-This is the second in our Islamic Finance Series. To see the Introduction Post, please click here. In this post we speak briefly about the various major instruments which are crucial to a functioning Islamic finance system.
Instrument 1: Trust Finance (Mudaraba)
(Rab-ul-mal or A) provides the capital. While (Mudarib or B) manages the investment using his expertise. Typically, Mr. A (Rab-ul-mal) provides QR 50,000 for investment as a grocery shop in Hargaisa City. Mr. B (Mudarib) manages the shop. Profit is determined separately and distributed by applying a pre-fixed sharing ratio. Any loss is carried by A (Rab-ul-mal) unless B (Mudarib) was negligent. All the assets are owned by A (Rab-ul-mal). B (Mudarib) can buy out A (Rab-ul-mal). Mudaraba can be ‘restricted’ or ‘un-restricted’.
Instrument 2: Partnership Finance (Mosharaka)
All parties provide capital towards the financing of the investment. The profit is shared on a pre-arranged ratio. The loss is shared on the exact proportion to the capital invested by each party. All parties participate in the management of the investment but not necessarily required to do so. An extra amount can be paid to the investor bank to reduce its holding shares in the company. Another scenario is where a Bank (non-active Mosharik) invests QR 100,000 in a company established by A (active Mosharik) in a pharmaceutical company, where A invests QR 100 and manages the company.
Instrument 3: Cost-Plus Financing (Morabaha)
A (Financier) buys a factory on behalf of B, for in a Cost-Plus agreement. B (the buyer) agrees to purchase the factory from A (the investor) in one of two ways: (a) immediate payment or (b) a deferred payment. The mark-up is a means of rewarding the bank for: seeking out the factory at best price, locating the factory at best price, or purchasing the factory at best price. The mark-up does not relate to time – it does not increase with the passing of time and remains as prearranged. The investor bank owns the property between the completions of the two sales and assumes all risk.
Instrument 4: Leases (Ijar)
Ijar is defined as sale of Manafa’a (i.e. sale of right to utilize the goods for a specific period.) It is similar to a conventional lease. Ijar is a contract under which a Bank (Lessor) buys and leases out an asset or equipment required by its client A (lessee) for a rental fee. Lessor assumes ownership right. Lessor can intermittently re-negotiate the value of the rental to ensure the rental charge is in line with its equivalent mark value.
Instrument 5: Advance Purchase (Salam)
This type of finance usually refers to a finance contract of Agricultural Products. It involves forward purchase of specified goods for full forward payment. A forward sale is for property, the delivery of which is deferred, against a price payable immediately.
Instrument 6: Commissioned Manufacture (Istisna’a)
Banks finance construction and manufacturing projects under this type of financing. A (investor) buys goods from B. B undertakes to manufacture the goods according to pre-agreed specifications for a profit.
Instrument 7: Interest-Free Loan (Quard-Hassan)
Security may be taken. A nominal Administration Fee maybe applied – this cannot be made proportional to the amount lent or the term of the loan.
Instrument 8: Islamic Banking Insurance (Takaful)
Takaful is a method of creating a pool of payments contributed by a group of participants making up an agreed sum which is put in turn into a common fund that will be managed according to Sharia.
Read more (Part 1).
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