ISLAMIC BANKING

OPERATIONS

TOPIC 5: FINANCING
ISLAMIC FINANCING
• In Islamic financing lectures, we will examine the uses of
funds, namely, the types of financial instruments offered
by the bank to generate revenues

• The most common feature of any Islamic commercial bank

involves two main sectors, namely,
• the personal or retail sector
• the corporate or trade sector
ISLAMIC FINANCING
• However, not all retail financing involves personal
customers exclusively
• likewise, not all corporate financing involves customers
with corporate business operations.
• This category is drawn broadly on the basis of the scale of
business required by the customer

• We will look at the two types of uses of funds in Islamic

finance, namely,
• retail financing
• corporate financing
USE OF FUNDS
RETAIL FINANCING
• Retail financing can be defined as financing activities where
the main emphasis is on service for the individual customers
rather than for businesses or corporate customers
• It is a business segment which delivers financial services
through a network of outlets and service points such as at
the branch level
• The characteristics of retail financing requirements are
relatively narrow as compared to that of corporate needs and
are specific in fulfilling basic individual necessities such as
home and vehicle purchases, and access to cash facilities
• Similarly, Islamic banks offer a wide range of traditional retail
financing as offered by their conventional counterparts
RETAIL FINANCING
• In this lecture, the focus of Islamic retail financing shall be
on the three common categories, namely,
• home financing
• automobile financing
• personal financing
HOME FINANCING
• The most common models and structures in Islamic home
financing offered by many Islamic banks worldwide are
either based on
• murābaḥah and bayʿ bi thaman ājil (deferred payment
sale),
• mushārakah mutanāqiṣah (diminishing partnership),
• ijārah (leasing), or
• parallel istiṣnāʿ (construction-required sale).
BAYʿ BI THAMAN ĀJIL
HOME FINANCING
• The bayʿ bi thaman ājil (commonly referred as ‘BBA’) home
financing is based on the Sharīʿah concept of deferred
payment sale.
• The term BBA is commonly used in Malaysia and Brunei.
BBA is also known as bayʿ muʾajjal in the South Asian region,
and as bayʿ murābaḥah in the Middle Eastern countries
• In the BBA structure, the bank purchases the asset from the
vendor on a cash basis and sells it to the customer on credit
• The credit price is made up of the selling price which
comprises the cost price of the asset plus the profit margin
charged by the bank
• The selling price has to be fixed and agreed at the time the
contract is executed
BAYʿ BI THAMAN ĀJIL
HOME FINANCING
• The selling price is computed based on three components,
namely,
• purchase price of the asset
• profit margin
• tenure of financing
• In principle, the profit rate in a BBA financing is fixed, and
cannot be adjusted to reflect changes in cost of fund or
market interest/profit rate
• Any re-pricing or changes made to the profit rate will alter
the selling price and will produce more than one selling
price for one single contract, rendering the BBA invalid
BAYʿ BI THAMAN ĀJIL
HOME FINANCING
MUSHĀRAKAH MUTANĀQISAH
HOME FINANCING
• The mushārakah mutanāqiṣah (diminishing mushārakah)
financing facility combines the contracts of
• Mushārakah
• Ijārah
• Bayʿ
• Haneef, Kunhibava and Smolo (2011) explained mushārakah
mutanāqiṣah for home financing in three stages
• First, it consists of mushārakah between the customer and
the bank.
• This is done through the contract of sharikat al-milk.
• For example, the customer and the bank buy a house with
initial capital investments of 10 per cent and 90 per cent
respectively
MUSHĀRAKAH MUTANĀQISAH
HOME FINANCING
• The second stage is implemented through the contract of
ijārah between the customer and the bank
• The customer rents the bank’s undivided share or portion
in the house and makes the rental payments
• Finally, the customer will continue to buy gradually the
units representing the bank’s share until the house is fully
owned by him
• Slowly, the share of the customer in the house will
increase while the share of the bank will decrease through
the periodical redemption of the units by the customer,
until the house is fully owned by the customer
MUSHĀRAKAH MUTANĀQISAH
HOME FINANCING
• This purchase of the bank’s share is carried out through
the sale contract (bayʿ)
• At the beginning of the arrangement, the customer signs a
waʿd agreement whereby he agrees to buy the outstanding
share from the bank gradually
• The mushārakah mutanāqiṣah is an innovative and
flexible instrument for Islamic financing
• The contract is mostly used in the area of property
venture, asset acquisition and business working capital
• Many banks that provide home financing facilities have
adopted the mushārakah mutanāqiṣah
MUSHĀRAKAH MUTANĀQISAH
HOME FINANCING
PARALLEL ISTISNĀʿ
HOME FINANCING
• In the case of a property under construction, some IFIs adopt
the Sharīʿah concept of istiṣnāʿ
• The word istiṣnāʿ literally means a request, invitation or
inducement to manufacture or to construct something
• The istiṣnāʿ can be defined as a purchase contract of an
asset whereby a buyer will place an order to purchase the
asset which will be delivered in the future
• In other words, the buyer will require a seller or a contractor
to deliver or construct the asset that will be completed in the
future according to the specifications given in the sale and
purchase contract
• Both parties of the contract will decide on the sale and
purchase prices and the settlement can be delayed or
arranged based on the schedule of the work completed
PARALLEL ISTISNĀʿ
HOME FINANCING
• The AAOIFI defines parallel istiṣnāʿ as two forms of
separate contracts
• The first contract involves the financial institution as a
manufacturer, builder or supplier and concludes a
contract with the customer
• In the second contract, the financial institution acts as a
purchaser and concludes another contract with a
manufacturer, builder or supplier to fulfil its contractual
obligations towards the customer in the first contract
• A profit is then realised through the differences in the
prices of the two contracts.
PARALLEL ISTISNĀʿ
HOME FINANCING
TAWARRUQ HOME
FINANCING
• Tawarruq home financing is another alternative home
financing introduced by an Islamic bank in the Middle East
• Besides being used as a home financing instrument,
tawarruq is commonly used by Islamic banks as a mode of
financing to facilitate cash transactions such as
• personal financing
• working capital financing
• business cash line
• Nevertheless, the tawarruq concept remains controversial
since many Sharīʿah scholars deem it similar to the bayʿ
al-ʿīnah which is used to circumvent the prohibition of ribā
TAWARRUQ HOME
FINANCING
AUTOMOBILE
FINANCING
• In the retail banking business, automobile financing is
another popular product offered by the Islamic banks
• The most popular structure is the al-ijārah thumma al- bayʿ
(commonly referred as 'AITAB') or the Islamic hire
purchase
• Some jurisdictions use different terms such as ijārah wa
iqtināʿ or ijārah muntahiyah bi al-tamlīk which is
associated with a leasing contract (ijārah) with an
intention to own the asset
• Ownership is secured through the transfer of ownership to
the customer upon completion of the financing tenure
through a contract of sale with a nominal price or simply
executing a gift (hibah) with no consideration
AL-IJĀRAH THUMMA
AL-BAYʿ FINANCING
• The AITAB vehicle financing is an Islamic vehicle
financing facility, which is based on the Sharīʿah concept
of ijārah (leasing) and bayʿ (sale)
• This can be defined as a contract of lease which is
subsequently followed by a sale contract
• The ijārah (lease) has been developed to be adapted into a
hire purchase contract for it to be a viable tool in Islamic
financing
AL-IJĀRAH THUMMA
AL-BAYʿ FINANCING
AL-IJĀRAH THUMMA
AL-BAYʿ FINANCING
• Nadia approaches an IFI and applies for leasing of a car
for a period of two years. The cost of the car is
USD100,000
• Nadia is willing to pay the lease rentals on a monthly basis
• The profit rate stipulated by the IFI on the financing
amount is 6 per cent flat rate
• The IFI has agreed to purchase the vehicle now and lease
it to Nadia immediately
• At the end of the lease-term, the ownership of the car will
be transferred to Nadia for no additional amount
AL-IJĀRAH THUMMA
AL-BAYʿ FINANCING
The computation of the lease rentals will be as follows:
TLR = Financing amount + (Financing amount × 𝑖 × 𝑦)

Step 1: Total Lease Rental (TLR)

Where:
𝑖 = Rate of return per year = 6%
𝑦 = Number of lease years = 2 years
So,
TLR = USD100,000 + (USD100,000 × 6% × 2 years)
= USD112,000
AL-IJĀRAH THUMMA
AL-BAYʿ FINANCING
Step 2: Total Profit (TP)
TP = TLR – AF
= USD112,000 – USD100,000
= USD12,000
Step 3: Monthly Lease Rental (MLR)
MLR = TLR ÷ n
Where:
n = Number of months in the lease period
= 2 years × 12 months = 24 months
So, MLR = USD112,000 ÷ 24
= USD4,666.67