Investment is the action of deploying funds with the intention and expectation that they will earn a positive return for the owner (Brokington 1986, p.68). Funds may be invested in either real assets or financial assets. When resources are used for purchasing fixed and current assets in a production process or for a trading purpose, then it can be termed as real investment. The establishment of a factory or the purchase of raw materials and machinery for production purposes are examples in point. On the other hand, the purchase of a legal right to receive income in the form of capital gains or dividends would be indicative of financial investments. Specific examples of financial investments are: deposits of money in a bank account, the purchase of Mudaraba Savings Bonds or stock in a company. Ultimately, the savings of investors in financial assets are invested by the respective company into real assets in the form of the expansion of plant and equipment. Since Islam condemns hoarding savings and a 2.5 percent annual tax (Zakat) is imposed on savings, the owner of excess savings, if he is unable to invest in real assets, has no option but to invest his savings in financial assets.

When money is deposited with an Islamic Bank, the bank, in turn, makes investments in different forms approved by the Islamic Shariah with the intent to earn a profit. Not only a bank, but also an individual or organization can use Islamic modes of investment to earn profits for wealth maximization. Some popular modes of Islamic Investment are discussed below. A comparison is also attempted between the Islamic Modes of Finance and these of conventional banks. 

A. ISLAMIC MODES FINANCE

At the beginning it is better to give a clear definition of "Islamic Modes of Finance". The word "Modes" literally means "methods", or in other words, it refers to systematic and detailed rules, stipulations and steps to be followed for accomplishing a specific thing. The thing that needs to be accomplished in this context is, however, the subject matter of each of the said modes, i.e. any of the different types of investment activities (trade, leasing, real estate, manufacturing, agriculture, agriculture production etc., or, using Shariah expressions Murabaha, Mudaraba, Musharaka, Ijarah, Istisna, etc.). The word "Finance" in one of its different meanings refers to the supply of money capital or credit, provided by either a person (household), or an organization (private or public - financial or non financial). The word "Islamic" is inserted in the above expression to restrict the type of rules that can govern different modes of finance to the Shariah rules. A complete definition for the term "Islamic Modes of Finance"' may be given as follows:

"The systematic and detailed Shariah rules that govern the contractual relationship of an investment activity that can be applied for attracting money capital" (Fahmy & Sarkar). 

1. BAI-MURABAHA

1.1 Meaning of Murabaha

The terms "Bai-Murabaha" have been derived from Arabic words Bai and Ribhun. The word 'Bai' means purchase and sale and the word 'Ribhun' means an agreed upon profit. "Bai-Murabaha" means sale for an agreed upon profit. Bai-Murabaha may be defined as a contract between a buyer and a seller under which the seller sells certain specific goods permissible under Islamic Shariah and the Law of the land to the buyer at a cost plus an agreed upon profit payable today or on some date in the future in lump-sum or by installments. The profit may be either a fixed sum or based on a percentage of the price of the goods.  

1.2 Types of Murabaha

In respect of dealing parties Bai-Murabaha may be of two types (IBBL 1986, pp.1-2):

-          Ordinary Bai-Murabaha, and

-          Bai-Murabaha order on and Promise.

Ordinary Bai-Murabaha is a direct transaction between a buyer and a seller.  Here, the seller is an ordinary trader who purchases goods from the market in the hope of selling these goods to another party for a profit.  In this case, the seller undertakes the entire risk of his capital investment in the goods purchased. Whether or not he earns a profit depends on his ability to find a buyer for the merchandise he has acquired. 

Bai-Murabaha order on and Promise involves three parties - the buyer, the seller and the bank. Under this arrangement, the bank acts as an intermediary trader between the buyer and the seller. In other words, upon receipt of an order and agreement to purchase a certain product from the buyer, the bank will purchase the product from the seller to fulfill the order.

However, it should be noted here that the Islamic Bank acts as a financier in this transaction.  This is the case, not in the sense that the bank finances the purchase of goods by the consumers; rather it is a financier by deferring payment to the seller of the product. Thus, there is a chance that this transaction could resemble nothing more than a loan for which interest (Riba) is earned, which is contrary to Islamic beliefs.

Therefore, to avoid this potential misuse of the Bai-Murabaha relationship, the bank should purchase the goods on behalf of the bank from the seller and sell the goods to the buyer, receiving payment on behalf of the bank as well. In this way, the profits generated by the transaction to each of the parties involved cannot be misconstrued as interest or (Riba) profits.

There are some important features of Bai-Murabaha as given below.

1.3 Important Features of Murabaha

1. A client can make an offer to purchase particular goods from the bank for a specified agreed upon price, including the cost of the goods plus a profit.

2. A client can make the promise to purchase from the bank, that is, he is either to satisfy the promise or to indemnify any losses incurred from the breaking the promise without excuse.

3. It is permissible to take cash/collateral security to guarantee the implementation of the promise or to indemnify any losses that may result.

4. Documentation of the debt resulting from Bai-Murabaha by a Guarantor, or a mortgage, or both like any other debt is permissible. Mortgage/Guarantee/Cash Security may be obtained prior to the signing of the Agreement or at the time of signing the Agreement.

5. Stock and availability of goods is a basic condition for signing a Bai-Murabaha Agreement. Therefore, the bank must purchase the goods in accordance with the specifications of the client, thereby taking ownership of the goods before signing the Bai-Murabaha agreement with the client.

6. Upon acquiring the goods, the bank assumes the risk of ownership. In other words, the bank is responsible for damages, defects, and /or spoilage to the merchandise until such time that it is actually delivered to the buyer.

7. The bank must deliver the goods to the client at the date, time, and place specified in the contract.

8. The bank sells the goods at a price above the cost to obtain a profit.  The sale price that is charged by the bank is agreed upon in the Bai-Murabaha.  The profit can be stated in terms of a flat dollar amount or on a percentage of the purchase price.  If a percentage is used, the percentage shall never be expressed in terms of time, in order to avoid confusion that the price is a form of interest (Riba), which is not allowed.

9. The price agreed to in the agreement is binding on both parties.

10. It is permissible for the bank to contract with a third party to buy and receive the goods on its behalf. This agreement must be a separate contract.

These features make Bai-Murabaha distinctive from all other modes of Islamic Investment. There are certain steps to accomplish a deal of Bai-Murabaha as shown below (ABIIB 1995, p.12). 

1.4 Steps of Bai-Murabaha

First Step: The client submits a proposal regarding his requirements of the bank. The client sends a proposal with the specifications of the commodity to be acquired from the bank. The proposal also indicates details regarding the date, time and place of delivery as well as price and form of payment information. The bank responds by sending a counter proposal either accepting the buyer's price or stipulating a different price. 

Second Step:     The client promises to buy the commodity from the bank on a Bai-Murabaha basis, for the stipulated price. The bank accepts the order and establishes the terms and conditions of the transaction. 

Third Step: The bank informs the client (ultimate buyer) of its approval of the agreement to purchase.  The bank may pay for the goods immediately or in accordance with the agreement.

The seller expresses its approval to the sale and sends the invoice(s).

Fourth Step: The two parties (the bank and the client) sign the Bai-Murabaha Sale contract according to the agreement to purchase.

Fifth Step: The Bank authorizes the client or its nominee to receive the commodity

The seller   sends the commodity to the place of delivery agreed upon. The client undertakes the receipt of the commodity in its capacity as legal representative and notifies the bank of the execution of the proxy.

The Bai-Murabaha has some legal rules. These rules are mentioned below (Ibid, pp.14-16).

1.5 Rules of Bai-Murabaha

1. It is permissible for the client to offer to purchase a particular commodity, deciding its specifications and committing itself to buy it on Murabaha for the cost plus the agreed upon profit.

2. It is permissible that the mutual agreement shall contain various conditions agreed upon by the two parties, especially with respect to the place of delivery, the payment of a cash security to guarantee the implementation of the operation and the method of payment.

3. It is permissible to stipulate the binding nature of the promise to purchase.  Thus, the agreement can only be satisfied by either fulfilling the promise to purchase or by indemnifying the bank for any losses incurred if the promise to purchase is not fulfilled.

4. It is a condition that the bank purchases the requested commodity (first purchase contract) before selling it on Murabaha to the buyer. The contract in the first purchase must be settled, in principle, between the source seller and the bank.

5. It is permissible for the bank to authorize a second party including the buyer to receive the commodity on its behalf. This authorization must be in a separate contract, particularly if the buyer is going to receive the goods on behalf of the bank. This is necessary to avoid any conflicts with the ensuing Murabaha sale.  

6. Once the bank takes ownership of the goods, it is responsible for any damages or defects. Thus, if the goods are damaged, the bank is liable and must repair the damage prior to delivering the goods to the purchaser.

7. It is a condition that the Bai-Murabaha contract be drawn at the last phase. That is after the promise to purchase and the purchase of the commodity in the name of the bank and receipt of the commodity directly by the bank or through an agent.

8. The legal rules of Bai-Murabaha must be observed in drawing the contract of the Murabaha sale connected with a promise to purchase.  Particularly concerning the issue of the transparency of the cost of the first purchase and the amount of profit because discrepancies lead to disputes, which may invalidate the contract.

9. It is permissible to document the debt resulting from Bai-Murabaha by a guarantor or a mortgage, like any other sale on credit. Further, it is permissible that the mortgage accompanies the contract, because it is possible to take a mortgage on actual debt as well as promised debt before it is realized.  However, the mortgage shall only be in effect if the debt is actually incurred.

The areas of application of Bai-Murabaha are discussed below.

1.6 Application of Bai-Murabaha

            Murabaha is the most frequently used form of finance in Islamic banking throughout the world. It is suitable for financing the different investment activities of customers with regard to the manufacturing of finished goods, procurement of raw materials, machinery, and other required plant and equipment purchases.  

2. MUSHARAKA (PARTNERSHIP)

2.1 Meaning of Musharaka

The word Musharaka is derived from the Arabic word Sharikah meaning partnership. Islamic jurists point out that the legality and permissibility of Musharaka is based on the injunctions of the Qura'n, Sunnah, and Ijma (consensus) of the scholars.  It may be noted that Islamic banks are inclined to use various forms of Shariakt-al-Inan because of its built-in flexibility. At an Islamic bank, a typical Musharaka transaction may be conducted in the following manner.

One, two or more entrepreneurs approach an Islamic bank to request the financing required for a project.  The bank, along with other partners, provides the necessary capital for the project. All partners, including the bank, have the right to participate in the project. They can also waive this right. The profits are to be distributed according to an agreed ratio, which need not be the same as the capital proportion. However, losses are shared in exactly the same proportion in which the different partners have provided the finance for the project (Hussain 1986, p.61). 

2.2 Types of Musharaka

      Musharaka may take two forms:

i)        Permanent Musharaka and

ii)       Diminishing Musharaka.

  These are discussed below (ABIIB 1995). 

Permanent Musharaka

In this case, the bank participates in the equity of a company and receives an annual share of the profits on a pre-rate basis. The period of termination of the contract is not specified. This financing technique is also referred to as continued Musharaka.

The contributions of the partners under this mode may be equal or unequal percentages of capital for the purpose of establishing a new income-generating project or to participate in an existing one. In this arrangement, each participant owns a permanent share in the capital structure and receives his share of the profits accordingly. This type of a partnership is intended to continue until the company is dissolved.  However, one can exit the partnership by selling his share of the capital to another investor. 

Permanent Musharaka is used by Islamic Banks in many income generating projects.  They can provide financing to their customers, in exchange for ownership and profit sharing in the proportion agreed upon by both parties.  In addition, the bank may leave the responsibility of management to the customer-partner and retain the right of supervision and follow up.

The three steps to establishing Permanent Musharaka are discussed below.

One - Partnership in Capital: The bank tenders part of the capital required in its capacity as a partner and authorizes the customer/partner to manage the project. The Partner tenders part of the capital required for the project and is entrusted with what he holds from the bank funds.

Two - Results of the Projects: The intent of the project is growth. However, the project may be profitable or it may loss money.

Three - The Distribution of wealth accrued from the Project: In the event a loss is incurred, each partner bears part of the loss proportionate to his share in capital. In the event the venture is profitable, earnings are divided between the two parties (the bank and the partner) in accordance with the agreement.

The following is a discussion of those legal rules that apply to the Musharaka relationship:

Rules for Permanent Musharaka

1. It is a condition that the capital provided by each partner is specific, existent and easily accessible.  It is inappropriate to establish a company with borrowed money, for the purpose of profit. 

2. It is permissible for partners to have unequal ownership in the project. The percent of ownership is set forth in the agreement. 

3. It is a condition that the capital of the company is money and valuables. Some of the jurists permit contributing merchandise as invested capital. However, the merchandise must be evaluated, and the value agreed upon by all parties.  Once the value has been established, it is counted as capital and stipulated in the contract as such. 

4. It is impermissible to impose conditions forbidding one of the partners from work.  The company is built on honor and each partner implicitly permits and gives power of attorney to the other partner(s) to dispose of and work with capital as is deemed necessary to conduct business. However, it is permissible for one partner to have full responsibility for the operations of the company, provided he is granted this authority by the other partners. 

5. A partner is a trustee of company funds in his possession and is held responsible for their proper use. It is permissible to take a mortgage or a guarantee against company assets, but it is impermissible to take security for profit or capital.

6. It is a condition that each partners' share of the profits be known to avoid uncertainty.  Also, it is required that the ownership interest be in percentage terms and not a fixed sum, because this would violate the requirements of a partnership. 

7. In principle, profit must be divided among partners in ratios proportionate to their shares in capital but some of the jurists permit variation in profit shares, so long as it is agreed to by all of the partners. This may be the case when one of the partners is more dexterous and more diligent and does not agree to parity, so variation in the sharing of profits becomes necessary.  

8. In principle, a partnership is a permissible and non-binding contract.  Thus, if a partner wishes, he could rescind the agreement provided that this occurs with the knowledge of the other partner or partners.  Rescinding the agreement without the knowledge of the other partners' prejudices the rescinding partner's interest. On the other hand, some of the jurists take the view that the partnership contract is binding up to the liquidation of capital or the accomplishment of the job accepted at the contract.

Application of Permanent Musharaka

Permanent Musharaka is helpful in providing financing for large investments in modern economic activities.  Islamic banks can engage in Musharaka partnerships for new or established companies and activities.  Islamic banks may become active partners in determining the methods of production cost control, marketing, and other day-to-day operations of a company to ensure the objectives of the company are met.  On the other hand, they can also choose to either directly supervise or simply follow up on the overall activities of the firm. As part of the agreement, Islamic banks will share in both profits and losses with its partners or clients in operations of the business.   

Diminishing Musharaka

Diminishing or Digressive Musharaka is a special form of Musharaka, which ultimately culminates in the ownership of the asset or the project by the client. It operates in the following manner.

The Bank participates as a financial partner, in full or in part, in a project with a given income forecast. An agreement is signed by the partner and the bank, which stipulates each party's share of the profits.   However, the agreement also provides payment of a portion of the net income of the project as repayment of the principal financed by the bank. The partner is entitled to keep the rest. In this way, the bank's share of the equity is progressively reduced and the partner eventually becomes the full owner.

When the bank enters into a Diminishing Musharaka its intention is not to stay in the partnership until the company is dissolved. In this type of partnership, the bank agrees to accept payment on an installment basis or in one lump sum, an amount necessary to buy the bank's partnership interest. In this way, as the bank receives payments over and above it's share in partnership profits, it's partnership interest reduces until it is completely bought out of the partnership.

After the discharge, the bank withdraws it claims from the firm and it becomes the property of the partner.  The decreasing partnership arrangement is an Islamic bank innovation.  It differs from the permanent partnership only in continuity.  It appears that there are four steps of the diminishing partnership. Those are mentioned below.

Steps of Diminishing Musharaka

1. Participation in Capital: The bank - tenders part of the capital required for the project in its capacity as a participant and agrees with the customer/partner on a specific method of gradually selling its share in capital back to the partner.

2. The partner - tenders part of the capital required for the project and agrees to pay the agreed upon amount in return for the ultimate full ownership of the business.

3. Results of the Projects: The intent of the project is capital growth. The project may be profitable or lose money.

4. The distribution of the Wealth accrued from the Projects: In the event of loss each partner bears his share in the loss in his exact proportionate share of capital.  In the event that the project is successful, profits are distributed between the two partners (the bank and the customer) in accordance with the agreement.

5. The bank sells its Share of Capital: The bank expresses its readiness, in accordance with the agreement, to sell a specific percentage of its share of capital.

6. The partner pays the price of that percentage of capital to the bank and the ownership is transferred to the partner.

This process continues until the bank has been fully compensated for it's capital share of the business. In this way the bank has its principal returned plus the profit earned during the partnership and vice versa.

In the first Conference of the Islamic Banks in Dubai, the conferees studied the topic of partnership ending with ownership (decreasing partnership) and they decided that this type of business relationship may take one of the following forms.

The First Form:  In this form, the bank agrees with the customer on the share of capital and the conditions of partnership. The Conference decided that the bank should sell its shares to the customer after the completion of the partnership. Furthermore, they determined that the selling of the banks interest to the partner should be done under an independent contract. 

The Second Form:  In this form, the bank participates in financing all or part of the capital requirements in exchange for sharing in the prospective earnings. In addition, the bank gains the right to retain the remainder of the income for the purpose of applying it towards the capital provided by the bank. 

The Third Form:  In this form, the bank and partner's ownership is determined by stocks comprising the total value of the asset (real estate). Each partner, (the bank and the customer) gets its proportionate share of the earnings accrued from the real property. On an annual basis , the partner may purchase a  prescribed number of the bank's shares until such time that the partner becomes the sole owner of the real property.

There are some legal rules for diminishing Musharaka as given below.

Rules for Diminishing Musharaka

In addition to all the legal rules that apply to the permanent partnership which also apply to the decreasing partnership, the following rules also must be observed.

1. It is a condition in the decreasing partnership that it shall not be a mere loan financing operation. In other words there must be shared ownership and all the parties must share in the profits or losses during the period of the partnership.

2. It is a condition that the bank must completely own its share in the partnership and all rights of ownership with regard to management of the business. In the event that bank authorizes its partner to manage the business, the bank shall have the right of oversight supervision and follow up.

3. It is impermissible to include in the contract of decreasing partnership a condition that adjudges the partner to return to the bank the total of its shares in capital in addition to profits accruing from that share, because of resemblance to Riba (usury).

4. It is permissible for the bank to offer a promise to sell its shares in the company to the partner, if the partner pays the value of the shares. The sale must be concluded as a separate deal with no connection to the contract of the company. 

Application  of Diminishing Musharaka

The decreasing Musharaka is suitable for the financing of industrial businesses that have regular income. It can be considered to be the appropriate mode to finance collective investment. In this arrangement, the bank earns periodic profits throughout the year and it encourages the partner to participate in the joint investment. In addition it fosters individual ownership by allowing the partner to gradually buy the bank's ownership interest. In terms of society as a whole it corrects the course of the economy by developing a mode of positive partnership instead of the negative relationship of indebtedness. In addition, it assists in the equitable distribution of societies wealth.   

2.3 Concluding Remark

Financing through a Musharaka partnership is investment-based. The capital provider has full control in the management of the business. In addition, he shares proportionately in both the profits and losses of the business. Therefore, the rate of return is uncertain and can be either positive or negative. The cost of capital is also uncertain and there exists perfect correlation between the relationship of cost of capital and rate of return on capital.   

3. MUDARABA

3.1 Definition of Mudaraba

The term Mudaraba refers to a contract between two parties in which one party supplies capital to the other party for the purpose of engaging in a business activity with the understanding that any profits will be shared in a mutually agreed upon. Losses, on the other hand, are the sole responsibility of the provider of the capital. Mudaraba is also known a Qirad and Muqaradah (Shirazi 1990, p.31).

Mudaraba is a contract of those who have capital with those who have expertise, where the first party provides capital and the other party provides the expertise with the purpose of earning Halal (lawful) profit which will be shared in a mutually agreed upon proportion.  This type of business venture serves the interest of the capital owner and the Mudarib (agent).

The capital owner may not have the ability or the experience to run a profitable business. On the other hand, the agent (the Mudarib) may not have adequate capital to invest in a business or project.  Therefore, by entering into a contract of Mudaraba each party compliments one another, allowing a business venture to be financed. The following are the steps of the Mudaraba contrac (ABIIB, p.53).

3.2 Steps of Mudaraba

The bank provides the capital as a capital owner. The Mudarib provides the effort and expertise for the investment of capital in exchange for a share in profit that is agreed upon by both parties.  

1. The Results of Mudaraba: The two parties calculate the earnings and divide the profits at the end of Mudaraba. This can be done periodically in accordance with the terms of the agreement, subject to the legal rules that apply. 

2. Payment of Mudaraba Capital: The bank recovers the Mudaraba capital it contributed before dividing the profits between the two parties because the profit is considered collateral for the capital.   

3. Distribution of wealth resulting from Mudaraba: In the event a loss occurs, the capital owner (the bank) is responsible for the entire loss.  In the event of profits, they are divided between the two parties in accordance with the agreement between them, subject to the capital being recovered first.   

3.3 Rules of Mudaraba

There are some legal rules that govern the business relationship Mudaraba which are as follows.

1. It is a condition in Mudaraba that the capital be specific in nature. In other words, the amount of capital must be known at the inception of the contract. The purpose of this rule is to ensure that there is no uncertainty about the amount of capital and, thus, no uncertainty about the division of profits.   

2. It is a condition that capital must be in the form of currency in circulation. However, merchandise can be contributed, so long as both parties to the business arrangement agree upon its value.   

3. It is a condition that the capital cannot be subject to indebtedness.  

4. It is permissible for a Mudarib to mix his private capital with the capital of the Mudaraba, thus becoming a partner. In addition, it is also permissible for the Mudarib to dispose of capital on behalf of the Mudaraba.   

5. It is a condition that the capital of the Mudaraba is delivered to the Mudarib. Some of the jurists permit the capital owner to withhold capital and release it gradually according to the needs of the Mudarib since the Mudaraba adjudges unrestricted disposal.  

6. It is permissible for the capital owner to deliver capital to two Mudharibs in a single contract.  It is permissible for the capital owner to vary the in profit sharing agreement between the two Mudharib based upon differences in the services provided  

7. It is permissible to impose restrictions on the Mudarib as long as the restriction is beneficial and does not hinder the agent's ability to make a profit.   

8. It is permissible for the Mudarib to hire an assistant to perform difficult work that he is unable to perform on his own.  

9. The disposal of capital by the Mudarib is restricted to reasons that are conducive to the Mudaraba. The Mudarib must not lend or donate any of the Mudaraba capital. Further, he is not allowed to enter into indebtedness nor enter into another partnership agreement with the Mudaraba capital. However, these activities are permissible if the capital owner consents and authorizes the agent to use his discretion.  

10. The Mudarib is not required to contribute any capital to the Mudaraba contract except when he is found to be negligent in the way the funds are handled. It is permissible to take a surety or mortgage from the Mudarib to guarantee payment in the event of negligence violation of the contract conditions. However, it is impermissible to take a mortgage as a guarantee of capital or profit.  

11. It is a condition that profits be carefully and properly accounted for to avoid confusion by the parties to the contract. The contracting parties should stipulate how profits are to be shared on a percentage basis. It is impermissible to stipulate a fixed lump sum as profit.   

12. Profits in a Mudaraba relationship are distributed according to the agreement of the two contracting parties. It is a condition that the capital owner be solely responsible for any losses.   

13. The Mudarib shall collect his share of the profit only after obtaining the permission of the capital owner. In addition, the Mudarib can not collect his share of profit until after capital outlay is recouped.   In the event the profits are split prior to the closing of the Mudaraba, any losses incurred shall be reimbursed by the distributed profits.   

14. The Mudarib does not receive his share of the profits until the final settlement of the Mudaraba. Once the Mudaraba has been settled, neither party is liable to the other without a new agreement being made.  

15. The Mudaraba agreement may be terminated if one of the two parties decides to rescind the agreement. This is possible because the Mudaraba is an optional non-binding agreement. Some of the jurists hold the view that Mudaraba is binding and it cannot be rescinded if the Mudarib commences work.  

3.4 Concluding Remark

It is an investment-based form of financing. The provider of capital in Mudaraba has no role in the management of the capital. However, he has to bear the risk of capital loss as well as the opportunity cost of capital for the entire period of the contract. The rate of return is quite uncertain and the cost of capital is also uncertain. Hence, there is a perfect correlation between cost of capital and rare of return on capital.  

4. BAI-SALAM

4.1 Meaning of Bai-Salam

Bai-Salam is a term used to define a sale in which the buyer makes advance payment, but the delivery is delayed until some time in the future. Usually the seller is an individual or business and the buyer is the bank.

The Bai-Salam sales serve the interests of both parties (Ibid).

1. The seller receives advance payment in exchange for the obligation to deliver the commodity at some later date. He benefits from the Salam sale by locking in a price for his commodity, thereby allowing him to cover his financial needs whether they are personal expenses, family expenses or business expenses.

2. The purchaser benefits because he receives delivery of the commodity when it is needed to fulfill some other agreement, without incurring storage costs. Second, a Bai-Salam sale is usually less expensive than a cash sale. Finally a Bai-Salam agreement allows the purchase to lock in a price, thus protecting him from price fluctuation. 

4.2 Steps of Bai-Salam

1. Cash sale or Sale on Credit - The bank pays the agreed upon price at the time of the contracts inception. The seller agrees to the delivery of the commodity some specified date in the future. 

2. Delivery and Receipt of the Commodity on the Specific due Date: There are several options for delivery available to the bank

a)      The bank may receive the commodity and resell it to another party for cash or credit.

b)      The bank may authorize the seller to find another buyer for the commodity.

c)       The bank may direct the seller to deliver the commodity directly to a third party with whom the bank has entered into another agreement.

3. The Sale Contract: The bank agrees to sell the commodity for cash or a deferred price, which is higher than the Salam purchase price.  The buyer agrees to purchase and to pay the price according to the agreement.

There are some rules for Bai-Salam as given below. 

4.3 Rules of Bai-Salam

1. It is a condition that the commodity known by both parties to the agreement. Misunderstandings about the commodity may lead to disputes, which could void the contract.

2. It is a condition that the quality of the commodity be monitored closely, as very little variation from specifications in the contract are allowable. If the commodity cannot be monitored for quality standards, a Salam transaction is impermissible.

3. It is a condition that the commodity be deliverable on the due date. If there is uncertainty about the ability to deliver the commodity at the due date, a Salam transaction is impermissible.

4. It is permissible to draw a Salam sale contract for a total to be delivered increments on different specified future dates.

5. It is a condition that the commodity is a liability debt. The seller is obliged to deliver the commodity when it is due, according to the specifications stipulated in the contract, whether or not his firm produces the commodity or obtained from other firms. 

6. Salam sales are impermissible on existing commodities because damage and deterioration cannot be assured before delivery on the due date. 

7. Salam is impermissible on Land lots and real estates.

8. Salam is permissible on a commodity of a specific locality if it is assured that it is almost always available in that locality and it rarely becomes unavailable.

9. It is a condition that the purchase price in Salam is specified and advanced to the seller at the time of signing of contract. 

10. It is a condition in a Salam sale that the due date is known to avoid confusion, which may lead to a dispute.

11. It is a condition that the place of delivery be stated in the contract if the commodity requires special handling and delivery arrangements.

12. It is permissible to take a mortgage on Salam debt to guarantee that the seller satisfies his obligation by delivering the commodity on the due date.

13. It is impermissible for the buyer of a Salam commodity to sell the commodity before receiving it. It is known that the Salam commodity is a liability debt to the seller and not a commodity that exists. However, it is permissible for the buyer to draw a parallel Salam contract without connecting it to the first Salam contract.

Typical Bai-Salam transactions are discussed below:

4.4 Application of Bai-Salam

Salam sales are frequently used to finance the agricultural industry. Banks advance cash to farmers today for delivery of the crop during the harvest season. Thus banks provide farmers with the capital necessary to finance the cost of producing a crop.

Salam sale are also used to finance commercial and industrial activities. Once again the bank advances cash to businesses necessary to finance the cost of production, operations and expenses in exchange for future delivery of the end product. In the meantime, the bank is able to market the product to other customers at lucrative prices. 

In addition, the Salam sale is used by banks to finance craftsmen and small producers, by supplying them with the capital necessary to finance the inputs to production in exchange for the future delivery of products at some future date.

Thus as has been demonstrated, the Salam sale is useful in providing financing for a variety of clients, including farmers, industrialists, contractors and traders. The proceeds in a Salam sale may be used to cover the finance of operation costs and capital costs.

4.5 Concluding Remark

The Bai Salam agreement is a combination of debt and trading. The capital provider has no control over the management of capital provided. However the capital provider takes all of the risk as profits cannot be determined until the commodity is delivered and the final sale price is determined. In addition the capital provider incurs the opportunity cost associated with the capital outlay. Like the other three previously discussed modes of finance there is no certain rate of return. In addition the cost of capital is uncertain ex-ante. Also, there is no correlation in the relationship of cost of capital and rate of return on capital.  

5. ISTISNA'A  SALE

5.1 Definition of Istisna'a Sale

The Istisna'a sale is a contract in which the price is paid in advance at the time of the contract and the object of sale is manufactured and delivered later (IDB 1992, p.28). The majority of the jurists consider Istisna'a as one of the divisions of Salam, Therefore, it is subsumed under the definition of Salam. But the Hanafie school of Jurisprudence classifies Istisna'a as an independent and distinct contract. The jurists of the Hanafie school have given various definitions to Istisna'a some of which are: "That it is a contract with a manufacturer to make something" and "It is a contract on a commodity on liability with the provision of work".  The Purchaser is called 'Mustasnia' contractor and the seller is called 'Sania' maker or manufacturer and the thing is called 'Masnooa', manufactured, built, made (ABIIB). Islamic banks can utilize Istisna'a in two ways.

1. It is permissible for the bank to buy a commodity on Istisna'a contract then sell it after receipt for cash or deferred payment.

2. It is also permissible for the bank to enter into a Istisna'a contract in the capacity of seller to those who demand a purchase of a particular commodity and then draw a parallel Istisna'a contract in the capacity of a buyer with another party to manufacture the commodity agreed upon in the first contract.

Each transaction is deemed a separate contract with payment being made in cash either immediately or on a deferred basis. Any disagreements that may arise are settled under each contract separately according to the provisions therein. The steps of the Istisna'a sale and the parallel Istisna'a have been discussed below.

5.2 Steps of Istisna'a Sale

Istisna'a Sale Contract:  The Buyer expresses his desire to buy a commodity and brings a request to purchase the commodity to the bank. The method of payment, whether cash or deferred is set forth in the agreement. The bank agrees to deliver the commodity to the buyer at some agreed upon time in the future. 

The Parallel Istisna'a Contract: In order that the bank is able to deliver said commodity in the Istisna'a agreement, the bank enters into a parallel Istisna'a agreement with a third party to either manufacture or otherwise deliver-said commodity. Obviously, the bank stipulates a price that is lower than that agreed to in the original agreement and requires delivery on or before the date stipulated in the original contract.

The seller, in the parallel agreement, agrees to manufacture the specific commodity and to deliver it on the due date agreed upon.

Delivery and Receipt of the Commodity: The seller in the parallel Istisna'a agreement, delivers the commodity to the bank on the agreed upon date. The bank, in turn, delivers the product to the buyer of the original Istisna'a contract, in accordance with the original agreement. In this way, all parties fulfill their obligations to the contract.

5.3 Rules of Istisna'a Sale

1. It is a condition in the Istisna'a contract to clearly define dimensions and specifications of the product being purchased. This is important to ensure that there is no room for dispute over what is required.

2. The Istisna'a contract is only used for objects that can be manufactured. It can not be used to purchase corn, wheat, barley, fruit or any natural product.

3. The object sold in a Istisna'a contract is a fixed liability debt and it is permissible for the object to be a custom manufactured product, made in accordance with certain specifications.

4. The maker should supply the materials. If they are supplied by the buyer, the contract is Ijara and not Istisna'a.

5. Once the contract is drawn the ownership of the asset is confirmed to the buyer and the purchase price is confirmed to the manufacturer.

6. It is not a condition in the Istisna'a contract to advance the price. Usually part of the price is paid in advance and the remainder is withheld until the time of delivery.

7. It is a condition that the time of delivery be specified in the agreement to avoid confusion that may lead to a dispute over the transaction.

8. It is a condition that the place of delivery be stated in the contract if the commodity requires special handling and delivering arrangements.

9. The buyer may stipulate in the Istisna'a contract that the commodity shall be manufactured or produced by a specific manufacturer, or manufactured with specific materials. This is not permitted in a case of Salam Sale.

5.4 Application of Istisna'a Sale

The Istisna'a contract allows Islamic banks to finance the public needs and the vital interests of the society to develop the Islamic economy in accordance with Islamic teachings. For example Istisna'a contracts are used to finance high technology industries such as the aviation, locomotive and ship building industries. In addition, this type of business transaction is also used in the production of large machinery and equipment manufactured in factories and workshops. Finally, the Istisna'a contract is also applied in the construction industry such as apartment buildings, hospitals, schools, and universities to whatever that makes the network for modern life. One final note, the Istisna'a contract is best used in those transactions in which the product being purchased can easily be measured in terms of the specified criteria of the contract. 

6. QARD HASAN  (Benevolent loans)

Qard Hasan is a contract in which one of the parties (the lender) places into the ownership of the other party (the borrower) a definite parcel of his property, in exchange nothing more than the eventual return of something in the same value of the property loaned.

Ausaf Ahmad (1998, p.49) mentioned that since interest on all kinds of loans is prohibited in Islam, a loan that is to be given in accordance with the Islamic principle, has to be, by definition, a benevolent loan (Qard Hasan) i.e. a loan without interest. It has to be granted on the grounds of compassion, i.e. to remove the financial distress caused by the absence of sufficient money in the face of dire need. Since banks are profit driven organizations, it would seem that there is not much opportunity for the application of this technique. However, Islamic banks also play a socially useful role. Hence they make provisions to provide Qard Hasan besides engaging in income generating activities.

There may be slight variations among different Islamic banks in the use of this technique. The Faisal Islamic Bank of Egypt provides interest-free benevolent loans to the holders of investment and current accounts, in accordance with the conditions set forth by its board of directors. The bank also grants benevolent loans to other individuals under conditions decreed by its Board. On the other hand, the Jordan Islamic Bank Law authorizes it to give "benevolent loans (Qard Hasan) for productive purposes in various fields to enable the beneficiaries to start independent lives or to raise their incomes and standard of living (Ibid, pp.49-50). Iranian banks are required to set aside a portion of their resources out of which interest free loans (Qard Hasan) can be given to small producers, entrepreneurs and farmers who are not able to secure financing for investment or working capital from other alternative sources, and needy customers. It should also be noted that Iranian banks are permitted to charge a minimum service fee to cover the cost of administering these funds.

Finally, in Pakistan, Qard Hasan is part of the bank's normal financing activities. Qard Hasan loans are granted compassionate basis and no service charges are imposed on the borrower. While these loans are considered loans of compassion, they are expected to be repaid when it is possible for the borrower to do so. Furthermore in Pakistan, Qard Hasan operations are concentrated in the head office of each bank. Branch offices are not permitted to extend these loans.  

7. BAI-MUAJJAL (Deferred Sale)

7.1 Meaning of Bai-Muajjal

The terms "Bai" and "Muajjal" are derived from the Arabic words 'Bai' and 'Ajal'. The word 'Bai' means purchase and sale and the word 'Ajal' means a fixed time or a fixed period. "Bai-Muajjal" is a sale for which payment is made at a future fixed date or within a fixed period. In short, it is a sale on credit.

The Bai-Muajjal may be defined as a contract between a buyer and a seller under which the seller sells certain specific goods, permissible under Shariah and law of the country, to the buyer at an agreed fixed price payable at a certain fixed future date in lump sum or in fixed installments.

There are some important features of Bai-Muajjal as given below (ABIIB).

7.2 Important Features of Bai-Muajjal

1. It is permissible and in most cases, the client will approach the bank with an offer to purchase a specific good through a Bai-Muajjal agreement.

2. It is permissible to make the promise binding upon the client to purchase the goods from the bank. In other words, the client is required to either satisfy the promise or to indemnify the bank for damages caused by breaking the promise without excuse.

3. It is permissible to take cash/collateral security to guarantee the implementation of the promise or to indemnify the bank for damages caused by non-payment.

4. 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.

5. Stock and availability of goods is a basic condition for signing a Bai-Muajjal Agreement. Therefore, the bank must purchase the goods in accordance with the specifications of the client, prior to signing the Bai-Muajjal Agreement with the client.

6. All goods purchased on behalf of a Bai-Muajjal agreement are the responsibility of the bank until they are delivered to the client.

7. The bank must deliver the goods to the client at the time and place specified in the contract.

8. The bank may sell the goods at a higher price than the purchase price to earn profit.

9. The price is fixed at the time of the agreement and cannot be altered.

10. The bank is not required to disclose the profit made on the transaction.  

7.3 Some Observations

This type of financing by the bank is considered to be more risky than the other Islamic modes of investment previously discussed.  Therefore, the application/proposal for Bai-Muajjal investment must be reviewed very carefully to ensure the client can ultimately make payment. . The following steps may be taken to ensure the Bai-Muajjal Investment is a good proposition for the bank:

1. The bank may meet with the prospective client regarding his investment needs and business experience prior to an application /proposal is submitted.  

2. The bank may review the client's past performance and other financing arrangements he may have had with the bank in the past. 

3. The bank may review its current investment policy regarding this type of financing arrangement to ensure the proposal meets bank guidelines. 

It should be remembered that if the Bai-Muajjal investment is not secured by first class collateral securities, it becomes more risky than investments under other modes of Islamic banking.

The following points should receive attention before making any investment decision under Bai-Muajjal.

1. Whether the goods that the client intends to purchase are marketable and have steady demand in the market.

2. Whether the price of the goods is subject to frequent and violent changes.

3. Whether the goods are perishable in short or in long-term duration.

4. Whether the quality and other specifications of the goods as desired by the client can be ensured.

5. Whether the goods are available in the market and the bank will be in a position to purchase the Goods in time and at the negotiated price.

6. Whether the sale price of the goods is payable by the client at the specified future date in lump sum or in Installments as per the agreement.  

8. IJARAH

8.1 Definition of Ijarah

Fuqaha (jurists) have defined Ijaraha as ownership of a benefit for consideration. This is also known as lease or Hire contract. Al-Ijarah is an Arabic term. This has been derived from the Arabic term "Ujr" or "Ujrat" which means 'consideration' or 'return' or 'wages'.

According to Islamic Shariah (jurisprudence), Ijarah is a contract between two parties - the lessor and the lessee, where the lessees (Hirer or Mustajir) have the right to enjoy/reap a specific benefit against a specified consideration/rent/wages from the lessor - the owner (Muajjir). 

8.2  Elements of Ijarah

According the majority of Fuqaha, there are three general and six detailed elements of Ijarah:

1. The wording: This includes offer and acceptance

2. Contracting parties: This includes a lessor, the owner of the property, and a lessee, the party that benefits from the use of the property.

3. Subject matter of the contract: This includes the rent and the benefit.

The lessor (Mujjir) - The individual or organization who leases out/rents out the property or service is called the lessor.

The lessee: (Mustajir) - The individual or organization who hires/takes the lease of the property or service against the consideration rent/wages/remuneration is called the lessee (Mustajir).

The Benefit (Maajur) - The benefit that is leased/rented out is called the benefit (Maajur).

The rent (Aj'r or Ujrat) - The consideration either in monetary terms or in quantity of goods fixed to be paid against the benefit of the goods or service is called the rent or Ujrat or Aj'r.      

8.3 Rules for Ijarah

It is condition that the subject (benefit/service) of the contract and the asset (object) should be known comprehensively.

1. It is a condition that the assets to be leased must not be a fungible one (perishable or consumable) which can not be used more that once, or in other words the asset(s) must be a non-fungible one which can be utilized more than once, or the use/benefit/service of which can be separated from the assets itself.

2. It is a condition that the subject (benefit/service) or the contract must actually and legally be attainable/derivable. It is not permissible to lease something, the handing-over of the possession of which is impossible. If the asset is a jointly owned property, any partner, according to be majority of the jurists, may let his portion of the asset(s) to co-owner(s) or the person(s) other than the co-owners. However, it is also permissible for a partner to lease his share to the other partner(s),

3. It is a condition that the lessee shall ensure that he will make use of the asset(s) as per provisions of the Agreement or as per customs/norms/practice, if there is no expressed provision.

4. The lease contract is permissible only when the assets and the benefit/service derived from it are within the category of 'Halal' or at least 'Mobah' as per Islamic Shariah.

5. The lessor is under obligation to enable the lessee to the benefit from the assets by putting the possession of the asset(s) at his disposal in useable condition at the commencement of the lease period.

6. In a lease contract, the period of lease and the rental to be paid in terms of time, place or distance should be clearly stated.

7. Everything that is suitable to be considered a price, in a sale, can be suitable to be considered as rental in a lease contract.

8. It is a condition that the rental falls due from the date of handing over the asset to lessee and not from the date of contract or use of the assets.

9. It is permissible to advance, defer or install the rental in accordance with the Agreement.

10. It is permissible to review the lease period or the rental or the both, if the lessor and the lessee mutually agree to do so.

11. The leased asset is a trust in the hands of the lessee. He will maintain the asset(s) with due prudence and shall not be held responsible for the damage or destruction of the asset without transgression, default or negligence, otherwise he must be responsible for the same.

12. The lessor/owner bears all the costs of legally binding basic repairs and maintenance including the cost of the replacement of durable parts on which the permanence and suitability of the leased assets depends.

13. It is permissible to make the lessee bear the cost of ordinary routine maintenance, because this cost is normally known and can be considered as part of the rental.

14. It is permissible for the lessee to let the asset to a third party during the lease period whether for the same rental or more as long as the asset is not affected by the change of user and not barred/restricted by the Lease Agreement/customs to do so.

15. It is permissible to purchase an Asset bearing a lease contract. The lease contract may continue since the purchased agrees to its continuity up to the end of the lease term. All rights and liabilities emanating from the lease contract will transfer to the new owner. But if the sale-contract is drawn and the purchaser is oblivious of the lease contract, he has the right to rescind the purchase contract and the lease continues.

16. As soon as the lease period terminates the lessee is under obligation to return the Asset to the owner or if the lessor agrees he may enter into a fresh lease contract or purchase if from the lessor on payment of agreed upon price as per market rate.

17. The lease contract is binding and no one party shall unilaterally rescind except reasons that abrogate binding contracts such as damage or destruction.

18. If the leased asset is damaged or destructed by the act of Allah and if the lessor offers a substitute with the same specifications agreed upon in the lease contract, the contract does not terminate.

19. It is permissible to sell the leased Asset by the lessor to the lessee during the tenure of the lease period either part by part or in full at a time. As soon as any part or in full the Asset is sold during the tenure of the Lease Agreement, the lease contract for that part or for the full Asset as the case may be, be lapsed and the rental ceased to apply.

20. It is permissible for the lessee to promise or to give undertaking to purchase the leased asset during the tenure of the lease period, either part by part or in full or at the end of the lease period in full. It is also permissible for the lessor to give similar promise to sell the Asset.

21. The lease with promise to purchase and sale is different from the memorandum of sale. The rent paid by the lessee cannot, in any way, be considered as part of the price of the Asset, rather it is the price of the service of the Asset.

22. It is permissible to divide the cost price of the Asset and ownership of the lessor to the Asset into several parts and to sell each part of ownership on payment of proportionate price/equity of the lessor under a separate sale contract. 

9.   HIRE-PURCHASE UNDER SHIRKATUL MELK or IJARAH MUNTAHIB BIL TAMLEK 

Hire-Purchase under Shirkatul Melk has been developed through practice. Actually, it is a synthesis of three contracts: (a) Shirkat; (b) Ijarah, and (c) Sale. These may be defined as follows:

Definition of Shirkatul Melk: 'Shrkat' means partnership. Shirkatul Melk means share in ownership. When two or more persons supply equity, purchase an asset and own the same jointly and share the benefit as per agreement and loss in proportion to their respective equity, the contact is called Shirkatul Melk. In the case of Hire Purchase under Shirkatul Melk, Islamic banks purchase assets to be leased out, jointly with client under equity participation, own the same and share benefit jointly till the full ownership is transferred to the client.

Definition of Ijara: The term 'Ijara' has been defined as a contract between two parties, the lessor and the lessee, where the lessee enjoys or reaps a specific service or benefit against a specified consideration or rent from the asset owned by the lessor. It is a lease agreement under which a certain asset is leased out by the lessor or to a lessee against specific rent or rental for a fixed period.

Definition of Sale contract: This is a contract between a buyer and a seller under which the onwnership of certain goods or asset is transferred by the seller to the buyer against agreed upon price paid by the buyer. In the case of Hire Purchase under Shirkatul Melk, the lessor bank sells or transfers its title to the asset under a sale contract on payment of sale price.

Thus in Hire Purchase under Shirkatul Melk mode, both the bank and the client supply equity in equal or unequal proportion for purchase of an asset like land, building, machinery, transports, etc., purchase the asset with that money, own the same jointly, share benefit as per agreement and bear the loss in proportion to their respective equity. The share/part or portion of the asset owned by the bank is leased out to the client partner for a fixed rent per unit of time for a fixed period. Lastly, the bank sells and transfers the ownership of its share/part/portion to the client against payment of price fixed for that part either gradually part by part or as a whole within the lease period or on expiry of the lease agreement. Hire-Purchase under Shirkatul Melk contract is to a great extent similar to the contract of Ijarah Montahia Bil Tamlek as termed by Accounting and Auditing Standards Board of the Account and Auditing Organization of Islamic Financial Institutions (AAOIFI). 

9.1 Stages of Hire Purchase under Shirkatul Melk

Hire Purchase under Shirkatul Melk Agreement has got three stages:

1. Purchase of asset under joint ownership of the lessor and the lessee.

2. Hire, and

3. Sale and transfer of ownership by the lessor to the other partner - lessee.

9.2 Important Features

1. In case of Hire Purchase under Shirkatul Melk transaction the asset/property involved is jointly purchased by the lessor (bank) and the lessee (client) with specified equity participation under a Shirkatul Melk contract in which the amount of equity and share in ownership of the asset of each partner (lessor bank and lessee client) are clearly mentioned. Under this agreement the lessor and the lessee become co-owners of the asset under transaction in proportion to their respective equity.

2. In Hire Purchase under Shirkatul Melk Agreement the exact ownership of both the lessor (bank) and lessee (client) must be recognized.  However, if the partners wish and agree the asset purchased may be registered in the name of any one of them or in the name of any third party clearly mentioning the same in the Hire Purchase Shirkatul Melk Agreement.

3. The share/part of the purchased asset owned by the lessor (bank) is put at the disposal possession of the lessee (clients) keeping the ownership with him for a fixed period under a hire agreement in which the amount of rent per unit of time and the benefit for which rent to be paid along with all other agreed upon stipulations are clearly stated. Under this agreement the lessee (client) becomes the owner of the benefit of the asset not of the asset itself, in accordance with the specific provisions of the contract that entitles the lessor (bank) the rentals.

4. As the ownership of leased portion of asset lies with the lessor (bank) and rent is paid by the lessee against the specific benefit, the rent is not considered as price or part of price of the asset.

5. In the Hire Purchase under Shirkatul Melk agreement the Lessor (bank) does not sell or the lessee (client) does not purchase the asset but the lessor (bank) promise to sell the asset to the lessee only if the lessee only if the lessee pays the cost price/equity price of the asset as fixed and as per stipulations on which the lessee also gives undertakings.

6. The promise to transfer legal title by the lessor and undertakings given by the lessee to purchase the ownership of leased asset upon payment part by part as per stipulations are affected only when it is actually done by a separate sale contract.

7. As soon as any part of lesssor's (bank's) ownership of asset is transferred to the lessee (client), that becomes the property of the lessee and hire contract for that share/part and entitlement for rent thereof lapses.  

8. In Hire Purchase under Shirkatul Melk Agreement, the Shirkatul Melk contract is effected from the day the equit7y of both parties deposited and the asset is purchase and continues up to the day on which the full title of lessor is transferred to the lessee.

9. The hire contract becomes effective from the day on which the lessor transfers the possession of the leased asset in good order and usable condition, so that the lessee may make use of the same as per provisions of the agreement.

10. Effectiveness of the sale contract depends on the actual sale and transfer of ownership of the asset by the lessor to the lessee. It is sold and transferred part by part it will become effective part by part and with the sale and transfer of ownership of every share/part, the hire contract for the share/part will lapse and rent will be reduced proportionately. At the end of the lease, the period when the full title of the asset will be sold and transferred to the lessee, the lessee will become the owner of both the benefit and asset, hire contract will fully end.

11. Hire Purchase under Shirkatul Melk are binding contracts, and the parties to it - the bank and the client - are committed to meet their obligations in accordance with the relevant agreement.

12. Under this agreement, the bank acts as a partner, as a lessor and at last as a seller; on the other hand the client acts as partner, as a lessee and lastly as purchaser.

13. Ownership risk is borne both by the lessor and lessee in proportion to their ownership equity.

14. Under this agreement the role of lessee is one of a trustee, the leased asset being a trust in his hands: he will manage, in favor of the interest of thee lessor at his own cost the exact subject of lessee, except in cases of emergencies and acts of Allah.

15. The lessee is responsible for keeping the leased asset (s) in good condition throughout the whole period of lease, and if the asset is damaged or defrayed due to transgressions default or negligence of the lessee, he shall be responsible to compensate for that.

16. The lessee cannot without obtaining prior written permission of the bank make changes in the exact item of lease, and or remove it from its place of installation, and transfer it to another location.

17. In a hire purchase under Shirkatul Melk agreement, any stipulation may be made, provided it is not against the nature and requirements of the contract itself, nor does it violate the Lessee laws of Islam, and is also acceptable to both parties.

18. Hire purchase under Shirkatul Melk facileties may be for medium-term and long-term period, which may be utilized for the expansion of production and services. as well as housing activities. The duration of hire purchase under Shirkatul Melk contract shall not exceed the useful life of the subject asset of the transaction. The bank should not normally enter into a Hire Purchase under Shirkatul Melk transaction for items with useful life of less than two years.

19. Hire Purchase under Shirkatul Melk transaction facilitates the client (lessee) to get benefit from the lease asset in exchange of rental and also to become full owner of the asset by purchasing it.

Hire Purchase under Shirkatul Melk Mode is a combination of three contacts. All rules governing the lease contract should be applicable in this mode also. Moreover, the rules for Musharakah and sale contracts will also apply to this. In addition, the following should also be followed:

1. Under Hire Purchase Shirkatul Melk Agreement, both the lessor and the lessee must pay their respective equity as agreed upon to purchase the desired asset under joint ownership.

2. Ownership of the asset of both the lessor and the lessee should be recognized as per law of the land.            

10. SOME ISLAMIC FINANCIAL INSTRUMENTS

An Islamic financial instrument can be defined as "an instrument representing a share in a joint capital collected for investment with the aim of realizing profit, issued by the investing party in his capacity as Mudarib (agent-manager) or by a third party on his behalf; such certificate is negotiable and capable of being turned into liquid money".

10.1 Participation Term Certificates (PTCs) 

In Pakistan, Participation Term Certificates (PTCs) have replaced debentures. PTCs are transferable corporate instruments based on the principle of profit and loss sharing to replace debentures for providing medium and long-term funds for industrial and other financing. Instead of receiving interest, as in the case of debentures, the holders of PTCs share in the profit or loss of companies raising finance through this device. The PTCs have the following features:           

1. The Certificates are issued for a specific period not exceeding 10    (Ten) years, excluding the grace period. 

2. The broad principles governing the legal aspects of Participation Term Certificates (PTCs) are prescribed by the Government by making suitable amendments in the statutes governing the operations of corporate entities (the Company Laws).

3. As PTC finance is provided for a specific period, it is secured by a legal mortgage on the fixed assets of the company. It also enjoys a floating charge on the current assets. 

4. For the purpose of allocation of profit to PTC holders, the investments rank Pari Passu with equity, and share in profit on a basis to be determined by mutual agreement. 

5. Profits for the purpose of determining return to the PTC holders are taken to be pre-tax profit before appropriations. 

6. Profit payable to PTC is treated as deductible expense for income-tax purpose. 

7. The share of PTC holders in the profit is deducted prior to the claim of shareholders in the profits of the company in any given year.

8. In case of loss, the first recourse is made to the free reserves, including the credit balance in the profit-and-loss accounts of the issues, and the balance of the loss (if any) is shared between the PTC holders and other providers of funds in proportion to their funds.  

9. The proceeds of PTCs are used exclusively for the project or the business concerned, and the sponsors are required to give an undertaking to conduct the business with diligence and efficiency, in accordance with sound engineering, financial and business practices and such other terms as may be agreed between the parties.

10. In order to provide protection to the purchasers of PTCs, a trustee is appointed who is responsible, inter alia, for the appraisal of the business or the project. The trustee has the right to call for any information from the company, visit premises where the business or the plant and machinery of companies are located and have access to their records. 

11. An option is also given to the PTC holders to convert a certain portion of outstanding PTCs into ordinary shares. 

12. A right option is also given to the existing ordinary stockholders to subscribe to the fresh issues of PTC. 

13. Permission to issue PTC's can be obtained from the Controller of Capital Issues in the case of non-banking companies and from the State Bank of Pakistan in the case of banking companies. 

10.2 Mudaraba Certificates 

Mudaraba Certificates are being used by Islamic Investment Companies to mobilize funds for investment in a variety of ways. Mudaraba Certificates are usually of two types: Specific purpose Mudaraba Certificates and General purpose Mudaraba Certificates. Specific purposes Mudaraba Certificates are related to financing of specific projects and mature only on the completion of the project. General purpose Mudaraba Certificates can have a specific or an indefinite duration. Both types of certificates can be issued in negotiable form, either registered or bearer. Mudaraba Certificates can be distributed in an underwriting or sales effort of a fixed term, or be continuously available or be available on a periodic basis.

Mudaraba Law: A special law called the Mudaraba Companies and Mudaraba (Floatation and Control) Ordinance 1980 governs the floatation and operations of Mudaraba. The Mudaraba Companies and Mudaraba Rules-1981 subsequently supplemented the Law. The Mudaraba Law provides the necessary legal framework for the flotation of Mudaraba in Pakistan. Under this law, management companies, banks and financial institutions can register themselves as Mudaraba Companies and float a Mudaraba for a specific or general purpose. The objects of any Mudaraba will be restricted to only such business as are permitted under the Islamic Shariah.

In order to ensure that Mudaraba are not used in any activity that is repugnant to the tenets of Islam, the prospectus of each Mudaraba will need a prior clearance from a Religious Board. Furthermore, after the Mudaraba goes into operation, the Law imposes additional responsibility on the auditors to certify that all business conducted, investments made and expenditure incurred are in accordance with the objects, terms and conditions of the Mudaraba. To safeguard the interest of the Mudaraba Certificate-holders, a number of protective clauses have been provided, including quicker and simpler adjudication by a tribunal. In order to promote the growth of Mudaraba and keeping in view the larger interest of Mudaraba Certificate - holders, the entire income of the Mudaraba funds has been exempted from income take, provided that 90 percent of the income is distributed to the Mudaraba Certificate-holders. The salient provisions of the Mudaraba Law are described below:

Registration - Only companies that are registered as "Mudaraba Companies" can float a Mudaraba to be eligible for registration as a Mudaraba Company, the following conditions must be fulfilled:            

1. It should be a company in the private or public sector registered under the Companies Act or any other Law in force.

2. If solely engaged in floatation and management of Mudaraba, its paid-up capital should not be less than Rs. 5.00 million.

3. If also engaged in business other than floatation and management of Mudaraba, the company must have capital of such amount and nature as may be prescribed. 

Types: A Mudaraba can be multipurpose or specific purpose:           

1. A multi-purpose Mudaraba is one, which has more that on specific purpose or objective.

2. A specific purpose Mudaraba is one, which is set up for a specific purpose or objective.

3. Both types of Mudaraba can be either for a limited period or for perpetuity.

A Mudarib shall be a legal person capable of suing or being sued in its own name through the Mudaraba Company.

Floatation - Floatation of Mudaraba may be authorized on fulfilling the under-noted conditions:

1. The company requesting for permission is registered as a Mudaraba Company.

2. A prospectus containing name, type of Mudaraba, amount, conditions, business prospects, mode of distribution of profit, and proof of Management Company's own contribution is filed with the Registrar.

3. The consent of the Controller of Capital Issues has been obtained.

4. The business of the Mudaraba is not opposed to any injunction of Islam.

Conditions for Mudaraba - Conditions for Mudaraba are as follows:

1. The assets and liabilities of each Mudaraba shall be separate for each Mudaraba and also distinct from those of the Mudaraba Company.

2. Separate bank accounts shall be maintained for each Mudaraba.

3. All money received with application shall be kept in separate accounts until either refunded or certified by the Registrar that Mudaraba Certificates have been issued.

4. If the minimum amount is not subscribed by the specified date, money received shall be refunded within 15 (fifteen) days of the specified date.

5. Mudaraba Certificates shall be transferable in the manner prescribed in the prospectus.

6. Mudaraba Certificates must be issued within 30 (Thirty) days of allotment.

Conditions for Mudaraba Companies - Conditions to be fulfilled by Mudaraba Companies are as listed below:

1. The Mudaraba Company shall not engage in any business of the same nature in competition with the Mudaraba floated by it.

2. The Mudaraba Company shall subscribe in each Mudaraba floated by it not less than 10 percent of the total amount offered for subscription.

3. The Directors and officers of the Mudaraba Company or their relatives shall not obtain loans, advances or credit from Mudaraba fund or against its security.

4. Profit and loss account and the balance sheet along with the Auditors and the Company's report shall be circulated to Mudaraba Certificate-holders within 6(six) months of the close of accounting period. 

10.3 Government Investment Certificates 

The Government of Malaysia introduced Investment Certificates in 1983. The Government Investment Certificates are liquid short-term government certificates introduced by the Malaysian Government through an Act of Parliament (The Government Investment Act-275 of 1983). These certificates enable the Islamic bank and other institutions as well as individuals to lend short-term funds to the Government without interest but on the Shariah principle of Qard Hasan. Under this principle, while the repayment of the principle amount of the loan is obligatory, the payment and magnitude of reward for the loan is at the absolute discretion of the borrower - the government.

The salient features and provisions of the Malaysian Government Investment Act-275 and the relevant Investment Certificates are as under:

1. The Minister of Finance is authorized to receive, on behalf of the Government of Malaysia, at such times and upto such maximum amounts as he may from time to time specify, investment of moneys from any person - of a sum of ten thousand ringgit (Malaysian dollar) or a multiple of ten thousand ringgit.

2. The money received as above shall be applied and be appropriated to the following purposes -

   i)        Repayment of moneys so received, to such extent as the Minister of Finance may determine, and

   ii)       Payment, with the prior approval of the Dewan Rakyat (Parliament) into the Development Fund (of the Government).

3. Any person making an investment shall declare the period for which the investment is made, which shall be one full year or more; and at the end of that period the money invested shall be repaid.

4. The Minister shall issue a receipt in the form of an Investment Certificate.

5. Investment Certificates shall be transferable by endorsement and delivery.

6. No interest shall be paid on investments in the Government Investment Certificates but there shall instead be paid dividends.

7. The Minister of Finance shall from time to time, by order published in the Gazette, declare the rates of dividends to be paid on investments in the Certificates.

8. Dividends on each investment shall become due annually on the anniversary of the date of its making and shall be paid at the Federal Treasury to the holder of the Investment Certificate relating to the investment on presentation of the Certificate.

9. No dividend shall be due or payable on any investment after the period for which the investment was made.

10. An investment shall be repaid on maturity to the holder of the Investment Certificate relating to the investment on his tendering the certificate.

11. No investment shall be repaid except upon surrender of the Investment Certificate relating thereto for cancellation.

12. The moneys represented by investment Certificates, and the dividends thereon, are charged upon and shall be payable out of the consolidated Fund.

13. No stamp duty shall be leviable or payable on any Investment Certificate or on the transfer thereof.

14. The Minister of Finance may, be notification in the Gazette, delegate to the Accountant General or the Central Bank of Malaysia any or all of the powers or duties conferred upon him by this Act.

15. Any person who forges or alters any Investment Certificate or any word, figure, marks, sign, signature, or facsimile upon or attached to any investment certificate, or who offers or utters or disposes of any Investment Certificate knowing the same to be forged or altered shall on conviction be liable to imprisonment for a term not exceeding fifteen years.

Government Investment Certificates having similar features have also been introduced in Egypt and Yemen.                                   

10.4 IDC, IIC and MB 

Three potential instruments proposed in the Seminar on Developing a System of Financial Instruments, jointly sponsored by the Islamic Development Bank and the Government of Malaysia, held in Kuala Lumpur 1986, were Islamic Deposit Certificates (IDCs), Islamic Investment Certificates (IICs) and Muqarada Bonds (MBs). These appeared promising the IDC proceeds are meant to be used by the issuing bank for general purposes, while IIC proceeds are meant for investment in a specific project or activity by the issuing bank. The MBs proceeds are meant to be used for income-yielding public utility projects, such as electricity and telecommunications, and infrastructure development projects such as construction of roads and bridges.

The common denominator for all the above three instruments is that they are all based on the principle of profit sharing. The holders of IDC and IIC will also share in the losses, if any, but not the holders of MBs, as the nominal value of MBs would be guaranteed by the Government, which is a third party independent from the other two. It is of interest to note that Muqarada Bonds have already been adopted as a financial instrument in Jordan, though with a limited scope.

It may be pointed out that the financial instruments certificates described above may serve well in an integrated Islamic Financial System. In countries where Islamic banks co-exist with interest-based banks, the role of Islamic banks would be quite different. They would have not only to generate incremental savings, but also to divert savings from non-Islamic financial institutions. Therefore, the rates of return offered by Islamic banks in a mixed system will have to be competitive with those offered by rival institutions. A project that appears good on paper may well turn out to be a failure if people behind it as dishonest or incompetent. The Islamic banks will, therefore, have to evaluate not only the project but also the persons selling the project for purpose of financing. Needless to mention, the necessary legal framework should also be there.

In conclusion, Muslim theoreticians and practitioners have helped in evolving new Shariah-based financial instruments. These have proved to be effective instruments for mobilization of savings, and have proved their usefulness in meeting the corporate requirements in a modern Islamic economy. Nevertheless, the newly evolved instruments of finance need to be further refined and developed to incorporate necessary sophistication so as to meet the changing environment of financial markets. Moreover, further research is needed for developing methodology for equitable sharing of profit and loss among the suppliers and the users of funds. It is imperative to develop a cadre of Islamic bankers and financial analysts, risk management, project appraisal and monitoring, and equity financing. Finally, a transformation of the thinking and the approach of the Muslim society as a whole would be essential for the widespread and successive operation of the Islamic Shariah-based financial Instruments. 

B. COMPARISON OF ISLAMIC AND CONVENTIONAL MODES OF FINANCING 

Before we go on make a comparison between the modes of finance of Islamic banks and those of conventional banks, let us very briefly state the financial arrangements of the later. 

1. MODES OF ADVANCE OF THE CONVENTIONAL BANKS

Conventional banks engage in the following types of financing arrangements:       

1.1  Loans

The most obvious form of financing by a conventional bank is the loan arrangement. The bank advances (loans) a lump sum to an individual (the borrower) for a set length of time at either a fixed or viable rate of interest. The borrower repays the loan with equal installments over the prescribed term or in one lump sum at the end of the term.  There are no checks issued in this type of relationship.  

1.2  Overdrafts

The extension of financing through overdrafts can only occur when there is an existing demand deposit account. An overdraft occurs when the amount of a check presented for payment to the bank exceeds the clients deposit balance. The banks may choose to pay on the item, thereby causing a negative balance in the client's account.  This negative balance is effectively an extension of financing and can be a prior arrangement with the bank. In addition, overdraft facilities may be extended against deposit certificates and/or government promissory notes.

1.3  Cash credits

Cash credit is a popular mode of borrowing by traders, industrialists and agriculturalists. It is a separate account by itself and does not require having any other account with the bank. It resembles the use of overdrafts on a checking account. It is an arrangement whereby the borrower may withdraw funds as needed for day-to-day operations without the delay associated with making a loan. The borrower may not exceed a predetermined limit and must deposit cash back into the account as funds become available from daily operations. Interest is charged on the daily balance in the account.  

1.4  Medium term loans

This type of loan is advanced to industries and agriculture for fixed capital requirements. These loans are also granted to traders for purchase of fixed assets, to transport operators for purchase of vehicles, and to self-employed persons for purchase of equipment. These loans are usually extended for a term of 3 to 7 years and in special cases up to 10 years and are generally repayable by instalments. Since it will take a year or two to derive the full benefits of expansion or renovation, instalments for repayment may commence after one or two years of the disbursement of the loan. Interest is charged on annual basis.  

1.5  Hire-purchase advances

Under this arrangement, conventional banks grant advances to its clients engaged in hire-purchase business relating to transports, refrigerators, and televisions, for example. This type of financing is usually repaid with instalments including principal and interest. The bank generally requires immovable property as collateral against this type of financing.   

1.6  Bills purchased/discounted

Export-Import businesses are performed through opening of  L/Cs with Bank. The client, while opening the L/C, comes to an agreement with the bank that the latter will repay the bill received on the farmer's behalf on a certain date onward in exchange for a specific rate of interest determined at the time of agreement. If the bill happens to reach well ahead of the date mentioned, the bank may purchase the bill, if requested, with a discount. In this case, the bank makes the return twice: first, by charging interest and then by discounting the bill.  

2. COMPARISON OF FINANCIAL MODES 

For an effective comparison between the modes used by the two systems of banking, the following categorizations common to both may be adopted:

1. modes related to project financing,

2. modes related to financing trade and commerce, and

3. special modes or system specific modes.

In line with the above categorization, medium and long-term loans under conventional banking, and Mudaraba and Musharaka of PLS-banking come under category (a). Under category (b), loans, cash credits, Hire Purchase and bills purchased/discounted of conventional banking and Murabaha, Bai-Salam and Bai-Muajjal of PLS-Banking may be listed.  Loans and cash credits of conventional banks may be categorized under (c) to satisfy the working capital needs of the borrower. For Islamic banks, there are no similar modes like its conventional counterpart to meet working capital needs. Though the "Qard Hasan" is customarily grouped under this category, it is not widely practiced by PLS-banks since this mode, by its very nature, does not earn a return.  Qard Hasan is benevolent loans, made on an interest free basis.

Keeping in mind the above categorizations, one may analyze the similarities or differences between the modes of conventional and those of the PLS-banking. As far as the first category is concerned, unlike PLS banks, conventional banks advance money in exchange for a predetermined fixed rate of interest. That is, under the conventional banking system, every advance made by a bank is a contract between the bank and the client with the following essential features: (i) a creditor-borrower relationship is established; (ii) the lending or borrowing is time bounded qualifying specific date(s) on which a certain percentage of interest on borrowed capital becomes due for payment along with the principal; and (iii) the income of the bank is known and prefixed and not in any way related to or variable with the income of the borrower generated from the borrowed money.

On the other hand, the financing arrangements under the PLS system of Islamic banks, have the following features: (a) it is a contract between two partners - the bank and the client-providing a partner-partner relationship; (b) the contract is time bounded in the sense that the client has to return the capital on/within specific date(s). However, the return of the bank is not fixed either from the standpoint of time or that of the rate; and (c) bank shares a prefixed ratio of profit expressed in percentage terms. This is not a prefixed rate of return calculated on capital advanced. Thus, income (profit) for a PLS-bank, unlike the practice of its conventional counterpart, fluctuates with the profits of the borrower.

In summary, in conventional banking, the bank is simply a financier and is not directly concerned about the success or failure of the project for which the loan was made, as long as it receives its payments. This is so because the bank's income (interest income) does not fluctuate with the fluctuations in the profit generated from the specific project. In other words, conventional banks advance financing in return for a guaranteed fixed return. On the other hand, a PLS-bank has a high interest in the performance of each project it finances because its income is directly related to the returns from each project it finances.  Thus, with regard to the first grouping of financing methods, the conventional bank is a risk-avatar, whereas the PLS-bank is a risk-taker.

With regard to the second class of financing methods, those that are generally used for financing trade and commerce, the only comparison worth mentioning is that in Conventional banking, fixed interest payments are made to the bank, whereas in the Islamic counterpart, the bank earns a profit margin. The Murabaha, Bai-Salam and Bai-Muajjal arrangements have often been accused of being 'Riba' practices.  However, the accusation is countered by the argument that the PLS-banks, unlike its conventional counterparts, are obliged to buy the goods and establish the bank's ownership, prior to selling the goods for a profit. 

Finally, concerning the third class of investment types, these modes are very much system specific and hence no meaningful comparison is possible. 

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