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Islamic financial instruments – a conceptual framework

Commercial banks around the globe have designed and utilized Islamic financial instruments according to the rules of Shariah. Section 5(b) of Banking Companies Ordinance-1962 defines the business of banking as “banking means the accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise and withdrawable by cheque, draft, order or otherwise.” By analyzing both sides of the balance sheet of any Islamic bank, it is quite clear that like conventional banks, Islamic banks can also efficiently provide most of the banking services. However, the assets-side of the balance sheet looks different in financing, but this is matched with liability-side products, where customers are not risk averse. This helps in channeling the flow of capital to risk assets and provide equitable distribution of profits and loss to be shared by all members of the financial system.

Activities of the Islamic banks in Pakistan since 2000, have perceived the success as banking of choice due to various Islamic Financial instruments, which have visionary prospects towards economic growth. As State Bank of Pakistan has been playing a leading role in the promotion and development of Islamic Banking in the country on sound footings, so these instruments will have far-reaching effects on the economic development of Pakistan. We will look into both sides of the balance sheet of an Islamic bank from financial instruments perspective.

Liability-Side Financial Instruments
a) Current Accounts

Current Accounts in Islamic Banks are chequing accounts that work on the basis of ‘qard’ (loan). It provides convenience to the customers by putting their money in Riba-free account and accessing it without any restriction of minimum balance maintenance. This product offers to the customers the ease of performing all their daily transactional needs in a safe and convenient way.

b) Savings Accounts

Savings Accounts of an Islamic Bank work on the basis of ‘Mudarabah’. Mudarabah is a partnership in profit whereby one party provides capital (Rab-ul-Mal) and the other party provides labor (Mudarib), wherein the customer (Rab-ul-Mal) deposits his money with Islamic Bank (Mudarib) in order to earn competitive returns on their deposit. These accounts provide comfort to the customers by depositing their money in a Riba-free account and earn Halal profits, without any limitation on withdrawals.

c) Investment Accounts

An Islamic bank’s term deposits certificates are Mudarabah-based short term to long term deposit products with flexibility of return on monthly, quarterly, semi-annual and annual basis.

Asset side financial instruments
a) Working Capital Financing Products:

Murabahah is a sale in which costs and profits are disclosed to the end customer. Different methods for payments of price of things purchased are present under Murabahah. The price can be:

  • Prompt /on spot
  • Deferred (to be paid in full on a particular date in future)
  • Deferred with installments (equal or unequal installments of price to be paid during a particular period in future)

Payment methods break Murabahah into three types:

  • Murabahah with spot payment of price, called Murabahah Mu”ajjalah
  • Murabahah with deferred payment of price, called Murabahah Muwajjalah
  • Murabahah with payment of price in installments during a certain period is also called Murabahah Mu”ajjalah

At Islamic banks, Murabahah is a short term financing facility in Pakistani Rupees and foreign currencies for purchasing raw materials or any other asset through bank. Murabahah can also be utilized as financing against imported merchandise (FIM), where the subject matter (imported goods) are kept as security.

About Istisna

Istisna is simply a sale transaction where a commodity is transacted before it comes into existence. Istisna is the second exception where a sale is allowed without existence of the goods sold. The first one being the Salam. Istisna is an order to a manufacturer to produce a specific commodity for the purchaser. It is necessary that the manufacturer uses his own material to manufacture the required goods. If the manufacturer provides his services to produce the item and the material is from ordering party, then this transaction will not be an Istisna transaction. Istisna can be used for made-to-order commodities where a customer orders a specific good with some specifications to be manufactured in a particular period of time and delivered to him after completion. Islamic banks use Istisna as a short term facility extended to exporters and local manufacturer to finance material, labor costs and overheads.

b) Long Term Financing Products
  • Ijarah (Leasing)

The literal meaning of Ijarah is to give something on rent. In Islamic jurisprudence, this term is used in two different situations. Firstly, it means to employ the services of a person on wages given in exchange of his hired services. This kind of Ijarah is not the subject matter of this article. The second type of Ijarah, which is being used in Islamic banking, means: to transfer the rights of use of a particular property to another person in exchange for a rent claimed from him. ” In this while, the ownership of the item remains with the bank (lessor), only the right of use is transferred to the person renting it (lessee). It is just like someone takes a house on rent and pays a rent to the owner of the house for use of his house, the ownership remains with landlord. In Islamic banks Ijarah is a medium to long term Islamic leasing facility for procurement of plant / machinery, vehicles, etc. the subject matter of Ijarah may be purchased locally or imported by the customer.

Diminishing Musharakah

Diminishing Musharakah is usually done under shirkat-ul-milk. This type of Musharakah is primarily used for real estate financing. It involves the bank taking share in the ownership of a specific asset along with the customer and then gradually transferring complete ownership to the customer. There are three different components of diminishing Musharakah:

  1. Joint ownership of the bank and the customer.
  2. Customer as a lessee uses the share of the bank and pays rents.
  3. Redemption of the share of the bank by the customer until he acquires full ownership, (gradual).
The writer is a Karachi based freelance columnist and is a banker by profession. He could be reached on Twitter @ReluctantAhsan

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