Islamic Banking and Finance - Essay Example

Student’s Name: University: Course: Tutor: Date: Introduction Financial systems have become more critical in the modern economy to facilitate the efficient allocation of resources. Financial intermediation is the core part of this financial system. This makes the financial intermediaries look for various ways they can perform their intermediation responsibility between the suppliers and users of funds. They gather and process information about economic activities of various entities. Their main functions are asset transformation, brokerage, risk transformation and conducting orderly payments. Asset transformation is the process of matching the demand for and supply of financial assets and liabilities. It also includes transforming the maturity scale and looking for the financial assets and liabilities of the ultimate lenders and borrowers (Iqbal & Greuning, p16) Financial intermediation in Islamic world has an established history record and had contributed significantly to economic development over time. ‘Sarrafs’ were financiers in early days who played the role of the traditional and fundamental functions of conventional financial institution, for example, intermediating between the lenders and borrowers, operating a secure and dependable domestic and across border payment system, providing services such as issuance of promissory notes and letters of credit to customers. Financial historians equate the functions of sarrafs as that of modern banks. Sarrafs operated through a well coordinated network and functioning markets. History has it that financial intermediaries in early Islamic days helped one another to overcome liquidity deficiency on the ground of mutual understanding borrowers (Iqbal & Greuning, p17). The Shariah laws present a set of intermediation contracts that are meant to assist in the execution and financing of efficient and transparent economic activities. These contracts are adequate to offer a wide range of banking services. This led to establishment of the world’s first Islamic bank back in 1985, although it is only in the last ten years that Islamic finance has become popular with many people especially outside Middle East region (Watts, para3). To be able to purchase four John Deere tractors at $100 000, three new ploughs at $20 000 and cane cutter at $75 000 Rafiq and Sarah can go for an Islamic financial product called murabahah. This is a sale contract at a profit markup. Under murabahah there is a sales contract facility called bay mu’ajjal. In this case the bank sells goods and property against deferred payments. Its distinguishing characteristic from cash sale is that the payment can be made later after supply. The future payment may not necessarily be higher than the cash price and therefore it might turn to be friendly. In addition there is another sale contract under murabahah called bay al-murabahah where the seller declares the actual cost incurred in bringing the commodity to it current state and then both seller and the buyer agree on adding an agreed profit margin. In other words, this is mutual buying and selling contract. In this case no financial intermediation is engaged. Rafiq and Sarah should know that there is mode of finance which has been created which combines the two concepts of mu’ajjal and bay al-murabahah. The bank receives order from the client to purchase a certain commodity or asset at a particular price. The client then enters into agreement with the bank that he will buy the product once the bank has bought it though at a rescheduled price which incorporates a pre-arranged profit margin in favour of the bank. It is in the discretion of the client and the bank to agree whether the client should pay as a lump sum or installments (Islamic Financial Products, para4). According to Islamic Financial Products there are some fundamental rules that govern murabahah that Rafiq and Sarah need to acquit themselves with. They include: i. The subject of sale must be present at the time of sale. ii. The subject of sale must be in the ownership of the seller at the time of sale. iii. The time of delivery must be precise iv. The subject of sale must be in the constructive or physical possession of the seller. v. The delivery of the sold commodity to the buyer must be definite and should not depend on an eventuality or chance. vi. As in any sales contract the price must be specified and once specified it cannot be increased in case of default. vii. The payments schedule must be precise (Islamic Financial Products, para5). It is very important to note that in the event of default of payment on the part of the client the financier has only recourse to the items financed and there is no additional penalty or mark-up applied to the outstanding amount. This translates that the sum repaid does not increase with passage of time like in the case of conventional banks. Before going for this facility it is crucial to note that there is no money given to the client instead the bank buys the assets based on the client’s requirements. This is to ensure that the financing is asset-based creating real assets and inventories. In murabahah the Islamic bank is so concerned about the purpose in which the asset will be used into (Islamic Economics para10-12). In the case of acquiring a special Plant & Equipment for fruit pulping that will be manufactured by Smart Packers Ltd at a cost of $200 000. Where the manufacturer says it will take six months to build the plant and ready for delivery. It is true there is there is a financing instrument designed for this purpose and it is ‘al-istisna’ translated as a contract to manufacture. In this contract a party orders another to manufacture and provide the commodity or the asset. In the contract, the description of delivery date, price and payment date are set and the contract cannot be cancelled by one party without the consent of the other. It is important to note that al-istisna is different from salam in a number of aspects. These are: i. The subject of istisna is usually a thing that requires manufacturing while salam can be on other things that do not need manufacturing. ii. In case of istisna payment can be delayed unlike salam where the full payment is necessary. iii. In case of salam the time of delivery must be specified but in istisna this is not very necessary. Al-istisna Al-Tamwili consists of two separate istisna contracts. The first contract is between the bank and the beneficiary, in which the price is payable in future by the purchaser in agreed installments and the bank accept to deliver manufactured product at a given time. The second contract is a form of sub-contract between the contractor and the bank. The contractor agrees to manufacture the product according to stipulated conditions. Normally, the bank would pay for the product in advance or during manufacturing in installments. The manufacturer would deliver the product to the bank on the agreed date or the purchaser would be allowed to receive the manufactured product directly from the manufacturer (Islamic Financial Products, para8). Bay Bithamin Ajil(BBA) is a form of murabahah mostly used in Malaysia and some other South East Asia countries which allows the buyer to pay in installments some time after delivery of goods (Islamic Economics para14). According to Fatwa management system (2010) tawarruq is process of buying goods without immediate payments and selling them to other person other than the seller in order to obtain cash. For it to be acceptable the buyer should fully possess the goods and then sell them to the second buyer. Salam is a form of sale contract where the price is paid in advance at the time of entering into contract. The price is paid for the commodity to be supplied in particular future. There are some main rules that govern the salam sale: i. The price must be paid fully at the time of the contract. ii. The quality and quantity of goods to be sold should be determinable by specification. iii. Goods are only sold by attributes specifications and not on particularized factory, farm or area. iv. The precise date and place of delivery must be specified (Islamic Financial Products, para7). One is also allowed to enter a Salam sale contract on one whole thing although to be possessed at different times in explicit parts. Salam sale is not permitted on existing commodities since damage and deterioration cannot be ascertained before delivery on the due date. Delivery may become impossible in this case. Salam is acceptable if a commodity of a specific locality is certain that it almost always exists in that locality and it hardly ever becomes unavailable. It is also acceptable to acquire insurance and guarantor on Salam debt to warranty that the seller satisfies his obligation by bringing the commodity sold to the buyer, which is a liability on the due date. It is not permitted for the buyer of a Salam commodity to sell it prior to receiving it because that is comparable to the prohibited sale of debts before holding (Islamic Economics, para40). Sukuk are secondary financial instruments based on returns from real assets or usufruct. They are primarily certificates of ownership which can be traded in the secondary markets. In the recent past, financial experts have developed a number of these instruments to cater for a varied tastes and preferences from customers. They include, muqarradah bond/sukuk, ijara sukuk, mubarahah sukuk, salam sukuk etc. These instruments should represent share in equity, usufruct, money, real assets or debt or a combination of any of these. Additionally, the principal and expected return on investment cannot be fully assured. Holders of these financial instruments are the owners of any rights attached to these instruments and bearers of all related risks. An instrument which has a debt object should not earn any return and its negotiability must be accordance with Shariah rules (Islamic Financial Products, para12). Dealing in equity share can be acceptable in Shariah provided the following conditions are met: i. The main activities of the company one wants to invest in are not in violation of Shariah. Consequently, it is not allowed to buy shares of the companies offering financial services on interest such as conventional banks, insurance companies, or any other companies that conduct businesses not approved by Shariah, for example manufacturing and selling liquors, haram meat pork or deal in gambling, night club activities. ii. If the main business is permissible but the companies deposit their surplus amounts in interest bearing account or they borrow money on interest. The shareholder must express displeasure against such activities and raise his voice in the annual general meeting. iii. If some income received from interest bearing accounts is incorporated in the total income of the company, the fraction of that income paid in the dividend to the shareholder should be given to charity course. For example, if ten percent of the whole income of the company is from interest bearing account, ten percent of the dividend should be given to charity. iv. The shares of a company are negotiable on condition that the company has some non-liquid assets. If all the assets are in liquid form they cannot be negotiated because if most assets are in form of money that means they cannot be traded (Usmani, para40) Rafiq and Sarah can use istisna to finance the building of their homes. The conditions needed for one to qualify are that the client may have his own land or not. If the client has his own land and he looks for financing for the construction of a house, the bank may agree to to construct the house on that land, on the basis of Istisna, and if the client has no his own land and he wants to purchase the land also, the bank may undertake to provide him with a constructed house on the specified piece of land. Since it is not a requirement in Istisna that the price be paid in advance, nor is it necessary that it be paid at the time of the delivery, rather, it may be deferred to any other time according to the contract of the parties, thus, the time of payment may be agreed in whatever manner they wish. The payment may also be in installments. Additionally, it is not compulsory that the financier or the bank construct the house personally. He can enter into an equivalent contract of Istisna with a third party, or may hire a contractor. In these cases, he can compute his cost and fix the price of Istisna with his client in a way that it will give him a reasonable profit over his cost. The payment of installments by the client may begin, right from the day when the contract of Istisna is entered by the parties, and may go on during the building of the house and after it is transferred to the client. In order to ensure the payments of installments, the bank may keep the title deeds of the house or land as security, or documents of ownership of any other property, until the client pays all installments. The bank will be liable for the construction of the house in total conformity with the qualifications detailed in the contract. In case of inconsistency, the bank will undertake such modification at its own cost as may be essential for bringing it in accord with the terms of the contract (Islamic Economics para12). Conclusion Islamic bank have devised many innovative financial products based on profit sharing principles of Islamic religion and risk sharing. These products have proved to be practicable and profitable for both the banks and clients. Generally Islamic banks are mostly active in trade and commodity finance, property and leasing areas. . Works Cited Islamic Financial Products, (2006): Islamic Banks & Financial Institutions Information System. Retrieved 21st May, 2010 from: http://www.ibisonline.net/En/IslamicFinancialProducts/IslamicFinProducts.htm Islamic Economics, (2009): Instruments of Islamic Banking and Finance. Retrieved 21st May, 2010 from: http://www.islamic-world.net/economics/instrument_bank_finance.htm Fatwa management system (2010): Tawarruq through Islamic banks. Retrieved 21st May, 2010 from: http://infad.usim.edu.my/modules.php?op=modload&name=News&file=article&sid=7913 Usmani, M. T. (2010): Principles of Shariah Governing Islamic Investment Funds. http://www.albalagh.net/Islamic_economics/finance.shtml Iqbal, Z. & Greuning, H. (2008): Risk analysis for Islamic banks. World Bank. Watts, C., (2010): Is Islamic finance at tipping point. Retrieved 21st May, 2010 from: http://www.economist.com/sponsor/qfc/index.cfm?pageid=article10 Read More