The Islamic economic system presents diverse modes of business contracts which are the foundation of Islamic financial institutions (IFIs) operations in the world. All those contracts comply the core principles of Islamic law (Shariah) which prohibits the Interest (Riba), Uncertainty (Gharar), Gambling (Maisir) and involvement in such businesses which are unethical and hazardous for the society. Simultaneously there is a rationale of equitable participation, distribution of wealth and management of risk (ElQorchi, 2005). The following is a brief overview of all the contracts which are widely used in today’s Islamic banking and serve as building blocks for designing various instruments, products and/or services.
According to Siddiqui (2008), like traditional banks, Islamic banks also offer a range of financial products and services. These are consumer financing, trade related financing and investment financing etc. The most common Islamic financial contracts are cost plus sale (Murabaha), profit and loss sharing (Mudarabah), partnership or joint venture (Musharaka), forward contracts (Salam and Istisna), Leasing (Ijarah),
credit sale (Bay “bi-thaman ajil”), In addition there are zero interest loan or benevolent loans for poor farmers and needy students termed as (Qardul Hasna).
However Iqbal & Mirakhor (2007) bring the idea that in IFIs, contracts dealing with commercial and business transactions can be classified into four broad categories.
1. Transactional Contracts
2. Financing Contracts
3. Intermediation Contracts
4. Social Welfare Contracts
“This classification based on the function and purpose of contract provide us with a framework to understand the nature of credit creation types of financing instruments, intermediation and the different roles each group plays in the economic system” Researcher and academic like El Qorchi (2005), Chong et al. (2009), divide Islamic financial contracts and/or instruments in two categories (i) Debt-creating such as
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Salam, Istisna, Murabaha and Kafalah, and (ii) Non-debt creating such as Mudarabah and Musharakah.
3.1.1. Murabaha (Cost plus Sale / Mark-Up Trade)
This mode of Shariah compliance contract is the most commonly used financial contract in Islamic banks. In fact a big amount of financial transactions of Islamic banks are based on the cost plus or mark-up trade contract. According to Henry and Wilson (2004) one study reveals that in Islamic banks, the share of Murabaha
financing alone accounts for between 45 percent and 67 percent of total financing. The Murabaha contract is being used for commodity or trade financing such as consumer goods, raw materials, real estates, machinery, equipments and including the letters of credit as well. Predominantly banks engage in Murabaha financing on short- term basis. (Siddiqui, 2008; A-Rahman, 2010)
The bank purchases the assets on the request of client (with promise to purchase) and then resell it to client on agreed cost plus or mark-up price and with deferred or flexible payment terms. To be validated Murabaha contracts bear the conditions that before the transaction, both parties should agree on the mark-up and payment terms, the rate of profit must not be fixed on the length of repayment period, there should not be any hidden or increased charges on transaction even if the circumstances change or client fail to pay within agreed payment duration.
Siddiqui (2008) assert that in a broad context Murabaha contracts are more likely the consumer loan, lines of credit and working capital facilities that any conventional bank provides except the above mentioned conditions and prohibition of interest.
3.1.2. Musharakah (Partnership or Joint venture)
Siddiqui (2008) assert that, under the Musharakah mode of contract IFI engage in a direct investment with the client in the form of equity participation and risk sharing. Usually Musharakah financing is used by banks for financing trade, imports and to issue letter of credits and also in agriculture and industry.
In Musharakah both parties can share the profits according to pre-agreed ratios however if there is a loss than it will be divided in proportion to their equity participation. All parties have right to take part in its management and to work for it.
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However Ayub (2007) describes that the partners may agree upon a condition that the management shall be carried out by one of them. But in this case the sleeping partner should be entitled to the profit only to the extent of his investment, and the ratio of the profit allocated to him should not exceed the ratio of his investment as discussed earlier.
3.1.3. Mudarabah (Profit and Loss Sharing)
This mode of Shariah compliance contract can be described as a contractual relationship between two parties, the financer (rabb-al-mal) and entrepreneur (mudarib) to combine their human and financial resources in an investment project for profit and loss sharing. It is similar to Musharakah mode except that in Mudarabah only one party invest the entire capital and other (client) provide its expertise to manage the project. In practice, Islamic bank’s PLS account is most simple example of Mudarabah contracts where client deposit funds for bank to invest or Bank finance entire capital in clients’ project. Profit sharing is pre-agreed between the two parties however the losses are only borne by the fund provider except in the case of misconduct, negligence, or violation of the conditions agreed upon by the bank. (Henry & Wilson 2004, El Qorchi 2005, Siddiqui 2008)
According to Vogel & Hayes (1998), mostly Islamic banks engage in Mudarabah
contracts to finance well established and mature businesses as well as new ventures with greater risks and profit potential.
3.1.4. Ijarah (Leasing)
In simple terms Ijarah implies a contract to give something on rental basis. Greuning & Iqbal (2008) assert that, technically it is a contract of sale, but not the sale of tangible asset rather it is a sale of the rights to use the asset for a specific period of time. In Islamic banking there are two ways in which Ijarah works.
(i) Simple Ijarah (Operating Lease): In operating lease, the financer/bank purchases the assets and leases it to the client for an agreed rental and period of time. Usually it involves leasing of machinery equipment, buildings and other capital assets.
(ii) Ijarah wa iqtina (Financial Lease): In this mode of Ijarah the financer/bank signs a contract with client, allowing him the ownership of the asset after the end of lease
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term however client does not only pay rental but also a gradual payment for the ownership of the asset. The instrument has been used increasingly in a range of asset classes including ships, aircrafts, telecom equipment and power station turbines, etc.
3.1.5. Salam (Sale Contract)
In Islamic banking Salam is commodity sale contract, whose delivery will be in a future date for a cash price, which means, it is a financial transaction in which price is advanced in cash to the seller, who abides to deliver a commodity of determined specification on a definite due date. The deferred is the commodity sold and described (on liability) and the immediate is the price. In other words a Salam sale contract is a futures contract.
According to Iqbal & Mirakhor (2007), Salam is similar to conventional forward contracts in terms of function but is different in terms of payment arrangements. In Salam contract buyer pays the seller full negotiated price of a specific product. Another condition of Salam is that the transaction is only legitimate to the products whose quality and quantity can be fully specified at the time when contract is made. Siddiqui (2008) affirms that, the Salam contract can be used to meet the capital requirements as well as cost of operations of farmers, industrialists, contractors or traders as well as craftsmen and small producers. The bank benefits from entering into a Salam contract with a seller because usually a Salam purchase by the bank is cheaper than a cash purchase. Due to this reason the bank is secured against price fluctuations, barring those extreme circumstances of a price deflation or a market crash when post Salam prices could dip lower than currently contracted Salam sale prices.
3.1.6. Istisna (Partnership in Manufacturing)
The term Istisna refers to a contract whereby a manufacture/contractor agrees to produce and deliver well-described goods at a given price on a given date and time in future.Istisna in similar to Salam contract except in Istisna the buyer does not need to pay the full price of asset in advance, it may be paid in instalments with preferences of the parties or partly in advance and the balance later on. However it should be based on mutual agreement. (Iqbal & Llewellyn, 2002; Vogel & Hays, 1998).
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Iqbal & Mirakhor (2007) affirm that after Salam the Istisna contract is the second kind of sale contract where an asset is bought or sold before it comes into existence. However there are some conditions in regard to Istisna contract. Firstly the underlying assets is required to be manufactured or constructed, secondly there is enough flexibility in regard to payments and time of delivery as mentioned above, thirdly Istisna can be cancelled before the manufacturer undertake manufacturing.
3.1.7. Qar-dul-Hasan (Gratuitous Loans)
Islamic banks provide such a facility on a limited scale to poorer sections of society such as needy students or small rural farmers. Such loans would have negative NPVs for the banks (Siddiqui, 2008). Traditional banks do not have any such benevolent loan structures, any benevolence is only manifested through charities and grants or scholarships, but not through non-returnable zero interest loans.
El. Qorchi (2005) states that while the main types of Islamic financial instruments are conceptually simple; they may become complicated in practice as some banks combine aspects of two or more types of instruments to suit customer requirements.