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Home > Capital Markets Checklists > Key Islamic Banking Instruments and How They Work

Capital Markets Checklists

Key Islamic Banking Instruments and How They Work


Checklist Description

This checklist provides an overview of Islamic banking instruments, such as murabaha, bai salam, istisna, ijara, and mudaraba.

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Definition

The need to fully conform to shariah law has created both challenges and opportunities for financial institutions aiming to serve their growing Muslim client base. Requirements that money cannot be used for the purposes of making money (effectively forbidding the charging of interest), and the need for investments to deliver some form of collective or community benefit, have necessitated a high degree of innovation from Islamic financial institutions to develop a range of new products for customers seeking full compliance with shariah law.

Among the leading Islamic banking products are the following.

Murabaha

A kind of “cost-plus” transaction in which the bank buys the asset then immediately sells it to the customer at a pre-agreed higher price payable by installments. This price is set at a level that takes account of the time value of money until the customer’s monthly payments cover the bank’s selling price, less any deposit paid. This facility is often used in the way that mainstream banking customers might seek a mortgage when buying property.

Bai Salam

A kind of forward sales contract which requires the buyer to pay in advance for goods that are to be supplied later. Bai salam contracts are often used in manufacturing; a buyer would expect to receive a more attractive price when paying in advance with funds that can be used in the meantime by the producer.

Istisna’a

Istisna’a, another form of forward sales contract, is a longer-term financing mechanism under which a price is agreed before the asset described in the agreement is actually built. Sellers can then either create the asset themselves or subcontract, with buyers also having the option of paying the entire sum due either in advance or as installments during the manufacturing process. Istisna’a, meaning “asking someone to manufacture” in Arabic, is a common form of financing in the construction industry.

Ijara

A form of shariah law-compliant leasing involving rights over the use of an asset under which the bank buys the asset then leases it to the customer over a fixed period in return for a pre-agreed monthly price. Provisions can be made for the customer to buy the asset at the end of the agreed period. Thought needs to be given to issues such as the provision of insurance, as the asset is effectively owned by the bank during the lease period.

Mudaraba

A form of investment partnership between a bank and a business that shares the risk and losses or profits between both parties at pre-agreed levels. A mudaraba transaction, bringing some of the benefits of a business loan to shariah-compliant business customers, effectively requires the bank to take a stake in the business, with clients investing their time and expertise in running the enterprise.

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Advantages

  • Islamic banking instruments permit Muslims to benefit from a growing range of financial products in compliance with shariah law.

  • Some products require a partnership between the client and the bank, encouraging both parties to take a longer-term view.

  • Islamic banking dictates that transactions should serve to provide some form of benefit to the community at large, rather than setting pure profit as the aim.

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Disadvantages

  • With some financial aspects of shariah law open to interpretation, some instruments may be offered by some institutions, but not by others.

  • Some non-Muslim clients could find that the conditions imposed by Islamic banks prevent them from taking advantage of shorter-term opportunities.

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Action Checklist

  • When entering into leasing-style arrangements, ensure that all “grey” areas are covered by the agreement, such as the insurance and maintenance costs of the asset.

  • Islamic banking is by definition more stable than conventional mainstream banking in that it outlaws involvement in speculation or short-term industry “trends.” However, clients must ensure that they are committed to operating within the boundaries set by shariah law before using Islamic banking services.

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Dos and Don’ts

Do

  • Appreciate that the stability of the Islamic banking sector can come at the price of a slower pace of product innovation.

  • Recognize that the rapid growth in Islamic banking globally could present an attractive source of funds for businesses prepared to make a long-term commitment to operation under shariah principles.

Don’t

  • Don’t ignore the aim of Islamic banking to bring a wider benefit to society.

  • Don’t see Islamic banking institutions as financial services providers for Muslims only; such banks can be valuable long-term commercial partners for a range of individuals and companies.

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Further reading

Book:

  • Iqbal, Munawar. A Guide to Islamic Finance. London: Risk Books, 2007.

Articles:

  • Patel, Ebrahim. “Islamic finance: Special report.” Accountancy SA (June 2008): 40–44. Online at: tinyurl.com/3qp8xys [PDF].
  • Wilson, Scott B. “Islamic finance: Origins, emergence and future title.” Illinois Business Law Journal (September 18, 2007). Online at: tinyurl.com/3erd9k5

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