ECON 6816

ISLAMIC BANKING SYSTEM AND OPERATION

Assoc. Prof. Dr. Asyraf Wajdi Dusuki

Head, Research Affairs
International Shariah Research Academy for Islamic Finance (ISRA)
1
 Outline
Transactional Contract
Financing Contract
Sale-based

Lease-based

Equity-based

Islamic Supporting Contracts

Finance
Class Hybrid Instruments
Parameters in structuring
Hybrid Intruments
2
 Islamic Bank is a Sharia`ah-Compliant
Financial Intermediary !
Savings &
Investment Financing

Surplus Units Deficit Units

Individuals Financial Individuals
Intermediary
Businesses (e.g. bank) Businesses
Government Government

Return on investment Return on

& savings financing

Banks Liabilities Banks Assets

Structure of Banks Balance Sheet
As Financial Intermediary

Asset Liability

Sales-based Mudarabah

Lease-based Wadiah

Equity-based Qard

Other Supporting
Others
Contracts
General Classification of Contract in Islam

Profit-making Contracts
Exchange Contracts
Charitable Contracts
()
()
Cooperation Contracts
() 5
 Wadiah Yad Amanah; Wadiah
Deposit-taking Contracts Yad Dhamanah, Mudarabah;
al-Qard
Various forms of
Islamic Contracts BBA deferred sale;
used in Banking Sales-based Contracts Murabahah cost-plus sale;
Bai al-Inah, Bai al-Tawarruq

Ijarah Wa Iqtina; Ijarah

Lease-based Contracts Thumma Al-Bai, Ijarah
Muntahia Bitamleek

Equity-based Contracts Mudarabah, Musyarakah

Kafalah/Dhaman (Guarantee);
Fee-based Contracts Wakalah (agency)

Musyarakah Mutanaqisah
Hybrid Contracts (Dimishing Partnership),
Promise/Undertaking AITAB etc.
Wa`ad
6
 Contract of Sale
Contract of sale is considered to be the core
contract of Islamic commercial law.
In bilateral contracts, rules of gharar and riba is
applicable unlike in unilateral contracts.
Objective of sale contract is transfer of ownership
and possession from one party to another.
Contracts of sale may involve the exchange of:
1. commodity for another commodity (barter trading)
2. commodity for money (trading activities)
3. money for money (sarf currency exchange)
 Classification of Sale Contracts
Delivery:
1. Sale with immediate delivery :
- e.g. bay al-murabahah, bay al-tawliyyah, bay al-wadiah etc.
2. Sale with deferred delivery of the thing sold:
- Bay al-salam (forward sale) & bay al-Istisna (sale on order)

Nature of profit:
1. Regular sale (Bay al-musawamah)
2. Trust sales (uqud al-amanah):
1. Mark-up (Murabahah)
2. At-price sale (bay tawliyyah)
3. Sale at a loss (wadiah)
4. At-price partial sale (al-Ishrak)

Manner of payment:
1. Cash sale, sale by immediate payment.
2. Deferred payment sale (thaman ajil). But it is not applicable
contracts like salam, sarf, bay al-dayn etc.
 Prohibited Sales
Sales of Debt Nasiah (postponed credit)
Sale of Madum (non existent)
Sales of Undelivered Item
Sales of Mulamasah (touch)
Two Sales in One
Sales of Najash
Sales of Gharar
Sales of Munabadha (shedding)
Sales of Hasa (pebbles)
Sales of Prohibited Items
Sales of Inah (postponed payment)
Sales of grape to wine maker
Sales with credit (salaf)
Etc.
 Element of Islamic Sales
Contracts:

Avoidance of Batil
Justice to both
(unfairness,
seller and buyer
deception &
(full satisfaction)
uncertainty)

Seller needs to Prevention from

be more vigilant disputes

11
 Any transfer of wealth or property
has to be made through a valid
contract or `aqad

Divine Sources Mutual Consent

(Quran & Sunnah) (Redho)
12
 Murabahah &
Bay` Bithaman
Ajil

Bay` `Inah Bay` Tawarruq

Common Types of Sale-

based contract

Bay` Istisna Bay` Salam

Bay`
Musawamah

Sale-based contracts are widely used in Islamic banking and finance

 14

Bay Al-Musawamah
Musawamah is a regular kind of sale in which
price of the commodity to be traded is
negotiated between the parties without any
reference to the price paid or cost incurred by
the former.
Also known as common sale: sale at negotiated
prices.
Thus it is different from Murabahah in respect of
pricing formula. Unlike Murabaha, the seller in
Musawamah is not obliged to reveal his cost.
Hence, no reference to the original price of the
commodity at all.
 Contd
All other conditions relevant to Murabahah
are valid for Musawamah as well.
Musawamah can be an ideal mode where the
seller is not in a position to ascertain precisely
the costs of commodities that he is offering to
sell.
Other sales may be mentioned is bay al
tawliyah (at par value) and bay al wadhiah (at
a discount) 15
 16

Murabahah
(Cost Plus Profit Sale)
Murabahah refers to the sale and purchase transaction for the
financing of an asset whereby the cost and profit margin (mark-
up) are made known and agreed by all parties involved.
The settlement for the purchase can be either on a cash basis, a
deferred lump sum basis or on an installment basis, which are
specified in the agreement.
Its legality is derived from Quran (general on sales), Sunnah and
practices of the companion.
Modern Murabahah: Bay Al Murabahah Lil Amir bi Al Shira (A
sale at an agreed margin of profit to one who has ordered to its
purchase)
 17

Special Features of Murabahah

It is a sale and purchase contract based on
trust (`aqd al amanah)
Thus, it requires full disclosure and
transparency between the parties
Cost and amount of mark-up must be
disclosed
Payment of price can be spot or deferred,
depending on the agreement between the
parties (if deferred, time and mode of
payment should be defined as in BBA)
 Observations
The Islamic banking practice in Malaysia tends to confine
Murabahah to short & medium term financing and BBA
to long term asset financing.
This has nothing to do with any Islamic law requirement.
BBA in Islamic law is simply a method of payment, i.e.,
deferred payment and thus, it applies to all kinds of
sales where the payment is deferred whether on the
basis of instalments or lump sum payment at the end of
the tenor.

18
 Shari`ah and Legal Issues
In Murabahah
The seller is obliged to disclose the actual cost price
or purchase price of the asset that is intended to be
sold to the customer on the basis of Murabahah.
The failure to disclose, or the disclosure of incorrect
cost price will render the contract voidable.
Following this principle, there are many other issues
to be considered:
19
 Contd
Murabahah cannot be effected on an asset which cost
price is not known or cannot be known due to the
nature of the asset or the contract leading to the
acquisition of that asset.
Cost price includes insurance premium, transportation
cost, import duty, etc.
Mark-up formula could be in terms of amount or in
terms of percentage and this formula must be
20
disclosed and agreed up-front.
 Murabaha To The Purchase Orderer
Bay Al Murabahah Lil Amir bi Al Shira
It is a sale in which two parties or more negotiate and
promise each other to execute an agreement according
to which the orderer asks the purchaser to purchase an
asset of which the latter will take legal possession.
The orderer promises the purchaser to purchase
the asset from him and give the ordered a profit
thereon. The two parties would conclude a sale after
the possession of the ordered to the asset.
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 Murabahah Trade
Financing

Customer buys commodity

via murabahah on Trader transfers
deferred payment terms Commodity to Bank

Customer approaches
bank, promises to Bank buys commodity
buy commodity from bank on cash basis
Letter of Credit (LC)
(Murabahah)

Need to produce Buyer

Trader Required documents (Applicant)
(Beneficiary)
Eg. commercial invoice
Customer request for
BL (Bill of landing), Murabahah LC
Advice LC etc (Customer promise
to buy the goods
from the bank)

Bank purchase
required goods on
Advising Bank behalf of the Issuing Bank
customer

Issue LC
 Bay Dayn

Bay` `Inah Bay` Tawarruq

There are differences of practice

between different countries

Bay` Bithaman
Ajil (BBA) Bay` Sarf
 Bay Al Inah
It is a financing contract which involves the sale and buy
back transaction of an asset by a seller. It involves the
following:
1. A seller sells an asset to a buyer on a cash basis.
2. A seller will later buy back the same asset on a deferred
payment basis where a price is higher than a cash price.
Also,
1. When a seller sells an asset to a buyer on a deferred basis.
2. The seller will later buy back the same asset on a cash basis
with a price which is lower than the deferred price.
Bay al-Inah is so controversial, hence, majority of jurists
regard it illegal and considered to be a legal device (hilah) for
riba taking 26
Bay al-Inah Personal financing
How can I borrow
RM100,000 to get
married? Bank sells asset

RM 150,000
Customer pays
on deferred
Banks Pays on
cash basis
RM 100,000
Customer sells
back asset
Negotiable Islamic Debt Certificate (NIDC)
Mechanism

Shares Cert

Pay $1 million by cash

(Bank now secures deposit)

Pay $1 m + profit rate on deferred

(e.g. 7.5% = $37,500;
Total $1,037,500, payable in 6 months

Shares Cert

Syahadah al-Dayn (NIDC) issued

May sell Syahadah al-Dayn

in secondary market
 Bay Al Inah

Legal Illegal
Sale and buy Two
Sale and buy
Sale and buy back contracts
Sale and buy back after
back with without any are tied Two sales in
back with some
some time intention to (conditioned one
similar price modification
interval do so - upon
to the object
Coincidence another)
 The `Inah-based Instruments are
controversial

Majority of scholars
Disallow and nullify
Bay al`inah

Motive/Intention
Hilah legal trick to
Camouflage for interest
Circumvent riba
-based transactions
 Bay` Bithaman Ajil (BBA)
BBA is originally not a kind of sale
Rather, it is a way in which the payment of the
sale price is made i.e. Deferment.
Hence, conceptually, BBA is applicable to every
sale contract, be it murabahah (cost-plus sale),
tawliyah (sale at cost), wadiah (discounted
sale) or even a normal sale.
In Malaysia, BBA refers to long term deferred
sale, while murabahah refers to short term
deferred sale.
 Modern Application
1. It is widely used as a mode financing for
various items such as house, land, shares,
consumer goods and motor vehicle.
2. Overdraft facility
3. Education financing package
4. Personal financing
5. Refinancing of assets
6. Sukuk Issuance
 Developer/Vendor
BBA HOME FINANCING
MODUS OPERANDI

5. Bank pay
developer
the 90% Sales & Purchase
balance Agreement (S&P)
1. 10% down 1. Beneficial
payment ownership

Property Sale Agreement (PSA)

3. BBA price
(deferred payment)
3. House

2. House
2. Cash price
(90% balance)
BANK Property Purchase Agreement (PPA) Customer
BBA STANDARD DOCUMENTS
Letter of Offer
Property Purchase Agreement (PPA)
Property Sale Agreement (PSA)
Other documents
Charge (Form 16A);
Deed of Assignment (by way of security)
Other subsidiary documents
 Floating Rate BBA House Financing
It is actually BBA House Financing with Ibra Feature
Under this BBA financing with ibra features, the selling price of
the asset sold to the customer on deferred terms would be fixed
at a profit rate known as the ceiling profit rate
However, contrary to BBA with fixed rate, the periodical
installments of this financing will fluctuate and vary depending
on certain benchmark (such as BLR plus margin) for a particular
period
It means that the ibra will be given on monthly basis and will
differ from one month to another
On the maturity of the financing, the total installments are
calculated and should not exceed the original selling price
Any shortfall will be treated as an ibra (rebate) given to the client

35
The Mechanics of BBA Floating Rate

Rebate
Some Shariah and Legal Issues:
Liability of the owner (maintenance, repair,
takaful, etc? Who
- Non-existence (in case of house under
construction or to be constructed)
- Non completion of purchased house or non
delivery
- Rebate clause
- Right to recall the facility
- Rescheduling of the facility (installment)
- Refinancing? 37
Contd
Compensation clause
Inability of the customer to pay (default in payment)
Selling the right of receivables
Effect of bankruptcy
Cross default
Ownership? The Dilemma on the Transfer of
Ownership? Risk with ownership?
Shifting of all responsibilities to the customer: Fair and
equitable documentation
Profit without risk?
Creating another charge over the property? 38
 Legal Dilema
Recently BBA was declared to be not Islamic and not compliant to IBA:
Abdul Ghani Patails High Courts judgment on 11 BBA cases, July 2008 .
Currently, its final decision is subject to appeal.
The disputed issue is the documentation which is said to be injustice to
customer, thus, do not carry Islamic spirit.
Most Islamic contract litigated in court, since 1994 with the case of
Bank Islam Malaysia Berhad v. Adnan Bin Omar [1994] 3 AMR 44
Subject also to Rules of High Court which charges interest payment for
default in payment.
BNM Nusantara Shariah Scholars Dialogue has recommended cease of
BBA contract application gradually.
However, even the jurisdiction of civil court to hear Islamic banking
disputes is contested. It uncertain whether it can be the right forum or
have the right judges to decide on matters involving Shariah principles
especially when it is not bound to consult Shariah Advisory Council.
 What is Bay` Tawarruq?
Literally: from root word of wariq, which denotes silver.
Tawriq means seeking or acquiring silver
Technically: the purchasing of a commodity on credit by the
mutawarriq (seeker of cash) and selling it to a person other
than the initial seller (3rd party) for a lower price on cash.
It is a sale contract, whereby a buyer buys an asset from a seller
on deferred payment and subsequently sells the assets to the
third party for cash, with a price lesser than the deferred price.
This transaction is called tawarruq, mainly because when the
buyer purchases the asset on deferred terms, it is not the buyers
intention to utilise the benefit from the purchased asset, rather
to facilitate him to attain liquidity (waraqah maliah).
 Tawarruq Model of Home Financing

4.Property

4.RM200,000

Customer
Property
Owner/Developer
2.RM350,000
3.RM200,000 Deferred

2.Electrical
Appliances

1.RM200,000

1.Electrical
Appliances worth
RM200,000
Electrical Appliances
Wholesaler
Commodity Murabahah Deposit Placement

US$ 1 Million on spot

Client/Islamic Bank
Broker A US$ 1.1
Million
Where is this
deferred
proceed invested?

US$ 1 Million on
spot
Broker B Conventonal Bank
 Ruling on Tawarruq

Classic Organized
Tawarruq Tawarruq
Allowed by
many jurist Prohibited by Allowed by Prohibited by
- condition: some jurist some jurist most jurists
object not such as Ibn and applied in - Similar to
sold back to Qayyim some IFIs Inah
Original Seller 43
Organized Tawarruq vs. Fiqhi
Tawarruq

44
 Ijarah (Leasing)
Ijarah contract is a form of exchange contract (`aqd al mu`awadah)
usufruct vs. rent.
Ijarah literally means the sale of usufruct bay al manfaah.
Various definition was given by jurist but it can be understood as the
contract to use the usufruct of a permissible thing for a known
counter value.
Thus, the main subject of ijarah is the usufruct and not the object.
Ijarah contract is a form of exchange contract (`aqd al mu`awadah)
usufruct vs. rent.
Legal basis for Ijarah is derived from Al Quran, Sunnah of the Prophet
and Ijma. In Islam, there is two type of Ijarah: Ijarah amal (service)
and Ijarah ain (manfaah of ain/ item)
Modern application: Home, vehicle and machinery financing, sukuk
issuance etc.
46
 Salient Features of Lease Contract
Asset to be leased must have a valuable use or have a
usufruct. It must also be free from any defect and a
legal asset.
Asset to be leased must not be consumable which
cannot be returned to the lessor in its original form at
the end of the lease period.
Ownership of the asset remains with the lessor and
only the usufruct is transferred to the lessee.
Liabilities and risks incidental to ownership will reside
with the lessor except liabilities / risks / expenses
referable to the use of the leased asset.
Period of the lease must be in clear terms 47
 Contd
The purpose and mode of usage should be agreed upfront
and the rent must be known and must be something of
value.
The lessor could be the legal owner or the equivalent ( agent,
natural or legal guardian)
The leased asset is a trust in the hands of the lessee. He shall
guarantee if damage was caused due to his negligence or
mala fide. Thus it is permissible to require the lessee to put
security deposit as guarantee of all obligations.
The rental payment commences after the delivery of the
leased asset, actually or constructively.
The lease contract terminates upon the loss / non-existence
of the usufruct and expiry of lease period
Lease contract is a bilateral contract. Any termination, in
normal cases, must be mutually agreed. 48
 Issues
1. Floating rental
2. Repairs and Takaful premium
3. Service and maintenance expenses
4. Default in payment.
5. Sublease
6. Lease back to lessor. Ijaratan?
7. Using of KLIBOR or LIBOR as a benchmark in determining
the rental, in fixed or floating.
8. Separate letter of sale? Automatic transfer or sale of
assets upon expiry of ijarah.
9. Sale of Ijarah receivable?
10. Right to repossession.
 Modern Types of Lease
Ijarah (Operating Lease). Ijarah means leasing
of asset pursuant to a contract under which a
specified permissible benefit in the form of a
usufruct is obtained for a specified period in
return for a specified permissible
consideration.
It is a manfaah (usufruct) type of contract
whereby a lessor (owner) leases out an asset
to its customer at an agreed rental fee and
pre-determined lease period upon the `aqad
(contract). The ownership of the leased
equipment remains in the hands of the lessor.
 Ijarah Muntahiah Bi Tamlik
(Financial Lease)
Hire purchase contracts has been used as a mode of
financing in the conventional banking practices. Similar
product is also available for customers in the Islamic
financial system which is Shariah compliant.
Ijarah Muntahiah Bi Tamlik has similar rules to the ordinary
Ijarah except that it is associated with a promise by the
lessor to transfer ownership at the end of the Ijarah period
via a separate sale agreement or gift or token or gradual
transfer. It may also involve contract of agency whereby at
the initial satge, the client is appointed as an agent of the
bank to purchase the asset on behalf of the bank before
the bank leases it to the client.
It may also be called as Al Ijarah Thumma Al Bay (AITAB) or
Ijarah wa Iqtina. It is commonly described as hire purchase-i.
51
 AITAB Modus Operandi
vehicle

3. Bank
Vehicle
purchases
purchase 1. Customer identifies vehicle
identified
price of choice
vehicle

2. Customer engages
Bank for financing

4. Ijarah contract

Use of vehicle

Rental payments

4. Promise to sell

5. Al-Bay contract
5. At end of ijarah period, Bank sells vehicle to
Customer for nominal price
 Deposit Payment
It is a practice that the Bank does not finance 100%
of the cost of asset, and normally ask for some
commitment from the Client.
The asset under IHPi will belong to the Bank, but the
deposit payment is made by Client.
Although there is no big issue on this, Syariah
scholars emphasize that in Islamic transaction, the
intention and purpose of the payment must be made
clearer, especially to the Client, to ensure that the
Client fully understands the purpose of deposit
payment and function it serves.
 Deposit Payment
The issue arising is only pertaining to the function of deposit and its
legality from Sharah point of view. The main concern is the position of
deposit-payment made to the vendor (seller), not to the bank, which is
a common practice everywhere. In this case, members of National
Sharah Advisory Council have decided that the deposit paid by the
customer to the vendor must be perceived as a payment made on
behalf of the bank, causing the following contractual liabilities:
1. As between the bank (owner) and vendor (seller), the deposit is
considered part of the purchase price of the asset paid by the bank to
the vendor.
2. As between the customer (hirer) and the bank, the deposit is
considered the first rental payment and will be accounted in
determining the monthly rental payment.
 Transfer of Ownership in EOD
Bank usually adopts the recovery mode as to exercise banks
right in the event of default to exercise the Purchase
Undertaking which entitle the Bank to transfer the ownership
of the asset to Client. This will enable the bank to:
1. claim for whole Sale Price in EOD according to terms in
Purchase undertaking (e.g. after 2 consecutive defaults).
2. Claim the Payment of indebtedness after auction. If the Client
is unable to pay, the asset will be sold in the public auction. If
there is any shortfall ( the Client (now being the owner of the
asset) will pay for the balance.
 Purchase Undertaking
PU should spells out clearly the event /
manner of transfer of ownership to the
customer (lessee/hirer).
E.g.
1. Event of default (EOD)- after 2 consecutive
defaults
2. At the end of ijarah period- customer will buy
the asset at a nominal value (RM10)
 DIRECT LEASING
3. Bank pays airplane manufacturer

5. Bank lease
airplane to
airline

4. Airplane manufacturer delivers airplane to bank

6. Airline pays 7. At the end of

rental lease term airline
take ownership

2. Airline approaches bank to seek

1. Airline places order with airplane
financing
manufacturer
 Ijarah Mausufah Fi Zimmah
(Forward Lease)
Ijarah Mausufah Fi Zimmah means an ijarah contract which is
executed for an asset undertaken by the lessor to be delivered to
the lessee according to accurate specifications, even if the asset is
not owned by the lessor.
During the period that the leased asset/property is under
construction, the lessor may ask the lessee to pay a certain portion
of pre agreed lease rental as a forward lease.
The forward lease rental payment will be considered as a debt to
the lessor until the delivery of the leased asset to the lessee.
Ijarah Mausufah Fi Zimmah can be in a form of Ijarah or Ijarah
Muntahiyah Bi Tamlik.
58
Case Studies on Islamic Shipping
Finance
Case Studies on Forward Lease
This is an Istisna plus Ijarah Mawsufah Fi
Zimmah arrangement in relation to
construction of vessel for Brunei Gas Carrier
Sdn. Bhd.
The structure involves BGC SPV as the owner
and user of the gas tanker but the
ownership is split between beneficial
(Orphan SPV) and legal (BGC SPV) to justify
the repayment of cost + profit.
Essentially, the structure was designed to
ensure effective repayment mechanism to
the participants (financial institutions).
 What is Orphan SPV?
Orphan company - A company which has no identifiable shareholder/
owners - e.g., an SPV owned by a charitable trust. If the trust is a public
charitable trust, there is no identifiable beneficial owner of the SPV.
In most UK securitisations, the SPV is structured as "an orphan subsidiary"
with the shareholding transferred to a charitable trust. Therefore, even
though there is no direct control of the originator on the SPV, it is a matter
of common knowledge that the SPV is a figment of the originator. The
originator does maintain operational control over the SPV.
This ownership structure of the SPV is devised to avoid consolidation, both
from bankruptcy as well as accounting viewpoint.
To avoid consolidation from legal and accounting viewpoint, the originator
must hold no equity interest, and no residual interest in the SPV.
Therefore, very convoluted methods are followed in UK practice for
extraction of the originator's profit from the transaction. These include:
deferred consideration, an intermediary trust holding legal interest on
behalf of both the originator and the issuing SPV, interest swap, retained
interest, management fee, brokerage, etc.
 Engage in Istisna plus
construction
Ijarah
(1) Lessor is the beneficial owner of the vessel Arrangement
and the lessee is the registered owner and
Ship Builder operator of the vessel to Construct
(2) Lessor will lease its beneficial interest in
the vessel
Vessel
Forward Lease Agreement
ORPHAN SPV
(Mudarib/Purchaser
Istisna Agreement
/ Lessor
Seller/Lessee (1) Purchaser and the Seller agree that the
Seller will build the Vessel Mudarabah
(2) Purchaser agrees to pay the Istisna cost as Agreement
the price for the Seller per forming the works
(3) Seller agrees to sell by way of Istisna to
Purchaser its beneficial interest in the constructed
Vessel and Purchaser agrees to purchase the
constructed vessel for the Istisna; cost. Financier
(Rabbul-Maal)
 Ijarah Sukuk
Ijarah is very suitable for securitisation, because it is
asset backed.
The purchase of the sukuk will be evidenced by
ijarah certificate. This certificate, is an evidence of
proportionate ownership in a tangible asset, thus, it
can be negotiated and traded freely in secondary
market.
As it represents the holders proportionate
ownership in the leased asset, it allows him to enjoy
part of the rent received from the underlying asset.
Ijarah is being used for many sukuk issuance
nowadays due to AAOIFI pronouncement in end of
2007.
Direct Structuring: Sukuk al Ijarah
1. SPV issues Sukuk to
raise fund
Investor 2. SPV purchases the asset
3. SPV rents asset to Co.
1. 6.
3. 4. Co takes delivery of
Co. SPV asset
5. 5. Co makes deferred
2. payment
4. 6. SPV distributes payment
Supplier

64
 Sale Leaseback: Sukuk al Ijarah
1. Co. sell asset to SPV
Investor
2. SPV issues Sukuk to
purchase the asset
2. 4.
3. 3. SPV leases asset to
Co. SPV company at deferred
1. price. Co makes
periodic payments
4. SPV distributes
payments

65
 Equity vs Debt Instruments
Does Islam prefer equity over debt
instruments?
Quranic verses on debt: Al-Baqarah 282
Economic impact?
Maqisidic approach?
 CONTRACTS OF PARTNERSHIP
1. Musharakah:
It is a form of partnership where two or more persons
combine capital, labour or efforts or creditworthiness to
share profits; enjoying similar rights & liabilities

2. Mudharabah:
A contract between two parties in which one provides
capital (funds) and the other works with the capital.
What is Musharakah?
Musyarakah from shirkah literally means
partnership. Commonly known as profit-loss
sharing
Technically it refers to the commingling of
capital provided by the partners for the purpose
of sharing in profit.
Musyarakah is established by means of an
agreement or arrangement whereby two or
more persons agree that each of them
contributes to the capital of the partnership
either in the form of cash or in kind and shares
in its profit and loss.
BNM
Training Any profit derived from the venture will be
Session distributed based on a pre-agreed profit sharing
ratio, but a loss will be shared on the basis of
equity participation.
Its legality is derived from Quran, Sunnah and
Ijma
 CLASSIFICATION OF SHIRKAH

General partnership Contractual partnership

Joint ownership of (Shirkat al-Aqd)
Property (Shirkat al-Milk)
Common or most of
the modern form of
Partnership or
Based on type of capital
Musharakah

Amwal Amal Wujuh Based on terms of partnership

Shirkat al-Mufawadah al-Inan

unlimited investment limited investment
partnership partnership
 Salient Features of Musharakah
Capital

Jointly contributed by all partners

Can be in monetary or non monetary

Not debt

Wadiah saving and trademarks can be
capital for Musharakah

Parties cannot guarantee its return
except by an independent 3rd party

Managing parties are agents/ trustee,
liable in case of negligence or
misconduct

A new partner can be admitted during
the running of the venture and a transfer
of shares to 3rd party is also allowed
subject to approval of all partners
(takharuj)

A unilateral waad to purchase asset of
the venture or to purchase the other
partners equity (such as in Musharakah
Mutanaqisah) is permissible but on
condition that it does not violate the
fundamental of the contract or the profit-
loss sharing principle

Purchase of asset must not be on face
value?
Management

All partners may involve in the venture
management but they may waive such
rights

Manager of the venture may be a 3rd
party (wakalah/ ijarah) or a partner and
he is entitled to remuneration

Managing partners are trustee and
agent to the others

Managing parties are agents/ trustee,
liable in case of negligence or
misconduct

They are responsible to report to all
the partners. The report is to be prepared
with due care and diligence

Musharakah can be for various venture
Termination / Dissolution
Via:

Mutual agreement

Expiry of tenor

Completion of venture

Court order

Death of a partner, if agreed by all not
to resume venture

Bankruptcy

Impairment of capital
Profit Sharing Rights

At agreed ratio or based on capital
contribution ratio

Preferably, a sleeping partner do not
receive more than a managing partner

Percentage and not a fixed amount

Any partner may waive right to receive
profit (tanazul) and may give it to others

Realisation of profit via actual value of
asset by way of sell or constructive
valuation

Partners can mutually agree to set aside
profit as reserve

Parties cannot guarantee profit but an
independent 3rd party may .

Loss shall be shared by partners based
on their capital contribution ratio

A partner may agree to undertake the
loss of another partner

Loss of a partner may be undertaken by
an independent 3rd party

Manager will have to compensate for
loss due to negligence or misconduct
 Modern Application
Simple Partnership
Equity or share in company
Financing (project financing, syndicated financing, asset
financing, working capital financing, small and medium
enterprise financing and trade financing)
Letter of Credit
Sukuk Issuance
Unit Trust
Project Financing
 Letter of Credit
Letter of Credit based on Musharakah: Both the financier and the
customer contribute to the LC and will later share the proceeds of the
sale.

4. Bank sells its share to the customer

through a spot or deferred payment
CUSTOMER based on Murabahah concept ISLAMIC BANK

2. Customer request for a Musharakah LC

1. Customer (Where customer and bank becomes 3. Issue LC to beneficiaries
and IB enter partner to purchase goods from according to agreed T&C
into dealings beneficiaries) -customer puts deposit as a - Bank pays the beneficiaries
(contract of share upon the beneficiaries
sale) with presenting documents that
beneficiaries conforms to the instruction

BENEFICIARIES
 Sukuk Musharakah

Capital Proceeds
Investment
Venture
Investor Capital

Issuer

X% Loss borne on basis of equity participation Y%

Outcome Profit shared based on pre-agreed ratio X:Y
What is Mudharabah?
Mudharabah means partnership in profit.
Commonly known as profit sharing contract.
One party provides capital (rabb al-mal) and
the other party acts as an entrepreneur
(mudharib) who solely manages the project.
A combination of financial and managerial
resources of the parties.
If the venture is profitable, the profit will be
distributed based on a pre-agreed ratio.
In the event of a business loss, the loss shall
be borne solely by the provider of the capital
Bank unless it is due to the misconduct or
Negara negligence of the mudharib.
Training
Session The entrepreneur will loss in term of his effort
will not be compensated
Its legality is derived from Quran, Sunnah
and Ijma.
 Modus Operandi of Mudarabah
Manage the capital
CAPITAL
PROFIT
-Shared according to
predetermined ratio
-Profit sharing cannot be
fixed amount/ a fixed on
capital contribution
Provide capital
LOSS
-Born solely by Rabb al-Maal
-Mudarrib will only be
personally liable if the loss
is due to his negligence
 Single -tier
Mudharabah Multi-tier
Mudarib
Yudarib

Restricted Unrestricted

a contract in which the capital provider where there is no limitation as to time or

restricts the actions of the mudarib to a place or any particular type of business, or
particular location or to a particular type of any particular vendor or purchaser Al
investment as the capital provider considers Majelle
appropriate, but not in a manner that would
unduly constrain the mudarib in his operations.
AAOIFI
 Salient Features of Mudharabah
Capital Management Profit Sharing Rights

The capital contribution of one party is
the essence of this contract

Can be in monetary or non monetary

Not debt

Always available for entrepreneur use

Source: from Muslims or non Muslim,
caution from companies that deals with
illegal business

Enable effective mobilization of the
capital

Fiduciary relationship, mutual goodwill
as capital entrusted with entrepreneur
(trustee): should act in full integrity and
highest standard of market practices

Capital provider: no control over
management

At agreed ratio may be revised

Percentage and not a fixed amount

May be tied to a specific benchmark

Parties may waive right to receive profit
and transfer it to others (tanazul)

Profit distributed after deducting
operating expenses

Profit may be set aside as reserve

Assigning profits to one party only?

Capital redemption prevail over profit
distribution after payment of all
outstanding payments

Entrepreneur do not guarantee return
of capital except on negligence or breach
of contract

An independent 3rd party may
guarantee return of capital

Must be Shari'ah Compliant venture
Guarantee profit , can by an

One party can rescind before independent 3rd party may .
commencement of business. It is non-
binding, but not after start of the venture

Mudharabah contract may be restricted
or unrestricted, the entrepreneur must
strictly follow terms of contract

Termination / Dissolution
Via:

Unilateral termination before start of venture

Mutual agreement

Expiry of tenor

Completion of venture

Death of manager / entrepreneur

Non fulfillment of fundamental mudharabah condition
 Modern Application
Simple Partnership
GIA and SIA (Investment Accounts)
Letter of Credit
Sukuk Issuance
Takaful Structure
Unit Trust
Project Financing
 80

Mudharabah Investment Accounts

There are two types of Mudharabah investment account,

the General Investment Account (GIA), and the Special
Investment Account (SIA)
In GIA, the mudarabah arrangement is of a general mandate
(mudarabah mutlaqah) and the ratio of profit sharing is
more or less uniform / standard, advertised as a ready
package between the bank and the customer
In GIA, the minimum investment amount is lower than the
SIA
 81

Contd
In SIA, the mudarabah arrangement is of a specific
mandate (mudarabah muqayyadah), for e.g., the
customer can place restrictions to the bank as to the
type of dealing, or project that the bank can enter into
with the capital
The ratio of profit sharing can be negotiated between
the customer and the bank
The minimum investment amount is higher than the GIA
 82

Mudharabah Saving and Current Account

Mudharabah can also be use as a deposit product.

The client will be the capital provider and the bank will be
the manager
The deposit will be invested and the profit will be shared
between the two parties
The customer is required to maintain certain amount in
the account as the mudarabah capital
The remaining deposit will be treated as wadiah
(safekeeping) and can be withdrawn at any time

Dr. Mohamad Akram Laldin

 83

Issues To Be Considered
1. Investment from certain individuals and companies
2. Investment of a minor
3. Advertisement of gift prior to the contract
4. Guaranteeing profit/capital?
5. Variation of the ratio of profit and loss sharing
6. Pre-mature withdrawal of capital-mudarabah investment
 Mudharabah vs. Musharakah
Musharakah
Parties Parties provide capitals and work
with the capitals
There can be silent partner
Profit: -Can be shared according to :
-1. ratio of capital contribution,
-2. mutually agreed ratio
It cannot be fixed amount , must
be as a percentage of profit
Loss Borne according to the ratio of
capital contribution
Mudarabah
Some partners provide capital and
some work with the capital
Capital provider cannot interfere in the
management, no control over it.
In accordance to agreed ratio
It cannot be fixed amount , must be as
a percentage of profit
Borne solely by the capital provider.
The entrepreneur shall not bear any
portion of the loss except in the case
of misconduct or negligence
 Sukuk Mudharabah
Contract of Mudharabah

Sukuk Mudharabah
Investor Issuer
(Rabb al-mal) (Mudharib)

Loss borne Capital Proceeds

totally X% Y%
Capital
by Investor
Profit shared based on pre-agreed ratio X:Y

Investment
Outcome
Venture
 PG Municipal Bond
Security
Trustee Bond Holder

Profit Sharing
Issues sukuk Bond Proceeds
1st tier Mudarabah
SP Investors mudarabah Cap cont
V Y%
X%

Profit PG Municipal
SPV

2nd tier Mudarabah

Cap cont
Profit sharing
Admin SPV PG Local Authority
X% Y% (Administrator)

Manage and Administrate

Profit From
Tax Collection
Tax Collections 86
 Types: Legal Definition
1. Wadi`ah Yad A Custodian of a
Amahah person
2. Wadi`ah Yad To keep the property of
Dhamanah another in his safe
custody by explicit and
implicit terms

What is Al-Wadi`ah ?
A safe custody
Custodian not allowed
contract btw
to use and benefit
the depositor &
from the deposited
the custodian
item

Being an amanah contract, Custodian not liable for his

does not impose any undertaking and not
liability on the custodian entitled to any profit
gained from the contract
 Wadi`ah Yad Dhamanah
The custodian is a trustee and guarantor to safeguard the
deposited asset.
The deposited asset/property need not be
separated/segregated
The deposited asset/property can be used for trading etc.
The custodian has a right to any income derived from the
utilisation of the deposited asset
Depositor can take back the deposited asset at any time
Wadi`ah Yad Dhamanah is like Qard (loan); therefore all
principle of loan would be applicable
Thus as a loan WYD cannot generate any pre-agreed
benefit/income to the depositor, over and above the
principal amount of deposit, otherwise tantamount to riba
 Shariah Issues

Current Account
Saving
Account Hibah
Minor Insufficient
fund for Overdraft
(Guardian)
Advertisement of cheque facility
Deposits from Hibah prior to or at clearance
Individuals or a time of the
companies contract is not
(Verification?) allowed
 DEPOSIT SERVICES PRODUCTS

Negotiable
Sale & Buy Back
Saving/ Current Investment Islamic Deposit
Arrangement
Account Account Certificate
(SBBA)
(NIDC)

Qard
or
Mudarabah Bay al-`inah Bay al-Dayn
Wadiah Yad
Dhamanah
 Other Deposit Products / Structures
 While the two main deposit instruments used in deposit taking in Islamic
banks in Malaysia are the wadiah savings account and the mudarabah
investment account, there are a number of other possible structures
 Negotiable Islamic Deposit Certificates (NIDC)
 Offered as a wholesale / money market deposit product by a number of
Islamic banks (for e.g., Maybank Islamic, Hong Leong Islamic Bank)
 Commodity Murabahah Deposit-i
 Structured based on Tawarruq
 E.g., offered by Citigroup Singapore to HNWI
 Structured Deposit Products
 E.g., offered by Maybank,
Maybank, suitable for HNWI
 Pure Al-Qard Structures
 Absolutely no returns or benefits provided to depositors
 E.g., Al-
Al-Rajhi Malaysias savings and current accounts
 Combination Structures
 Each deposit split into stipulated portions (Mudarabah
(Mudarabah & Qard
Qard))
 E.g., KFH Malaysias savings and current accounts
 Al-Wakalah
(Agency or Delegation)
Wakalah is a contract of agency which gives the power to a
person to nominate another person to act on his behalf as long
as he is alive based on the agreed terms and conditions.
Its legality is based on the Quran, Sunnah and Ijma
Wakalah is commonly used in Letter of Credit-i
The agent in the contract is a trustee, and thus liable to
guarantee if loss or damage was caused due to his negligence
or misconduct
Delegation Al-Wakalah has four pillars:
1. The Delegator Al-Muwakkil
2. The Delegatee Al-Wakeel
3. The wording of the Delegation
4. The subject of the Delegation 94
 Conditions for Delegator and Delegatee
The delegator and delegatee must be Sane A'aqil, Mature Baligh and
competent Rashed (i.e. not Qaaser)
The delegator must only delegate that which is permissable by
Shariah
The Delegator must own the thing or have the right he/she wishes to
delegate
The delegatee in addition to the above condition the delegatee must
accept only the delegation which is permissable by Shariah

The wording of the Delegation

There must be an offer and acceptance between the Delegator
and the Delegatee
There must be no duress (force) upon either party
There must be no ambiguity in the wording i.e. it must be clear
as to the delegation i.e. whether it is specific or general and 95
restricted or un-restricted.
 The Subject of Delegation
It must be known to the delegatee and present if it is a
thing e.g. (represent me in the meeting or sell my car for
RM 25000)
It must be delegatable by the Shariah e.g. to sell, buy,
contract or donate etc.
It must be in the area of permissibility by Shariah e.g. it is
not allowed to ask someone to oppress, to sell alcohol,
or to legislate law etc..
It is narrated from Abu Daud and Tirmidhi upon the
authority of Urwa that the Messenger Muhammad (saw)
used to delegate people to manage affairs of others and
would specify for them some revenue.
96
Termination of Wakalah
Wakalah can be terminated for several reasons:
The completion of duty
The delegator perform the duty himself
The delegatee become unqualified to perform the duty
Refusal of delegatee to perform the duty
The absence (damage) of the subject of delegation
The delegator terminate his delegatee.
Death or insanity of the agent or the delegator

Application of Wakalah:
1. Letter of credit (LC ) based on wakalah.
2. Private banking investment
3. In BBA house financing
4. A proposed new Sukuk structure
97
Letter of Credit
(LC)- Wakalah

Need to produce
Seller Required documents Buyer
(Beneficiary) (Applicant)
Eg. commercial invoice
BL (Bill of landing),
Advice LC etc
Apply LC

Issue LC
Advising Bank Issuing Bank
 Letter of Credit
Islamic vs. Conventional
Contract based on agency Contract based on agency
(Wakalah)

Charged commission Charged commission

Reimbursement by Transit interest may occur

notification

Only halal goods may

No such restriction
be transacted
 Al Jualah
(Promise to Reward)
A unilateral undertaking to pay a specific reward for
certain or uncertain work or a promise from a party to pay
whoever perform a task a specific reward
Majority of ulama considered it as permissible based on
Quran and Maslahah but disputed by Hanafis
Parties must be eligible to conduct the transaction and the
reward must be specific and certain.
Some jurist associated it with hire or leasing contract but
there are some distinction between them.
 Jualah is different from Ijarah
Jualah Ijarah
1. Reward after the completion 1. Reward or fee can be given
before, during or after completion

2. Gharar is tolerated 2. Gharar is not tolerated

3. Cannot stipulate condition of 3. Condition of prepayment of fee

prepayment of fee can be stipulated

4. Not binding on the 2nd party and 4. Binding on both parties, cannot
can be terminated unilaterally be voided without certain valid
reason