Islamic Finance Enterprise Unit (IFEU)

Blog Entry Common instruments offered by Islamic Finance Feb 7, ’08 10:03 PM
for everyone

With the prohibitions dictated by Islamic Finance, the method to undertake transactions differs, in concept, to Western philosophies. The main instruments are:

·         Shariah compliant Current and Saving Accounts – In the absence of interest, there needs to be some incentive to gain a customer and this is done through a profit sharing exercise whereby at the end of the year, banks allocate profit to the account holders, which may be equivalent to, but not the same as, a conventional saving rate. Also, since an overdraft facility would amount to charging interest, banks may offer interest free loans (Quard- Hassan) to customers on specific request.·         Murabaha (Cost-plus sale) – Murabaha essentially is undertaking a trade with a markup and is used for short-term financing, similar in form to purchase finance. An example would be a bank purchasing a tangible asset of some sort from a supplier with the resale based on the cost plus an agreed markup. This is most often used to finance property, since the bank would not be allowed to charge interest on any loan. Once such a debt covenant is in place between a bank and the customer, repayments can begin until a completion point where the asset is transferred to the customer. There is no interest rate risk which is essentially covered within the markup percentage, identified at the outset.·         Ijara (Leasing) – Ijara is a leasing contract whereby one party leases an asset for a specific amount of time and cost from another party, usually a bank. The bank would bear all the risk and a portion of the installment payment goes towards the final purchase of the asset at the time of transfer of asset. This can also be set up as a lease-purchase contract for the term of the asset’s specified lifetime. ·         Musharaka (Equity Participation) – There is very little difference between this and a joint venture agreement. The parties involved contribute in varying degrees of assets, technical expertise etc. and agree to a percentage of the returns as well as the risk. All parties must invest a certain amount of capital. In the case of purchasing a property under this sort of arrangement, it is purchased by both the bank and the customer together, and the repayments made are partly rent and partly a buyback. ·         Mudaraba (Partnership Financing) – Mudaraba is very similar to Musharaka and is a trustee type finance contract under which one party provides the labour while the other provides the capital.·         Istinaa (Commissioned Manufacture) – Istinaa is the solution for manufacture of goods since speculation prevents the selling of something that one does not yet own. With a promise to produce a specific product that can be made under certain agreed specifications at a determined price and on a fixed date, an Istinaa contract is established. Specifically, in this case, the risk taken is by a bank who would commission the manufacture and sell it on to a customer at a reasonable profit for undertaking this risk.
 

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