Introduction to Islamic Banking and Finance:

Principles and Practice

M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni

Chapter 3

Financial Instruments of
Islamic Banking and Finance
Learning Objectives

Upon completion of this chapter, the reader should be able to:

• Describe the sources and uses of funds and the operation of

bank accounts by Islamic banks;
• Understand how exchange-based contracts are utilized as
financial instruments in Islamic finance;
• Understand how service-based contracts are utilized as
financial instruments in Islamic finance;
• Understand how partnership contracts are utilized as
financial instruments in Islamic finance; and
• Know the nature of supporting contracts in Islamic finance,
including the unilateral supporting contracts.
1- Sources and Uses of Funds by Islamic Banks

• Sources and application of funds

is the record of the cash inflows and outflows in an Islamic
bank or financial institution over a period of time

• Dual banking system

A banking system of a
country or territory that
incorporates both the
conventional and Islamic
financial systems
Sources and Uses of Funds by Islamic Banks

Sources of Funds

Two major sources

1. Transaction deposits: risk-free funds which do not yield
return e.g. current accounts based on the wadi’ah concept

2. Investment deposits: profit-making but have risk of

capital loss, depending on amount invested by bank
 Sources and Uses of Funds by Islamic Banks

Other sources
1. Current Accounts: account opened by individuals,
companies and firms by depositing cash, cheques and/or
bills (based on concept of wadi’ah)

2. Saving Account: funds deposited in saving account yield

some returns depending on bank financial results. Based on
wadi’ah, mudarabah and musharakah concepts

3. Investment Account: the most important source of funds

for Islamic banks; the customer and the bank enter into a
joint-venture agreement, based on mudarabah concept
2-Concept of Exchange-Based Contract

Exchange-based contracts in Islamic law have been

transformed into viable (debt financing) instruments:
- Murabahah (Mark-up)
- Istisna’ (Manufacture Sale)
- Salam (Forward Sale)
- Bay Dayn (Sale of Debt)
- Tawriq (Securitisation)
- Sarf (Sale of Currency)
- Tawarruq (Cash Financing)
- Bay Inah (Sale with immediate purchase)

Debt-based financing instruments: Financial instruments

that create debt-like relationships between parties
Concept of Exchange-Based Contract

Murabahah (Mark-up)

• Murabahah: cost-plus financing contract where a sale is

made at a specified profit margin
• Establishes a form of mutual contract between two parties
where they agree to the mark-up
• Murabahah is derived from the root word ribh which means
profit, gain or a legal addition
Concept of Exchange-Based Contract

The specific conditions for a valid murabahah

transaction:
1. Goods subject to murabahah
2. Original Cost Price of the Goods and any Addition
Procurement Costs
3. Margin of Profit

Margin of profit (also net margin): Ratio determining the

degree at which profit is realised, calculated by dividing net
profits by sales
Concept of Exchange-Based Contract

Istisna’ (Manufacturing Contract)

• Istisna’: A manufacturing contract of a made-to-order
asset based on a deferred delivery basis. It is a transaction
on a commodity before the commodity is produced
• The manufacturer is morally obliged to produce items:
- at the agreed time
- in accordance with specifications (price, quality,
description)
• The price, specification, description and quality of the
commodity to be manufactured should be fixed with the
consent of the parties to the contract
Concept of Exchange-Based Contract

Salam or Bay al-salam (Forward Sale)

• A forward sale contract where advance payment is made for

goods to be delivered later

- does not require the commodity to exist at the time of

concluding the contract
- the delivery of the commodity is deferred

• Facilitates the commercial activities of farmers before crops

are harvested - farmers get paid in advance before a
harvest
Concept of Exchange-Based Contract

Salam (Forward Sale)

There are 10 conditions for the validity of a salam contract

as generally agreed upon by Muslim jurists – see page x

Bay Dayn (Sale of Debt)

• Bay al-dayn (sale of debt) A sale and purchase transaction

involving a quality debt

• Muslim jurists are not unanimous on the permissibility of

this form of sale
Concept of Exchange-Based Contract

Tawriq (Securitisation)

• Tawriq is a process of converting an asset into cash issued

as tradable certificates of investments (tradable in the
secondary market)

• Is the equivalent term for securitization in Islamic

commercial jurisprudence.

• The end product of tawriq is the issuance of sukuk or

sanadat to a large number of investors
Concept of Exchange-Based Contract

Sarf (Sale of Currency)

Definition and Nature

• bay’ al-sarf: a foreign exchange contract involving

exchange of currencies either of the same or of different
kinds

• The delivery of both currencies has to be made in full at the

time of concluding the contract

• The contract of exchange must take place at the same

sitting where the contract is drawn up
3-Concept of Service-Based Contract

The service-based contracts include:

• ijarah (leasing)
• ijarah muntahia bi al-tamlik (financial lease)
• ijarah thumma al-bay (leasing and subsequent purchase)
• ujrah (fees)
• ju’alah (commission)

Ijarah (Leasing)

• Ijarah: Financing mechanism involving rental of an asset or

hire purchase where a form of rental fee is paid for a stipulated
period of time agreed by the parties
• In Islamic jurisprudence the term has been used in different
ways
Concept of Service-Based Contract

• Modern application of ijarah are:

- Al-ijarah thumma al-bay’ (a contract of lease ending
with sale)
- Ijarah muntahia bi al-tamlik (leasing ending with
ownership)

Ijarah Muntahia Bi al-tamlik (Financial Lease)

A typical lease contract which concludes in a transfer of

legal title and confers ownership on the lessee
- Ijarah means lease
- Tamlik denotes ownership
Concept of Service-Based Contract

Ijarah thumma al-bay (Leasing and Subsequent

Purchase)

• Ijarah thumma al-bay: a contract of lease subsequently

followed by a sale contract
• Two separate contracts are concluded under this chain
transaction
- The ijarah contract
- The purchase contract
Concept of Service-Based Contract

Ijarah mausufah fi dhimmah (Forward Lease)

• Ijarah mausufah fi dhimmah lease agreement is concluded

on a contract not in existence

• The lessor delivers the asset to the lessee in accordance

with agreed specifications

• The modern application of forward lease is diverse; it can be

used in:
- medical treatment
- education
- tourism
Concept of Service-Based Contract

Ujrah (Fees)

• Ujrah: a payment for usufruct in the use of another

person’s property or payment for service in contract of
ijarah

• Most Islamic financial institutions charge service fees for

services rendered to customers. Services fees should be
paid for through the ujrah scheme

• Ujrah has been used by a number of banks for Sharī‘ah-

compliant credit card schemes
Partnership Contracts in Islamic Finance

Concept of Equity-Based Contract

• The equity-based contracts generally involve some sort of
partnership

• Partnership contracts which have been transformed into

financial instruments are
- Mudarabah (trust financing)
- Musharakah (joint-venture partnership)
- Mmharakah mutanaqisah (diminishing partnership)
Partnership Contracts in Islamic Finance

Mudarabah (Trust Financing)

• Mudarabah is a form of partnership where one party (rab
al-mal) provides the funds and the other party (mudarib)
assumes the role of the entrepreneur through effective
management

• While rab al-mal is the sleeping partner in the partnership

contract, the mudarib is directly involved in the day-to-day
running of the business

• The parties share the profit of the business venture based

on agreed percentage and bear any loss incurred
• In the event of losses the entrepreneur loses his/her labour
and the financier loses the capital
4- Partnership Contracts in Islamic Finance

Modern application of Mudarabah

Mudarabah in Islamic banking and finance is being used in:

- venture capital
- project financing
- unit trust
- General Investment Account (GIA)
- Specific Investment Account (SIA)
Partnership Contracts in Islamic Finance

Musharakah (Partnership Contract)

• Musharakah is a word of Arabic origin meaning ‘sharing’

• It is a form of shirkat al-amwal where all partners invest

capital into the joint-venture

• Musharakah emphasises practical participation of parties in

the partnership business

• Musharakah is a form of partnership between two or more

parties based on mutual trust
5- Supporting Contracts

Hawalah (Transfer of Debt)

In literal terms, hawalah means assignment, bill of
exchange, or promissory note.In the juristic sense, it is a
special type of security contract which simply means debt
assignment.

Essential Elements of Hawalah

• Muhal: The creditor/person to whom the transfer is made
• Muhil: The transferor or debtor who assigns the debt
• Muhal ‘alayhi: The transferee of the assigned debt
• Al-Muhal bihi: The transferred debt, assigned from one
debtor to another
Supporting Contracts

Rahn (Collateral/Pledge)
A collateral, pledge or mortgage offered as security for a debt
that allows the creditor to take away the debt from such
security in the event of any default on the part of the debtor

• The legality of rahn (mortgage) contract is established in the

Qur’an and Sunnah

• The significance of rahn contract is that it is a voluntary

charitable contract (tabaru’)
• The modern application of rahn contract employed in
contracts involving credit transactions such as deferred sale
or loans from IFIs
Supporting Contracts

Muqasah (Setting-off)

Muqasah: A debt settlement through a counter-

transaction or offsetting

Types of Muqasah:
1. Muqasah al-Qanuniyyah (Legal Set-off)
2. Muqasah al-Talabiyyah (Set-off on Demand)
3. Muqasah al-Ittifaqiyyah (Consensual Set-off)

Types of debt that can be set off:

• Duyun al-naqd (currency debts)

• Duyun al-‘ard (commodity debts)
• Manfa’a (usufruct)
Supporting Contracts

Kafalah (Guarantee)

Kafalah: A binding promise to be liable for the debt of a

principal debtor in case they default or fail to redeem the
debt but such liability does not relieve the principal debtor
from liability

Legality of Kafalah
The concept of guarantee has been in practice since the
time of the Prophet (PBUH)
Key Terms and Concepts

• Bay al-dayn
• Hawalah
• Bay al-Inah
• Hibah
• Bay al-salam
• Hilah
• Bay al-sarf
• Ibra’
• Bill of Exchange
• Ijarah
• Debt-based financing
• Ijarah mawsufah fi
instruments
dhimmah
• Dual banking system
• Ijarah muntahia bi al-tamlik
• Equity capital
• Ijarah thumma al-bay’
• General investment account
• Ijma
(GIA)