
(al-ghurm bi al-ghunm) (Majallah Articles 85 and 87) link ‘entitlement of gain’ to the
‘responsibility of loss’ (Kahf and Khan 1988: 30). The implications of these maxims is a
preference for profit-loss sharing instruments and also that the party enjoying the full benefit of
an asset or object should bear risks of the ownership (Vogel and Hayes 1998). for risk
management and capital planning at the bank level and requires higher levels of risk disclosure
to improve market discipline.
IOSCO is a global multilateral organization dealing with regulatory issues related to capital
markets. It published the Objectives and Principles of Securities Regulation, also known as the
IOSCO Principles, in 1998 which were then updated in 2010 after the GFC. The document
consists of 38 core principles for the regulation of the securities markets and entails three key
elements: investor protection; ensuring fair, efficient and transparent markets; and the reduction
of systematic risks. The key focus of the IOSCO's core objectives of securities regulation is on
disclosure and transparency (Singh 2013). Similarly, IAIS (2015), an association of national
level insurance regulators, has published various regulatory documents that include the
Insurance Core Principles. Updated in 2015, the document has 28 core principles for the
development of a sound and stable insurance industry.
Although the Basel regulatory principles and guidelines should apply to all banks, there are some
additional regulatory requirements for Islamic financial institutions.11 This stems from the use
of Islamic financial contracts on both the liability and asset sides. The unique feature of Shariah
compliance not only introduces risks to Islamic finance that are different from those of its
conventional counterpart but also limits the use of certain risk mitigation instruments and
products from which conventional financial institutions are able to benefit. Thus, governance and
regulation of Islamic financial institutions requires a clear understanding of the risks arising in
Islamic finance and then proposing appropriate measures to mitigate them. The Islamic Financial
Services Board (IFSB), an international standard-setting body for the Islamic financial industry,
has specified standards for Islamic financial institutions that are compatible with Basel
standards.12 IFSB is responsible for coming up with regulatory standards for all three segments
of the financial sector and has published various principles, standards, disclosure requirements
and guidance notes for Islamic banking, takaful and Islamic capital markets.
11
The regulatory regimes under which Islamic banks are operating can be classified into three
types: Islamic, dual, and conventional. Islamic regulatory regimes are found in Iran and Sudan.
The banking laws and regulatory requirements have adopted Islamic financial transactions as the
only acceptable forms. The dual banking system is one in which both Islamic and conventional
banking services are available. Islamic banking services are provided either by Islamic banks or
through windows in conventional banks, or both. The operation of Islamic banking in a
conventional regulatory regime would require the design of institutions and Islamic financial
products that can operate under the existing laws and regulations. The regulatory framework of
Islamic finance differs from country to country. While in some countries the same departments
or units are responsible for regulating all financial institutions, in a few countries separate units
exist within the regulatory bodies to deal with the Islamic financial segments of the financial
sector. Traditional Islamic modes of financing can be broadly classified into equity and debt
instruments. While equity instruments are mudarabah and musharakah, debt-instruments arise
from sale transactions. These fixed-income instruments include murabahah (cost-plus or mark-up
sale), bai-muajjal/murabahah (price-deferred sale), istisna/salaam (object deferred sale or pre-
paid sale) and ijarah (leasing).6 We outline the basic concepts and properties of these
instruments below. a) Murabahah/Bay Muajjal: Murabahah is a sale contract at a mark-up. The
seller adds a profit component (mark-up) to the cost of the item being sold. When the purchase is
on credit and the payment for a good/asset is delayed, then the contract is called bai-muajjal. A
variant would be a sale where the payments are made in instalments. These contracts create debt
that can have both short and long-term tenors. In these debt contracts, the supplier of the good
has a claim on a fixed amount that must be paid before arriving at a profit. Shariah governance
framework is an important determinant of Islamic banking practices and the types of products
offered. In a survey of Islamic financial institutions, 21% of the respondents identify Shariah
compliance issues as being among the biggest internal threats (MEGA 2016: 51). Thus, a robust
Shariah governance regime that can ensure Shariah compliance in Islamic financial institutions is
required. IFSB (2008) proposes four aspects that Shariah governance systems should entail at the
level of Islamic financial institutions. These are issuance of Shariah pronouncements, ensuring
day to day compliance with the Shariah pronouncements, internal Shariah compliance review
and audit, and annual Shariah compliance audit to ensure that the internal Shariah compliance
review has been properly carried out. To undertake these functions, IFSB identifies different
Shariah organs which include an in-house Shariah compliance unit/department, internal Shariah
review/audit unit and SSB.
The IFSB (2008) leaves the responsibility of Shariah governance at the level of organizations
without any firm commitment to regulatory overview. However, to reduce Shariah compliance
risks and ensure that the Islamic banks fulfill their fiduciary duties of conducting business
according to Shariah principles, there may be a need for the regulatory bodies to provide Shariah
governance frameworks and guidelines. Two broad criteria can be used to classify Shariah
governance regimes. The first is the existence of a national framework for Shariah governance in
the form of law/regulations supported by a complementary national Shariah supervision
mechanism at the regulatory level. The goal of the national Shariah governance framework will
be to accomplish the broader Shariah requirements of the industry and protect the interests of
stakeholders not served at the organizational level. An active national Shariah authority (NSA)
will be able to address Shariah/fiqh related issues, harmonize Shariah interpretations, and ensure
compliance with Shariah principles. Another important area that would help reduce legal risks is
the product clearance role where the NSA would identify the permissible modes of
financing/investment and clear all new products coming into the market.
The second aspect of the Shariah regulatory framework would set up requirements to strengthen
the organizational Shariah governance structures and processes. Other than requiring Islamic
banks to have a Shariah Unit/Department, elements can include requirements related to various
aspects of Shariah governance at the organizational level. The issues under regulatory purview
can include the terms of reference of SSB, defining the duties and role of SSB members,
approving the appointment of SSB members, specifying the qualifications and minimum number
of members in the SSB, and identifying the position of the SSB in the governance structure. The
code of conduct of SSB members can limit the number of banks they can serve in, maintain
independence, avoid conflicts of interest, etc. The banks may also be required to have a Shariah
compliance manual and an external Shariah audit. The operational issues related to Shariah
governance would be ensuring the information disclosure of products, proper use of charity
funds, and the separation of funds and risks if Islamic windows exist.
Issues related to harmonization and standardization have implications at the macro and micro
levels. In the former, there is a need to harmonize the contractual stipulation of Shariah with the
laws of the country that are based on Western legal systems to reduce friction and avoid
confusion in dispute resolutions.

Creation of paper money; While BCBS has published guidelines relating to liquidity risk
management prior to the GFC, the central role of liquidity in exacerbating the crisis has lead to
the inclusion of specific liquidity requirements in Basel III.13 The objective to introducing the
regulatory liquidity requirements along with the capital requirements is to promote a more
resilient banking sector by improving its ability to withstand shocks from different sources
(BCBS 2010). As liquidity problems faced by banks are a key feature of the crisis, Basel III has
added liquidity requirement ratios in addition to reinforcing the capital requirements.
Specifically, the liquidity coverage ratio (LCR) has been introduced to ensure liquidity in banks
in the short term and net stable funding ratio (NSFR) has been proposed to promote medium and
long-term resilience to liquidity shocks.
IFSB (2012) principles for liquidity risk management identify the following for liquidity
infrastructure for Islamic finance: business laws (securities, capital markets, bankruptcy, etc.),
secure and efficient payment systems, well-functioning Islamic money markets, and timely and
accurate information disclosure and transparency. IFSB (2015) issued Guidance Notes on
quantitative measures for measuring liquidity risk management in Islamic financial institutions
and identifies issues related to LCR and NSFR. Given the short history of its development and
the restrictions imposed by Shariah principles, the Islamic banking sector faces several
restrictions that will constrain its adoption of Basel III liquidity requirements. The challenges
that Islamic banks will face in meeting their liquidity needs will be identified. The chapter will
also outline some key infrastructure institutions that are needed to support the Islamic financial
sector at both the private and public levels.
In conventional banks, the funding of liquidity needs of banks can be met either from private
sources such as other financial institutions or inter-bank money markets. As interest based loans
are prohibited by the Shariah, Islamic banks cannot borrow funds to meet liquidity requirements.
Furthermore, Islamic banks are prone to additional liquidity risks for various reasons. In most
jurisdictions there is no organized Islamic money market from which funds can be sought in
times of need. Second, as most assets of Islamic banks are predominantly debt-based, they are
illiquid due to Shariah restrictions on the sale of debt. Thus, raising funds by selling debt-based
assets is not an option that Islamic financial institutions can use.
Abdullah (2010) provides an overview of some of the liquidity management instruments used in
different countries. In the UAE, the central bank launched debt based commodity murabahah
(tawarruq) Islamic certificates of deposits with maturities of one week to a year. To facilitate the
liquidity management of Islamic banks, the Central Bank of Bahrain started issuing short-term
salam based sukuk. As salam sukuk are debt based and not tradable, the central bank has now
moved on to issuing ijarah based ones which, being asset-based, are tradable. However, a lack of
active secondary markets for sukuk can hinder their sale at appropriate prices. Malaysia is one of
the few countries that has an Islamic Interbank Money Market (IIMM) in which mudarabah
based interbank investments can be used (Abdullah 2010). Similarly, Islamic banks in Indonesia
can either use the Domestic Interbank Shariah Financial Market operates using a mudarabah
based Interbank Investment certificate or place their excess liquidity with the central bank under
the Wadiah Certificate scheme. As indicated, when liquidity requirements of banks can be met at
the private level, the central bank can provide the required liquidity. One of the safety-nets
available to banks in emergency situations is to get emergency funds from the central bank
which acts as the lender of last resort (LLOR) to protect the banking sector in such situations.
Islamic banks, however, can face problems in using this facility as most of the existing LOLR
facilities are interest based. IFSB (2015: 77) identifies the preconditions for developing a Shariah
compliant LOLR as having a suitable legal framework for appropriate regulatory and remedial
powers, coming up with a Shariah compliant model of LLOR, and having in place a robust
supervisory and Shariah governance framework. A survey of IFSB of central banks of its 24
member countries carried out in 2012 shows that only six had Shariah compliant LOLR facilities
(IFSB 2013: 108). The study also revealed that of the 20 countries surveyed only two had
facilities of discount windows that met Shariah requirements and five countries had Shariah
compliant deposit services for Islamic banks.
One of the issues related to the financial sector and economic crisis is the role of the LOLR at the
international level, particularly when the liquidity required is in foreign currencies. Note that the
role of LOLR at the international level is important when the whole financial sector of a country
is affected by a crisis, not when an individual financial institution is in distress. There are
suggestions that organizations such IMF can play the role of an international LOLR (Giannini
1999). In fact, the IMF has, to some extent, played a role in providing liquidity to countries in
economic distress. However, unlike the domestic central bank, an international LOLR may not
have regulatory powers (Obstfeld 2009). Another option of dealing with a liquidity crisis at the
global level is to use a multilateral network of reciprocal swap arrangements between central
banks of different countries (Landau 2014, Obstfeld 2009). Under this arrangement foreign
currency can be swapped with domestic currency to meet to meet liquidity needs. The swaps
were used by central banks such as the Federal Reserve in the aftermath of the recent GFC.
Information and governance infrastructure are key to financial sector development and effective
market discipline (World Bank 2005: 241). The opacity of information increases risks and the
costs of capital and reduce trading volumes affecting the functioning of financial markets
adversely. There are two key aspects of information infrastructure that help in making sound
decisions on financing and investments which in turn promote the development of the financial
sector and economy. First, good quality information on financial instruments, organizations and
markets must be provided to the investors and customers. Second, accurate and reliable
information on credit worthiness of clients must be available to reduce risks and losses of
financial institutions. These are discussed below.
3.5.1. Accounting and Auditing Framework/Transparency and Disclosure
An important element of a well-functioning financial architecture is the accounting and auditing
framework that gives outside investors high-quality information. Good accounting systems
producing high-quality disclosure and transparency are essential for informed decision making
and promoting efficient resource allocation (World Bank 2005: 247). High quality disclosure of
information and accounting practices mitigates information asymmetry and increases investor
protection and enhances their confidence and the credibility of markets (Kothari 2000). The
quality of disclosure depends on the quality of accounting standards and also on the institutional
factors that include laws and regulations requiring compliance with disclosure standards to
protect consumers.
Given the key role of a sound information infrastructure, different international bodies are
encouraging the adoption of different international accounting standards to promote financial
stability and economic efficiency at the national level and improve the comparability of
statements between countries in an increasingly globalized world. A key component of the
standards and codes initiative of the World Bank and International Monetary Fund (IMF) to
strengthen the international financial architecture includes an initiative for adopting international
standards (IMF and World Bank, 2005). After the recent global financial crisis, additional
international bodies such as G20 and the Basel Committee Banking Supervision are also
supporting the use of standards globally (Pacter, 2014). International Accounting Standards
Board (IASB), an independent global standards-setting body of the IFRS Foundation, is
responsible for developing accounting and reporting standards to bring about ‘transparency,
accountability and efficiency to financial markets around the world’ to serve ‘the public interest
by fostering trust, growth and long-term financial stability in the global economy.’14 The
resulting standards developed by IASB, the International Financial Reporting Standards (IFRS),
are used by different countries to develop country level accounting standards.
Some of the accounting requirements of Islamic banking operations may not be covered by the
international accounting standards (Archer and Karim, 2007; Hamid et al., 1993). While some
conditions in IFRS are not relevant for Islamic banks, some contractual requirements arising
from Shariah compliance may not be covered in international standards. Recognizing this, the
Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) was
established as a standard-setting body to issue accounting and auditing standards for Islamic
financial institutions in accordance with the Shariah (AAOIFI, 2010). Though AAOIFI uses
IAS/IFRS as a basis for developing its standards when they do not contradict Shariah principles,
it also introduces additional guidelines that are unique to the Islamic financial sector. In order to
achieve fair presentation for all stakeholders, AAOIFI requires Islamic financial institutions to
provide statements of compliance with its standards. IFSB has issued principles and guidelines of
good corporate governance, transparency and disclosure of relevant information.15
3.5.2. Credit-Reporting Systems and Rating Agencies
A key component of information infrastructure that can promote the development of a stable
financial sector is the availability of information on the credit quality of individuals, instruments
and organizations. By reducing the asymmetric information problems of adverse selection and
moral hazard, the availability of credit information enables the better evaluation of risks of
default of different stakeholders (IMF and World Bank 2005: 257). The ratings can also be used
to price different products appropriately, thereby increasing their marketability. Two broad
categories of credit information institutions relevant to the financial sector can be identified.
First, specialized credit rating agencies (CRAs) provide the credit ratings of large businesses,
corporations and financial securities. While the ratings of securities play an important role in the
proper functioning of capital markets, the ratings of corporations are used to determine the
regulatory capital requirements under Basel II and Basel III. IOSCO (2003) provides the
principles to guide the activities of CRAs, and IOSCO (2004) details the code of conduct for
CRAs. The four key elements covered in these documents include: Quality and Integrity of the
rating Process; Independence and Conflicts of Interest; Transparency and Timeliness of Rating
Disclosure; and Confidential Information.
Furthermore, credit-reporting registries gather information on the credit quality of individuals
and smaller firms that are not rated by the rating agencies. A sound and effective legal and
regulatory framework for credit registry must strive to balance between the sharing of relevant
information with the privacy and protection of consumers. WB and IMF (2005) identify the legal
and regulatory framework that is needed for a sound credit reporting system to include laws on
data and consumer protection and regulations on bank secrecy, consumer credit and fair credit
granting.
While information produced by credit registries can be used by both conventional and Islamic
financial institutions to make decisions on whether or not to finance clients and small businesses,
there are some specific issues that may arise when rating Islamic financial securities such as
sukuk. Furthermore, other than providing the risk attributes of these securities, there is also a
need to disclose Shariah related issues inherent in these structures (Ahmed 2013). However, as
most traditional CRAs may not be equipped to provide a rating in Shariah compliance due to the
lack to expertise, there may be a need for a specialized organization to do the Shariah ratings.
The International Islamic Rating Agency (IIRA) based in Bahrain is the only rating agency that
rates the Shariah quality rating of Islamic financial institutions but has not ventured into rating
Islamic securities and sukuk
3.4.2. Lender
Since the lack of financial literacy and safeguards to protect consumers were among the factors
contributing to the recent financial crisis, there has been renewed interest in a robust regulatory
framework to enhance consumer protection after the recent GFC. Recognizing this, the G20,
along with the OECD came up with the G20 High-Level Principles on Financial Consumer
Protection in 2011 which identifies 10 broad principles that can enhance the protection of
financial consumers. These are: legal, regulatory and supervisory framework; role of oversight
bodies; equitable and fair treatment of consumers; responsible business conduct; disclosure and
transparency; financial education and awareness; protection of consumer assets against fraud and
misuse; protection of consumer data and privacy; complaints handling and redress; and
competition (OECD 2011).
Similarly, the World Bank came up with Good Practices for Financial Consumer Protection in
2012 and it identifies the key features of practices to protect consumers of the banking,
insurance, nonbank financial institutions, and securities sectors. The common features of
consumer protection across these sectors include the following: consumer protection legal and
regulatory institutions; sound disclosure and sales practices; customer account handling and
maintenance; privacy and data protection; dispute resolution mechanism; guarantee and
compensation scheme in times of financial distress; financial literacy and consumer
empowerment; and competition (World Bank 2012). A robust consumer protection regime would
also include some architectural elements such as consumer protection laws and financial
education and enforcement mechanisms (Lukonga 2015). In this regard, IFSB has come up with
certain guidelines that address some of the issues arising in Islamic finance.16
16
While most of the consumer protection issues related to the conventional finance equally apply
to consumers of Islamic finance, there are certain unique issues that arise in the latter due to
Shariah compliance. Other than architectural elements, an additional requirement for Islamic
finance is to ensure Shariah compliance (Lukonga 2015). One of the key issues relates to
ensuring the Shariah compliance of products and services provided to consumers by having a
robust Shariah governance regime (Neinhaus 2015). As many customers of Islamic finance use
the services with the expectation that the products comply with the Shariah, the regulators should
ensure that this is the case. Some of the specific issues that regulators need to consider are
strengthening governance protection of investments account holders, sukuk investors, and
developing Shariah compliant deposit schemes. While the use of funds from the unrestricted IAH
should be disclosed to the account holders, IFSB recommends that the IOSCO principles for
Collective Investment Schemes (CIS) should be applicable for management of restricted IAHs
(Lukonga 2015: 26). In the asset management sector, Amana Income Fund was launched in the
US in 1986 as the first Islamic mutual fund. 1990s: Some other types of nonbank financial
institutions were established in the 1990s. The first Islamic pawnshop, Muassasah Gadaian Islam
Terengganu, was established in the Terengganu state of Malaysia in 1992 (Hisham et. al. 2013).
In Islamic project financing, the first major co-financed transaction involving project financing
was the USD1.8 billion Hub River power project in Pakistan that started in 1993. Al-Rajhi
Banking and Investment Corporation provided a USD92 million Istisna’ facility in a total
investment of USD 1.8 billion for the project. Similarly, a USD200 million tranche by Kuwait
Finance House for a USD2 billion petrochemical plant for the Equate Petrochemical Company
was a joint venture between the Union Carbide corporation and the Petrochemical Industries
Company, a subsidiary of Kuwait’s national oil company in 1996 (Esty 2000). In capital
markets, the first corporate sukuk was issued by Shell in Malaysia in 1990. Furthermore, to meet
the demand of Muslim investors, the Dow Jones Islamic index was also launched in 1999. 2000s:
IDB established the Awqaf Properties Investment Fund in 2001 to invest in developing awqaf
properties in different parts of the world on a commercial basis. In the same year, IDB also
launched the first infrastructure fund with a capital commitment of USD 730 million. 7 Injazat
Technology Fund E.C established in Dubai in 2001 was one of the first Islamic venture capital
funds. In Asia, CIMB Muamalat Fund I was the first Islamic private equity fund founded in 2002
(Wouters 2008). Islamic leasing companies started in 2000 and since then several have been
established in the GCC region (Henry 2012). A few Islamic hedge funds were also structured and
marketed after the mid-2000s, but these did not get traction due to a lack of demand (Gassner
2007). After the publication of Guidelines for Islamic Real Estate Investment Trusts (REITs) by
the Securities Commission of Malaysia in 2005, the first Islamic REIT AlAqar KPJ REIT valued
at RM 481 was issued in the country in 2006. 2010s: Among the key innovations in Islamic
financial institutions after 2010 were crowdfunding platforms. While Liwwa was an asset based
platform launched in Jordan in 2013, Shekra was an equity based crowd funding platform
launched in Egypt in the same year (CCA and FCA 2013). 2.4.2. Supporting International
Infrastructure Institutions The progression of different international infrastructure institutions
supporting the Islamic financial sector over the years is shown in Table 2.3. The infrastructure
institutions classified according to the architectural features identified in Chapter 1 are discussed
below. Legal Infrastructure The International Islamic Center for Reconciliation and Commercial
Arbitration (IICRCA) was established in Dubai, UAE in 2004 and started operations in 2007.
The goal of IICRCA is to One finding from empirical studies that is relevant to Islamic finance is
the distinction between investors and consumers among retail clients (IFSB 2015: 96). While the
retail investor interacts with the different segments of the financial sector and makes appropriate
risk-return decisions, the consumer has little knowledge and experience of the financial markets.
The appropriate policy for the former would be to have more disclosure and for the latter to have
protection against misspelling and the improvement of their financial literacy. IFSB (2015)
identifies several key instruments for protecting financial consumers. Firstly is empowering
customers so that they can make better informed choices. This can be accomplished by, among
other things, requiring disclosure of relevant information by financial institutions, providing
consumer awareness and education programs, and having consumer advice institutions. Secondly
is establishing a sound regulatory and supervisory framework that can ensure good practices and
the fair treatment of financial consumers. This can be done through product and conduct
regulations. Thirdly is instituting an efficient complaints handling and dispute resolution
framework that addresses the concerns of clients effectively and treats consumers fairly (IFSB
2015, 96-98). Finally, there must be a deposit protection scheme for customers when financial
institutions fail and close down.
Financial education programs are important tools for empowering consumers on the demand
side. There is a need to introduce financial literacy schemes at different levels to reduce the
information asymmetry so that consumers can make more informed decisions. Consumers who
are financially literate can not only make better financial decisions but also facilitate the smooth
functioning of financial markets (World Bank 2015). This is particularly true as financial
products have become more complex and the risks in products are difficult to understand
(Lukonga 2015: 6). Financial literacy forms an important part of the regulatory response to
protect consumers in the aftermath of the GFC. World Bank (2012) considers financial literacy
as a tool for consumer empowerment and protection. Although the financial regulator can take
the lead in this, different government and non-government organizations should be involved in
developing and implementing financial education and literacy programs by using a range of
initiatives and channels such as publications, webpages, television, radio and mass-media. A
sound financial education framework will target all segments of the population including
schoolchildren, the youth, and the community at large. OECD (2012) came up with OECD/INFE
High-Level Principles on National Strategies for Financial Education in 2012 and National
Strategies for Financial Education in 2015, providing a detailed framework to promote financial
education globally.
While studies show that the general level of financial literacy among financial consumers is low,
literacy issues for the Islamic financial sector become even more challenging as the industry is
relatively new and there is a lack of awareness of its principles among the general public. Islamic
financial modes of financing and products are diverse with each having their own unique features
which add to their complexities. The result is that there is a low level understanding of Islamic
financial products even among the educated and elite (Lukonga 2015: 27).
3.6.2. Deposit Insurance
As a part of the regulatory regime, protection of the assets of depositors when banks cease to
operate is an important component of the consumer protection framework and for ensuring
financial stability. Deposit insurance schemes act as a financial system safety-net when financial
institutions shut down and also help prevent systemic risks (IFSB 2015: 100). Deposit insurance
schemes enhance the confidence of the clients in such cases and promote financial system
stability (Calomiris and White 1994; FDIC 998). The scheme should be complemented by a
sound and prudent regulatory and supervisory framework so that its use is kept to a minimum.
As the conventional deposit insurance schemes may not fulfill the Shariah principles, there is a
need to have Shariah compliant deposit insurance schemes. While there is no issue to protect
depositors of current account holders by using Shariah compliant deposit insurance, issues can
arise to insure PSIA depositors. Contractually, PSIA deposits are mudarabah contracts that share
the risks and cannot be guaranteed (IFSB 2015: 70). Restricted PSIA are treated as CIS by IFSB
as they cannot be guaranteed under the scheme. The case with unrestricted PSIA, however, is
more complex. As in most jurisdictions, the unrestricted PSIA are treated as deposits for capital
adequacy purposes, and there are arguments for giving them the same protection as deposits of
conventional banks to level the playing field between Islamic and conventional banks (IFSB
2015: 70).
3.7. Human Capital & Knowledge Development Framework
In order to be compliant with the Shariah, Islamic finance requires specific knowledge and skills
on finance, Shariah and the laws of the host country. However, being a relatively new industry,
there is a scarcity of qualified professionals who are proficient in these areas. There is a need for
talented professionals not only at the level of financial institutions but also at the level of
regulatory bodies. In a survey carried out by MEGA (2016), 63.5% of the respondents identify
the availability of qualified Islamic finance staff to be limited and 18.2% indicate it to be very
scarce (p. 47). In the same survey, more than half of the respondents identify developing human
resources as a top priority that needs the most attention (p. 48) and 28% of the respondent
identify a shortage of qualified personnel to be one of the biggest internal threats facing Islamic
finance (MEGA 2016: 51).
The rapid growth in the Islamic finance industry is expected to create a huge demand for skills
and knowledge in the field. A report by A.T. Kearney (UAE) Ltd in December 2006 indicated
that the booming Islamic banking sector will need 30,000 jobs in the Gulf in 10 years. Another
study by AlJarhi of the International Association for Islamic Economics indicated that the
Islamic banking and finance industry will need about 300,000 new staff educated and trained in
Islamic finance and banking. One of the key challenges that will need to be resolved is to
ensure that there is enough manpower with the knowledge and skills of different aspects of
Islamic finance (bankers, lawyers and Shariah scholars) to support the growth of the industry.
provide an alternative dispute resolution and reconciliation platform to settle cases applying
Islamic law for disputes arising in Islamic financial industry. Regulatory Standard Setting
Bodies The Islamic Financial Services Board (IFSB) was established in 2002 in Kuala Lumpur,
Malaysia as a regulatory standard setting body for Islamic banks, takaful and capital markets by
introducing new, or adapting existing, international standards consistent with Shariah
principles. IFSB promotes the development of a prudent and transparent Islamic financial
services industry to ensure the soundness and stability of the industry. As of December 2015,
IFSB has published 24 standards that include 17 Standards and Guiding Principles, 6 Guidance
Notes and one Technical Note. The International Islamic Financial Markets (IIFM) was
established in 2002 in Bahrain as a global standard setting body focusing on ‘standardization of
Islamic financial contracts and products templates relating to the capital and money market,
corporate finance and trade finance’. 8 To date, IIFM has published seven standards of different
products. Shariah Related One of the key Islamic jurisprudential institutions is the Islamic Fiqh
Academy (IsFA) established in 1981 in Jeddah, Saudi Arabia under the auspices of the OIC.
Though IsFA issues Islamic legal rulings on different issues, it also covers Shariah rulings in
economic and financial matters that are relevant for the Islamic financial sector. Though
Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) were first
established to develop accounting, and auditing for Islamic financial institutions, it also
develops and publishes Shariah standards for Islamic financial contracts. To date, AAOIFI has
published 54 Shariah standards and four Shariah governance standards.

Time value of money- The Liquidity Management Centre (LMC) was established in Bahrain
in 2002 to help Islamic financial institutions manage their liquidity mismatch through money-
markets and short and medium term liquid investments by providing short and medium term
Shariah compliant instruments. The International Islamic Liquidity Management Corp. (IILM)
was established in 2010 in Malaysia to create and issue short-term Shariah-compliant financial
instruments to facilitate effective cross-border Islamic liquidity management. The goal of IILM
is also to foster The Accounting and Auditing Organization for Islamic Financial Institutions
(AAOIFI) was first established as the Financial Accounting Organization for Islamic Banks and
Financial Institutions in 1991 in Bahrain by Islamic financial institutions to develop accounting,
auditing and governance standards for Islamic financial institutions. Other than the Shariah
standards, AAOIFI has issued 27 financial accounting standards, 7 governance standards, 2
codes of ethics and one guidance note. The Islamic International Rating Agency (IIRA) was
established in Bahrain in 2005 to carry out ratings for Islamic financial institutions and Islamic
capital market products by incorporating the unique features of Islamic finance. Other than
providing credit ratings, IIRA also carries out Shariah Quality Rating (SQR) to assess the status
of Shariah compliance in different financial institutions. Human Capital and Knowledge
Development The Islamic Research and Training Institute (IRTI) was established by Islamic
Development Bank in 1983 to undertake and advance research and training that would enable
economic, financial and banking activities conforming to Shariah and promote economic
growth and development. One of the key functions of IRTI includes helping to develop a
dynamic and innovative Islamic financial services industry by contributing to basic and applied
research. The Global Islamic Finance Development Center of the World Bank based in Istanbul
Turkey was inaugurated in 2013. The Center is a knowledge hub for conducting research and
training and providing technical assistance and advisory services to World Bank Group client
countries interested in developing Islamic financial institutions and markets. Facilitating
Institutions The Islamic Development Bank established in 1975 was one of the first Islamic
financial institutions with an objective to ‘foster socioeconomic development in member
countries and Muslim communities in non-Member countries in accordance with the principles
of the Shariah’.9 One of the strategic thrusts of the Islamic Development Bank identified in its
Vision 1440H document was to ‘Expand the Islamic financial industry’. Over the years, IDB
has been instrumental in not only coming up with innovative instruments (such as Awqaf
Properties Investment Fund and Infrastructure funds), but it also has been instrumental in
establishing the key infrastructure institutions identified above (such as IICRCA, IIFM, IFSB
and IILM). Based in Bahrain, the General Council for Islamic Banks and Financial Institutions
(CIBAFI) was established in 1981 as a global association of Islamic financial institutions.
CIBAFI aims to foster sound industry practices among financial institutions and also promote
the development of the Islamic financial sector using advocacy, research awareness and
information sharing and professional development.

Settlement of debts; Different financial and banking laws and acts govern different segments of
the financial sector. The Banking Companies Act, 1991 (BCA 1991) amended in 2003 governs
the banking sector in the country. While no specific act on Islamic banking exists, BCA 1991
incorporates some provisions of Islamic banking. The NBFI is governed by the Financial
Institutions Act, 1993 (Act 27 of 1993) and the regulations have been made thereunder (BB
2005-06).
The insurance business in the country is undertaken under the Insurance Act 1938. The
government passed two insurance laws in 2010 in a bid to further strengthen the regulatory
framework and make the industry operationally vibrant. The new laws are the Insurance Act
2010 and the Insurance Development and Regulatory Authority (IDRA) Act 2010. As in the case
of banking, there is no separate act for takaful operations in Bangladesh. However, the Insurance
Act 2010 provides for the appointment of Shariah consultants for the proposed Insurance
Development and Regulatory Authority (IDRA) to function properly. IDRA has yet to form the
five-member board for the body. The Securities and Exchange Commission Act 1993 amended
in 2012 governs the capital markets. While Bangladesh has securities and trust laws, currently
there are no specific provisions to accommodate sukuk issuance.
In summary, no separate act or law relating to Islamic finance (banking, takaful and capital
markets) exist in the country. The legal framework for the Islamic financial industry is
established by some clauses or provisions that are incorporated in the existing financial acts .
and laws.

Section 29 of Income Tax Ordinance, 1984 stipulates that interest and profits paid to Islamic
banks can be deducted from income of businesses for tax purposes.19 The Income Tax
Ordinance 1984 allows Islamic banks to deduct profits for tax purposes, but the rule of VAT is
the same for both conventional and Islamic banks. Double taxation issues remain with the
Islamic banks, especially in the case of a transfer of property under the ijarah contract.
Bullion trade; As discussed in Chapter 1, WB and IMF (2005:5) identify pillars of financial
system architecture that can promote the stability and development of the financial sector as
being macro-prudential surveillance and financial stability analysis, sound financial system
supervision and regulation, and financial system infrastructure. The latter includes legal
infrastructure for finance, systemic liquidity infrastructure and transparency, governance and
information infrastructure, payments and securities settlement systems, creditors’ rights, the
provision of incentives for strong risk management and good governance, credit reporting
systems, etc. All the elements of the financial architecture apply to the stability and development
of the Islamic financial sector. Some of the elements of financial architecture are neutral and
apply to both Islamic and conventional finance. These include sound and sustainable
macroeconomic policies, effective market discipline, well-regulated payment and clearing
systems, etc. However, there are certain unique features in the Islamic financial sector that may
not be covered by conventional architectural institutions and require specific attention. The
elements of the Islamic financial architecture that need special attention can be divided into
seven categories: legal, regulations and supervision, Shariah supervision, liquidity, information
and transparency, consumer protection and human capital. Specific infrastructure issues that
arise due to unique features arising from Shariah compliance in each of these categories are
discussed below. Dispute Settlement/Conflict Resolution Framework and Institutions
There is no special dispute resolution framework for cases involving Islamic finance. All cases
related to defaults and non-performing loans are placed under the jurisdiction of the Money Loan
Court for both Islamic and conventional banks. But for a violation of the Negotiable Instruments
Act 1881, the Islamic banks suit cases at the civil courts.
Bankruptcy and Resolution of Banks
The Bankruptcy Act of 1997 covers individuals and as well as companies (GOB 1997a).
Additionally, the Companies Act (Bangladesh) 1994 (Act No. 18 of 1994) (GOB 1997b) WB
and IMF (2005) identify three broad elements of the legal infrastructure for the financial sector.
Firstly are the laws that set the legal and regulatory framework for the industry. The laws under
this category include central banking laws, banking laws, tax laws and laws related to safety nets.
The second set is the commercial laws under which banks operate. The relevant laws under these
would be company law, including corporate governance law or regulations, land laws, contract
laws, consumer protection laws, and creditors’ rights and insolvency laws. The final element is
the judicial system that involves courts and rule of law related issues. A well-functioning judicial
system reduces legal risks and provides remedies to parties in case of disputes and bankruptcies.
3.1.1. Supporting Islamic Finance Laws Laws provide the framework for establishing
appropriate institutions and markets in three key financial sectors: banking, insurance and capital
markets. The key laws necessary for each of these financial sectors are not only those that enable
the formation and operation of financial institutions and markets but also those that enable the
formation of a central bank to carry out monetary policy and establish and give authority to
certain public bodies to regulate and supervise financial institutions and markets (WB and IMF
2005: 223). In many countries, the central bank plays the regulatory and supervisory roles and
the central banking law authorizes it to perform these functions. The financial institutions' laws
provide the legal basis to establish specific financial institutions, define their scope of operations
and governance, and include issues related to the protection of different stakeholders. For
example, the banking law specifies the requirements to establish a bank and defines the banking
activities that these institutions can undertake. The law covers various operational issues such as
governance structure and requirements, information disclosure obligations, the protection of
depositors and other stakeholders, dealing with distressed banks, etc. The capital market law
covers various aspects to ensure the smooth functioning of the securities markets. The law
encompasses issues such as the conditions to issue securities to the public, their registration and
trading, and regulations related to organizations dealing with the securities market such as
brokers, dealers etc. Securities law reduces problems associated with raising funds from markets
by clearly specifying a contracting framework for issuing securities. These laws also prevent
self-dealing by instituting rules, incentives and penalties to prevent such activities. An important
aspect of protecting investors is the requirement by securities law to disclose all relevant
quantitative and non-quantitative information of listed companies. Financial and real transactions
may be identified differently under business law. The unique nature of Islamic financial products
and organizations that are not covered by conventional financial laws necessitate the coming up
with of laws that can support the activities of the former. As products of Islamic banks involve
dealings with real goods and services, the law has to provide for these institutions to carry out
trading and investment activities. It will be difficult for Islamic banks to operate under
conventional banking laws as these do not recognize the special features of Islamic banking
practices. As a result, specific laws may be required to enable Islamic banks to use financial
products that are based on sale, leasing and investments using risk-sharing modes. Similarly,
insurance law defines the activities of the insurance business that are qualitatively different from
takaful. One key feature of takaful is that the capital of the takaful operator is separated from the
participants risk fund and the participants have certain rights that are not recognized by
conventional insurance laws. While Shariah compliant stocks will fulfill certain sector wise and
financial ratios criteria, the nature of sukuk is very different compared to bonds. Thus, securities
laws should cater to the unique nature of Islamic securities and sukuk to not only protect the
investors and stakeholders but also for the sustainable growth of the Islamic capital markets.
highlights procedures for the winding-up of companies during insolvencies, and the Banking
Companies Act 1991 also elaborates on dissolution and insolvency issues. Under the Bankruptcy
Act (Chapter 1, Section 37), ‘bank-debt’ is identified as a loan given or a financing benefit in
respect of which a claim may be made by a bank company as defined in the Banking Companies
Act 1991 or by a financial institution as defined in the Financial Institutions Act 1993. The
provisions of the Bankruptcy Act 1997 and the Companies Act 1984 apply equally for both
conventional as well as Islamic banks. Thus, there are no specific insolvency laws dealing with
issues for Islamic banks and takaful companies.
4.1.3. Financial System Regulation and Supervision Framework
Different segments of the financial sector are regulated by different entities. Bangladesh Bank
(BB) (the central bank of the country) is responsible for regulating banks and non-bank financial
institutions, Bangladesh Securities and Exchange Commission (BSEC) regulates the capital
markets, the Insurance Development and Regulatory Authority (IDRA) is the regulator of the
insurance sector, and the Micro-credit Regulatory Authority (MRA) acts as the regulator of
microfinance institutions. The regulatory and supervisory arrangements for these entities are well
defined with strong legal underpinnings. A coordination council, to enhance financial stability
through improved coordination between regulators comprising Bangladesh Bank, the Bangladesh
Security Exchange Commission (BSEC), the Insurance Development & Regulatory Authority
(IDRA), the Registrar of Joint Stock Companies (RJSC), and the Microcredit Regulatory
Authority (MRA) was established under a MOU signed among them in 2012.
The Bangladesh Bank Order (BBO) 1972 with all amendments up to 2003 defines the main
functions of Bangladesh Bank (BB) which includes regulation and supervision of banking
companies and financial institutions (GOB 1972). There is no specific provision or indication for
BB to perform duties or take initiatives that promote the Islamic financial system or regulate and
supervise Islamic financial institutions. Considering the growth and its share in the country’s
financial sector, BB should take various steps to facilitate Islamic banking. Bangladesh Bank
issued the ‘Guidelines for Islamic Banking’ in 2009 to provide a regulatory and supervisory
framework for Islamic banks in the country. However, BB has not yet established the Islamic
Banking Department to deal with different issues relating to Islamic finance.
BB issued a circular on 'Identifying Risk Factors Relating to Islamic Mode of Investment under
Risk Based Capital Adequacy for Banks' on July 20, 2009 (BB 2009). The circular provides
guidelines for management of the Capital Adequacy Framework for Islamic Banks by detailing,
among other things, the capital charges for different types (credit, market and operational) of
risks. It covers various risks arising in different modes of financing such as murabahah, ijarah,
salam, etc. and highlights pertinent issues regarding the capital adequacy of Islamic banks.
BB has recently issued a guideline named 'Onsite Supervision Guidelines December, 2015' that
also applies to Islamic banks (BB 2015c). Chapter 21 of the Guidelines deals with the
supervision of Shariah based banks and conventional banks having Islamic banking
branches/windows. It briefly discusses the norms and rules of supervision by recognizing the
specific features of Islamic modes of finances. At the time of inspection of Islamic banks and
windows of conventional banks/FIs relevant issues arising from Shariah compliance are also
considered besides the general operational issues arising in conventional banks/FIs.
Bangladesh Bank became member of the Islamic Financial Services Board (IFSB) in 2002.
While it is a member of the IFSB, as Bangladesh Bank regularly joins in on different meetings
and its officers have work as members of guideline preparation committees, it has not taken Most
economic and financial transactions have tax implications that affect costs and/or profits. Tax
laws relevant to banking are related to income (profit, withholding), transactions (capital gains
and stamp duties) and goods and services (value-added tax). For example, while interest paid on
debt can be deducted as costs, dividends paid are considered taxable income in most
jurisdictions. Similarly, withholding taxes on interest and other income such as dividends can be
different so that Islamic financial instruments are taxed differently compared to their
conventional counterpart. As Islamic financial products are based on sale, leasing and
partnership contracts, the tax implications can make these products more costly compared to
their conventional counterparts. For example, home financing and ijarah sukuk may involve
double stamp duties with the latter also having capital gains tax due to sale and buy-back
features. Thus, there is a need to change the tax laws to level the playing field for Islamic finance
with conventional finance. One way to do this is to consider the economic substance of Islamic
financial products as financing tools and applying the rules of interest to profit generated in
financial transactions. An example of this is in the UK where tax laws treat profit in a mudarabah
contract and returns payable on sukuk are treated as interest for tax purposes (any steps to
implement IFSB guidelines and principles for Islamic banks and Islamic non-bank financial
institutions. Under Strategic Goal:2 and Objective No. 2.10 in the Second Strategic Plan (2015-
2019) of Bangladesh Bank, BB has set a target to improvise its Islamic Banking Regulation
framework in line with IFSB and AAOIFI Standards by the year 2019 to help the Islamic
banking sector (BB 2015b: 9).
The Insurance Development and Regulatory Authority (IDRA) established by the Insurance
Development and Regulatory Authority (IDRA) Act 2010 replaced the office of the Chief
Controller of Insurance as a regulatory body to control, guide and supervise the insurance
industry in Bangladesh. While a number of takaful companies exist, the regulations for the
insurance industry do not deal with the specific issues related to them. As a result, takaful
companies are facing difficulties as they have to follow the conventional insurance act and
regulations. For example, the regulatory requirement to invest 30% of the investable funds with
government securities and bonds makes compliance difficult for takaful companies due to a lack
of these instruments. While the government has issued Islamic bonds, their returns are relatively
low compared to their conventional counterparts.20 Furthermore, the relatively small number of
Shariah-compliant companies in the stock market restricts investment opportunities and returns.
Thus, takaful operators cannot operate on a level playing field with their conventional
counterparts.
The Bangladesh Securities and Exchange Commission (BSEC) was established in 1993 as the
regulator of the country’s capital market through an enactment of the Securities and Exchange
Commission Act 1993 (amended in 2012). As a statutory body attached to the Ministry of
Finance, BSEC has overall responsibility to formulate and administer securities regulations.
There are no specific regulatory guidelines for sukuk or Islamic securities issued by the
Commission.
4.1.3. Shariah Governance Framework
Neither the financial laws nor the Bangladesh Bank Order 1972 make any provisions for BB to
deal with Shariah governance issues. As a result, BB does not have an apex Shariah
Supervisory Board nor does it play an active role in framing Shariah governance regimes for
Islamic financial institutions. However, the Guidelines for Islamic Banking 2009 issued by BB
addresses some Shariah related issues. It emphasizes promoting Shariah compliance of the
Islamic financial sector by strengthening the Shariah governance framework. Other than
providing advice on Shariah related issues arising in financial businesses to BB and financial
institutions, Section 3 of the guidelines identifies the functions of the Shariah Supervisory
Committee (SSC). The section on Responsibility for Shariah Compliance in BB (2009) make
the board of directors of the respective banks responsible for ensuring that the activities of the
banks and their products are Shariah compliant by forming an independent SSC with
experienced and knowledgeable persons in Islamic jurisprudence. It also provides fit and proper
criteria for selection of members of the SSC which include relevant educational Sustainable
development of any financial industry must have a suitable legal framework which includes an
effective dispute resolution mechanism (Grais, Iqbal, and El-Hawary, 2004). Courts and other
dispute settlement institutions ensure ex post implementation of contracts and enforcement of
property rights in case of any breach of contracts or exercise of rights (Pistor and Xu 2003). As
the contracts used in Islamic banking products are derived from the Shariah and the Islamic
financial contracts' legitimacy should be judged by the principles of Islamic law, the ideal
situation would be to use Shariah as the governing law to settle disputes. Thus, the dispute
resolution issue becomes complicated due to the duality of laws in play in Islamic finance
transactions. While the contracts use Islamic law, the courts in most jurisdictions use some
variant of Western commercial law to adjudicate. This would mean using non-Islamic legal
system to resolve disputes involving Islamic financial contracts. The outcome of these disputes
will partly depend on the legal system and whether supporting Islamic banking law exists or
not. One way to resolve the problem of adjudicating disputes in courts using non-Islamic civil
laws is to include choice-of-law and dispute settlement clauses (Vogel and Hayes, 1998). If
Islamic law is chosen as the law of choice to settle disputes, the contracts can opt for
commercial arbitration and be shielded from the national legal environment. While some
Islamic arbitration centers exist, parties are reluctant to take disputes to these institutions due to
the lack of precedence that creates legal risks. There is uncertainty regarding outcomes due to
the differences of opinion among different scholars and schools and the absence of a
standardized codified Islamic law. As such, partners in transactions avoid using Islamic law as
they want to avoid the "impracticalities or the uncertainty of applying classical Islamic law"
(Vogel and Hayes, 1998: 51).

Delivery in exchange of currencies;

Islamic banks in Bangladesh will face excess liquidity problems as long as they cannot invest in
interest-bearing government treasury bills and bonds. In the absence of limited alternatives to
interest-bearing government securities, Islamic banks still experience a huge amount of surplus
liquidity which remans idle in their vaults and with the Bangladesh Bank. Recognizing the
problem, Bangladesh Bank has introduced two supportive measures to support liquidity
management in Islamic finance. Among those, BB introduced a discriminatory statutory liquidity
requirement (SLR) framework for the Islamic banks since 1983 after the inception of Islamic
banking in the country. Instead of making it mandatory for Islamic banks, Bangladesh Bank has
been following a discriminatory policy towards maintenance of CRR and SLR. The required
ratio for maintenance of SLR, in a broad sense, by the conventional banks is fixed at 19.50%
while at the same time being fixed at 11.5 percent of their total demand and time liabilities for
Islamic banks.
The second initiative was the introduction of a Shariah compliant government liquidity
instrument, the Bangladesh Government Islamic Investment Bond (GIIB), in 2004 (BB 2004).
GIIB provides a cushion for Islamic banks to park their excess liquidity and use these as a
vehicle to maintain the required amount of SLR. Effective from 1st January 2015, the GIIB has
been made short-term (three months) in tenor. However, currently there are no long term Islamic
bonds such as sukuk where Islamic banks can park their excess liquidity There are limited
Islamic financial instruments and relatively inactive secondary market for trading Islamic short-
term Islamic financial securities. BB issued a Guideline on Islami Interbank Fund Market (IIFM)
on 27 December 2011 (BB 2011). As indicated, Islamic banks have taken the initiative to
establish an interbank Islamic money market with the encouragement of BB.
BB has taken three initiatives to provide a liquidity management infrastructure for the Islamic
banks. The requirement of maintaining the SLR (including CRR) still remains well below at
12.5%, compared to the requirement of the conventional banks (19%). The introduction of the
Bangladesh Government Islamic Investment Bond (BGIIB) was the beginning of providing a
cushion for the Islamic banks to park their excess liquidity by using it as a vehicle to maintain
the required amount of SLR. There are however no Shariah complaint lenders of the last resort
facilities for Islamic banks (IFSB 2014).
4.1.5. Information Infrastructure and Transparency
Accounting and Auditing Framework/Transparency and Disclosure
The Institute of Chartered Accountants of Bangladesh (ICAB) is the national professional
accounting body responsible for regulating the accounting profession in the country. Among
others, ICAB issues the Bangladesh Accounting Standards (BFRS) in line with International
Accounting Standards (IAS).
Bangladesh Bank Guidelines for Conducting Islamic Banking requires that licensed Islamic
financial institutions should maintain proper accounting standards and prepare financial
statements that can be conveniently audited. It provides the framework that Islamic banks can
use to comply with the different laws of the country (BCA 1991 and Companies Act 1994), the
IFRS and also the AAOIFI. While Islamic banks are required to comply with the disclosure
requirements of the Securities and Exchange Rules of 1987 and the Listing regulations of the
Dhaka and Chittagong Stock Exchanges, they are also required to adjust their financial
statements according to the IFRS.21 The Guidelines, however, do not address the necessary
adjustment of financial transactions that is required to comply with the requirements of the
International Financial Reporting Standards (IFRS). So, reporting institutions are required to
adjust their Financial Statements as per their own requirements.
21 BB
Rule 12(2) of the cited Securities and Exchange Rules prescribing compliance with the
International Accounting Standards (IAS) states that 'The financial statements of an issuer of a
listed security shall be prepared in accordance with the requirements laid down in the Schedule
and in the International Accounting Standards as adopted by the Institute of Chartered
Accountants of Bangladesh (ICAB)". It is also to be noted that in case the requirements of the
guidelines and circulars issued by the Bangladesh Bank differ with those of other regulatory
authorities and financial reporting standards, the guidelines and circulars issued by the
Bangladesh Bank prevail. The Guidelines for Islamic Banking 2009 give details on the
modalities of specimen reporting formats and Financial Statements for Banks operating under
Islamic Shariah. It also stipulates that the BB may specify standards related to transparency and
disclosure requirements that entail information that is accurate, clear, timely and not misleading.
The Guidelines do not address all aspects of the Shariah and require Islamic banks to follow the
Shariah rules set by their respective Shariah Supervisory Committee as well as those of the
AAOIFI. The banks are required to disclose, among others, the types of Islamic deposits, the
class of Shariah contracts used (such as Murabaha, ijarah, Mudaraba, salam, istisna'a etc),
obligations to zakat payments, and income derived from Shariah non-compliant activities.
Islamic banks are also required to include Shariah Committee Reports as a part of their Annual
Reports, and the regulatory guidelines provide the minimum disclosure that should be included
in the report.
Overall, the Guidelines on accounting issues provide the minimum disclosure requirements on
Shariah related issues that should be followed by the Islamic banks. As a result a lot of
information may be absent which is vital for fair disclosure. In the Bangladesh context, despite
the requirement to comply with the BFRS, three Islamic banks have voluntarily opted to comply
with both BFRS and AAOIFI FAS.22
Rating Agencies
Bangladesh Bank has 8 ratings agencies licensed by the Bangladesh Securities & Exchange
Commission (BSEC). In case banks have an international exposure they can also use the ratings
of the international rating agencies such as Fitch, Moody and Standard & Poor. Islamic banking
branches and windows of the conventional commercial banks are rated on the same basis as their
conventional counterparts. Bangladesh Bank issued a guideline on the External credit rating
under the "Implementation of Basel III in Bangladesh" on 21 December 2014 (BB 2014). The
methodology of the rating is stated as 'The capital requirement for credit risk is based on the risk
assessment made by External Credit Assessment Institutions (ECAIs) recognized by BB for
capital adequacy purposes". While the conventional Rating Agencies rate the Islamic banks in
Bangladesh, there has been no sukuk introduced to date in the country. Of the eight ratings
agencies, one (Emerging Credit Rating) has introduced ratings specifically for Islamic financial
institutions.23
4.1.6. Consumer Protection Architecture
Consumer Protection and Financial Literacy
The Consumer Rights Protection Act, 2009 (Act No. 26 of 2009) (GOB 2009) was enacted in the
country to provide for the protection of the rights of consumers, prevention of anti-consumer
rights practices and for the purpose of making provisions for matters connected therewith.
Bangladesh Bank has taken steps to enhance Consumer Protection and Financial Literacy. The
second Strategic Plan 2015-2019 of Bangladesh Bank (BB 2015b) also recognizes empowering
consumers by protecting and educating consumers to be one of the key enablers of the
development of the financial sector in the country. To make its financial inclusion initiatives
fruitful and comprehensive, BB has strengthened the consumer empowerment framework and
initiated financial education programs. This is being done by adopting an action plan to 'develop
comprehensive consumer protection framework through improvising existing guidelines on
customer service and complaint management'.
BB has set up a dedicated department for attending consumer complaints within its own structure
and issued a comprehensive 'Guidelines for Customer Services & Complaint Management in
banks (BB 2014). These Guidelines are formulated with specific objectives like attaining and
retaining customer satisfaction and interest protection and bank/financial institution goodwill,
reputation and financial stability. The Guidelines are structured and focus on the aspects of
institutional and individual ethical standards, customer service quality, customer awareness
programs, and complaint management systems. The document serves the purpose of providing
guidelines to all bank companies and financial institutions on customer services and complaint
management systems that are expected to be in place. It sets out minimum standards that shall be
expected to be achieved by complaint cells of any banking company /financial institutions.
For educating the consumers, BB has arranged an array of Cross Country Road Shows, SME
Fairs, MSME credit programs and capacity building programs, Open Agri-Credit Disbursement
Programs School Banking conferences in collaboration with banks. It has designed a Financial
Education web portal.24
24 Bangladesh
Islamic Finance literacy programs are conducted by the individual banks. Islamic banks
frequently arrange client awareness programs and distribute different types of Islamic product
brochures. Some Islamic banks also arrange seminars and workshops at their branches.
Bangladesh Bank also encourages Islamic banks to increase their financial inclusion net and take
appropriate measures to increase their financial literacy program.
Deposit Insurance
Deposit Insurance Systems (DIS) was first introduced in August 1984 as a scheme in terms of
‘The Bank Deposit Insurance Ordinance 1984". In July 2000, the Ordinance was repealed by an
Act called "The Bank Deposit Insurance Act 2000" (GOB 2000). Deposit Insurance in
Bangladesh is now being administered by this Act. In 2006, Bangladesh Bank became the
member of International Association of Deposit Insurers (IADI). While the direct rationale for
deposit insurance is customer protection, the indirect rationale for deposit insurance is that it
reduces the risk of a systemic crisis involving, for example, panic withdrawals of deposits from
sound banks and the breakdown of the payments system.
A department called 'Deposit Insurance Department' (DID) has been set up at the head office of
the BB to protect small depositors, enhance public confidence, enhance market discipline,
enhance the stability of the financial system, ensure orderly payment systems in case of the
winding up of any insured bank, increase savings, and encourage economic growth. There are
two divisions in the department: Deposit Insurance Division and Liquidated Bank Monitoring
Division. In case of the winding up of an insured bank, the BB is obliged to pay to every
depositor an amount equal to his/her deposits not exceeding Taka 100,000. There is no Shariah
compliant deposit insurance scheme for Islamic banks (IFSB 2014).

Chapter 7
Salam & Parallel Salam - mechanism, applications and AAOIFI Shariah standards- Salam
is a sale whereby the seller undertakes to supply some specific goods to the buyer at a future date
in exchange of an advanced price fully paid at spot.
Here the price is cash, but the supply of the purchased goods is deferred. The buyer is called
“rabb-us-salam”, the seller is “muslam ilaih”, the cash price is “ra’s-ul-mal” and the purchased
commodity is termed as “muslam fih”, but for the purpose of simplicity, I shall use the English
synonyms of these terms.
Salam was allowed by the Holy Prophet (peace be upon him) subject to certain conditions. The
basic purpose of this sale was to meet the needs of the small farmers who needed money to grow
their crops and to feed their family up to the time of harvest. After the prohibition of riba they
could not take usurious loans. Therefore, it was allowed for them to sell the agricultural products
in advance.
Similarly, the traders of Arabia used to export goods to other places and to import some other
goods to their homeland. They needed money to undertake this type of business. They could not
borrow from the usurers after the prohibition of riba. It was, therefore, allowed for them that they
sell the goods in advance. After receiving their cash price, they could easily undertake the
aforesaid business.
Salam was beneficial to the seller, because he received the price in advance, and it was beneficial
to the buyer also, because normally, the price in salam used to be lower than the price in spot
sales. The permissibility of salam was an exception to the general rule that prohibits the forward
sales, and therefore, it was subjected to some strict conditions. These conditions are summarized
below:

1. First of all, it is necessary for the validity of salam that the buyer pays the price in full to
the seller at the time of effecting the sale. It is necessary because in the absence of full
payment by the buyer, it will be tantamount to sale of a debt against a debt, which is
expressly prohibited by the Holy Prophet (peace be upon him). Moreover, the basic
wisdom behind the permissibility of salam is to fulfil the instant needs of the seller. If the
price is not paid to him in full, the basic purpose of the transaction will be defeated.
Therefore, all the Muslim jurists are unanimous on the point that full payment of the price
is necessary in salam. However, Imam Malik is of the view that the seller may give a
concession of two or three days to the buyers, but this concession should not form part of
the agreement.
2. Salam can be effected in those commodities only the quality and quantity of which can be
specified exactly. The things whose quality or quantity is not determined by specification
cannot be sold through the contract of salam. For example, precious stones cannot be sold
on the basis of salam, because every piece of precious stones is normally different from
the other either in its quality or in its size or weight and their exact specification is not
generally possible.
3. Salam cannot be effected on a particular commodity or on a product of a particular field
or farm. For example, if the seller undertakes to supply the wheat of a particular field, or
the fruit of a particular tree, the salam will not be valid, because there is a possibility that
the crop of that particular field or the fruit of that tree is destroyed before delivery, and,
 given such possibility, the delivery remains uncertain. The same rule is applicable to
every commodity the supply of which is not certain.2
4. It is necessary that the quality of the commodity (intended to be purchased through
salam) is fully specified leaving no ambiguity which may lead to a dispute. All the
possible details in this respect must be expressly mentioned.
5. It is also necessary that the quantity of the commodity is agreed upon in unequivocal
terms. If the commodity is quantified in weights according to the usage of its traders, its
weight must be determined, and if it is quantified through measures, its exact measure
should be known. What is normally weighed cannot be quantified in measures and vice
versa.
6. The exact date and place of delivery must be specified in the contract.
7. Salam cannot be effected in respect of things which must be delivered at spot. For
example, if gold is purchased in exchange of silver, it is necessary, according to Shariah,
that the delivery of both be simultaneous. Here, salam cannot work. Similarly, if wheat is
bartered for barley, the simultaneous delivery of both is necessary for the validity of sale.
Therefore the contract of salam in this case is not allowed. All the Muslim jurists are
unanimous on the principle that salam will not be valid unless all these conditions are
fully observed, because they are based on the express ahadith of the HolyProphet (peace
be upon him). The most famous hadith in this context is the one in which the Holy
Prophet (peace be upon him) has

said:

Whoever wishes to enter into a contract of salam, he must effect the salam according to the
specified measure and the specified weight and the specified date of delivery.

However, there are certain other conditions which have been a point of difference between the
different schools of the Islamic jurisprudence. Some of these conditions are discussed below:
(1) It is necessary, according to the Hanafi school, that the commodity (for which salam is
effected) remains available in the market right from the day of contract up to the date of delivery.
Therefore, if a commodity is not available in the market at the time of the contract, salam cannot
be effected in respect of that commodity, even though it is expected that it will be available in
the markets at the date of delivery.
However, the other three schools of Fiqh (i.e. Shafi’i, Maliki, and Hanbali) are of the view that
the availability of the commodity at the time of the contract is not a condition for the validity of
salam. What is necessary, according to them, is that it should be available at the time of delivery.
This view can be adopted in the present circumstances.
(2) It is necessary, according to the Hanafi and Hanbali schools that the time of delivery is, at
least, one month from the date of agreement. If the time of delivery is fixed earlier than one
month, salam is not valid. Their argument is that salam has been allowed for the needs of small
farmers and traders and therefore, they should be given enough opportunity to acquire the
commodity. They may not be able to supply the commodity before one month. Moreover, the
price in salam is normally lower than the price in spot sales. This concession in the price may be
justified only when the commodities are delivered after a period which has a reasonable bearing
on the prices. A period of less than one month does not normally affect the prices. Therefore, the
minimum time of delivery should not be less than one month.
Imam Malik supports the view that there should be a minimum period for the contract of salam.
However, he is of the opinion that it should not be less than fifteen days, because the rates of the
market may change within a fortnight.
This view is, however, opposed by some other jurists, like Imam Shafi’i and some Hanafi jurists
also. They say that the Holy Prophet (peace be upon him) has not specified a minimum period
for the validity of salam. The only condition, according to the Hadith, is that the time of delivery
must be clearly defined. Therefore, no minimum period can be prescribed. The parties may fix
any date for delivery with mutual consent.
This view seems to be preferable in the present circumstances, because the Holy Prophet (peace
be upon him) has not prescribed a minimum period. The jurists have prescribed different periods
which range between one day to one month. It is obvious that they have done so on the basis of
expedience and keeping in view the interest of the poor sellers. But the expediency may differ
from time to time and from place to place. Likewise, sometimes it is more in the interest of the
seller to fix an earlier date. As far as the price is concerned, it is not a necessary ingredient of
salam that the price is always lower than the market price on that day. The seller himself is the
best judge of his interest, and if he accepts an earlier date of delivery with his free will and
consent, there is no reason why he should be forbidden from doing so.
Certain contemporary jurists have adopted this view being more suitable for the modern
transactions.
It is evident from the foregoing discussion that salam was allowed by Shariah to fulfil the needs
of farmers and traders. Therefore, it is basically a mode of financing for small farmers and
traders. This mode of financing can be used by the modern banks and financial institutions,
especially to finance the agricultural sector. As pointed out earlier, the price in salam may be
fixed at a lower rate than the price of those commodities delivered at spot. In this way, the
difference between the two prices may be a valid profit for the banks or financial institutions. In
order to ensure that the seller shall deliver the commodity on the agreed date, they can also ask
him to furnish a security, which may be in the form of a guarantee or in the form of mortgage or
hypothecation.11 In the case of default in delivery, the guarantor may be asked to deliver the
same commodity, and if there is a mortgage, the buyer / the financier can sell the mortgaged
property and the sale proceeds can be used either to realize the required commodity by
purchasing it from the market, or to recover the price advanced by him.
The only problem in salam which may agitate the modern banks and financial institutions is that
they will receive certain commodities from their clients, and will not receive money. Being
conversant with dealing in money only, it seems to be cumbersome for them to receive different
commodities from different clients and to sell them in the market. They cannot sell those
commodities before they are actually delivered to them, because it is prohibited in Shariah.
But whenever we talk about the Islamic modes of financing, one basic point should never be
ignored. The point is that the concept of the financial institutions dealing in money only is
foreign to Islamic Shariah. If these institutions want to earn a halal profit, they shall have to deal
in commodities in one way or the other, because no profit is allowed in Shariah on advancing
loans only. Therefore, the establishment of an Islamic economy requires a basic change in the
approach and in the outlook of the financial institutions. They shall have to establish a special
cell for dealing in commodities. If such a special cell is established, it should not be difficult to
purchase commodities through salam and to sell them in the spot markets.
However, there are two other ways of benefiting from the contract of salam.
Firstly, after purchasing a commodity by way of salam, the financial institutions may sell it
through a parallel contract of salam for the same date of delivery. The period of salam in the
second (parallel) transaction being shorter, the price may be a little higher than the price of the
first transaction, and the difference between the two prices shall be the profit earned by the
institution. The shorter the period of salam, the higher the price, and the greater the profit. In this
way the institutions may manage their short term financing portfolios.
Secondly, if a parallel contract of salam is not feasible for one reason or another, they can obtain
a promise to purchase from a third party. This promise should be unilateral from the expected
buyer. Being merely a promise, and not the actual sale, their buyers will not have to pay the price
in advance. Therefore, a higher price may be fixed and as soon as the commodity is received by
the institution, it will be sold to the third party at a pre-agreed price, according to the terms of the
promise.
A third option is sometimes proposed that, at the date of delivery, the commodity is sold back to
the seller at a higher price. But this suggestion is not in line with the dictates of Shariah. It is
never permitted by the Shariah that the purchased commodity is sold back to the seller before the
buyer takes its delivery, and if it is done at a higher price it will be tantamount to riba which is
totally prohibited. Even if it is sold back to the seller after taking delivery from him, it cannot be
pre-arranged at the time of original sale. Therefore, this proposal is not acceptable at all.
Since the modern Islamic Banks and Financial Institutions are using the instrument of parallel
salam, some rules for the validity of this arrangement are necessary to observe:
1. In an arrangement of parallel salam, the bank enters into two different contracts. In one of
them, the bank is the buyer and in the second one the bank is the seller. Each one of these
contracts must be independent of the other. They cannot be tied up in a manner that the rights
and obligations of one contract are dependant on the rights and obligations of the parallel
contract. Each contract should have its own force and its performance should not be contingent
on the other.
For example, if A has purchased from B 1000 bags of wheat by way of salam to be delivered on
31 December, A can contract a parallel salam with C to deliver to him 1000 bags of wheat on 31
December. But while contracting parallel salam with C, the delivery of wheat to C cannot be
conditioned with taking delivery from B. Therefore, even if B did not deliver wheat on 31
December, A is duty bound to deliver 1000 bags of wheat to C. He can seek whatever recourse
he has against B, but he cannot rid himself from his liability to deliver wheat to C.
Similarly, if B has delivered defective goods which do not conform with the agreed
specifications, A is still obligated to deliver the goods to C according to the specifications agreed
with him.
2. Parallel salam is allowed with a third party only. The seller in the first contract cannot be made
purchaser in the parallel contract of salam, because it will be a buy-back contract, which is not
permissible in Shariah. Even if the purchaser in the second contract is a separate legal entity, but
it is fully owned by the seller in the first contract the arrangement will not be allowed, because in
practical terms it will amount to ‘buy-back’ arrangement. For example A has purchased 1000
bags of wheat by way of salam from B, a joint stock company. B has a subsidiary C, which is a
separate legal entity but is fully owned by B. A cannot contract the parallel salam with C.
However, if C is not wholly owned by B, A can contract parallel salam with it, even if some
share-holders are common between B and C.
Chapter 8
 Istijrar - types, applications and conditions

Meaning:
Istijrar refers to an agreement where the buyer purchases commodities under a single agreement
from a supplier in part by part from time to time in different quantities and each time there is no
offer or acceptance or bargain required. The deal will be considered as a sole agreement where
all terms and conditions are finalized.
Istijrar means purchasing goods time to time in different quantities. In Islamic jurisprudence
Istijrar is an agreement where a buyer purchases something from time to time; each time there is
no offer or acceptance or bargain. There is one master agreement where all terms and conditions
are finalized.
Examples:
 X keeps on taking medicines from a medical store as and when needed and pays him at
the end of a month.
 Y pays monthly for a newspaper in advance and receiving the newspaper daily.
Types
Istijrar mainly is of two types. These are:
1. The price is determined after all transactions of purchase are complete.
2. The price is determined in advance but the purchase is executed from time to time.
The first kind is relevant with the Islamic mode of financing. This kind is permissible with
certain conditions.

1. In the case where the seller discloses the price of goods at the time of each transaction;
the sale becomes valid only when the buyer possess the goods. The amount is paid after
all transactions have been completed.
2. If the seller does not disclose each and every time to the buyer the price of the subject
matter, but the contractors know that it is being sold on market value and the market
value is specified and determined in such a manner that it does not vary and it does not
lead to differences of the contractors.
 3. If at the time of possession, the price of subject matter was unknown or contractors agree
that whatever the price shall be, the sale will be executed. However, if there is significant
difference in the market price and the agreed price, it may cause conflict. In such a case,
at the time of possession, the sale will not be valid. However, at the time of settlement of
the payment, the sale will be valid.
The validity will relate to the time of possession. Therefore the ownership of the buyer in the
subject matter will be proved from the time of possession. After the payment of price the buyer’s
usage of the subject matter will be valid from the time of the possession.
As far as the use of Istijrar in Islamic banks is concerned, at present they are involved in four
kinds of activities, namely Murabahah, Ijarah, Mudarabah and Musharakah. Out of these four,
the concept of Istijrar can be applied to only the first three cases, due to the reason that Istijrar
cannot be applied to borrowers of the bank. However, the same concept can however be applied
to suppliers of the borrower.
However, Istijrar can work with suppliers of the borrower. In this case, the bank enters into a
Murabahah with the suppliers on the basis of Istijrar. The bank enters into an Agreement to
Purchase with the suppliers (which are mainly trading companies) that it will purchase assets
from them at a market price or at a predetermined discount from the market price. Whenever the
bank has a new customer, it can purchase the assets from the suppliers on the basis of Istijrar and
sell it onwards to the customer on the basis of Murabahah.
It might very well be probable that the bank might enter into a pseudo-Istijrar agreement with the
suppliers rather than a true one. This is the case when the bank enters into an agreement with the
customer that it is going to sell certain assets in a certain quantity to them within a specified time
period. The customer may then purchase the assets from the banks in tranches rather than at once
and complete the whole purchase within the specified time period in order to complete the
agreement.
The above type of Istijrar is referred to as Istijrar with Pre-agreed Sale due to the reason that the
customer purchases a given amount of assets from the bank over a period of time but the price of
the assets purchased is always known before the sale. Given the above, there is no difference of
opinion between Shariah scholars as far as accepting this type of transaction as Bai-Ta’ati is
concerned. However, the use of Ta’ati in case of a Murabahah transaction is not acceptable, as it
leads indirectly to Riba in case the bank does not take possession of the assets before they are
sold to the customer. Hence if Ta’ati is to be used in this case, then the only way to do it is that
the bank should purchase the assets some time before selling it to the customer. This would
ensure possession that is not just constructive but the bank would have title to the assets before
they are sold to the customer.
Uses of Istijrar
Istijrar is used in transactions like Murabahah, Ijarah and Mudarabah. The concept of Istijrar can
be applied in Murabahah transaction. The bank may use the concept of Istijrar for acquiring
goods from suppliers and selling those goods to buyer on Istijrar basis by adding some amount of
profit on a deferred payment basis.
It is required to get ready template purchase requisition letter so that it unmistakably specifies the
specifications of the goods. The supplier needs to send a confirmation letter to the bank and then
from the bank to the purchaser that portrays every single required detail of the merchandise
alongside costs. describes all the required details of the goods along with prices. This is done to
avoid any ambiguity and dispute. The provider needs to send a confirmation letter to the bank
and after that from the bank to the buyer
Area of Application
 The Bank may practice Istijrar with the provider when buying the goods in various
arrangements from a single or few supplier(s).
 The Bank may practice Istijrar with the provider when offering the products under
Murabahah by obtaining through Letter of Authority against the dealership.
 The Bank may practice Istijrar with the provider when acquired merchandise is conveyed
in portions and installment is made after completion of supplies.
 The Bank may exercise Istijrar with the client on pitching the products in various
arrangements to a specific customer, etc.
 Unit # 9

Istisna and Parallel Istisna - mechanism, applications and AAOIFI Shariah standards;

Istisna
In Islamic finance, a contract to manufacture goods, assemble or process them, or to build a
house or other structure according to exact specifications and a fixed timeline. ... Istisna avoids
making or receiving interest payments, which is forbidden by the Islamic religion.
Istisna’ means asking someone to construct, build or manufacture an asset. In Islamic finance,
istisna' is generally a long-term contract whereby a party undertakes to manufacture, build or
construct assets, with an obligation from the manufacturer or producer to deliver them to the
customer upon completion. In practice, the key advantage of an istisna’ contract is that it can
provide flexibility to the customer, where payments can be made in installments linked to project
completion, at delivery or after project completion. In contrast to istisna', for salam contract the
payment has to be made in full, in advance.
Infrastructure projects are the main examples of istisna' application. This includes: construction
of power plants, factories, roads, schools, hospitals, building and residential developments. The
parties to an istisna' contract are: the Producer or Manufacturer; the Bank (i.e. the financier); and
the Customer (i.e. purchaser of goods).
Figure 1: Istisna’ Structure
The below diagram shows istisna' structure:

Source: Islamic Banking and Finance, 2009 (Spiramus Press Ltd)

The above structure is also known as “simple istisna'”, where it is assumed that the buyer has the
required financing to directly coordinate with the manufacturer on the project. If the buyer does
not have the financing, then the below parallel istisna' structure can be used.
Figure 2: Parallel Istisna’ Structure
The parallel istisna' involves: the customer (the buyer); the Islamic bank (the seller); and the
manufacturer (in some cases it can also involve sub-contractors), where the buyer can obtain
financing from the Islamic bank The following diagram shows parallel istisna' structure:
 Source: Islamic Banking and Finance, 2009 (Spiramus Press Ltd)
Istisna’ Validity, Amendments and Cancellations
In order for the istisna' to be valid, the price must be fixed from the outset. In the event of any
unforeseen event that causes a delay in delivery the price of istisna' can be amended, if it is
mutually agreed. After the manufacturer has started the work, the contract cannot be cancelled
unilaterally.

Istisna’ Risk Mitigation

Risk Description Mitigation

Delay in delivery of goods from the producer Link pricing of the istisna' to
Delivery Risk
to the customer at maturity. delivery.

Non- The producer is either unable or is unwilling to The price can be paid in
Performance manufacture the goods during assigned time. installments.

The producer delivers defected/inferior goods, Quality assurance agreement,

Quality Risk which is realized by the customer only at the with producer to rectify
time of delivery. defects.

Cost incurred by the producer turns out to be Producer to handle increase

Increased costs
higher than anticipated, which causes the in costs, unless it is due to an
of Production
producer to default on performance. unforeseen event.

In the case of parallel istisna’, the goods once

Storage Risk delivered by the producer will be at the bank's Insurance / Takaful.
risk before being sold to the customer.

Source: IslamicMarkets.com; Meezan Bank.

Istisna' Documentation
There are three sets of documentation involved in istisna':
1. Master Istisna' Agreement
The agreement is signed between the Bank and the Customer, outlining the terms and conditions
of the production of goods, including: cost price, delivery location, quantity and quality.
2. Agency Agreement
In the case of Agency Agreement, the Bank will appoint the producer of goods its Agenet to sell
the goods. Generally, this documents also sets out the agency fees schedule (Notice of
Appointment).
3. Corporate Guarantee
This agreement is between the Bank and the Customer, guaranteeing the payment obligation in
the case of default. This can include a mortgage or pledges on receivables.
In practice Istisna' contracts can be arranged with other Sharia' compliant agreements
including: kafalah, takaful; rahn; hamish gedyyah (security deposit), or arbun (down payment).
Istisna’: Hadith
The Islamic underpinning of istisna' can be found with the following two ahadith:
The Prophet (PBUH) required that a pulpit (platform) be built for preaching [Bukhari 2/908]
The Prophet (PBUH) required that a finger ring be manufactured for Him [Bukhari 5/220 and
Muslim 3/1655]
Parallel Istisna'a.
Parallel Istisna'a. An istisna'a contract in which the buyer (manufacture orderer, or almustasni')
doesn't set a condition in the contract obliging the seller (al-sani') to undertake manufacturing the
subject matter (commodity, asset, item, etc) by himself. ... The second contract is referred to
as parallel istisna'a.
The parallel istisna contract involves three parties and It consists of two separate contracts. The
first contract is between the ultimate purchaser (customer) and the seller (Islamic bank), where
the Islamic bank as seller is responsible to deliver the asset to customer according to given
specifications. The second istisna contract is between the Islamic bank (as buyer) and the
manufacturer of the asset. The following steps are involved in parallel istisna contract.
1. The customer wants to purchase the certain assets to be manufactured or constructed (for
example house) and approaches the Islamic bank for financing.
2. The Islamic bank (as seller / manufacturer) enters into istisna contract with customer. The
price is determined as bank’s cost plus profit margin.
3. The Islamic bank (buyer) enters into the parallel istisna (second istisna) contract with the
contractor to construct the asset (house) as per the agreed specifications with customer.
4. The Islamic bank pays the cost of construction to the contractor in the second istisna contract.
5. After the completion of manufacturing process, the Islamic bank delivers the asset to the
customer (ultimate buyer) upon the delivery date. Sometimes, the Islamic bank appoints the
contractor its agent to deliver the asset to the customer on its behalf.
6. The customer pays the price of istisna asset to the Islamic bank in form installments or lump
sum according to their agreement.

Application of Istisna in Islamic Financial Institutions

How is the lease (istisna) contract used in modern Islamic financial institutions and what is the
process of "parallel salam"?
Today, we are going to learn how the concept of istisna is used as a mode of financing in
prevalent Islamic financial institutions. The contract of istisna is applicable for various industrial
projects which can be manufactured according to given specifications. For example,
the istisna contract can be used for house financing. If the client seeks financing to construct the
house at his open land, the Islamic bank may undertake to construct the house on the basis
of istisna contract. Likewise, the contract of istisna can be employed in advance technology
industries and in the manufacturing of equipment such as aircrafts, automobiles, ships and
factory equipment. As we discussed in the previous article, it is not necessary in istisna contract
that financier himself construct the asset. He can enter into a parallel istisna contract with a third
party. Generally, the Islamic banks uses the parallel istisna contract as they don’t have the
required expertise to construct or manufacture the asset themselves. In the following, we explain
both types of istisna contract in order to get the complete picture.

Types of istisna

The istisna contract can be categorized into two types: classical istisna and parallel istisna.
Classical istisna
The classical istisna contract has been discussed by the jurists and Shariah scholars in fiqh
literature. This type of istisna involves only two contracting party namely the buyer (also known
as mustasni) and the seller (also known as manufacturer and sani). The classical istisna has the
following mechanism:
1. The customer (buyer) approaches the manufacturer (seller) to construct a specified asset for
him. They agree on specifications of the asset, the price and the date of delivery at the time of
contract execution.
2. The customer pays the price to manufacture in cash or installments according to their
agreement.
3. After the completion of manufacturing process, the manufacturer delivers the completed asset
to customer on delivery date.
Parallel istisna
The parallel istisna contract involves three parties and It consists of two separate contracts. The
first contract is between the ultimate purchaser (customer) and the seller (Islamic bank), where
the Islamic bank as seller is responsible to deliver the asset to customer according to given
specifications. The second istisna contract is between the Islamic bank (as buyer) and the
manufacturer of the asset. The following steps are involved in parallel istisna contract.
1. The customer wants to purchase the certain assets to be manufactured or constructed (for
example house) and approaches the Islamic bank for financing.
2. The Islamic bank (as seller / manufacturer) enters into istisna contract with customer. The
price is determined as bank’s cost plus profit margin.
3. The Islamic bank (buyer) enters into the parallel istisna (second istisna) contract with the
contractor to construct the asset (house) as per the agreed specifications with customer.
4. The Islamic bank pays the cost of construction to the contractor in the second istisna contract.
5. After the completion of manufacturing process, the Islamic bank delivers the asset to the
customer (ultimate buyer) upon the delivery date. Sometimes, the Islamic bank appoints the
contractor its agent to deliver the asset to the customer on its behalf.
6. The customer pays the price of istisna asset to the Islamic bank in form installments or lump
sum according to their agreement.
AAOIFI Shariah standards;
Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is
a Bahrain based not-for-profit organization that was established to maintain and
promote Shariah standards for Islamic financial institutions, participants and the overall
industry.The Commission also organizes a number of professional development programs
(especially the Islamic legal accountant program and the observer program and forensic auditor)
in their effort to upgrade the human resources working in the industry and the development of
governance structures controls the institutions.
Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) is an
independent industry body dedicated to the development of international standards applicable for
Islamic financial institutions. The Bahrain-based organisation started producing standards as
early as 1993.
AAOIFI standards have been developed in consultation with leading Sharia scholars, with
several counties adopting them. Although AAOIFI standards are not binding on members, over
the last few years the organisation has made significant progress in encouraging the widespread
adoption of the standards.
Countries where AAOIFI standards are either mandatory or recommended include: Bahrain,
Malaysia, UAE, Saudi Arabia, Lebanon, Syria, Sudan and Jordan. Prior to implementation of
AAOIFI standards many financial institutions in these countries were operating under a “semi-
regulated market” (Al Baluchi, 2006), where accounting policies were determined with the
assistance of the bank’s Sharia Supervisory Board (SSB). In addition, over this period,
International Accounting Standards (IAS) or respective national accounting standards were
followed by Islamic banks. Hence, the unique requirements of Islamic financial institutions were
not being met. To give two examples:

a. Fiduciary risk: the Mudaraba contract places liability of the loss on the mudarib.
b. Displaced commercial risk: where Islamic banks “smooth” the returns Investment
Account Holders (IAH) by varying the percentage of profit taken as Mudarib share.
As a result, with the support of banking authorities, AAOIFI standards were created. In an
industry that is often quite fragmented, it is hoped that the development of AAOIFI standards
will go a long way in promoting convergence in Sharia standards and leading to further growth
in this nascent market.
Incorporation

AAOIFI was established in accordance with the Agreement of Association which was signed by
Islamic financial institutions on 26 February 1990 in Algiers. Then, it was registered on 27
March 1991 in Bahrain. It has members from more than 45 countries, including central banks
and Islamic financial institutions and other parties working in the financial industry and banking,
Islamic International. The Commission has obtained support for the application of the standards
issued by it, where these standards are dependent today in the Kingdom of Bahrain and the
Dubai International Financial Centre, Jordan, Lebanon, Qatar, Sudan and Syria . The competent
authorities in Australia, Indonesia, Malaysia, Pakistan, Saudi Arabia and South Africa issued
guidelines derived from the standards and publications.

Organizational Structure
The organizational structure of AAOIFI includes a general assembly. AAOIFI also has a board
of trustees and an accounting and auditing standards board each consisting of fifteen part-time
members, a Shari‘ah committee consisting of four part-time members, an executive committee,
and a secretary-general who is a full-time executive and heads the general secretariat.
AAOIFI Standards – The following standards have been developed by AAOIFI:
Accounting Standards:
1. Objective of financial accounting for Islamic banks and financial institution (IFIs).
2. Concept of financial accounting for IFIs.
3. General presentation and disclosure in the financial statements of IFIs.
4. Murabaha and Murabaha to the purchase orderer.
5. Mudaraba financing.
6. Musharaka financing.
7. Disclosure of bases for profit allocation between owners’ equity and investment account
holders.
8. Equity of investment account holders and their equivalent.
9. Salam and Parallel Salam.
10. Ijarah and Ijarah Muntahia Bittamleek.
11. Zakah.
12. Istisna’a and Parallel Istisna’a.
13. Provisions and Reserves.
14. General Presentation and Disclosure in the Financial Statements of Islamic Insurance
Companies.
15. Disclosure of Bases for Determining and Allocating Surplus or Deficit in Islamic Insurance
Companies.
16. Investment Funds.
17. Provisions and Reserves in Islamic Insurance Companies.
18. Foreign Currency Transactions and Foreign Operation.
19. Investments.
20. Islamic Financial Services Offered by Conventional Financial Institutions.
21. Contributions in Islamic Insurance Companies.
22. Deferred Payment Sale .
23. Disclosure on Transfer of Assets.
24. Segment Reporting.
25. Consolidation.
26. Investment in Associates.
Auditing Standards:
1. Objective and principles of auditing.
2. The Auditor’s Report.
3. Terms of Audit Engagement.
4. Testing for Compliance with Shariaa Rules and Principles by an External Auditor.
5. The Auditor’s Responsibility to Consider Fraud and Error in an Audit of Financial Statements.
Governance Standards:
1. Sharia Supervisory Board: Appointment, Composition and Report.
2. Sharia Review.
3. Internal Sharia Review.
4. Audit and Governance Committee for IFIs.
5. Independence of Sharia Supervisory Board.
6. Statement on Governance Principles for IFIs.
7. Corporate Social Responsibility.
Ethics Standards:
1. Code of ethics for accountants and auditors of IFIs.
2. Code of ethics for employees of IFIs.
Sharia Standards:
1. Trading in currencies.
2. Debit Card, Charge Card and Credit Card
3. Default in Payment by a Debtor.
4. Settlement of Debt by Set-Off.
5. Guarantees.
6. Conversion of a Conventional Bank to an Islamic Bank.
7. Hawala.
8. Murabaha to the Purchase Orderer.
9. Ijarah and Ijarah Muntahia Bittamleek.
10. Salam and Parallel Salam.
11. Istisna’a and Parallel Istisna’a.
12. Sharika (Musharaka) and Modern Corporations.
13. Mudaraba.
14. Documentary Credit.
15. Jua’la.
16. Commercial Papers.
17. Investment Sukuk.
18. Possession (Qabd).
19. Loan (Qard).
20. Commodities in Organised Markets.
21. Financial Papers (Shares and Bonds).
22. Concession Contracts.
23. Agency.
24. Syndicated Financing.
25. Combination of Contracts.
26. Islamic Insurance.
27. Indices.
28. Banking Services.
29. Ethics and stipulations for Fatwa.
30. Monetization (Tawarruq)
31. Gharar Stipulations in Financial Transactions
32. Arbitration
33. Waqf
34. Ijarah on Labour (Individuals)
35. Zakah
36. Impact of Contingent Incidents on Commitments.
37. Credit Agreement
38. Online Financial Dealings
39. Mortgage and its Contemporary Applications.
40. Distribution of Profit in Mudarabah-based Investments Accounts.
41. Islamic Reinsurance
42. Financial Rights and Its Disposal Management
43. Liquidity and Its Instruments
44. Bankruptcy
45. Capital and Investment Protection
To purchase Accounting, Auditing & Governance Standards (for Islamic Financial Institutions),
English version, please visit: http://www.aaoifi.com
AAOIFI Standard on Gold
Dr. Mohd Daud Bakar:
AAOIFI has been issuing more than 50 Shariah Standards already. This Shariah standard on gold
wouldn’t be the first and the last. As such, what is so special about this standard? Allow me to
share some of the insights that I am able to discover while working on this Shariah standard from
day one.
First things first. It is essentially meant to be a stand-alone standard in the sense that you can find
as many relevant principles of Shariah on gold as possible in one standard. It seems that the
initial drafters and the AAOIFI sub-committee of the standard have the motivation to compile
almost all relevant rulings dealing with gold under this standard. It will be easier for the readers
then to know the overall Shariah prescriptions without referring to many other Shariah Standards
of AAOIFI found elsewhere. In other Shariah Standards, many of the Shariah issues, if already
covered by other Shariah Standards, will be straight-away referred to that Shariah Standard so
that the reader may need to flip through relevant Shariah Standards to get what they need to
know.

Unit # 10

Bay` Bithaman Ajil

Bai Bithaman Ajil is a “deferred payment sale”, which works like a murabahah contract, but with
payment generally made on a deferred basis. In some countries Bai Bithaman Ajil is also known
as Bay’ al Muajjal (e.g. Pakistan) or Bay’ Muazzal (Bangladesh).
Although the Bai Bithaman Ajil contract goes by many names, in practice it works similarly to a
sales contract, with deferred payment and pre-agreed payment dates. The sale price quoted for
the asset in the contract is inclusive of the profit. The typical assets for such contracts are the
land, building, machinery and equipment.
Bai Bithaman Ajil is one of the most popular Islamic financing techniques used in Malaysia and
it can be considered as a substitute of the finance lease. It is used by customers to purchase assets
of substantial value in installments, from which they can generate future cash flows. In this
agreement, the customer gets the asset and is required to make payments as per the agreed tenure
in installments. The customer purchasing the asset is required to pay the profit to the financial
institution that arranges the assets.
Scholars have noted that excessive ambiguity (gharar) must be avoided in formulating the
contract. Hence, an asset having physical existence and identified by the customer, the risks of
gharar are minimized. However, if the sale or purchase agreement is for the house which is to be
constructed it may raise concerns over the legality of Bai Bithaman Ajil as the outcome of such
an agreement will be uncertain [2].
The concept of Bai Bithaman Ajil has been implemented in almost all financial institutions of
Malaysia since 1983 [3].
Related Verse from the Qur’an
“Those who devour usury will not stand except as stand one whom the Evil one by his touch
Hath driven to madness. That is because they say: “Trade is like usury,” but Allah hath permitted
trade and forbidden usury. Those who after receiving direction from their Lord, desist, shall be
pardoned for the past; their case is for Allah (to judge); but those who repeat (The offence) are
companions of the Fire. They will abide therein (forever).” (Al Quran, Al Baqrah, 2:275)

Bay` Bithaman Ajil - its legality, applications

The primary duties of Islamic banks and financial institutions in Malaysia are to carry out
Islamic banking and financial activities and to offer products that are in accordance with the
Islamic teachings. These products are subject to the scrutiny and approval of Bank Negara’s
Shariah Advisory Council (SAC) and the internal Shariah Advisory Bodies (SAB) or the Shariah
Committees of the respective financial institutions. Despite having been in existence for more
than 25 years, in the authors’ view, it is still questionable whether or not the Islamic banks and
financial institutions in Malaysia have been satisfactorily carrying out these duties. One area
worth examining is the transaction involving house buying, particularly the one that falls under
the purview of the Housing Development (Control and Licensing) Act 1966 (Act 118) and
transactions involving houses pending completion. This paper examines this area of transaction
and the loan agreement, affected via Bay’ Bithaman-Al-Ajil (BBA), provided by Islamic banking
and financial institutions in Malaysia. The purpose is to see to what extent the sale and purchase
agreement and the loan agreement have complied with the requirements of the Islamic Law in
protecting stakeholders and to provide practical suggestions to improve the existing practice. The
paper concludes that the current practice of the BBA contradicts with the teachings of Islam and
should therefore be modified and revamped until it is fully able to protect the interests of the
purchasers/borrowers.
THE APPLICATION OF BAY` BITHAMAN AJIL (BBA)
INTRODUCTION
The most popular type of financing by almost every Islamic bank in Malaysia is Bay’ Bithaman
Ajil (BBA). For example, in 1984, Bank Islam Malaysia Berhad, of the total new financing
granted, 77.6 per cent was granted under the principle of BBA and 9.7 percent under murabahah.
Thus BBA and Murabahah financing constituted 87.3 per cent of total financing granted. In
1997, BIMB used BBA and Murabahah as its main income-generating products of up to 90.5 per
cent of total assets. Almost the same percentage is also to be found in other banks. The heavy
reliance in this type of financing warrants further focused discussion.
The discussion in this chapter focuses on the concept of BBA, the differences in application in
Malaysia and other places, some potential Syariah and legal issues that might arise from its
application as well as a study of some of the clauses in the documentation of the BBA contract in
Malaysia.
DEFINITION
The Majallah which is mainly a Hanafi-based codification refers to BBA as Bay’ al-Muajjal. The
latter term has also been employed in Pakistan. It is only expected that the term is more
preferable to the government of Pakistan as the Hanafi school of law is also the official mazhab
in Pakistan. In Bangladesh, it is known as Bay’ Muazzal. This is not new but different names
connoting the same practice. In the Middle East, however, the same practice of BBA is used
under the term murabahah. This may lead to some confusion in Malaysia, as the practice in
Malaysia to employ both terms to two different products. This will be dealt with later in this
chapter.
As to the first definition, BBA is a sale contract in which the payment of the price is deferred and
payable at a certain particular time in the future. In fact, it can be
1 This article is taken from INCEIF CIFP Module on Applied Shariah In Financial Transactions.
implicated in any sale contract, including musawamah, and murabahah. It is however,
inapplicable for a salam contract, as the payment of salam must be settled in full at the outset of
the contract. From this, it is obvious that BBA is not a kind of sale; rather it refers to the manner
of payment via a deferred payment basis, be it a lump sum payment or installments. However,
modern practices in banking and finance have somewhat modified this situation. BBA has been
referred to as the sale and purchase transaction for the financing of an asset on a deferred and
installment basis with a pre-agreed payment period. With this limitation, other contracts such as
istisna’ would be excluded from the ambit of BBA though more often than not, the payment of
istisna’ price is also deferred.
LEGALITY OF BBA
In general, no issue arises from the practice of deferring the payment of sale price. The legality
cast over the sale contract in general is considered sufficient by jurists to allow BBA. Besides, it
is also reported in one Hadith by a Companion, Jabir, that the Prophet bought a camel from him
outside the city of Madinah whereby the payment was settled later on in Madinah. Also another
Hadith was narrated that the Prophet purchased a quantity of grain from a Jew on the basis of
deferred payment and he pledged his armour by way of security.
The dispute, however, arises from the practice of increasing the price due to the deferment in the
payment. According to the majority of jurists, increasing the price in BBA due to the deferment
in payment is allowed. For instance:
1) Al-Kasani said: “The price may be increased based on deferment.”
2) Ibn ‘Abidin said: “A price is increased based on deferment.”
3) Ibn Rushd said: “The time has been given a share in the price”.
4) Al-Nawawi said: “Deferment earns a portion of the price.”
All these quotations connote one important principle, the increment of price is allowed in case of
deferment of price in a sale contract. They also uphold that such an increase is permissible
because it is against the commodity and not against money. An increase against deferred
payment is only considered to be amounting to riba’ where the subject matter is money on both
sides. They, therefore, allow a seller to fix two prices of a commodity that is cash price and
credit price and give an option to a buyer to buy a commodity at any of the two prices.
Those who disallow the practice of BBA argue that BBA opens the back door to interest based
transactions. They argue that if the difference between spot and deferred prices of a commodity
is to be recognised, logically we can not reject interest, which in fact is based on the difference in
value of money between spot and deferred. This has been expressed by Sidiqi:
“I would prefer that bay’ al-muajjal be removed from the list of permissible methods altogether.
Even if we concede its permissibility in legal form, we have the overriding legal maxim that
anything leading to something prohibited stands prohibited. It will be advisable to apply this
maxim to bay’ al-muajjal in order to save interest-free banking from being sabotaged from
within.”
In the case whereby the practice of bay’ al-muajjal is unavoidable, he further suggested:
“Should some pressing situations defy any other solution, we can at least confine the use of bay’
al-muajjal specifically to them as a temporary measure, while prohibiting its use in other
situations.”
Beside this, there is a fear that the practice of BBA amounts to the prohibited “two sales in one”,
as mentioned in the Hadith: “The Prophet prohibited two sales in one.”
One of the interpretations of the Hadith deduces that it is a sale contract with two different
prices, that is one price in spot payment and the other deferred. However, this interpretation is
disputable. First, , this interpretation is not the only interpretation in the Hadith. Another
interpretation in the Hadith is the jumbling together of two contracts, in a way that the
conclusion of one contract is contingent upon the conclusion of the other. Even if the first
interpretation is to be accepted, it does not affect the practice of BBA, because in BBA practice,
the offer is caused upon one price only, so does the acceptance.
The different prices are only mentioned to the client during the negotiation period. Once the
client is settled to a certain period of payment, only one quotation of price is offered to the client.
Despite all these weaknesses in the argument for illegality, the fear that the practice of BBA will
be used as a camouflage for interest-based transactions cannot be totally neglected. The worry
expressed by the Council of Islamic Ideology (Pakistan) should be comprehended in that manner.
In this regard, the Council opines:
“However, although this mode of financing is understood to be permissible under the Shariah, it
would not be advisable to use it widely or indiscriminately in view of the danger attached to it of
opening a back door for dealing on the basis of interest.
THE PRACTICAL APPLICATION OF BBA (BAY’ AL-MUAJJAL)
The previous definition of BBA needs some further rectification. This is due to the fact that
though the practice of deferring the payment of the price is employed in all practices, the practice
of BBA in Malaysia is argued to be different from the practice of BBA in Pakistan and
Bangladesh. For us to have a clear picture of this, both structures must be explained further. In
practice, there are two methods in which Islamic banks apply BBA financing.
Modus Operandi of BBA Financing in Pakistan and Bangladesh
In Pakistan, the modus operandi for bay’ al-muajjal is as follows:
A. The customer will approach the bank for the purpose of applying for the facility. If the
customer has a specific item or property to purchase, he will detail all the necessary information
about the property that he intends to acquire. If he intends to purchase an asset, but has no
specific item in mind, he will give the bank all the necessary specifications on the asset. Among
others he will include the specification of the items, its grade, price, place, the supplier’s,
manufacturer’s or developer’s names, etc.
B. The bank will then purchase the said item as requested by the client. In the case where there is
no specific mention of the supplier’s, manufacturer’s or developer’s name, the bank is free to
buy it from anywhere the bank may find it, as long as it satisfies the specifications mentioned by
the client, and the price is reasonable compared to the market price of the asset.
C. There are mainly two ways in which the bank purchases the item. The bank may purchase the
item on its own. However, more often than not, the bank will simply appoint the client to be its
agent for purchasing the item on its behalf. In this case, the client will deliver the purchased item
to the bank.
D. Having possessed the property, the bank then sells the property to the customer. This happens
when the bank purchases the item on its own. In the case where the bank appointed the client to
be its agent, on purchasing the item on behalf of the bank, the client will then sell the asset to
himself. In this case he perform two roles: first as an agent when he purchased the asset from the
supplier and then as a buyer when he bought the item from himself (as an agent).
The practice of appointing the customer as the agent of the bank has been widely used by Islamic
banks even though it might cause some Syariah issues. As pointed out by one jurist:
“This practice is invalid because in contract of exchange (mu’awadat), the same individual
cannot become an agent or representative to two different parties at the same time
(simultaneously). However, the bank can appoint the customer as its agent/representative to
purchase a house from the developer but the same customer is not allowed to purchase the said
house for himself. This act will lead to fraud because probably the said house does not exist and
the application of BBA financing is merely to acquire cash as a debt / loan.”
It is obvious that the practice of BBA in this situation is the same as the practice of murabahah
which has been sufficiently elaborated in another relevant chapter. To avoid any overlapping,
this chapter will focus on issues peculiar to BBA only.
Modus Operandi of BBA Financing in Malaysia.
Basically, BBA financing is employed by the bank to provide medium to long term financing to
the clients who intend to acquire the following items:
A. Houses / shop houses
B. Land
C. Motor vehicle
D. Consumer goods
E. Shares
F. Overdraft facility
G. Education financing package
H. Personal financing
I. Other suitable and acceptable goods
It is obvious from the above-mentioned list of probable financing facilities that might be offered
to the customer that in some cases of financing, the purpose is to acquire a certain asset, such as
buildings, lands and motor vehicles. However, in certain cases of financing, the purpose is to
make available to the customer a certain amount of cash (as in personal financing). Hence, the
two main purposes of financing intended in the practice of BBA in Malaysia, are to finance the
acquisition of an asset and to provide liquidity (cash). It is within the purview of the second
purpose that refinancing has also utilised the BBA mode of financing as far as the Malaysian
practice is concerned.
BIMB in its official publication has detailed up the procedure in which BBA financing is
practised (for clearer elucidation, the quotation is made in full, without any alteration to the
wording):
A. The Bank may finance the customers who wish to acquire a given asset but to defer the
payment for the asset for a specific period or to pay by installments under the principle of Al-Bai
Bithaman Ajil.
B. The bank first determines the requirements of the customer in relation to his period and
manner of repayment.
C. The bank purchases the asset concerned.
D. The Bank subsequently sells the relevant asset to the customer at an agreed price which
comprises:
i- The actual cost of the asset to the bank; and
ii- The Bank’s margin or profit and allows the customer to settle the payment by
installments within the period and in the manner so agreed
E. The contract of Al-Bai Bithaman Ajil has been utilised by the Bank to provide the customers
medium and long term financing to acquire such items which may include landed properties,
houses, motor vehicles, furniture, stock and shares, etc. As explained earlier, it is a simple
contract whereby the Bank purchases the items on a cash basis and sells such items on a deferred
payment basis to customers requiring financing.
The publication goes on by giving two practical examples of this financing
A. Under the retail financing activities of the Bank, one of the popular financing items is house
financing.
• Purpose
House Financing facility may be extended for the purpose of purchasing a new house, to
purchase an existing completed house, to build a house on his own land.
B. Under the same concept of Al-Bai Bithaman Ajil but for a bigger amount, the Bank is able to
provide financing to corporate customers either singly or on the basis of syndication of the
financier.
• Purpose
As in the case of Retail Financing, facility may be extended to customers for the purpose of
acquisition of immovable assets such as landed properties and movable assets such as machinery,
transport equipment, etc. The facility may also be extended to finance working capital
requirements of the company by way of refinancing of assets
Several conclusions can be made from this explanation:
A. The practice of BBA in Malaysia is the same as what has been practised in Pakistan and
Bangladesh, and the same as the practice of murabahah in the Middle East.
B. BBA financing is applicable to retail financing as well as to corporate financing (project
financing)
C. Refinancing is also applicable in the BBA financing facility
D. BBA is applied in medium to long term financing.
The focus in this particular juncture is on the first and third issues. It is a matter of fact that the
explanation contained in that publication is totally contrary to actual practice. More confusing is
that, how can refinancing based on the concept of BBA be applied as the intention is not to buy
the asset (as the owner owns the asset already).
A thorough investigation of the legal documentation of the BBA facility will reveal the true
practice of BBA in Malaysia. This will lead us to the next point.
LEGAL DOCUMENTATION OF BBA FACILITY IN MALAYSIA
Financing the acquisition of assets such as house and land happens in two situations:
1) When an Issue Document of Title (IDT) has been issued.
2) When there is no IDT yet.
The legal documentation for these two situations has some differences; however, this section will
not discuss this difference in detail since it relates more to the issue of security. In passing, it can
be said that in the situation where the Issue Document of Title has not been issued, the bank
which provides financing facility to the client will secure the right, title and interest of the client
under the contract of sale and purchase with the developer, as security by way of an assignment.
In doing so, the bank and the client will sign a Deed of Assignment. On the other hand, if the
property taken as security has already had an issue document of title or strata title as the case
may be, and the chargor has interest in the property presently vested upon him, a security by way
of charge can be created over the land / property as an encumbrance. Hence, the first charge and
second or subsequent charges may be created in the prescribed statutory Form 16A and
annexure. The practice of creating legal charge in Islamic banking is at par with the practice of
its conventional counterpart.
Upon default, the financier may, after proper notice, initiate proceedings to secure back the
amount including selling the security by way of public auction or private treaty sale.
As for the BBA facility, basically three main agreements are of supreme importance. These are:
A. Sale and Purchase Agreement
It is not part of the documentation for the facility applied by the client. It is however, among the
most important agreements in obtaining such a facility from banks. To facilitate a better
understanding, an example might help.
Say, for instance, Encik Rosli intends to buy a house from a seller. Based on the Third Schedule
of Housing Developers (Control and Licensing) Regulation 1989, the Sale and Purchase
Agreement (Principal Agreement) will be signed between the two parties. Accordingly, Encik
Rosli would have to pay 10 per cent of the price of the property. The signing of this agreement is
compulsory, as the customer must provide the bank with this agreement before the application
for financing can proceed. Before 1996, a novation agreement was signed between Encik Rosli
(the client), the seller and the bank (as the financier) but this practice was later abolished. It has
been argued that the developer /seller refused to be a party to the agreement because they did not
want to be responsible for rights and liabilities that might be attached to it. Furthermore, it is not
the concern of the developer / seller as from whom and how the client acquires the money to
purchase the house. Besides, it was also argued that, this innovation agreement was also
insignificant, because by virtue of the client paying 10 per cent of the price, he has acquired the
beneficial ownership of the house. It is his right then to do whatever he wants with the house,
including selling it to someone else. It is not the concern of the seller/ developer on that matter.
B. Property Purchase Agreement
This is an agreement made between the client and the bank. The most significant wording of this
agreement normally reads:
“The customer has applied to the Bank for a financing and the Bank has approved the said
application and the Customer has agreed to enter into this Agreement with the Bank, whereby the
Bank, at the Customer’s request purchases from the Customer the Property at the purchase price
……”
It should be noted that that most of the time, the purchase price consists of the remaining balance
of the price of the house (say, 90 per cent), and some other costs such as lawyer’s fees, MRTA,
etc. This will certainly, increase the financing amount to be more than the remaining price of the
house. However, the financing amount that the bank is able or willing to finance is negotiable
between the client and the bank. In allowing so, the policies of the bank, creditworthiness of the
client etc. would be among the factors to determine the financing amount to be eventually
granted to the client.
C. Property Sale Agreement
Again, this agreement is signed between the client and the bank. The most significant wording of
the agreement normally reads:
“The Bank hereby agrees to sell and the customer hereby agrees to purchase the Property at the
Sale Price upon the terms and subject to the conditions herein contained.”
The Property Sale agreement shall be signed after the signing of the Property Purchase
Agreement so as to allow the Bank to sell back the asset to the client. The manner, in which the
payment of the price to be made will be detailed, based on the agreement reached between the
Bank and the client.
COMPARISON BETWEEN THE EXPLANATION AND THE EXACT FINANCING
DOCUMENTATION OF BBA FACILITY
From the abovementioned discussion, it is apparent that the main contradiction is a result of the
difference between the explanation on the practice of BBA and the real application of BBA by
virtue of financing documentation that have been drawn up. In the publication, the practice of
BBA has generally concurred with the practice of BBA as applied in Pakistan and Bangladesh.
By right, this should be shown clearly in the financing documentation. Interestingly, the
documentation documented a totally different structure and features all together.
These two diagrams might help in summarising this difference.
PSA
Bank
Developer
Bank
PPA
PSA
PPA
S&P
Developer
Client
Client
Diagram 2
Diagram 1
Diagram 1 shows the practice as mentioned by the publication. As explained before, the
developer will sell the asset to the bank on a cash basis. Having acquired the asset, the bank then
sells the asset to the client on BBA (deferred payment basis, with the mode of
payment to be agreed on between the bank and the client).
However, this practice is different from the practice shown in Diagram 2. This is the illustration
based on the legal documentation mentioned before.
In this practice, after acquiring beneficial interest over the asset (via S & P), the client then sells
the asset to the bank which will subsequently resell the asset to the client. This is clearly
documented in the standard BBA facilities offered in Malaysia.
If we were to consider the second leg of the transaction, that is Property Sale Agreement, than
the name BBA has been rightly given to the facility, as mentioned in Diagram 1. However,
should the contract of BBA be looked at as a whole, one may simply say that the exact Shariah
contract used is not BBA per se, rather it is another contract known as bay’ al-‘Inah. It is not the
intention of this chapter to discuss the contentious issue of the legitimacy of bay’ al-Inah in
Islamic law, as it will be dealt with later in a relevant chapter, but the question that should be
asked in this particular juncture, is whether it is appropriate to name the facility by looking at
only some parts of its structure, or will it be more appropriate to name it by looking at the whole
Islamic concept that has been utilised in the structuring of the facility. It is respectfully submitted
that in Islamic law, the use of whatsoever name over a particular contract would not change the
ruling over that contract because the ruling will definitely consider the substance, rather than the
name, but would it be better, at least to avoid any confusion by using the right nomenclature for
the right structure. It may be argued that the name BBA is also accurate because the payment in
the second transaction (PSA) is in fact deferred, but this might be argued by saying that looking
at the whole picture, for the purpose of a more proper connotation, the contract of bay’ al-‘inah
should be used, instead of BBA.
EXAMINATION OF SOME CLAUSES IN THE LEGAL DOCUMENTATION OF BBA
FINANCING
Some of the clauses found in the legal documentation might have some Shari’ah related issues.
Some of these clauses have been resolved by the National Shari’ah Advisory Council of Bank
Negara Malaysia (SAC of BNM). These issues are:
Illegality
In this clause, the provision reads:
“When the introduction or imposition of variation of any law order, regulation or official
directive or any change in the interpretation or application thereof by any competent authority
makes it apparent to the Bank that it is unlawful or impractical without breaching such law order
and regulation or official directive for the bank to maintain fund or give effect to the Bank’s
obligations hereunder the Bank shall not then be liable or obliged to make available the facility.”
This clause refers to the situation whereby the Bank would be allowed to disoblige itself from
fulfilling the terms and conditions of the agreement made with the client. But these exemptions
are only allowed with some qualifications:
A. With the introduction of new law;
B. New law has been regulated or new official directive has been issued by a relevant authority;
or
C. Change in the interpretation or application of related law
If any of these circumstances occur and the Bank believes that it is impossible for the Bank to
give or continue giving the facility to the client, the Bank may be allowed to discharge itself
from performing that duty.
Some examples might help in explaining this clause.
A. Bank A is financing the construction of luxury condominiums by a construction company.
Later on, the government instructed the Bank to terminate the facility as the construction of the
condominium is not in line with government policy on development.
B. In one of its financing facilities, Bank A has granted an export credit facility to a foreign
resident or institution which is later declared by the UN as one of the terrorist groups.
C. A credit facility has been granted by Bank A to a person who is later detected to be
involved in money laundering.
In all these examples, although initially, the financing facilities granted were all in order, the
Bank later discovered certain reasons where the continuation of those facilities was impossible.
In these situations, will the bank be allowed to discontinue the facility? The issue that might be
relevant in this situation is about the harm that the Bank might have caused to the client if the
facilities were to be terminated. The Shari’ah Advisory Council of Bank Negara (SAC of BNM)
opines that in these situations, the Bank is allowed to terminate the contract. It is very obvious
that the reason for discontinuing the facility as in examples 2 and 3 is that the continuation of the
facility will cause greater harm to society as a whole. Hence, the termination of the facility is
apprehended. In example 1,
it is ruled that the change in law, its interpretation, the change in the government’s policy, etc are
among those which are beyond the control of the bank. In Islamic law, the doctrine of unforeseen
events (afat samawiyyah) is a well known and well accepted doctrine. Hence, the provision of
illegality is allowed by the SAC to be included in the documentation.
Compensation Clause
The provision reads:
“Notwithstanding anything contained in this agreement, the Customer(s) hereby agree, covenant
and undertake to pay to the Bank compensation on overdue installments and payments of the
Purchase Price on the date of maturity of the BBA facility as follows:
a) For failure to pay any installments of the BBA Facility from the date of first drawdown until
date of maturity of BBA facility, the compensation rate that shall be applied is one per centum (1
per cent) per annum on the overdue amount or any other method approved by Bank Negara
Malaysia;
b) For failure to pay any installments and which failure continues beyond the maturity date of the
BBA facility, the compensation rate that shall be applied is the Bank’s current Islamic Money
Market Rate on the principal balance or any other method approved by Bank Negara Malaysia.
c) The amount of such compensation shall not be compounded on the principal amount.
This provision deals with the default of the client to pay the installments on the due date. In
general, it can be said that the failure to pay is mainly for two reasons. In certain circumstances,
the failure to pay is because of the constraining circumstances that the client might be in. In this
situation, it is advisable for the bank to indulge the client with some leniency. This has been
strongly recommended in al-Qur’an (al-Baqarah: 280): “And if he (the debtor) is in constraint,
then he must be given respite until he is well of”.
However, there are circumstances whereby the client has deliberately avoided paying, or has
delayed in his payment. Before the imposition of this ruling, some clients who had two or more
facilities (Islamic and conventional) will simply prefer the conventional first due to inability of
the Islamic bank to charge penalty over the delay in payment. This had caused severe hardship to
the smooth running of Islamic banking. In order to balance this inequity, the SAC of BNM has
allowed the imposition of this clause, simply to protect the bank from dishonest clients who
deliberately avoid payment.
In general, it can be said that contemporary jurists are of different opinions over this matter.
Some jurists maintain that if the client defaults in payment of the price at the due date, the price
should not be increased for the purpose of compensating the bank. However, one opinion (said to
be of the Malikis) allows this increase if the default was without valid reason. They view this as
part of the punishment to the buyer. This punishment can deter the buyer from being defaulted in
his payment. Nevertheless, this amount so recovered from the buyer shall not form part of the
income of the seller/the financier. The financier is bound to spend it for a charitable purpose on
behalf of the buyer. This position is accepted by the majority of contemporary jurists and has
been in practice for quite sometime in many Islamic banks in the Middle East. Based on this
opinion, when the client enters into a BBA financing facility, he will be required to undertake
that in case of default, he will have to pay a specified amount to a charitable fund maintained by
the bank.
In Malaysia, The SAC of BNM and SAC of the SC have allowed the imposition of one percent
penalty rate on late payments and unlike the previous opinion, this money can form part of the
income of the bank. This is considered as ta’widh (compensation) to the bank and cannot be
compounded. In allowing such imposition, they have compared the delay in paying off a debt
with ghasb (usurpation) for both of them are an act of obstructing the use of property and
exploiting it in a tyrannical way. If in the case of ghasb, the real owner of the property has been
obstructed from benefiting from his own property, hence, he should be compensated for that
reason. In late payment, the creditor stands to lose because he is deprived of the opportunity of
using the funds for other trading purposes, which he could if the debt is settled within the agreed
time. Therefore, this loss should be compensated by the debtor based on this analogy
It is argued that since the imposition of 1 per cent is based on the actual loss that Islamic banks
will acquire due to the default made by the client, this rate should be revised as the actual loss
incurred by the banks might be much greater than that. Yet, until now, no revision has been made
to this rate.
The SAC of BNM, though inclined to agree with this argument, believes that a more thorough
study is needed before any revision is to be made to this rate. Till the time this section was
prepared, the status quo of the rate remained.
Irrevocable Right to Consolidate, Debit or to Set-off
The provision reads:
“Without prejudice to any other remedies which the bank may have, the Bank may without
notice to the Customer (s) and at any time from time to time at its sole and absolute discretion
combine, consolidate or merge all or any of the customer (s)’ account or accounts of whatsoever
nature (whether current, deposit or loan account), ……and set-off or transfer any sum (whether
in the same or different currencies) standing to credit of any such account, agreement or contract
in or towards the satisfaction of the Sale price and any other monies owing to the Bank……”
Moreover, the SAC of BNM has allowed the facility documents to include a provision that
requires the client to open an account with the bank (if the client has no account with the bank)
and to allow the bank to debit and set-off this account for any amount due under the facility
given. The provision to that effect reads:
“You are required to maintain wadiah or mudarabah Current Account or other current account
with the Bank and the Bank is irrevocably and unconditionally authorised to at any time and
from time to time without reference to you and without any obligation whether at law or in
equity so to do, to debit your account for:
a) Any payment due under the facility; and
b) All expenses, duties, fees and other sums due and payable arising from the Facility including
but not limited to takaful / insurance premium and/or service charges (if any)
Provided further that no such debiting shall be deemed to be payment of the amount due (except
to the extent of any amount in credit in your current or other accounts) or shall be deemed to be a
waiver of an event of default.”
In its ruling, the SAC of BNM has allowed this practice of set-off from the existing account or a
newly created account of the client to satisfy any amount due from his BBA facility. This
practice in Islamic law is known as al-muqasah (off-setting of debt).
Cross Default
The provision of this effect reads:
“It is hereby expressly agreed and declared that any breach by the customer of the terms,
conditions, stipulations and agreements contained in this agreement and/or any other related
transaction documents in favour of the Bank shall be deemed to be a breach hereunder and shall
entitle the bank to enforce all or any of the remedies hereinbefore mentioned.”
This clause refers to situations whereby the client breaches any of the terms, conditions or
stipulations made in lieu of the facility given. It is not just that. The clause has also considered
any breach of any term, condition or stipulation made in other facilities granted by the Bank to
the customer as a breach that entitles the bank to enforce all the remedies mentioned including
the right to terminate the facility and accelerate the payment.
The SAC of BNM has allowed the imposition of such a clause provided that the client agrees to
its incorporation in the financing document. Once the client agrees to it, he will be bound to
fulfill that commitment. The SAC relies on the occasion reported in Sahih al-Bukhari.
In that Book, al-Bukhari relates the saying of a very well known judge, Qadhi Syuraih. He said
that once a person agrees to any imposition of rules, regulations or stipulations upon himself, he
is bound to follow that stipulation. As the client agrees to impose the clause regarding cross
default, he must strictly follow that condition.
Validity of Provisions
The provision on that reads:
“Subject to the provision of the Syariah, if any provision of this agreement becomes invalid,
illegal or unenforceable in any respect under any law, the validity, legality and enforceability of
the remaining provision shall not in any way be affected or impaired.”
The reason for the inclusion of this provision in the agreement is to protect the validity of other
clauses and in the case where one provision is declared to be invalid, it is severable without
effecting other provisions. The SAC of BNM in this matter rules that the clause to this effect is
allowed provided that the invalidity of that clause would not affect the pillars or essential
elements of the contract itself. However, if the clause that has been declared illegal affects the
pillar or essential elements of the contract, then the contract might be declared void or voidable,
as the case may be.
These are some provisions related to the documentation of BBA financing as practised in
Malaysia. It is rightfully submitted that there are also other issues which are also important and
need to be discussed. However, it is hoped that this brief discussion on some issues is able to
shed light over important clauses contained in the BBA facility agreements.
SOME OUTSTANDING ISSUES IN BBA FINANCING
Beside these issues, there are also several other issues that need some attention. Some of
these issues are discussed below:
Clause on Right to Recall the Facility
In legal documentation of conventional loan agreement, it is stated that the bank has the right to
recall the facility, repossess the property and terminate the facility. In BBA financing, the
situation is different. This is due to the fact that the ownership of the house has been transferred
to the client by virtue of the PSA. Hence, the Bank has no right whatsoever to repossess the
house. What the bank is entitled to is the payment price of the property. Therefore, the
conventional clause on ‘right to recall’ is not appropriate for the BBA facility. However, this
clause can be included in the BBA financing facility with certain modification. The right to recall
the BBA financing facility means that the Bank has all the right to terminate the facility and
claim for the unpaid amount, but not the right to repossess the property. If the property is used as
collateral, the bank can sell the property and claim on the unpaid amount and release the balance
to the client.
Third Party Financing
Third party financing can occur in two situations. First, the property is owned in a joint
ownership, but the application for financing is made only by one applicant. Second, the property
is owned by one person only, but the application is made by joint applicants (the owner and the
other person). In both circumstances, a letter of gift will be executed. In the former, the joint
owner of the house will execute a letter of gift on his portion of the property in favour of the
applicant before the facility can be processed, whilst in the latter, the owner will execute the
letter of gift in favour of the other applicants before the facility can be processed.
Third party Collateral
In certain circumstances, a person who requests for a facility is required to provide the bank with
extra collateral. If the person has some other property, then he can create a legal charge over that
property in favour of the bank in lieu of the facility requested. If the person has no other
property, he can also create a legal charge over a property that belongs to someone else.
However, before this charge can be created, a letter of gift must be executed, in which this third
party will execute a letter of gift in favour of the applicant. The client will then charge the
property in favour of the bank.
Right to Sell the Receivables to a Third Party
Once the BBA contract has been successfully completed, the client is responsible for paying the
selling price to the bank. The right to receive the payment is indisputably the sole right of the
bank. Hence, it is the right of the bank to sell the receivable that it will acquire from the client,
without having to request any permission from the client, because the right over the receivable
belongs totally to the bank. Normally these receivables will be sold to a third party who will then
issue a bond to finance the purchasing of these receivables.
Example of this bond is Mudarabah Cagamas Bond This bond was issued by Cagamas Berhad.
Under this facility, BIMB sells its Islamic housing financing facilities (BBA Receivables) to
Cagamas Bhd based on the concept of sale of debt at a discount. Following this transaction, all
rights of BIMB with regard to the debt are transferred to Cagamas Bhd. It means that the right to
receive debt from the BBA installment will be transferred to Cagamas. Therefore, the institution
would transmit to Cagamas all the installments received from the clients under the BBA on a
monthly basis. Cagamas, on the other hand, would issue mudarabah bonds to raise the necessary
funds to finance the purchase of these receivables. Through this, the bond’s holders become
investors to this business and Cagamas is the entrepreneur. They will benefit from the cash flow
stream derived from the house financing portfolio.
Following the rules of mudarabah, any profit derived from this business would be shared on a
pre-agreed ratio between Cagamas Bhd. and the holders of the bonds and any losses or
diminution of the amount invested will be fully borne by the holders of the bonds.
BBA Financing: Selling of the Non-existent.
As has been elaborated before, BBA financing facility in Malaysia is applied over property under
construction as well as completed property. Though no problem arises from the latter practice, a
leading Shariah issue might arise from the former. This is because, in BBA financing for house
under construction, the property that is transacted is not in existence yet. This might contradict
the ruling on the existence of subject matter in a sale contract. If the opinion of the majority of
jurists is to be applied, the BBA facility on property under construction is not allowed. Even if
the opinion of Ibn Taymiyyah and Ibn al-Qayyim that allows the selling of non-existent subject
matter is to be followed, one central issue still remains; their opinion in allowing the selling of
non-existent subject matter is based on the near certainty of delivery. Hence, they maintain that
even though the subject matter does not exist during the time of conclusion, the contract is still
valid provided that the parties to the contract are confident that the delivery is possible at the
future agreed time. If the opinion of Ibn Taymiyyah and Ibn al-Qayyim were to be taken into
consideration, will the application of BBA financing in Malaysia pass the test of certainty of
delivery? With the rate of non-completion being so high, can we say that the parties are certain
that delivery is possible at the agreed time? What about the delay in delivery which has caused a
lot of trouble to the house-buyers? With all these questions remaining unanswered, the practice
of BBA is said to defy the rule of certainty in delivery as prescribed by the two scholars.
To avoid any conflicting issues that might arise, it has been recommended that banks use other
types of financing for property under construction. For instance, banks can use the contract of
parallel istisna’ as it relates to the financing of asset involving future delivery. In istisna’, the
object of istisna’ (mustasna’) is not available now, but to be made available later by the
manufacturer or developer. Therefore, it is the most suitable accurate contract to be used as a
financing tool involving property under construction or property yet to be constructed.
BBA Facility: The Dilemma on the Transfer of Ownership
As the BBA contract is actually a sale contract, it requires for the transfer of ownership
pertaining to both legs of the transaction (the cash and the deferred). This leads to another issue,
the issue of possession (al-qabd). It is argued that since BBA is actually a kind of sale contract,
the transfer of ownership and taking of possession must truly happen. The possession of the
parties to the asset, however, could be construed according to the custom and it can take place in
different forms depending on the type of the asset. In terms of the practice of BBA in Malaysia,
the execution of PPA and PSA in the facility should result in transfer of ownership, irrespective
of whether the registration of the transfer is made or otherwise. It should be noted here that BBA
is not a loan given on interest. It is the sale of a property for a deferred price, which include an
agreed profit added to the cost. This is among the most important features of BBA financing.
In the case of Dato’ Haji Nik Mahmud bin Daud v. Bank Islam ([1996] CLJ at. P. 582), in order
to facilitate the granting of BBA facility to Dato’ Nik, the latter who is the registered owner of
25 pieces of land in Kelantan executed a PSA and PPA in favour of BIMB. It was then argued
that the parties transgressed the Kelantan Malay Reserve Land (MRE) as the execution of PPA
and PSA was tantamount to transferring the right and interest in such land to a ‘person’ who is
neither a Malay nor a native of Kelantan. The issue that has arisen is whether the execution of
the PSA and PPA amounts to a colourable exercise and defeats the purpose and intention of the
Malay Reservations Enactment 1930 of Kelantan (the Enactment), which prevents the transfer or
transmission of Malay Reservation Land in Kelantan to any person who is not a Malay. It is
ruled in this case that the execution of the PSA and PPA does not amount to any transfer of
ownership from Dato’ Nik to BIMB. The learned High Court judge explains:
“ …… In the instance case, it was never the intention of the parties, in as much as it can be said
to be within their contemplation, to involve any transfer of proprietorship. It is so happened that
the execution of the property purchase agreement and property sale agreement constituted part of
the process required by Islamic Banking procedure before a party can avail itself of the financial
facilities provided by the defendant execution of the two agreements, and in fact, it would be
observed that the property agreements would be rendered otiose and bereft of any consequential
value the moment the property sale agreement was signed… Accordingly, the execution of the
property purchase agreement had not transgressed the provisions….of the Enactment since there
was no dealing or attempt to deal with the said lands contrary to the provisions thereof.”
The Court of Appeal also upheld the decision of the trial judge ([1998] 3 MLJ at pp 393-394):
“It is clear that s 7 (i) of the Enactment prohibits any transfer or transmission or vesting of any
right or interest of a Malay in reservation land to any person not being a Malay. In this case, the
trial judge had found that the appellant was all along the registered proprietor of the properties;
in short, no transfer was being effected. Moreover, it was never the intention of the parties to
involve any transfer of proprietorship. Accordingly the execution of property purchase
agreement had not transgressed the provisions ss 7 and 12 of the Enactment since there was no
dealing or attempt to deal in the lands contrary to the provisions thererof. There was no reason to
disagree with the findings of the trial judge.
One may observe that even though the justice and equity have been carried out in this landmark
case on Islamic banking, the reasons given by the learned judge may be argued to be contrary in
relation to the nature of the BBA facility and has inadvertently caused serious conflict with the
concept of BBA contract, whereby, the contract should, from an Islamic law point of view, result
in the transfer of the ownership of the property from one party to another even only for a second.
The judgement has somehow equated the BBA facility with the conventional loan given with
interest. This is said to be in contradiction with the Shari’ah requirement on the transfer of
ownership. Although both seem to have similar characteristics, in which both created a debt to be
paid over the time in installments and this debt is over and above the capital given, but the way
the debt is created is the core difference between the two. It seems that the judgement has not
succeeded in appreciating this fact.
Floating Rate BBA
The previous discussion on BBA financing facilities is structured to be fixed rate financing.
Some people are convinced that fixed rated mechanisms such as this is more preferable as they
provide more financial stability. The nature of fixed-rate financing would enable them to plan
their cash flow since monthly payment is fixed throughout the financing period. Thus, some
customers might prefer to have this kind of facility, instead of having equivalent conventional
products, which are floating-rate in nature. This is so because the payment of the selling price
(purchase price together with a profit of the bank) will be fixed and settled by installment over a
long-term period. So, if the client, who is a government servant, is granted a financing facility to
buy a house, he will know the amount that he has to pay monthly, and this amount will be fixed
no matter how the BFR of the bank fluctuates. With that, he can plan his payment properly
without affecting his other monthly budgets.
However, it is argued by some that fixed-rates method of financing might affect the
competitiveness as well as the viability of Islamic banks, and sometimes it is not a preferred
mode of financing to some clients. It is submitted that the clients of Islamic banks are varied.
Some of them are Muslims who deal with Islamic banking for religious purposes. To this kind of
people, no matter how interest rates move, they will remain with Islamic banks as they believe
that having a loan with interest from conventional banking amounts to riba’. However, there are
clients who prefer Islamic banks due to certain other considerations. To them they will stay with
Islamic banks as long as the rates of payment are competitive compared to that of conventional
banks.
Once the rate of payment is higher, they will shift to conventional banking. In this case, the
fluctuation of interest rate matters a lot and will definitely affect their preference. If interest rates
are climbing, these clients would choose fixed rate financing facility, in which BBA (and also
istisna’) is prominent, to lock the payment price to protect themselves against the increasing
trend of interest rates. But when the interest rates are in a decreasing mode, they will convert
their financing to interest-based financing facilities for a relatively lower payment. So, the
fluctuation of interest rates in the market will definitely, affect the demand for BBA and other
Islamic fixed-rate modes of financing.
Besides, the fixed-rate modes of financing have also resulted in a funding mismatch to the
Islamic financial institutions because their long-term financing was funded by short- term bank
deposits which can give variable returns. It is a disadvantage to Islamic banks as they have
locked their financing profit rates over a long period, while at the same time they “have to give”
a competitive rate of return to their depositors, or otherwise these depositors will shift their
deposit to the conventional banks who can offer a better rate of return. So, Islamic banks will be
placed in a very difficult situation. It has to maintain a competitive rate of return and at the same
time cannot change the profit rate of the concluded fixed-rate contracts.
It is argued that this fixed-rate and price-rigidity factor has rendered Islamic banks to be very
vulnerable to economic and interest-rate volatility. As an innovation, Bank Negara Malaysia via
its working group, comprising representatives from Bank Negara Malaysia and the industry had
come out with the first variable rate financing product based on the concept of BBA. Under this
BBA financing with ibra’ features, the selling price of the asset sold to the customer on deferred
terms would be fixed at a profit rate known as the ceiling profit rate. However, contrary to the
BBA fixed rate, the periodical installments of this financing will fluctuate and vary depending on
certain benchmarks and the spread on the customer for a particular period. Say, for instance, if
the original monthly installment is RM 1,000.00, but the financing payment plus profit rate of
that month (calculated based on certain benchmarks such as BLR plus margin) is lower, certain
ibra’ will be given to the client, in order to reduce the monthly installments to match that of the
current market level. However, if the interest rate increases beyond the monthly installment
payment (BLR plus margin), the effective profit rate will remain at the ceiling rate. This means
that the client will only have to pay the installment at not more than the ceiling price that has
been agreed upon upfront.
It means that the ibra’ will be given on a monthly basis and will differ from one month to
another. On the maturity of the financing, the total installments are calculated and should not
exceed the original selling price. Any shortfall will be treated as an ibra’ (rebate) given to the
client.
It is hoped that such variable rate financing products will be able to reduce the vulnerabilities of
Islamic banks, especially in a dual banking environment where the Islamic banking system
operates in parallel with a conventional financial system. The flexibility of this financial
instrument has also manifested the compatibility of the
Shari’ah in providing a necessary mechanism to manage and mitigate risk in the modern
financial settting.
SUMMARY
It should be stressed again that BBA is one type of sale contract. As such, it has to carry all the
necessary features of a sale contract, including its essential elements (arkan), conditions (syurut)
as well as the legal effect of the contract. Among the most important legal effects that must really
be appreciated are the transfer of ownership and the rule of taking possession. The practical
applications of BBA financing, in Malaysia as well as in some other countries has been
extensively discussed in this chapter. It is rightly submitted that the term BBA as used in
Malaysia is different from the term in other countries. The practice of BBA financing in
Malaysia, if the whole procedure is to be considered based mainly on bay’ al-‘Inah, is different
from the practice of other countries.
Beside this issue, the practice of BBA in Malaysia inherits some other issues such as the issue of
qabd, selling of non-existent property, some clauses in legal documentation, etc. Lately, BNM
has taken the lead to initiate alternatives to the practice of BBA, namely musharkah mutanaqisah
(diminishing partnership) and AITAB (ijarah thumma al-bay’). The setting-up of some foreign
Islamic banks in Malaysia is anticipated to accelerate the products development process and new
products which have been offered in other parts of the world might be introduced in Malaysia
soon.
Bay’ al-Muajjal its comparison, documentation and related issues;
Bai Muajjal may be defined as sale under which the price of the item involved is payable on a
deferred basis either in lump sum or in instalments. This system could be of considerable use in
financing current input requirements of industry and agriculture as well as in the financing of
domestic and import trade. For instance, if the current cost of a bag of fertilizer to the bank is Rs.
50, the bank may sell it through its agent to farmers needing bank finance at Rs. 55 subject to
actual payment of this price after an agreed period. The bank would, however, pay Rs. 50 to its
agent prior to or immediately after the supply of the fertilizer by the agent under its instructions.
The possible mechanism in the case of domestic and import trade may be on the following
pattern: A business firm needs finance from a bank to pur- chase/import an item from a domestic
seller/manufacturer or foreign exporter. Instead of discounting a bill or making an advance, the
bank under an agreement with the firm concerned may purchase/import the commodity on its
own account and sell it to the firm at a price, to be settled in advance, which includes a mark-up
over the cost price for a reasonable profit margin for the bank. Payment from the firm would be
receivable by the bank after the agreed period.
Although to be in conformity with the Shari'ah, it is necessary that the sale item should come in
the possession of the bank before being handed over to the other party, however, that would be
sufficient for this purpose if the supplier from whom the bank has purchased the item sets it aside
for the bank and hands it over to any person authorised by the bank in this behalf, including the
person who has purchased the item in question2.
This system commends itself for its relative simplicity as well as the possibility of some profit
for the banks without the risk of having to share in the possible losses, except in the case of
bankruptcy or default on the part of the buyer. However, although this mode of financing is
understood to be permissible under the Shari'ah, it would not be advisable to use it widely or
indiscriminately in view of the danger attached to it of opening a back-door for dealing on the
basis of interest. Safeguards would, therefore, need to be devised so as to restrict its use only to
inescapable cases. In addition, the range of mark-up on purchase prices would also need to be
regulated strictly so as to avoid arbitrariness and the possibility of recrudescence of interest in a
different garb. The State Bank may, therefore, specify and from time to time review and vary the
sub-sectors/items for which banks may provide the needed finance under Bai Muajjal
arrangements. It may also lay dojyn the range of the profit margin in general or separately for
each sub-sector or item and may impose such other restrictions as may be deemed to be
necessary with a view to avoiding the emergence of unhealthy practices.
Bai-muajjal
The term ‘Bai-Muajjal’ has been derived from Arabic words ‫ عيﺒ‬and ‫( ﻝﺟﺍ‬Bai’un and Ajalun).
The word ‫ عيﺒ‬means purchase and sale and the word ‫ ﻝﺟﺍ‬means a fixed time or a fixed period. "
Bai-Muajjal " means sale for which payment is made at a future fixed date or within a fixed
period. In short, it is a sale on Credit
Bai-Muajjal may be defined as a contract between a Buyer and a Seller under which the Seller
sells certain specific goods permissible under Islamic Shari‘ah and Law of the land) to the Buyer
at an agreed fixed price payable at a fixed future date in lump sum or within a fixed period by
fixed instalments. The seller may also sell the goods purchased by him as per order and
specification of the Buyer.
In this Bank, Bai-Muajjal is treated as a contract between the Bank and the Client under which
the Bank sells the goods, purchased as per order and specification of the Client, to the client at an
agreed price payable at any fixed future date in lump sum or within a fixed period by fixed
instalments.
Thus it is a Credit sale of goods by which ownership of the goods is transferred by the Bank to
the Client but the payment of sale price by the Client is deferred for a fixed period.
It may be noted here that in case of Bai-Muajjal, the Islamic Bank is a financier to the Client not
in the sense that the Bank finances the purchase of goods by the Client, rather it is a financier by
deferring the receipt of the sale price of goods, it sells to the Client. If the Bank does not
purchase the goods or does not make any purchase agreement with seller, but only makes
payment of any goods directly purchased and received by the Client from the seller under Bai-
Muajjal Agreement, that will be a remittance/payment of the amount on behalf of the Client,
 which shall be nothing but a loan to the Client and any excess on this amount shall be nothing
but Interest (Riba).
Therefore, purchase of goods by the Bank should be for and on behalf of the Bank and the
payment of price of goods by the Bank must be made for and on behalf of the Bank. If in any
way the payment of price of goods is turned into a payment for and on behalf of the Client or it is
paid to the Client, any excess on it will be Riba
Feature

 It is permissible for the Client to offer an order to purchase by the Bank particular goods
deciding its specification and committing himself to buy the same from the Bank on Bai-Muajjal
i.e. deferred payment sale at fixed price.
 It is permissible to make the promise binding upon the Client to purchase from the Bank, that is,
he is to either satisfy the promise or to indemnify the damages caused by breaking the promise
without excuse.
 It is permissible to take cash / collateral security to Guarantee the implementation of the promise
or to indemnify the damages.
 It is also permissible to document the debt resulting from Bai-Muajjal by a Guarantor, or a
mortgage. or both like any other debt. Mortgage / Guarantee / Cash security may be obtained
prior to the signing of the Agreement or at the time of signing the Agreement.
 Stock and availability of goods is a basic condition for signing a Bai-Muajjal Agreement,
Therefore, the Bank must purchase the goods as per specification of the Client to acquire
ownership of the same before signing the Bai-Muajjal Agreement with the Client.
 After purchase of goods the Bank must bear the risk of goods until those are actually delivered to
the Client.
 The Bank must deliver the specified Goods to the Client on specified date and at specified place
of delivery as per Contract.
 The Bank may sell the goods at a higher price than the purchase price to earn profit.
 The price once fixed as per agreement and deferred can not be further increased.
 The Bank may sell the goods at one agreed price which will include both the cost price and the
profit. Unlike Bai-Murabaha, the Bank may not disclose the cost price and the profit mark-up
separately to the Client.
Categories of Proposal under Bai’ Al-Muajjal

 Bai’ Al-Muajjal Commercial

 Bai’ Al-Muajjal Industrial
 Bai’ Al-Muajjal Agriculture
 Bai’ Al-Muajjal Real Estate
 Bai’ Al-Muajjal Import/Export
 Bai’ Al-Muajjal Scheme

Bai’ muajjal – Islamic finance credit sale

Bai’ muajjal is a type of Islamic finance credit sale that is compliant with the shariah. Bai’
muajjal literally means credit sale. In a Bai’ muajjal the financial institution will earn a profit
margin on the price of a purchased asset or assets and will let the buyer pay off the price and they
can do so all at once or in installments. Both parties in this Islamic finance transaction must
agree upon the cost of the asset, as well as the profit margin.
Bai’ muajjal is also referred to as a deferred payment sale, but one of the main descriptions of
riba is a delay in payment that is not justified or the increase or decrease in the price if the
payment is right away or is delayed. Riba, in terms of shariah terminology, shows an excess of
payment without prudent consideration.
Bai’ muajjal is an Islamic finance activity and there are many Islamic financial institutions that
will have this kind of credit sale for those that follow the Muslim faith. Under shariah law, there
cannot be any fixed or floated payments accepted of interest, as well as other fees, for monetary
loans such as for a Muslim mortgage. Transactions in Islamic finance are not new, but more
Islamic banks in the 20th century were established in order to apply principals to individual or
commercial institutions that are in the Muslim community and to follow shariah law.
The Bai’ muajjal is a system of investment that is a credit sale where a financial institution,
which deals with Islamic finance, will but the goods according a parties choice for onward sales.
In this type of credit sale the stop delivery will be ensured. The sale price payment is deferred for
a fixed period of time. The financial institution that deals with the Bai’ muajjal will transfer the
ownership of the asset to the party before the sale price receipt. This is a way to follow shariah
law properly. Also, the financial institution will take on the risks of the asset or assets after the
purchase of them until the time when they are delivered to the individual or company.
The deferred price in the Bai’ muajjal can be set at an amount that is more than the spot price and
there are not any restrictions put on this action. This is the case as long as the price is set when
the purchase takes place. Once the price has been set by the terms of the contract is cannot
change. Understanding Islamic finance transactions is important in properly following shariah
law.

Unit # 11
 Mechanism, applications and AAOIFI Shariah standards of Tawarruq,
The term halal or permissible carries a comprehensive meaning which constituted the whole
process in engaging any activity. A fried chicken for example is halal only when it is slaughtered
islamically and prepared using halal ingredients. The same goes to others particularly business
activity. A business is considered halal or Shariah-compliant when it used permissible financing
method and involved in halal business activity. The basic premise is the Qur’anic propagation to
embrace Islam wholly not partially.
Introduction
In Islam, there are guidelines stipulated by Allah through His Messenger in conducting day to
day activities. In addition, tradition of Prophet Muhammad is the secondary source of reference
after Quran in determining the permissibility of any actions. Allah has stipulated what is halal
and what is Haram in order to guide the Muslim towards the happiness in the world and the most
important is in the hereafter.
Choosing the halal and leaving the haram is compulsory for Muslim.
Alserhan (2010) states that “the closer a person is to halal the more pure their actions are and the
closer their actions to haram the more chance that they are sinning”. Halal is an Arabic word
which means lawful or permissible in Shariah (Jonathan & Jonathan, 2010). In short, halal is
related to the Islamic teachings which means “permitted, allowed, lawful or legal”. While the
term haram is its opposite which carries the meaning “forbidden, unlawful or illegal”.
The term halal and haram is not limited to the food intake only but it carries comprehensive
meaning which include lifestyles and services ranging from finance, hospitality, and logistics
(Alserhan, 2010).
Thus, this paper attempts to delve into the matter by focusing on the implementation of Islamic
concept in financing small businesses the halal way.
Generally, there are many Islamic financing concepts being implemented in the market. One of
them is Tawarruq. Tawarruq is considered makruh (reprehensible) by most jurists and harus
(permissible) according to the Maliki school of thought for one very specific reason namely to
avoid riba’ (Ayub, 2009; Zuhayli, El-Gamal, & Eissa, 2007). Traditionally, the concept is
applied in a simple and natural manner.
In conformity with its meaning, the concept allows for an individual to get cash via purchase and
resell of a specific commodity.
Nevertheless, the contemporary scholars had raised doubt over the practice of Tawarruq
particularly by the Islamic banks. The OIC Islamic Fiqh Academy for example is concerned on
the possibility of non existence of physical commodities in Tawarruq structure as well as an
existence of fraudulent trading contracts which may lead to fictitious transaction. If one of these
occur in practice, therefore it is impermissible under Shariah’s point of view and thus the
contract is haramb (Islamic Finance News, 2010). It is essential to highlight that the concern
raised over Tawarruq by the jurists is on the application of the concept and not on the concept
itself.
In addition, Islamic finance is an asset-based system which promotes real physical economy
(Adel, 2010; Christos & Alexandros, 2009). Therefore, trading is permissible by Allah instead of
loan with increment. In terms of accounting treatment, such sales and trading should be included
in the balance sheet to show movement of an asset of the Islamic banks even though the asset is
held for only a few hours. Rosly (2010) further asserts that if any Islamic bank failed to produce
evidence in terms of proper accounting treatment, they are guilty of riba’ since there are no proof
that a true sale exists.
Raja Teh have once mentioned in a report that the practices of the Tawarruq that ought to be
tightened and not the rule of the permissibility of the concept (Islamic Finance News, 2010). It is
also immaterial to prohibit the whole concept and its implementation while only a few Islamic
banks who violate the concept (Rahman, 2011). The concept itself is being recognized by
Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) by issuing
Shariah standard on that matter.
Aznan once reported that if the contracts are properly executed and follows all the requirements
and rulings of the concept, it should not be prohibited because of the transactions in the contract
is organized (Islamic Finance News, 2010). However, OIC Fiqh Academy in Mecca ruled that
organized Tawarruq and reverse Tawarruq is impermissible in April 2009 since the arrangement
is a trick to get cash now by paying more cash at later date (S. H. Khan, 2009). On the contrary,
Alrajhi approved the concept of organized Tawarruq by undersigned an agreement with Suq Al-
Silac under Bank Negara which claimed to be the world’s first end-to-end Shariah compliant
commodity trading platform (Rahman, 2011).
Since Malaysia is still under transition period where dual banking is a common practice,
Tawarruq is regarded as a better mechanism in avoiding riba’ (Hasan, 2009). Due to the
common practice of conventional personal loan before the emergence of Islamic Banking,
Tawarruq should be the nearest alternative to the Muslim consumer in their liquidity
management. This is a good approach since engaging in riba’ is engaging with God’s angerd.
Therefore it should be departed from Muslim tradition.
The organization of the paper is as follow. Next sections will deal with the definition of
Tawarruq concept, its types, ruling on the concept and element of a valid sale contract. After
that, this paper will discuss on its arrangement and its application and last but not least is the
discussion on the arrangement to finance small entrepreneur using the concept. Before going into
further, it is best to understand the concept first so that it is easy to illustrate the arrangement
afterwards.
Definition of Tawarruq and its Types
In order to get a better picture on the concept, let’s shed the light on its term first. Literally,
Tawarruq means ‘darahim madrubah’ which referred from the Quran (Khayat, 2009). “(Allah)
(alone) knows best how long ye have stayed now send ye then one of you with this money of
yours to the town”e. According to Dabu (2007), the word Tawarruq is derived from the root
word ‘paper’. Al-Wariq’ that is dirham (minted coin from silver) (Ahmad, 2009; Dusuki, 2010).
Technically, Tawarruq means purchasing a commodity on a deferred price either in a form of
Musawamah or Murabahah (mark up sale), later selling it to a third party with the objective of
obtaining cash. The term Tawarruq is used in this type of transaction is influence by the
intention of the buyer of the asset who have no interest in utilizing the asset or gaining the
benefit of the asset since the main intention is obtain liquidity (Dusuki, 2010).
In practice, Tawarruq is also known as Commodity Murabahah (Dusuki, 2010; Islamic Finance
News, 2010). Though some do not recognized it as Commodity Murabahah due to the
association of
Tawarruq with Tawarruq al-Munazzam (Tawarruq with pre arrangement) (Ghani & Hussain,
2007). Due to this disagreement on the terminology used, Tawarruq has been divided into types
which distinguished its meaning and application. These types of Tawarruq will be discussed in
the following chapter.
Generally, there are two types of Tawarruq namely individual Tawarruq (Tawarruq al-Fardi)
and organized Tawarruq (Tawarruq al-Munazzam) (Dabu, 2007; Ghani & Hussain, 2007).
Individual Tawarruq is a pure Tawarruq whereby a buyer buys a commodity from a seller on
deferred term and later sells it to other person for immediate cash. When the buyer sells it, the
commodity is in his hand and he has the choice in either to keep it or to sell it in the future.
If the buyer has the intention to sell it, the sale contract is considered valid by the majority of
jurists even the buyer sells the commodity to other person (independent from original seller)
since the intention of all parties is not to engage in riba’ (Haneef, 2009). Therefore, Tawarruq is
allowed though some jurist considered it is reprehensible provided that third party is present as
an intermediary (El-Gamal, 2006; Kuwait Finance House, 2011a).
Tawarruq al-Munazzam is organized in a way that the buyer has the options in either keeps the
commodity or appoint the seller to be an agent to sell it or appoint a third party which is related
to the bank to sell the commodity. This type of Tawarruq is common in banking practice for the
purpose of consumer financing (Adel, 2010). The buyer practically has no options as the
purchased commodity is not intended to be purchased (Dabu, 2007). Rather, it is a facility to
allow the buyer to get cash. Hence, he appoints the bank as his agent to sell the purchased
commodity to any third party and the proceed will then be delivered to him.
3. Rulings on Tawarruq and the Essential Elements of a Valid Tawarruq Contract
The proponents of Tawarruq who approved the concept and considered it as permissible in Islam
are mainly based on the permissibility of trading as in the Quran “Allah permits trade and
prohibits riba’”f.
They assert that the usage of word al-bay (trade) in the Quran give the meaning of generality due
to the definite article al- in the beginning of the word bay. Thus, the word ‘trade’ is generalized
to all types of sale transactions including Tawarruq (Dusuki, 2010). The proponents of Tawarruq
also quoted a hadith which they claimed that the Prophet (peace be upon him) is prefer
transaction that involved two separate contracts that independent from each other.
“The Prophet (peace be upon him) appointed a man as governor of Khaybar, who later presented
him with an excellent type of dates (janib). The Prophet asked, “Are all the dates of Khaybar like
this?” He replied, “No, but we barter one sa’g of this (excellent type) for two sa’ of ours, or two
sa’ of it for three of ours.” Allah’s Apostle said, “Do not do that (as it is a kind of usury); rather,
sell the mixed dates (of inferior quality) for money, and then buy the excellent dates with that
money.”h The proponents of the concept also supported their interpretation with the legal
maxim, “the starting assumption for all statements, actions, contracts and conditions is
permissibility.”
Every sale contract must have elements that will ensure the validity of each transaction. The
elements that needed to be observed are offeror and offeree, offer and acceptance; and subject
matter of trade and consideration.
Offeror and Offeree
Offeror and offeree are the parties who wish to enter into a transaction. The contracting parties to
the contract must have legal capacity to enter into a contract (Bakar, 2008; Billah, 2006). A
person is considered as having legal capacity if he is intelligent enough (aqil) to understand the
contract and he has attained the age of majority (baligh).
Offer and Acceptance
Offer can be made orally, by writing or by conduct (Bakar, 2008). However, acceptance can be
implied even though the party is silence. The offer and acceptance must be concluded in the
same session (majlis) without a gap or interruptions. The sale must be done with free willing
without any coercion (ikrah) to enter the contract (Billah, 2006).
Subject Matter of Trade and Consideration
These are the general rulings for the traded asset to ensure the validity of the arrangement.
􀁸 The subject matter must be lawful in the eyes of Islamic Law and in accordance to the public
order or morality (Bakar, 2008).
􀁸 There must be an underlying asset in a trading and it is existed for sale (Bakar, 2008; Nawawi,
2009).
􀁸 The asset must be in possession of the seller at the point of sale (Dusuki, 2010).
􀁸 The asset must be in good working condition. Means that, it is not a scrap which cannot be
sold to other party due to its defectiveness. Therefore, is not allowed to be an underlying asset. In
other words, the asset must have commercial value (Nawawi, 2009).
􀁸 The asset must be able to be delivered to the buyer when the buyer asks for it (Bakar, 2008;
Hasan, 2009; Nawawi, 2009).
􀁸 The asset can be ascertained with detail description on to avoid dispute in future (Bakar, 2008;
Billah, 2006; Nawawi, 2009).
􀁸 In the case of the consideration, it is not restricted to a monetary price only, but it may also be
other form of commodity (like barter trade). However, the consideration must be certain either in
spot or future (Bakar, 2008; Billah, 2006).
These elements are essential in completing a valid Tawarruq arrangement. The contract may be
rendered invalid if one of the elements is not observed when conducting the transaction. In the
next section, this paper will discuss on the arrangement and application of this concept.
The Arrangement and Application
The Arrangement Method
In terms of arrangement, some banks uses agency contract in their arrangement while others does
not involved in the second sale transaction. The arrangement can be illustrated as below.
Islamic Bank as an Agent
Tawarruq may be applied by appointing the Islamic bank as an agent for the customer to
facilitate the transaction. When a customer approached the bank for financing, the bank will
obtains Tawarruq transaction documents from the customer including the document that appoint
the bank as an agent to sell the commodity back to the market (Bank Islam, 2011).
This technical concept works when the bank buys a commodity at London Metal Exchange
(LME) through a first broker on spot basis (Bank Islam, 2011). Under the Murabahah contract,
bank then sells the commodity to the customer at bank's selling price that is principle amount
plus profit on deferred payment term (Bank Islam, 2011). Under the Wakalah (agency contract)
contract, the customer requests the bank to sell the commodity in the market (Bank Islam, 2011).
The bank will be appointed as a sale agent on behalf of the customer and sells the commodity to
a second broker which is different from the first broker (Bank Islam, 2011). Wariq (proceed)
from the sale of commodity will be credited by bank to the customer's account. Finally, customer
will pay the amount due to the bank which has been agreed earlier on Murabahah concept by
way of agreed installment method (Bank Islam, 2011).
Non Involvement by Islamic Bank
Tawarruq transaction can also be realized by way of the customer finds his buyer or agent by
himself with no involvement by the Islamic bank. Firstly, the bank may sells any goods that
approved by Shariah to the customer on deferred term. Even though the goods are not in the
bank’s hand, the bank must give the detailed information on the delivery of the goods to the
customer (Kuwait Finance House, 2011b).
After the delivery took place, the customer may sell the goods to a buyer or an agent of his
choice (Kuwait Finance House, 2011b).

Fig. 1. Technical process of Tawarruq concept

Processes are as follows:
1. A customer approaches an Islamic Bank for financing based on Tawarruq concept.
Documents will be submitted together with the application forms to the Islamic Bank.
2. Once approved, the Islamic Bank will buy commodity from Broker A at RM10,500.
3. Islamic Bank will sell the same commodity to the customer at RM15,000 in deferred term.
The difference of RM4,500 is the profit earned by the bank. The customer will pay RM312.50
monthly for 48 months.
4. The customer will appoint the Islamic Bank as an agent to sell the commodity back on behalf
of him
for cash. In this example, the commodity is assumed to be valued at RM10,000. This is the
amount that the customer will receive in cash and the cash received might be deducted for any
direct cost incurred associated with the arrangement. Examples of direct cost are stamp duty for
agreement and agent fee. As an illustration, the stamp duty is RM20 and the agent fee is RM50.
The customer will receive RM9,930 nett in this facility.
Tawarruq in Retail Financing
The Islamic bank is offering financing for retail on Tawarruq basis. Small entrepreneurs are
individuals who conduct business on sole proprietorship basis and have little or no access to
obtain financing from banks. These people are not eligible for corporate banking and to opt for
personal financing is not a wise choice.

Fig. 2. Proposed Tawarruq Model

The modes of operation of the Tawarruq are as follow:
1. The customer approaches the bank and submits the application detailing the supplier
information, types of goods wanted (e.g. school bag) and its quantity (e.g. 1000 pieces),
quotation price (e.g. RM15 each) of the product as well as financing tenure ability (e.g. 24
months).
2. After credit evaluation is done and the financing is approved, the bank will issue letter of offer
detailing the information pertaining in buying the goods from the supplier and as well as offer
from the bank to sell the goods to the customer based on Murabahah contract and in deferred
term.
3. The customer then accepted the offer and the bank will arrange for goods ownership.
4. The bank then purchases the goods from the supplier and arrange for delivery. For the
delivery, the
customer may pick up the goods on behalf of the bank (by providing proof on collection) or the
supplier may deliver it to the address specified by the bank.
5. Once the goods are owned by the banks, bank later sell the goods to the customer based on
Murabahah contract which has been stipulated in the letter of offer as agreed by both parties. Let
say that the bank sells the bags to the customer for RM20 each which amounting to RM20,000.
6. The Tawarruq arrangement will be concluded when the customer sells the goods in retail to
the end customer to obtain profit from the sale. If the customer able to sell the bags at RM30
each, the customer is able to earn RM10,000 for 1000 bags sold. The customer also has the
opportunity to buy in bulk and enjoys the financing facility.
7. The customer will pay the bank RM833.35 monthly for 24 months.
The model is proposed with the intention to enrich the product offerings of the industry while
contributing to the economic development of individuals who are in need. This model may help
the small business owner expanding their business and this model suitable with the small
business owner whom has limited working capital. The profit rate imposed on the goods bought
from the supplier should be commensurate with their effort and should be based on win-win
situation between bank and the customer resulted to material finality which means directly linked
to the real economic development of the individuals whom conducting small business in retailing
(F. Khan, 2010).
The banks also need to ensure that the financing is allowed under Islamic Law and no financing
of sinful activities or goods should be compromised (F. Khan, 2010). Hopefully this Tawarruq
model will be regarded as real Tawarruq since the facility is not pre arranged and the customer is
able to buy goods that they desired with and sell it back with profit by the sale. Agency contract
is not included in the arrangement which serve the objective to mitigate the debate among jurists
on agency contract as well as the customers has the option to sell it to the third party as they
wish.
Muzarat (Tenancy)
The word Muzarat is derived from Zara, which means to ‘sow the seed’. Technically it is defined
as a transaction in which “the owner of agricultural land gives his land to another for cultivation
on terms of crop-sharing at a fixed rate”.
The term Mukhabarat is also used for Muzarat. However some ulema differen+ate between the
two by holding the view that if the seed is supplied to the tenant by the owner, it would be called
Muzarat, but if the seed is purchased by the tenant himself, the term Mukhabarat would be used.
The term Masaqat is also used in connec+on with these transac+ons. The difference between
Masaqat and Muzarat is that Muzarat refers to tenancy of land, whereas Masaqat refers to
tenancy of garden on the same terms as Muzarat.
There is a difference of opinion among the jurists of Islam on the legality or illegality of
Muzarat.
Kafalah
Kafalah is the guarantee for a loan and all loans must be repaid in due course according to
Islamic law. The law allows the lenders to demand some sort of security for the loan in the cases
where the borrower fail to repay the loan. As for the Shariah Advisory Council of Bank Negara
Malaysia, kalafah is defined as a guaranteed contract on certain asset, usufruct and/or services
provided by a guarantor to the parties involved. In international trade and finance, kafalah plays
an important role in facilitating trade across border by which the bank is asked as a guarantor of
payment in the international trade transaction. Islamic banks are able to offer bank guarantee,
standby letter of credit and shipping guarantee using the concept of kafalah. Additionally,
kafalah can be used to indemnify a third party from financial losses if one party fails to perform
its part of the deal. Such application is used in the form of letters of guarantees. In Malaysia, the
guarantee facility is not only issued by Islamic banks but also by financial institutions such as
Cagamas SRP Berhad and Credit Guarantee Corporation Berhad.
Kafalah in RHB Islamic Bank
The practice in Malaysia had shown that Kafalah concept is usually practiced by Islamic Banks
in trade financing sector in two products which are bank guarantee and shipping guarantee. For
this, we can look at bank-guarantee product from RHB Islamic Bank. Below figure illustrates
how Kafalah is undertaken in a letter of guarantee by RHB Islamic Bank.
Kafalah: The Structure Flow of Islamic Bank Guarantee (IBG) from RHB Islamic Bank
 1. Customer enters into a contractual agreement with the beneficiary (e.g. a Statutory Body)
to fulfill an obligation.

2. Customer approaches RHB Islamic Bank to request the issuance of Islamic Bank
Guarantee (IBG) facility.

3. RHB Islamic Bank issues IBG to the customer, as a surety to discharge the liability of
beneficiary in case the customer defaults. In return, a sum amount of fee is charged to the
customer.

4. In the event of default by the customer, the beneficiary will claim from RHB Islamic
Bank. RHB Islamic Bank makes immediate payment on first demand provided the claim
meets all the conditions of the guarantee.

5. If there is no default, the beneficiary will return the IBG to the customer followed by
RHB Islamic Bank’s cancellation upon maturity.
Kafalah: Shariah issues
In bank guarantee, the guarantor (RHB Islamic Bank) charges the customer a certain fee.
However, this practice remains a matter of debate among Shariah scholars. This is because some
scholars like Hanafi, Shafie, Maliki and Hambali schools did not permit charging fee for a
guarantee due to the nature of the contract (benevolent contract) and in the condition the
customer defaulted, the relationship between the guarantor and guaranteed party will change into
debtor-creditor, thus, charging a fee will lead to riba.
In contrast, some contemporary scholars like Shaykh Ahmad Ali Abdullah from the OIC
International Islamic Fiqh Academy permits charging a fee provided that the guarantee is not in
the form of a loan (Qard). Besides that, there is no issue on riba as the commitment provided
from the guarantor is considered as counter value following the fiqh maxim – al kharaj bi daman
(profit comes with liability). The Shariah Advisory Council of Bank Negara Malaysia has
allowed charging fee on letter of guarantee based on this basis.

1. The method used by RHB Islamic Bank in determining the actual cost RHB Islamic Bank
used one of the three methods in charging fees on bank guarantee which is by calculating
the actual cost. Although this method is allowed by AAOIFI, one thing to ponder is how
 the bank calculates its actual cost. There are always risks that the bank imposed
unnecessary fees to increase the profit margin.

2. The guarantee that the customer will pay back to the bank RHB Islamic bank and some
other banks accept collateral or pledge or cash deposits from the customer before
agreeing to issue the letter of guarantee to secure the bank’s risks. Islamic banks are not
exposed to any cash outlays unless their customer defaults on the performance of a
certain act.
Hawala

What Is Hawala?

Hawala is a method of transferring money without any money actually moving. Interpol's
definition of hawala is "money transfer without money movement." Another definition is simply
"trust." Hawala is an alternative remittance channel that exists outside of traditional banking
systems. Transactions between hawala brokers are made without promissory notes because the
system is heavily based on trust and the balancing of hawala brokers' books.
Hawala, also known as hundi, literally means transfer or remittance.

Understanding Hawala

Hawala originated in South Asia during the 8th century and is used throughout the world today,
particularly in the Islamic community, as an alternative means of conducting funds transfers.
Unlike the conventional method of transferring money across borders through bank wire
transfers, money transfer in hawala is arranged through a network of hawaladars or hawala
dealers.
Hawala dealers keep an informal journal to record all credit and debit transactions on their
accounts. Debt between hawala dealers can be settled in cash, property, or services. A hawaladar
who does not keep his end of the deal in the implied contractual system of hawala will be tagged
as one who has lost his honor and will be ex-communicated from the network or region.
Migrant workers who frequently send remittances to relatives and friends in their countries of
origin find the hawala system advantageous. Hawala facilitates the flow of money between poor
countries where formal banking is too expensive or difficult to access. In addition to the
convenience and speed of conducting hawala, the commission rates are usually low compared to
the high rates that banks charge. To encourage foreign exchange transfers through hawala,
dealers sometimes exempt expatriates from paying fees. The system is also easy to use, as one
only needs to find a trusted hawaladar to transfer money.

An Example of Hawala

How does hawala work? Let’s say Mary needs to send $200 to John, who lives in another town.
She will approach a hawaladar, Eric, and give him the amount of money she wants John to
receive, including the details of the transaction—the name of the recipient, city, and password.
Eric contacts a hawala dealer in the recipient’s city, Tom, and asks him to give John $200, on the
condition that John correctly states the password. Tom transfers the money to John from his own
account, minus commission, and Eric will owe Tom $200. The transaction initiated by Mary and
concluded by John’s receipt of the funds takes only one to two days or, in some instances, just a
few hours. No money is moved and no IOUs are signed and exchanged by Eric and Tom, as the
hawala system is backed only by trust, honor, family connections, or regional relationships.

Special Considerations

The very features that make hawala an attractive avenue for legitimate patrons also make it
attractive for illegitimate uses. Thus, hawala is frequently referred to as underground banking.
This is because money launderers and terrorists take advantage of this system to transfer funds
from one location to another.
Hawala provides anonymity in its transactions, as official records are not kept and the source of
money that is transferred cannot be traced. In addition, corrupt politicians and the wealthy who
would prefer to evade taxes use hawala to anonymize their wealth and activities.
Since hawala transfers are not routed through banks and, hence, not regulated by governmental
and financial bodies, many countries have been led to re-examine their regulatory policies in
regard to hawala.
[Important: Some countries have made hawala illegal due to the absence of bureaucracy in
the system.]
For example, in India, the Foreign Exchange Management Act (FEMA) and the Prevention of
Money Laundering Act (PMLA) are the two major legislative systems that deter the use of
hawala in the country.
Some FinTech companies are implementing the hawala system in providing financial services to
the unbanked and underbanked populations of the world. Mobile banking and payment
platforms, such as Paga and M-Pesa, are revolutionizing the financial system in certain
African countries by promoting financial inclusion through the hawala system of providing
financial services.

Key Takeaways

 Hawala (sometimes referred to as underground banking) is a method of transferring

money without any money actually moving and is an extremely archaic method of moving
money.
 Hawala provides anonymity in its transactions, as official records are not kept and the
source of money that is transferred cannot be traced.
 Some FinTech companies are implementing the hawala system in providing financial
services to the unbanked and underbanked populations of the world.
 Migrant workers who frequently send remittances to relatives and friends in their
countries of origin find the hawala system advantageous.
 Some countries, like India, have made hawala illegal due to the absence of bureaucracy
in the system.
Wakalah and Ju‘alah
Ijarah, by definition, is a contract of lease whose subject matter is a known service (khedmah),
and in which the consideration (badal) becomes due on an incremental basis in proportion to the
passage of time and effort exerted (services provided). On the other hand, ju'alah is a contract of
service whereby a party commissions another (a worker) with a task whose achievement is
probabilistic rather than sure- i.e., the task may be achieved or may be not), and task undertaker
(the worker) is entitled to the agreed amount (ju'l) only if the task is achieved.
Hawalah vs. Wakalah vs. Kafalah
There are various legally recognised forms of financing contracts in Islam, and Hawalah,
wakalah, and kafalah are three most commonly used concepts in modern Islamic banking. To a
great extent, hawalah resembles kafalah and wakalah since these contracts involve transfer of
risk and control. The main difference between hawalah and kafalah is that the principal debtor is
released from the debt under hawalah contract whereas kafalah is not.
Below table gives a comparison of hawalah, wakalah and kafalah which is based on various
resources, including academic publications and industry reports published by professional
bodies. These three service based contracts compared and contrasted according to three main
features: definition, legality and condition from each contract.

Comparison between Hawalah, Wakalah, and Kafalah

Hawalah Wakalah Kafalah

 Kafalah is an Arabic
word for
responsibility,
amenability or
suretyship. It often
refers to an act of
someone adding
himself to another
Hawalah means “change” or
person, and making
“transfer” and usually refers to
himself liable to
the transfer of debt from Wakalah refers to a
perform the
original debtor to the legal contract in which a party
responsibility,
personality. (muwakkil) authorizes
together with the
another party as his agent
person
(wakil) to perform a
Accounting and Auditing particular task, in matters
Organization for Islamic that may be delegated,
According to AAOIFI
Finance Institutions (AAOIFI) either voluntarily or with
Shariah Standard No.
Shariah Standard No. 7 define imposition of a fee
Definition 5, kafalah are
Hawalah as transfer of a debt
guarantees that are
liability from the transferor to
intended to secure
the payer. AAOIFI (2010) Shariah
obligations and
Standard No. 23 defines
protect amount of
Wakalah as “the act of
debts, either from
The effect of Hawalah is that one party delegating the
being uncollectible or
the creditor can no longer other to act on its behalf
from being in default
claim debt from original debtor on what can be a subject
since the claim should be made matter of delegation.”
against the new debtor named
Ibn Al-Qudamah
in Hawalah contract
defines kafalah as a
conjoining of the
guarantor’s liability to
the liability of the
guaranteed. Thus, the
debt would be
established on both of
them
 The hadith reported by Al-
Bayhaqi, in which the Prophet The evidence of Kafalah can be seen in
‫ صلى هللا عليه وسلم‬have said: permissibility is derived the Sunnah of the
“Delinquency of rich debtors is from the text in Al-Quran Prophet Muhammad
a form of transgression, so if hadith and ijma’. One of S.A.W., where Abu
one of you has his debt the text is “… so send Qatadah asked the
transferred to a rich person, let one of you with this Prophet to pray for a
him accept the transfer of silver coin of yours to the man to whom he (Abu
debt” (Narrated by Ahmad and city and let him look to Qatadah) had been a
the author of six books of which is the best of food guarantor for a debt
Legality Hadith as well as Ibn Shaybah and bring you provision
and Al-Tabarani in his ‘Awsat from it ….” (Surah
on the authority of Abu AlKahf, verse 19) In more recent times,
Hurayrah). AAOIFI Shariah
Standard No.5 has
From the ijma’ the jurists stated that guarantees
Al-Zuhayli (2003) recorded agreed that wakalah is are allowed with
that majority of the jurist view permissible and regards to contracts of
this Hadith that it is preferred recommended based on exchange and also
to accept the transfer of debt, ta’awun concept contracts of property.
since it is not an obligation.

According to Hanafis as There are four (4) In Kafalah there are

reported by AlZuhayli (2003), conditions pertaining to four (4) basic rules
there are five (5) conditions the basis of wakalah and conditions the
pertaining to the transfer of contract parties must adhere to
debt.
1. Guarantor who is of
1. The language of the contract 1. The muwakkil shall sound mind, has legal
must be intended for offer and authorize a specific wakil capacity and willingly
acceptance to transfer debt, and notify him of his give his consent and
and it can be in oral or in appointment. agreement to the
written form. 2. The Wakil (Bank) contract.
2. The principal debtor must be agent (wakil) to perform 2. Debtor, he does not
Condition
of eligible person to enter into a particular task, in need to have legal
contract and freely consent to matters that may be capacity and can even
the transfer of debt, meaning delegated, either be a minor, insane
no coercion involved because voluntarily or with person or a bankrupt.
coercion invalidate the imposition of a fee 3. Creditor who must
transfer. 3. Subject matter in be known to all
3. The creditor must have the wakalah contract should parties.
same criteria of the principal be known to agent and it 4. Guaranteed object
debtor but with additional is not permissible to or asset. This asset
condition which is issuance of delegate someone to must be an actual
acceptance by creditor in order perform unknown thing. asset that is possible
to signify recognition of the 4. Offer and acceptance to collect from the
 transfer. may be expressed guarantor. It should be
4. The transferee must fulfil verbally or by an asset that can be
similar conditions like the appropriate legally owned and
creditor just now. documentation or by any sold should the debtor
5. The debt must be fungible other methods accepted fail to fulfil his
debt and should be binding. by customary business obligations.
When such debt complied with practice which does not
the two conditions, the debt is contravene the Shariah
eligible to be transferred. principles.

There are other opinions with

regard to the conditions of
Hawalah contract, but the
author mainly highlights the
opinion from the Hanafis.

Istijrar - types, applications and conditions;

Chapter 9
Istisna and Parallel Istisna - mechanism, applications and AAOIFI Shariah standards;
Chapter 10
Bay` Bithaman Ajil - its legality, applications; Bay’ al-Muajjal its comparison, documentation
and related issues
Chapter 11
Mechanism,

applications and AAOIFI Shariah standards of Tawarruq,

Tenancy (muzarat),

Kafalah,

Hawala,

Wakalah and Ju‘alah