Contracts in Islamic Finance : Aqad or Contracts in Islamic Finance and definition of Mudaraba, Musharakah, Murabaha, Ijara and Salam.
In Islamic finance to generate profits must be done through transactions that do not violate Islamic rules, and contractual agreements must be far from the element of tyranny and fraud.
Contracts in Islamic Finance
Contracts in Islamic finance in field practice are currently most often used in buying and selling transactions or in Arabic it is called murabaha.
There are 5 main contracts in Islamic finance:
1. Mudaraba contracts in Islamic finance
The 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.
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.
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.
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.
2. Musharakah contracts in Islamic finance
The term refers to a financing technique adopted by Islamic banks. It is an agreement under which the Islamic bank provides funds which are mingled with the funds of the business enterprise and others. All providers of capital are entitled to participate in the management but not necessarily required to do so.
The profit is distributed among the partners in predetermined ratios, while the loss is borne by each partner in proportion to his contribution.
This is a classical partnership agreement. All parties involved contribute to towards the financing of a venture. The parties share profits on a pre-agreed ratio while losses are shared according to each parties equity participation.
Here again the reason is because in Islam, one cannot loose what they did not contribute. Management of the venture is carried out by all, some, or just one party member.
We add our funds to your funds, and participate in the equity of the project. We share profits and losses in direct proportion to our contributions.
Musharaka is another popular techniques of financing used by Islamic banks. It could roughly be translated as partnership. In this technique two or more financiers provide finance for a project. All partners are entitled to a share in the profits resulting from the project in a ratio which is mutually agreed upon.
However, the losses, if any, are to be shared exactly in the proportion of capital proportion. All partners have a right to participate in the management of the project. However, the partners also have a rig ht to waive the right of participation in favour of any specific partner or person.
In this form of Musharaka an Islamic bank participates in the equity of a project and receives a share of profit on a pro rata basis. The period of contract is not specified. So it can continue so long as the parties concerned wish it to continue.
This technique is suitable for financing projects of a longer life where funds are committed over a long period and gestation period of the project may also be long.
Diminishing Musharaka allows equity participation and sharing of profit on a pro rata basis but also provides a method through which the equity of the bank keeps on reducing its equity in the project and ultimately transfers the ownership of the asset on of the participants.
The contract provides for a payment over and above the bank share in the profit for the equity of the project held by the bank. That is the bank gets a dividend on its equity. At the same time the entrepreneur purchases some of its equity.
Thus, the equity held by the bank is progressively reduced. After a certain time the equity held b y the bank shall come to zero and it shall cease to be a partner.
Musharaka form of financing is being increasingly used by the Islamic banks to finance domestic trade, imports and to issue letters of credit. It could also be applied in agriculture and Industry.
This Islamic financing technique refers to a partnership between two parties, who both provide capital towards the financing of a project. Both parties share profits on a pre- agreed ratio, but losses are shared on the basis of equity participation. Management of the project is carried out by both the parties.
3. Murabaha contracts in Islamic finance
Sale on profit. Technically a contract of sale in which the seller declares his cost and profit. This has been adopted as a mode of financing by a number of Islamic banks.
As a financing technique, it involves a request by the client to the bank to purchase a certain item for him. The bank does that for a definite profit over the cost which is settled in advance.
Some people have questioned the legality of this financing technique because of its similarity to riba or interest.
A contract of sale between the bank and its client for the sale of goods at a price plus an agreed profit margin for the bank. The contract involves the purchase of goods by the bank which then sells them to the client at an agreed mark-up. Repayment is usually in instalments.
Used if you wish to purchase equipment or goods. We will purchase these items, and then sell them to you at cost – plus a reasonable profit.
Murabaha is the most popular and most common mode of Islamic inancing. It is also known as Mark up or Cost plus financing. The word Murabaha is derived from the Arabic word Ribh that means profit. Originally, Murabaha was a contract of sale in which a ommodity is sold on profit.
The seller is obliged to tell the buyer his ost price and the profit he is making. This contract has been modified a little for application in the financial sectoIn its modern form Murabaha has become the single most popular technique of financing amongst the Islamic banks all over the world.
It has been estimated that 80 to 90 percent of financial operations of some Islamic banks belong to this category. The Murabaha mode of finance operates in the following way: The client approaches an Islamic bank to get finance in order to purchase a specific commodity.
An interest-based bank would lend the money on interest to this customer. The customer would go and buy the required commodity from the market. This option is not available to the Islamic bank, as it does not operate on the basis of interest.
It can not lend the money on interest. It can not lend money with zero interest rate, as it has to make some money to stay in the business.
Some portion of total finance may be offered as an interest free loan, however, the banking institutions have to make profit in order to stay in business. Hence, what course of action is open to the bank? The Murabaha model offers a solution.
The bank purchases the commodity on cash and sells it to the customer on a profit. Since the client has no money, he buys the commodity on deferred payment basis.
Thus, the client got the commodity for which he wanted the finance and the Islamic bank made some profit on the amount it had spent in acquiring the commodity.
There are a number of requirements f or this transaction to be a real transaction to meet the Islamic standards of a legal sale.
The whole of Murabaha transaction is to be completed in two stages. In the first stage, the client requests the bank to undertake a Murabaha transaction and promises to buy the commodity specified by him, if the bank acquires the same commodity.
Of course, the promise is not a legal binding. The client may go back on his promise and the bank risks the loss of the amount it has spent. In the second stage, the client purchases the good acquired by the bank on a deferred payments basis and agrees to a payment schedule.
Another important requirement of Murabaha sale is that two sale contracts, one through which the bank acquires the commodity and the other through which it sells it to the client should be separate and real transactions.
The Murabaha form of financing is being widely used by the Islamic banks to satisfy various kinds of financing requirements. It is used to provide finance in various and diverse sectors e. g. in consumer finance for purchase of consumer durable such as cars and household appliances, in real estate to provide housing finance, in the production sector to finance the purchase of machinery, equipment and raw material etc.
However, probably the most common and the most popular application of Murabaha is in financing the short-term trade for which it is eminently suitable. Murabaha contracts are also used to issue letters of credit and to provide financing to import trade.
(Cost-plus financing) This is a contract sale between the bank and its client for the sale of goods at a price which includes a profit margin agreed by both parties.
As a financing technique, it involves the purchase of goods by the bank as requested by its client. The goods are sold to the client with a mark-up. Repayment, usually in instalments is specified in the contract.
4. Ijara contracts in Islamic finance
A form of leasing contract in which there is a transfer of ownership of service (for use of an asset) for a specified period for an agreed upon lawful consideration.
Instead of lending money on interest, Ijarah allows a financial institution to earn profits by charging rentals for the use of the asset. Often used by Islamic banks for financing. Under this scheme of financing an Islamic bank purchases an asset as per specification provided by the client.
The period of lease and the lease rental fee are set in advance and may be determined by mutual agreement according to nature of the asset. During the period of the lease, the asset remains in ownership of the bank (as lessor), but the client (as lessee) has the right to use it.
5. Salam contracts in Islamic finance
A forward sale where the full price of the goods is paid in advance at the time of contract; the goods are not available for immediate delivery but can be delivered at a specified time in the future.
In other words, a dvance purchase or a type of sale in which the full price of the goods is paid in advance and the goods are delivered later at a specified date in the future. It is similar to a modern forward sale contract.
Under Shari’ah, a sale cannot normally be effected unless the goods are in existence at the time of the contract. However, this type of sale is an exception provided the goods are defined and the time of delivery is fixed.
The exception was practiced in the early days of Islam to meet the needs of the small farmers in Arabia who required money to grow their crops and to feed their family until the time the crop could be harvested and sold; owing to the prohibition of riba they could not borrow money on interest; they were allowed to sell the agricultural produce in advance of cultivation for delivery later and take payment in advance.
The object of the sale must be tangible goods that can be defined as to quantity, quality and workmanship. The mode of financing is often applied in the agricultural sector, where Islamic bank advances money without interest for various inputs and in exchange receives a share of the produce, which it then sells after delivery.
To hedge against fall in prices, the bank can also sell the goods to a third party before delivery through a parallel contract of Salam.
Salam covers all tangible goods which are capable of being definitely described as to quantity, quality and workmanship.
Thank you for reading about info 5 Contracts in Islamic Finance, hopefully useful. The source is adapted from the website islamic-banking.com and image from olc.worldbank.org