Accounting and Financial Management

(AFM) EM502
Topic:
Islamic Financial Instruments

Dr. M. Sajid Ali Asghar

Assistant Professor (Department of Materials Engineering )
1. Why Islamic Finance has become popular ?
2. Main Islamic Financial Instruments: Banking
3. Main Islamic Financial Instruments: Capital
Markets
4. The future vision
 Islamic Financial Instruments

Don’t Forget We are trying to play football in a

basketball field.
 Why Islamic Finance has become
popular ?
Global Financial Crisis lessons
1. Global Economic and Financial System has
several vital problems.
– Loans Without Advance Payment
– Deregulation and Financial Innovation
– Injustice and Inequality

2. People do not always behave realistically

/rationally.
 Introduction
• A financial system that is based on Islamic
principles and values, which eliminates riba/Sood
and ensure a profit sharing mechanism in the
financial system.
• It may be characterized by the absence of interest
based financial institution and transactions,
doubtful transactions, stocks of companies
dealing in unlawful activities, unethical or
immoral transactions such as market
manipulation, insider trading short-selling etc.
 “Principles:”
Because Islam forbids simply lending out money at
interest ( Riba), Islamic rules on transactions (known
as Fiqh al-Muamalat) have been created to avoid this
problem.

• The basic technique to avoid the prohibition is the

sharing of profit and loss, via terms such as :
1. profit sharing (Mudharabah)
2. safekeeping (Wadiah)
3. joint venture (Musharakah)
4. cost plus (Murabahah)and
5. leasing (Ijara).
 The Principles of Islamic Finance
• Wealth must be generated from legitimate trade
and asset-based investment. (The use of money
for the purposes of making money is expressly
forbidden)
• Investment should also have a social and an
ethical benefit to wider society beyond pure
return.
• Risk should be shared.
• All harmful activities (haram) should be avoided.
Prohibited Elements In Islamic Finance
Riba
Definition
• Literally, it means excess, expansion, increase,
addition or growth.
• Technically, it refers to the “premium” that
must be paid by the borrower to the lender
along with the principal amount as a condition
for the loan or an extension in its maturity.
 Types of riba
a) Riba al-nasi’ah
• Belong to loan contracts. The term nasi’ah
means to postpone, defer or wait and refers to
the time that is allowed for the borrower to
repay the loan in return for the addition or the
premium.
• Example:-
– selling and buying properties
– personal loans
 b) Riba al-fadl
• Pertaining to trade contracts. It refers to the
exchange of different quantities or qualities of
the same commodity.
• Example:-
– a kilo of wheat being exchanged for 1.5 kilos of
wheat.
Differences between profit and riba
 Islamic Letter of Credit
• It is a written undertaking given by the Islamic
bank to the seller (the beneficiary) at the
request and on the instructions of the buyer
(the applicant) to pay at sight, or at a
determinable future date, a stated sum of
money within a prescribed time limit and
against stipulated documents which must
comply with terms and conditions.
 Islamic Bank Guarantee
• A guarantee Is promised by a third party to carry out
the obligations payable by one person to another in
the event of default.
• Under the syariah, and in accordance with the
principles of kafalah, an islamic bank may issue, at the
request of the customer, an islamic bank guarantee
(IBG) to a beneficiary named by the customer.
• The kafalah principle used in (IBG) is a surely given by
the first party who agree to discharge the liability of a
third party in case the second party defaults in fulfilling
his obligation
 History of Islamic Banking

• Islamic capitalism
• Currency: the gold dinar
• Early economic concepts and techniques
• Modern Islamic History:
– Institutional involvement 7o’s
– Dubai Islamic Bank 1975
 ISLAMIC FINANCIAL SYSTEM
Definition of Islamic Bank
• "An Islamic Bank is a financial institution whose
statutes, rules and procedures expressly state its
commitment to the principles of Islamic /Shariah
and to the banning of the receipt and payment of
interest on any of its operations"
• "Islamic Bank is essentially a normative concept
and could be defined as conduct of "banking in
consonance / agreement with the ethics of the
value system of Islam.“
 Objectives of Islamic Bank
• All it's activities are conducted on interest-free system according to Islamic
Shariah.
• Investment is made through different modes permitted under Islarnic Shariah.
• Investment-income of the Bank is shared with the Mudaraba depositors
according to a ratio to ensure a reasonably fair rate of return on their
deposits.
• Its aims are to introduce a welfare-oriented banking system and also to
establish equity and justice in the field of all economic activities.
• It extends Socio-economic and financial services to the poor, helpless and low
income group of the people for their economic up-liftment particularly in the
rural areas.
• It plays a vital role in human resource development and employment
generation particularly for the unemployed youths.
• Its aim is to achieve: balanced growth & equitable development of the
country through spread investment operations particularly in the priority
sectors and in the less developed areas.
 Pakistan and Islamic banking

• Departmental Objectives:
• Rules and Regulations for Islamic banking in
Pakistan
Meezan Bank
• Incorporated on January 27, 1997
• Strategy
• Growth
• Shareholders & Shariah Board
• Technology
 “Shariah Advisory
Council/Consultant”
• Shariah Supervisory Board (SSB) to advise
them and to ensure that the operations and
activities of the banking institutions comply
with Shariah principles.
• A number of Shariah advisory firms have now
emerged to offer Shariah advisory services to
the institutions offering Islamic financial
services.
 “In Meezan Bank”
• Meezan Bank has extensive experience and
expertise in developing and advising on the
creation of Shariah-compliant financial
products and services.
• The main objective of Meezan Bank’s Islamic
Financial Advisory function is to assist
Financial Institutions develop Islamic banking
alternatives by sharing our expertise, research
and success stories.
• This function works under the guidance of
Shariah Supervisory Board which comprises of
renowned Islamic Scholars from both Pakistan
and abroad.
• Successful implementation of the Islamic Banking
model rests upon the principles of Islamic
Shariah.
• A world-renowned Shariah Supervisory Board
and a highly qualified and experienced in house
Shariah Advisor are fundamental aspects of the
Bank's core.
 “Members of the Board”
1. Justice (Retd.) Muhammad Taqi Usmani (Chairman)
2. Dr. Abdul Sattar Abu Ghuddah
3. Sheikh Essam M. Ishaq
4. Dr. Muhammad Imran Ashraf Usmani (Shariah Advisor)

• The primary role of this Board is to maintain and

further strengthen this commitment and to ensure
strict Shariah-compliance in all areas of the Bank's
operations.
 “Islamic Financial Accounting
Standards”
• The Institute of Chartered Accountants of
Pakistan issues Islamic Financial Accounting
Standards (IFAS) for Islamic Mode of
financing.
• IFAS 1 (issued in 2005) concerns Musharakah
and Mudarabah. While, IFAS 2 (issued in
2007) relates to Ijarah.
 Islamic Modes of Financing.
1.) LOANS FINANCING BY LENDING
2.) TRADE RELATED MODES OF FINANCING
3.) INVESTMENT MODE OF FINANCING
1.) LOANS FINANCING BY LENDING
Interest Free Loans With Service Charges.
• The banks are permitted to lend funds free of
interest.
• They are to recover only the actual service
charges from the user of the funds .
• The maximum service charges permissible to
each bank is determined by the state bank of
Pakistan.
Partnership / Mudarabah (Profit sharing)

• A profit sharing contract, with one party providing 100

per cent of the capital and the other party (the mudarib)
providing its expertise to invest the capital, manage the
investment project and, if appropriate, provide labour.
• Profits generated distributed according to a
predetermined ratio, but cannot be guaranteed.
• Losses accrued are borne by the provider of capital, who
has no control over the management of the project.
• Often used for investment funds, with investors providing
money to the slamic bank, which it invests as mudarib,
taking a management fee.
 3.) INVESTMENT MODE OF
FINANCING
MUDARABA
• Partnership where in one partner provides the funds
for another to invest in a commercial enterprise.
• The investment comes from the “Rabb-ul-
Maal”(Investor).
• The management and work is an exclusive
responsibility of the “Mudhaarib” (Working Partner).
• Venture may for a fixed period or purpose.
Partnership / Mudarabah (Profit sharing)
 “Murabahah”
• In an Islamic mortgage transaction, instead of
loaning the buyer money to purchase the item, a
bank might buy the item itself from the seller,
and re-sell it to the buyer at a profit, while
allowing the buyer to pay the bank in
installments.
• The bank's profit cannot be made explicit and
therefore there are no additional penalties for
late payment.
• The goods or land is registered to the name of
the buyer from the start of the transaction.
 Musharakah
• Musharakah is a relationship between two
parties or more that contribute capital to a
business and divide the net profit and loss pro
rata.
 3.) INVESTMENT MODE OF
FINANCING
Musharaka
• Musharaka is “a joint
enterprises formed for
conducting business.
• All parties share in the capital.
• All parties share profits as well
as losses.
• Profits are distributed as per
agreed ratio.
• Loss is borne by the parties as
per capital ratio.
• Every partner is agent of other.
 “Musharaka al-Mutanaqisa”
• The bank and borrower form a partnership entity, both
providing capital at an agreed percentage to purchase
the property.
• The partnership entity then rents out the property to
the borrower and charges rent.
• The bank and the borrower will then share the profits
from this rent based on the current equity share of the
partnership.
• If default occurs, both the bank and the borrower
receive a proportion of the proceeds from the sale of
the property based on each party's current equity.
• Islamic banking is restricted to Islamically
acceptable transactions, which exclude those
involving alcohol, pork, gambling, etc.
• In theory, Islamic banking is an example of
full-reserve banking, with banks achieving a
100% reserve ratio.
 2.) TRADE RELATED MODES OF
FINANCING
a.) Mark Up or Bai Muajjal
• The mechanism of financing on the bases of mark up is
as follows:-
• The customer contacts the bank for financing the
purchase of goods .
• The bank purchases the required goods and sales these
to him on the price mutually agreed between the bank
and the customer .
• The agreed price which is based on bases of the banks
cost plus a profit margin of the bank (mark up).
• The payment can be made by customer in lump sum or
in installments over a specific period of time.
 Wadiah
• In Wadiah, a bank is supposed as a keeper and
trustee of funds. A person deposits funds in
the bank and the bank guarantees refund of
the entire amount of the deposit, or any part
of the outstanding amount, when the
depositor demands it.
 Hibah
• Hibah usually arises in practice when Islamic
banks voluntarily pay their customers a 'gift'
on savings account balances, representing a
portion of the profit made by using those
savings account balances in other activities.
 2.) TRADE RELATED MODES OF
FINANCING
b.) Ijarah or Leasing
• asset is passed to other party against a periodic rent
payment Process of Ijaarah The customer approaches
the Bank with a request for financing and enters into a
promise to lease agreement.
• The Bank purchases the item required for leasing and
receives title of ownership from the vendor
• The Bank makes payment to the vendor
• The Bank leases the asset to the customer after
execution of lease agreement.
• The customer makes periodic payments as per the
contract.
 “EIjara wa Eiqtina”
• It is similar to real estate leasing
• sell the vehicle at a higher-than-market price
to the debtor and then retain ownership of
the vehicle until the loan is paid.
 lease Ijarah (leasing)
• A contract where the bank buys and leases
out equipment required by the client for a
rental fee.
• Ownership of the equipment remains with the
lessor bank, which will seek to recover the
capital cost of the equipment plus a profit
margin out of the rentals payable
 Ijarah
• Ijarah means lease, rent or wage.
• Generally, the Ijarah concept refers to selling
the benefit of use or service for a fixed price
or wage.
 Ijarah thumma al bai'
• The first contract is an Ijarah that outlines the
terms for leasing or renting over a fixed
period, and the second contract is a Bai that
triggers a sale or purchase once the term of
the Ijarah is complete.
Islamic
banks
 Ijarah-wal-iqtina
• A contract under which an Islamic bank
provides equipment, building, or other assets
to the client against an agreed rental together
with a independent undertaking by the bank
or the client that at the end of the lease
period, the ownership in the asset would be
transferred to the lessee.
 AR -RAHNU
• Ar-Rahn, or mortgage or collateral/ security, is
defined in the Islamic jurisprudence as
“possessions offered as security for a debt so
that the debt will be taken from it in case the
debtor failed to pay back the due money.”
1.)LOANS FINANCING BY LENDING
Qarze Hasna
• Under the Qarze Hasna scheme interest free
loans are granted to the students who do not
have sufficient means to pursue their education.
• The students are given interest free loans for
carrying on the studies both with in Pakistan and
outside the country .
• For repayment of the loan are grace period of
two years is granted after competition of studies
 Qard Hassan Loan
• This is a loan extended on a goodwill basis,
and the debtor is only required to repay the
amount borrowed.
 Qard Hassan Loan
• interest-free loans or loans given to the
purpose of welfare assistance
• Debt repayments by certain parties to the
other without profit or payment of any
refunds made over time.
• social responsibility or welfare assistance from
the wealthy to those in need.
 Sukuk
• Sukuk is the Arabic name for financial
certificates that are the Islamic equivalent of
bonds. However, fixed-income, interest
bearing bonds are not permissible in Islam.
 Takaful
• Insurance by combining the risks of many
people enables each individual to enjoy the
advantage provided by the law of large
numbers.
 Wakalah
• This occurs when a person appoints a
representative to undertake transactions on
his/her behalf, similar to a power of attorney.
 OTHER ISLAMIC LAW
• No lying or cheating about the product that
you are selling.
• Pay salaries to workers as soon as he finishes
his job or even before his sweat dries!
• Company decisions has to be taken and
approved by all company partners not just by
most of them
• The Qur'an prohibits gambling (games of
chance involving money) & gharar
 DIFFERENCE between Islamic and
Commercial Banking
Islamic Banking
1) Functions and operations are based on Sharia’h principles
2) Promote risk-sharing between provider of capital
(investor) and user of funds (entrepreneurs)
3) Aim at maximising profit but subject to Sharia'h
restrictions

Conventional Banking
1)Functions and operations are based on fully man made
principles
2) Investor is assured of pre-determined rate of interest
3) Aim at maximising profit without any restrictions
DIFFERENCES BETWEEN CFS & IFS
DIFFERENCES BETWEEN CFS & IFS
 ADVANTAGES OF ISLAMIC
BANKING
Justice and Fairness:
• The main feature of the Islamic model is that it is based
on a profit-sharing principle, whereby the risk is shared
by the bank and the customer.
• This system of financial intermediation will contribute
to a more equitable distribution of income and wealth.
Liquidity:
• Follow the profit and loss-sharing principle to mobilize
resources and are less likely to face any sudden run on
deposits.
• As such, they have a minimum need for maintaining
high liquidity.
 ADVANTAGES OF ISLAMIC
BANKING
Better Customer Relations
• Financing and deposits are extended under the profit and loss
sharing arrangement. The banks are likely to know their fund users
better in order to ensure that the funds are used for productive
purpose and vice-versa for investors.
• It will develops better relations between the financial
intermediary and the fund providers or consumers.
No Fixed Obligations
• Islamic banks do not have fixed obligations such as interest
payments on deposits. Therefore, they are able to allocate
resources to profitable and economically desirable activities.
• Also holds good for Islamic financing, as the payment obligations
of the entrepreneur is associated with the revenue.
 ADVANTAGES OF ISLAMIC
BANKING
Transparency
• Transparent to the account holders on the investments made in
different areas and the profits realized from these investments. The
profit is then shared in the pre-agreed ratio.
Ethical and Moral Dimensions
• Strong ethical and moral dimensions of doing business and
selecting business activities to be financed, play an important role
in promoting socially desirable investments and better individual or
corporate behavior.
Banking for All
• Although based on Shariah principles to meet the financial needs of
Muslims, it is not restricted to Muslim only and is available to non-
Muslims as well.