Islamic Banking Manual PDF

Learn
Islamic Banking
with BankIslami
Base Version
January 2006
BankIslami Pakistan Limited
INTRODUCTION
This Study pack is about introducing Islamic banking. If this is the first time you are reading about Islamic
Banking, then you have arrived at just the right place. Why? It is because in our opinion, this is the most
simplified text on Islamic banking ever written so far. It will take you through the concepts of Islamic
Banking in a seamless manner, so much so that after going through this Study pack, you will wonder
why people always told you Islamic Banking is tough....
Within BankIslami, ALL employees are expected to pass the test based on this book before they are
allowed client contact or confirmation of services. As it is the FIRST step in our training process, it is
important that you grasp the concepts introduced in this book for an effective Product level training.
The fundamental precept of the book is that Islamic Banking can be learned by self study, albeit in a
structured manner. If you are new to Islamic Banking it will add to your knowledge which would be
approximately equal to 28 hours of workshop training. If you happen to have worked in Islamic Banking
before, we hope it will refresh your knowledge.
In writing this study pack, we have attempted to adhere to five basic principles which sets it apart from
other material that is available. Firstly, the discussion is object focused. We are more interested in telling
you what is a Murabahah, how it can be structured and what should be avoided instead of telling you the
evolution of Murabahah and various opinions about its permissibility in different schools of thoughts.
Secondly, the entire discussion is backed up with examples and where appropriate graphical
illustrations. Thirdly, the accompanied CD contains an eQuiz based on multiple-choice questions to
ensure you have actually learned the concepts. Fourthly, we cut no corners in telling you what you need
to know even at the risk of complicating the discussion. Fifthly, except for the first three chapters, which
must be read in sequence, it is modular, i.e. you can pick any chapter and read it. We have also included
Model Agreements so that you can actually see how the knowledge you have gained is used in the
practical world.
HOW TO USE THIS STUDY PACK:
This book, as we explained earlier, is primarily meant for those who are new to Islamic banking. It makes
no distinction of whether they are Muslims or not. Having said that, we believe, Islamic Banking can only
be learned meaningfully if the basic system of Islamic law and jurisprudence is explained. This in turn
requires some discussion about Quran, Sunnah, Hadith and the esteem and context in which they are
held by Muslims. It is only when you understand the importance of a commandment in Quran and what
is subject to interpretation and what is not, then you will be able to understand the true spirit of Islamic
Banking. Importantly, it will make your interaction with prospects and customers more meaningful.
This Study pack is designed for anyone and everyone who is interested in learning about Islamic
Banking. To make it easier to grasp, it is divided into nine (9) different Chapters. Each chapter is divided
into different Sessions. We suggest you read one Session at a time. Some of the Sessions are long and
you may split them into two or more sittings. You are encouraged to re-work the calculations where they
are provided specially in the Murabahah section. The accompanied CD contains eQuiz carrying MCQs
that are drawn from each chapter and tests all vital concepts introduced. Model agreements do not form
part of the testing material. Each chapter can be scored separately in addition to over all score. We
suggest you take the eQuiz after completing each chapter.
INTRODUCTION
FURTHER ASSISTANCE:
Improvement is a continuous process. We need your assistance and suggestions in improving this study
pack. Please send your suggestions to either myself or to Sheba M Khan at
sheba.khan@bankislami.com.pk. Issues relating to Shariah can be referred to either Mufti Irshad
Ahmad at irshad.ahmed@bankislami.com.pk or Muhammad Faisal Shaikh at
faisal.shaik@bankislami.com.pk.
Our thanks to the team that produced this Study Pack. Sheba led the team assisted ably by Nazia and
Ayesha. Anwar Farooqui, Faisal and Mufti Irshad wrote most of the material. Asad worked on the CD.
Mohammad Shahzad ensured the book is produced in a quality manner. To all of them we express our
gratitude.
A word of acknowledgment about our shareholders as well who have provided us with exemplary
support. Chief Justice(R) Mahboob Ahmad (Chairman of the Board, representing JSCL) for emphasizing
on training and development, Mr. Ahmed Randeree whose commitment to Islamic Banking is a source of
inspiration to all of us and Dubai Bank for agreeing to share the cost and making valuable suggestions.
Thank you very much.
This study pack also makes a statement about what BankIslami is - an Islamic Bank with very high
product authenticity, yet very contemporary. Keep it up at all times!
Hasan A Bilgrami
CEO
INTRODUCTION
Contents at a Glance
Chapter # Name of Chapter Page #
1 Islamic Economic System

Session 1: What is Shariah?
Define Shariah 1
Sources of Shariah 3
Define Fiqh 5
Session 2: Essentials of Islamic Economics
What are the objectives of Islamic Economics? 6
How Islamic economics compares with Capitalism Socialism? 6
What is the concept of wealth in Islam? 7
How the wealth is distributed in Islam? 7
Session 3: Economic Activities in Islam
The importance of Risk and Profit sharing 9
Why is trade permissible? 9
Why is investment in business permissible? 9
2 Riba and its Prohibition - Arguments and Rationale for its Prohibition
Session 1: Riba
What is Riba? 11
What the Holy book Quran says about Riba? 11
Prohibition of Riba in Hadith 12
Session 2: Common arguments in support of commercial interest
Answer to the arguments given in support of Commercial interest 14
Session 3: Gharar
What is Gharar? 16
What are the different types of Gharar? 16
Which businesses are haram? 17
3 Chapter 3 Islamic Sales Contract

Session 1: Islamic Law of Contracts
Islamic Law of Contracts 19
Essential element of a valid contract 19
Types of contracts in Islami 22
Session 2: Sale
What is sale? 23
Basic elements of Islamic sale contract 23
Types of sale 26
Session 3: Khiyar
What is Khiyar? 27
Types of Khiyar 27
What is Iqala? 27
Session 4: Agent
Concept of Agent (Wakeel) 29
Rights and Obligations of the Agent 29
4 Chapter 4 Murabahah
Session 1: Introduction
Define Murabahah 31
Payment options in Murabahah 31
Session 2: Murabaha Explained
Know the rules of Murabahah 33
Factors that distinguished from the other interest based modes 34
Know how a Murabahah transaction takes places 35
Take practical steps in construction a Murabahah transaction 35
Learn the limitatins of Murabahah mode 37
Session 3: Profit calculation
Learn how profit is calculated in Murabahah 39
Benchmarking to a prevailing benchmark 41
Process flow of a Sample Murabahah Transaction 41
Session 4: Murabahah Risks
Risks for Banks in Murabahah 44
Securities in Murabahah 45
5 Chapter 5 Salam
What is Salam? Its definition, purpose and rules. 47
Rules of Valid Salam contract 48
Comparing Salam and Murabahah 49
Parallel Salam? 49
Session 2: How to use Salam

Process flow of Salam 51
Risks in Salam and how they can be mitigated 51
What are the common mistakes in executing Salam 52
6 Chapter 6 Istisna
What is Istisna'? 53
Main features of Istisna? 53
How Istisna differ from Salam? 55
Session 2: Parallel Istisna
What is parallel Istisna'? 56
What is the process flow in Istisna'? 56
What is the scope of Istisna'? 57
7 Chapter 7 Ijarah (Leasing)

Session 1:
What is Ijarah? 59
Important features and basic rules of Ijarah. 59
Distinguishing factors of Ijarah. 59
Session 2:
What is the difference between Conventional Lease and Ijarah? 63
Different types of leases 65
Session 3:
What is the process flow of Ijarah? 66
How profit is calculated in Ijarah. 66
What are the risks in Ijarah? 67
8 Chapter 8 Mudarabah
What is Mudarabah? 69
What are the types of Mudarabah? 69
What are the rules of Mudarabah? 70
What are some issues in Mudarabah? 71
Session 2: Uses of Mudarabah
Deposits How does the Bank work as a Mudarib? 72
Investments How does the Bank work as a Rabb-ul-maal? 72
Profit and Loss Distribution in Mudaraba 73

Session 3: Process flow of Risks
What is the process flow of Mudarabah? 74
What are the risks in Mudarabah ? 74
Where Mudarabah can be used by Islamic Banks? 75
9 Chapter 9 Musharakah
What is Musharakah? 77
Types of Shirkah 77
Session 2: Rules, security and termination
Characteristics and rules of Musharakah 80
Rights and obligations of partners in Musharakah 81
Security in Musharakah 81
How a Musharakah can be terminated? 81
What are the differences between interest-based financing and 82
Musharaka?
Session 3: Diminishing Musharakah
What is Diminishing Musharakah? 83
Step-by-step procedure of Diminishing Musharakah 84
Where Musharakah can be used as a Mode of Financing? 85
Chapter 1:
Islamic Economic System
1
Chapter 1: Islamic Economic System
Session 1: What is Shariah?

Session Checklist
A. Define Shariah
B. Sources of Shariah
C. Define Fiqh
A. DEFINITION OF SHARIAH
Most people believe that Shariah and Islamic Law are similar. This can be misleading as
Shariah is far more comprehensive. (see Table A on next page)
Shariah explains and takes care of all aspects of spiritual, political, social, domestic
and private life of an individual.
Shariah is in principle meant for all Muslims, but also applies to a certain extent to
people living inside a Muslim society.
The regulations of Shariah can be divided into two groups:
Regulations on worship and ritual duties
Regulations of judicial and political nature which also include economic activities.
Throughout this document, we will be referring to Shariah regulations governing the

economic activities with a specific reference to Islamic Banking and Finance
Chapter 1: Islamic Economic System 2

Table A
ISLAM a panoramic view

B. SOURCES OF SHARIAH
There are two sources of Shariah.
1) Primary sources
2) Derived Sources
1) PRIMARY SOURCES
(a) Quran, The book of Allah
The Glorious Quran is the Book of Allah, Who has promised to safeguard its purity
from any violation. It gives main beliefs, principles and wide-ranging directives of
Allah. It is incumbent on each and every person who seeks the dignity of this world
and the bliss of the Hereafter, to regulate his life according to it. Unlike all other
writings, scriptures and books, this is a unique book as it is the Word of Allah in its
purest form as it is preserved in the same form as it was revealed to the prophet
Mohammed (SAW). It has an eternal message and universal relevance. Every
Muslim is required to implement its commandments.
Its contents are not confined to a particular theme or style, but contain the basis of an
entire system of life, encompassing a whole spectrum of issues that range from
specific articles of faith and commandments to general moral teachings, rights and
obligations, crime and punishment, personal and public law, and a host of other
private, social and economic concerns. These issues are discussed in a variety of
ways, such as direct stipulations, reminders of Allahs favors on His creation,
admonitions, and rebukes. Stories of past communities and civilizations are narrated,
followed by the lessons to be learned from their actions and subsequent fate.
The Quran has a number of unique characteristics, some of which are as follows:
It is the actual Word of Allah, revealed for the benefit of all mankind. Allah says:
"It is He Who sent down the criterion (Furqan) to His servant, that it may be an
admonition to all creatures" (Al-Furqan: 1).
It is complete and comprehensive. The Almighty says: "Nothing have We

omitted from the Book" (Al-An`am: 38), and "And We have sent down to thee the
Book explaining all things" (An-Nahl: 89).
It is a theoretical and a practical Book, not only moralizing but also specifically
defines the permissible and the forbidden. The importance of understanding the
message of the Quran and seeking Allahs pleasure and reward is obvious from
Quran itself and the sayings of holy prophet (peace and blessings be upon him).
It is Allahs eternal miracle revealed to Prophet Muhammad (peace and

blessings be upon him) for all succeeding generations. In response to those who
doubt the origin of the Quran, Allah the Almighty has challenged the most
articulate Arabs to produce a whole book, ten chapters, or even one solitary
chapter that can be remotely comparable to the Quran. But to this day, no one
has succeeded in meeting the challenge of the Almighty.
It contains a complete code that provides guidance for all areas of life, whether
spiritual, intellectual, political, social, or economic. It is a code that has no
boundaries of time, place or nation: Allah says: "Verily this Quran does guide to
that which is the most right" (Al-Israa: 9).

Allah, the Almighty, has taken upon Himself the duty of preserving the Quran
forever in its entirety. It has been preserved so well, both in memory and in
writing. The Arabic text we have today is identical to the text that was revealed
to the Prophet (peace and blessings be upon him) dot to dot and dash to dash.
Not even a single letter has yielded to corruption during the passage of
centuries, and so it will remain for ever, by the order of Allah.
(b) Sunnah / Ahadith
The Quran is the word of Allah which was revealed to Prophet Muhammad (peace
and blessings be upon him) and preserved both verbally and in writing by his
Companions. Apart from the Quran, whatever the Prophet uttered or did was also
preserved by the Companions. The word Sunnah includes the sayings of the
Prophet (peace and blessings be upon him) known commonly as Hadiths (i.e.,
sayings), his practices, and actions of his companions which gained his approval.
Both the Quran and the Sunnah fall under a common title Wahy (revelation or
inspiration); the difference between the two is that the Quran is a direct revelation
so the words are of Allah, which are recited (Matluw) in the formal prayer (Salah)
while the Sunnah is indirect revelation in the sense that the words are not from
Allah. Holy prophet (Sall-Allahu alayhi wa Sallam) said many directions he received
from Allah in his own words, these are not recited (Ghair Matluw) in the formal
prayers.
Ahadith act for Quranic teachings and directives as interpreter explainer' and
elaborator.
Adadith also stand for further explaining the teachings of Holy Quran or what the
Holy Prophet said on matters which are not elaborated in the Holy Quran.
2) DERIVED SOURCES
(a) Ijmaa - Scholarly Consensus
Ijma has been technically defined as the consensus of the jurists of a certain period
over a religious matter.
It in fact signifies the importance of delegated legislation to the Muslim community.

Ijma is considered a sufficient evidence for action because the Prophet of Islam
said, "Muslim (majority or main body) will never agree on a wrong mailer". Muslims
are unanimous on this that the agreement of the scholars of Islam on any religious
matter is a source of law in Islam.
(b) Qiyas - Analogy

Qiyas is the fourth important source of Islamic law, Qiyas or analogy is resorted to
in respect of problems about which there is no specific or clear provision in the
Quran or the Sunnah of the Prophet. To deal with such issues the scholars have
derived laws and principles through analogical deduction on the basis of the
provisions of the Quran and the Sunnah on some similar situation.
Contrary to its appearance, it is not an easy procedure. The Islamic scholars have
developed detailed principles of analogical deductions or Qiyas in the books of
Islamic jurisprudence.

C. WHAT IS FIQH?
Fiqh is utilization of both primary and derived sources of Shariah to get to a decision. It
covers every aspect of life. It gives the final and binding rulings on any matter arising out
of our daily lives.
The comprehensive nature of Shariah is due to the belief that a complete and perfect
legislation law must provide all that is necessary for a person's spiritual and physical
well-being. Thus, Shariah provides a complete code of life and as any complete code of
life, Shariah covers all possible actions of a Muslim. All directives of Shariah are divided
(in principle) into five categories: obligatory, meritorious, permissible, reprehensible, and
forbidden. The verdict of Quran on a few topics has been discussed in different places in
it, hence it is difficult for a common Muslim to know and understand the exact status of a
particular issue. It is here where the role of Fiqh starts.
Fiqh means 'understanding of details' and refers to the inferences drawn by scholars.
Shariah has certain laws which are regarded as divinely ordained, concrete and timeless
for all relevant situations (for example, the ban against drinking liquor as an intoxicant). It
also has certain laws which are extracted based on principles established by Islamic
jurists (Mujtahidun). So 'interpretation of an Islamic rule and collecting all the directives
and injunctions about it in one place and deciding it's status' is what Fiqh adds.
Therefore, it is easy to say that Fiqh is what jurists have attempted for to interpret divine
principles.
With a fast progressing world and innumerable steps taken by mankind since the
advent of Islam, new problems are cropping up every day and the Islamic Scholars
have to supply answers to these questions. In this connection, mention must be
made of an entity called Islamic Fiqh Academy based in Jeddah, Saudi Arabia. This
academy comprises of prominent Islamic scholars from all Muslim countries and
relating to all Islamic schools of thought. They meet regularly and give rulings on the
matters referred to them from all over the world. Most of the practices prevalent in
Islamic banking today have the approval of Islamic Fiqh Academy, Jeddah.
(http://www.fiqhacademy.org).

Session 2: Essentials of Islamic Economics
Session Checklist
A. What are the objectives of Islamic Economics?
B. How Islamic economics compares with Capitalism & Socialism?
C. Concept of Wealth in Islam
D. How the wealth is distributed in Islam?
A. WHAT ARE THE OBJECTIVES OF ISLAMIC ECONOMICS?
Islam considers economic activities of man as lawful, meritorious and at times obligatory
and necessary. However, economic activities are not the basic problem and therefore
economic progress is not the primary reason for human existence. This sentence is the
shortest differentiating point between Islamic economic objectives and those in
Capitalism & Socialism.
Economic activities therefore should be conducted, keeping in view all the time that:
These are lawful and the wealth is earned in 'halal' ways, as prescribed by Shariah
The wealth is fairly distributed in all sectors of the society and not concentrated in a
few hands.
B. COMPARISON WITH CAPITALISM AND SOCIALISM
Let us briefly talk about the three economic models to better understand the Islamic
system of economics.
1. Capitalism
2. Socialism
3. Islamic system
1. Capitalism
As you may be aware that this model encourages private ownership and believes that a
man is free to accumulate wealth without any restriction. Market forces are the prime
drivers of an economy. Even humanly-established laws are not applicable.
2. Socialism
On the other hand, Socialism model lays down that everything belongs to the State and
private ownership is prohibited. Hence, no one is allowed to accumulate wealth for his own.
Both capitalism and socialism in their purest form do not exist any where in the world.
With the demise of the former USSR, socialism has faced a serious set back, though its
diluted principles are practiced world over. Capitalism again in its diluted form is present
around the world.

3. Islamic System
Islam says that all wealth primarily belongs to Allah and it is given to man in trust. He has
to earn it under certain rules and share it with others through Zakat, Sadaqat etc. Private
ownership is allowed as long as other tenants i.e. Zakat, Sadaqat and prohibition of Riba
are followed.
C. CONCEPT OF WEALTH IN ISLAM
According to Islam:
Wealth in all its possible forms is created by Allah.
Therefore, primarily wealth is the property of Allah.
The right of property which a man possesses, has been delegated to him by Allah.
It should be used in such a way that it ensures success in the world and hereafter.
Since wealth has been received from Allah, it's use by man should also be subject to
the commandment of Allah.
Allah may command man to give a specified part of his wealth to others.
Allah may forbid use of wealth in a particular way.
D. DISTRIBUTION OF WEALTH IN ISLAM
Let us review the objectives of distribution of wealth in Islam.
1. Establishment of a practicable Economic System
By practicable economic system we mean a system that does not deny private
ownership and deprive human being from their basic rights nor it supports control of few
who have resources to maximize their wealth. Islam provides a system that has
balanced economic instructions which do not deprive anyone from his rights nor it leaves
some of them enjoying with resources in their hands.
Islam accepts the following within certain limits:
Laws of demand and supply

Motive of personal profit
Market forces
Natural relation of employer and employee
2. Enabling every one to get what is rightfully due to him
Islamic concept of deserving wealth is that both, those who have participated in
generating wealth and those who could not participate in the generation, have rights in
wealth.
Quran Says in Surah Al Ma'arij
In their wealth there is known right for those who ask for it and those who have need for
it (70; 24-25)

3. Eradicating the concentration of wealth
Prohibition of hoarding, interest, gambling, , Uqood Fasidh (Unlawful contracts) and

Gharar (excessive uncertainty)
Encouragement of Sadaqah, Laws of Inheritance and Mehar etc.
Quran says in Surah Al Hashr:

So that this wealth should not become confined only to the rich amongst you (59:7).

Session 3: Economic Activities in Islam

Session Checklist
A. The Importance of Risk and Profit Sharing.
B. Why is Trade permissible?
C. Why is investment in business permissible?
As in Capitalism and Socialism (where individuals or the state are left free to pursue economic
activities without any restriction) Islam draws a clear line between what is allowed or
permissible (Halal) and what is not allowed or impermissible (Haram). In this section, we will
highlight both sets of these activities i.e. Halal as well as Haram
A. THE IMPORTANCE OF RISK AND PROFIT SHARING (essential element of

Islamic economy)
Islam lays great stress on the fact that anybody who seeks a reward or earning from any
activity must also bear the risk relating to that activity. Islam abhors that one party enjoys all
benefits whereas other takes on all the risks. It is for this reason that Modarabah (Venture
Capital) and Musharakah (Profit & loss sharing) are the primary financing modes.
The aspect of risk sharing is actually the corner-stone of all economic activities in Islam.
The absence of this element in any undertaking makes it not according to the tenets of
Islam. At the same time, only presence of risk does not make a transaction Shariah
compliant. The underlying reason, rationale and motive has got be in accordance with the
principles of Shariah.
For example putting money in Fixed Deposits at fixed rate of interest does not involve any
risk sharing as return to depositor is almost guaranteed.
B. TRADE
Trading is the most favoured economic activity in Islam as the elements of risk taking and
profit sharing are prominently present. Please bear in mind that care is to be taken in
doing trade based activities as well because hoarding, exorbitant profits and cornering of
market by a few are again undesirable.
C. INVESTMENT IN BUSINESS
This is a desirable activity but it should be noted that Islam requires that all such
investments should be backed by assets. Generation of assets is a basic necessity which
is beneficial not only to the investor but to the society at large.
For example, investments in Government Securities, Defence Saving Certificates (DSCs) etc. may
not generate any assets as a substantial portion of the proceeds is to meet the revenue deficit of the
budget. Additionally the element of Riba (discussed later) is also not in accordance with Shariah.
Investments in shares of companies, which are doing permissible business, are allowed
as such investments form part of equity of the company thus acquiring the assets in that
company. Similarly since Sukok are asset based, they are Shariah compliant.

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11
Chapter 2:
Riba and its prohibition
Arguments and rationale for its
prohibition
12
Chapter 2 : Riba and its prohibition Arguments and rationale

for its prohibition
Session 1: Riba
Session Checklist
A. What is Riba?
B. What the Holy Book Qur'an says about Riba?
C. Prohibition of Riba in Hadith
A. RIBA (INTEREST)
You must have often wondered what the word 'Riba' actually means.
Riba means any excess compensation over and above the principal which is without due
consideration. It is a premium paid to the lender in return for his waiting as a condition for
the loan. In the words of Prophet (SAWS) Every loan that draws interest is Riba.
This is the biggest 'Haram' element in Islam which relates to any economic activity.
B. WHAT THE HOLY BOOK QUR'AN SAYS ABOUT RIBA?
It is essential for you to know that Riba has strictly been prohibited in the Holy Qur'an.
Below, we have given verses from the Qur'an which are revelations about Riba.
1. First Revelation about Riba in Qur'an

That which you give as interest to increase the peoples' wealth increases not with
God; but that which you give in charity, seeking the goodwill of God, multiplies
manifold. (Surah Rome, Verse 39)
2. Second Revelation about Riba in Qur'an

And for their taking interest even though it was forbidden for them, and their
wrongful appropriation of other peoples money, and We have prepared for those
among them who reject faith a grievous punishment (Surah al-Nisa', verse 161)
3. Third Revelation about Riba in Qur'an

Believers! Do not swallow riba, doubled and redoubled, and be mindful of Allah so
that you may attain true success ( Al Imran, Ayat 130)
You may have heard the argument that only compounding is Haram (prohibited) in
Islam. This verse directly rejects this argument.
Chapter 2 : Riba and its prohibition Arguments and rationale for its prohibition 13
4. Fourth Revelation about Riba in Qur'an
Those who devour Riba shall rise up before Allah like men whom Shaitan has
demented by his touch; for they claim that trading is like usury. But Allah has
permitted trading and forbidden usury. He that receives an admonition from his
Rabb and mends his ways may keep what he has already earned; his faith is in the
hand of Allah. But he that pays no heed shall be among the people of fire and shall
remain in it forever.
Allah destroys riba and nourishes charities. And Allah does not like any sinful
disbeliever. Surely, those who believe and do good deeds, establish Salah and
Zakah have their reward with their Lord, and there is no fear for them,nor shall they
grieve.
O you who believe, Fear Allah and give up what remains of your demand for
Interest, if you are indeed a believer. If you do not, then you are warned of the
declaration of war from Allah and His Messenger; But if you turn back you shall
have your principal: Deal not unjustly and you shall not be dealt with unjustly.
And if there be one in misery, then deferment till ease. And that you leave it as
alms is far better for you, if you really know. And be fearful of a day when you shall
be returned to Allah, then everybody shall be paid, in full, what he has earned. And
they shall not be wronged. (Verses of Surah Al Baqarah: 275-281)
C. PROHIBITION OF RIBA IN HADITH
The Holy Prophet (SAW) has also laid severe emphasis on avoiding Riba. Some of His
sayings, i.e. 'Hadiths', are given below;
From Hazrat Jabir Ibn-e-Abdullah (RA): The Prophet, (SAWS) cursed the receiver
and the payer of interest, the one who records it and the witnesses to the
transaction and said: "They are all alike [in guilt]. (Muslim, Tirmidhi and Musnad
Ahmad)
From Hazrat Abu Hurayrah (RA): The Prophet, (SAWS), said: "Riba has seventy
segments, the least serious being equivalent to a man committing adultery with his
own mother." (Ibn Majah)
From Hazrat Amr bin Al Aas (RA): When interest based dealing becomes
common among people, they will start facing draught and shortage of food. And
when bribery becomes norm among people they will live under constant fear of
their enemy.
From Hazrat Abu Hurayrah (RA) : The Prophet (SAWS), said: "There will certainly
come a time for mankind when everyone will take Riba and if he does not do so,
its dust will reach him." (Abu Dawud, Ibn Majah)
To sum up, In the words of Prophet (SAWS)
Every loan that draws any premium is Riba. (This Hadith is reported by Hazrat Harith
ibn Abi Usamah in his Musnad).
Conventional interest based transactions directly assist in concentration of wealth in a

few hands. Consider the following transaction:
1. Our friend Omar happily places Rs 100 with Bank ABC at 5% interest per annum,
which means at the end of one year he gets an amount of Rs. 5.
2. Bank ABC gives the same Rs 100 to Fancy industries on loan at 15% per annum
and earns Rs 15 on that money, out of which only Rs. 5 goes to Omar (the
depositor) and bank keeps Rs 10.
3 Now Fancy Industries manufactures goods worth Rs 100. Then it adds Rs 15

(which is the interest paid to the bank) plus Rs 10 as its own profit. Thus the sale
price jumps to Rs. 125 and when Omar purchases the goods from the shop,
he has to pay Rs 125. So against Rs 5 received as interest from the bank he has
to pay Rs. 25 for the same Rs. 100. He is a loser by Rs. 20.
You must now compare that if the same transaction would have taken place on the basis
of an Islamic mode of finance such as Mudarabah / Musharakah. The scenario will be as
follows:
1. Omar puts Rs. 100 with BankIslami on Mudarabah basis. They agree to share
profits on 80:20 basis, i.e. 80% of the earned profit goes to Omar and 20% goes
to BankIslami.
2. BankIslami invests the Rs. 100 received from Omar with Fancy Industries on
Mudarabah basis. They agree to share profits on 80:20 basis which means 80%
of the profit goes to BankIslami and 20% to Fancy Industries.
3. Since there is no cost of capital provided by the BankIslami to Fancy Industries, it

does not have to pay any fixed amount in the form of interest to the bank. Fancy
Industries will only add their profit of 10% to the cost of goods and sell it at Rs.
110. You must have noticed that this reduces the cost to Omar.
4. Fancy Industries makes a profit of Rs. 10. Please recall that they agreed to pay
80% of the profit to BankIslami . Hence they pay Rs. 8 to the Bank which is 80%
of the profit.
5. You would remember that BankIslami had also agreed to pay 80% of the profit to
Omar. Hence BankIslami pays Rs. 6.40 to Omar as his profit on investment.
6. Since Fancy Industries sells the goods at Rs. 110 in this case, when Omar
purchases the goods from the shop, he has to pay Rs. 110. He received Rs. 6.40
as profit on investment from BankIslami and he has to pay Rs. 10 as profit of
Fancy Industries. He is out of pocket by only Rs. 3.60, as against Rs. 20 in the
other example.
We can say in short that Omar has spent less and at the same time has avoided the
evils of Riba (Interest).
Session 2: Common arguments in support of

Commercial interest
Session Checklist
A. Answers to the arguments given in support of Commercial interest.
A. ARGUMENTS IN SUPPORT OF COMMERCIAL INTEREST
Now, we are going to discuss some of these arguments below and we are also giving
rebuttals of these arguments. Believe us, you will be coming across these arguments
every now and then. Going through the following pages will prepare you on how to deal
with them effectively.
Argument # 1:
Commercial Interest is charged from wealthy persons whereas usury is charged

from the poor. It does not exploit the poor while consumption interest or usury
exploits the poor.
Answer
Validity of a transaction (like sale, leasing etc.) is not based on the financial status of a
party. Law does not differentiate between poor and wealthy in crimes like bribery, theft
etc.
Argument # 2:
Riba (which is restricted in Qur'an) is something different from what is prevalent in

modern form these days. The present days interest was not in times of Holy
Prophet (Sall-Allahu alayhi wa Sallam).
Answer
You may tell the arguer that when something is prohibited, all its general or specific
forms are prohibited. For example gambling, pork, liquor and adultery are as Haram
now as they were in Jahiliyyah (The state of ignorance of the guidance from Allah) days.
Additionally, there are tonnes of material available now that proves that commercial
interest was also prevalent in the times of the Holy Prophet (SAW). The Fiqh Academy
Jeddah has ruled that commercial interest is indeed the one that is prohibited and is
therefore not allowed. It is one of the issues that is settled at the OIC level.
Argument # 3:
In a commercial loan the borrower and the lender are both getting profit the
borrower from the amount he invests in the business, and the lender in the shape
of interest he receives from the borrower. Therefore, there is no injustice which is
the basis of prohibition of Riba
Answer
This is again a misconception about prohibition of interest. There is injustice in Riba

because it means that profit of one party (lender) is confirmed whereas profit of the
other party (borrower) is uncertain.
Suppose a person borrows money from a lender and invests in a business. Later, the
borrower faces loss in the business due to some reason but he has to pay a fixed and
agreed amount of interest to the lender. The lender does not face any loss as he still
received interest from the borrower. This situation is unfair as the preferred Islamic
principle of profit and loss sharing was not practiced here.
You may also like to know that mere 'consent' or 'mutual benefit' of the parties does not
make any transaction acceptable. For a transaction to be within four corner of Shariah, it
has to be acceptable according to the principles of Shariah.
Argument # 4:
In a commercial loan arrangement, there is free consent of both, the borrower and
the lender. In Riba, consent of the borrower is not there since it is only the lender
who is getting the excess.
Answer
It is a gross misconception that many individuals think that the prohibition of interest is
only related to situations where the creditor (lender) is charging exploitatively high rates
of interest. They think that the only objective served by the prohibition of Riba is the
avoidance of injustice in the sense of exploitation of the poor debtor by the rich creditor.
But this is not true. Islam considers Riba itself injustice, whether it is between poor and
wealthy or it is only between wealthy people.
Secondly, as explained above, mutual consent does not make an activity haram or halal.
This is a common principle in every legal philosophy. So haram cannot be rendered halal
by mutual consent of involving parties, for example adultery and many forbidden types of
sale, etc, remain haram even when there is a mutual consent of both parties.
Session 3: Gharar
Session Checklist
A. What is Gharar?
B. What are the different types of Gharar?
C. Which businesses are haram?
A. WHAT IS GHARAR?
Let us take a look at another element that Islam does no allow to be practiced at all. It is
called Gharar!
Gharar simply means risk or unnecessary ambiguity or excessive uncertainty which

makes a transaction a matter of dispute between counter parties. For example, the
transaction of probable items whose existence or characteristics are not certain, thereby
making the transaction similar to gambling.
Many classical examples of Gharar are provided explicitly in the Ahadith.
They include the sale of fish in the pond / river / lake / sea, birds in the sky, an unborn
calf in its mother's womb, a runaway animal, un-ripened fruits on the tree, etc. All such
cases involve the sale of an item which may or may not exist as we cannot predict the
future. In such circumstances, to mention but a few, the fish in the sea may never be
caught, the calf may be still-born, and the fruits may never ripen. In all such cases, it is in
the best interest of the trading parties to be very specific about what is being sold and for
what price.
We used the words unnecessary and excessive to explain an important concept.

Uncertainty and ambiguity are part of human life and because one can not be sure of an
incident happening in future, so elimination of these elements completely from economic
transactions is not possible but they can be minimized up to a acceptable level as per
Shariah. You all must have faced some experience somewhere in your life that whenever
excessive element of uncertainty arose, it results in dispute between parties. That is why
such transaction are not allowed in Islam due to possible injustice with one of the parties.
B. TYPES OF GHARAR
There are two types of Gharar;
1. Jahalah
This type of Gharar means non-specification of a subject matter being sold e.g.
selling of a watch kept with other watches, in such a way that the buyer does not
exactly know the subject matter which means he does not know which specific
watch is being sold to him. Another example could be selling of something in a bag.
We are sure you will remember now that any transaction that has an element of
Gharar is not valid in Shariah.
Please take note of the Hadith which is narrated by many books on the authority of
'Abu Hurayra (RA) (translation of the version in Sahih Muslim) that:
The Prophet (SAWS) prohibited the pebble sale and the Gharar sale.
Gharar is strictly prohibited in Islam because of inherent injustice.
2. Gambling (Qimar):
Surely you must be knowing that gambling is another prohibited activity and is
condemned in Qur'an. It is considered haram because of huge element of Gharar.
In this study pack we are not going to deal with it.
In present day society, the prizes scheme e.g. Prize Bonds, lotteries, speculations
etc. also fall under this category.
C. WHICH BUSINESSES ARE HARAM?

You would recall that we talked about the fact that the importance of underlying
business bing in compliance with Shariah. Following is a brief list of activities that are
considered not in compliance with Shariah:
a) Manufacturing and trading of any thing considered Haram by Islam like liquor,
drugs, pork products.
b) Any business that involves obscenity like casinos, night clubs, pornography etc.
c) Business dealing in money lending on interest.
d) Business promoting indecency like prostitution, film making, dance and music
promoting institutions etc. etc.
We emphasize again that any kind of involvement in the above mentioned businesses is
prohibited by all means.Even employment in such businesses is not allowed.
Chapter 3:
Islamic Sales Contract
21
Chapter 3 Islamic Sales Contract
Session 1: Islamic law of contracts

Session Checklist
A. Islamic laws of Contracts
B. Essential elements of a Valid Contract
C. Types of Contracts in Islam
A. ISLAMIC LAWS FOR CONTRACTS
Islamic commercial law, known as Fiqh Muammalat in Islamic legal term, which
constitutes an important branch of law, dealing with issues of contracts and the legal
effects arising from a contract. Contract in Islamic law is a complex legal discipline in
both its jurisprudential and practical function. Also contract covers a variety of dealings
and transactions to meet the needs of the society.
Issues of commercial transactions, unlike devotional issues i.e. 'Ibadat', are bound to
change due to the changing circumstances and situations of both the object and subject
of the transactions.
B. ESSENTIAL ELEMENTS OF A VALID CONTRACT
1. Contractors Parties to a Contract

2. Subject Matter Goods / commodities / services
3. Consideration - Compensation
4. Wordings of Contract
1. Contractors
The parties to a contract should be:
a) Legally competent to enter into a contract i.e. they should be legally allowed to
undertake the transaction.
b) Mature, which is measured largely by two aspects, namely prudence and/or

puberty as revealed in the Quran:
"Prove orphans till they reach the marriageable age; then if you find them of sound
judgment, deliver over unto them their fortune".(Surah An Nisa, Verse 5)
c) Lastly, they should be in sound mind while undertaking the transaction.
Chapter 3 Islamic Sales Contract 22

2. Subject Matter
Islamic law stresses about the Subject matter of a contract in the following matters:
a. Ability to Deliver:
Delivery, on the other hand, indicates that the object must be capable of
certain delivery. The classical jurists therefore prohibit the sale of a camel
which has fled, a bird in the air or a fish in water.
There are two kinds of Delivery:
Physical delivery / Physical Possession:

Physically delivering a thing means giving it to other party by hand so that
he has the asset with him physically.
Constructive possession:
Delivery of goods in a manner where other party (to whom the goods are
delivered) takes no physical delivery of the commodity. Instead, the
commodity has come into his control and all the rights and liabilities of
the commodity are passed on to him including the risk of its destruction.
b. Lawfulness:
Lawfulness requires that the object should be lawful, that is something which
is legally permissible to be traded in. Also inherent in the lawfulness of the
object is the condition that the object should be legally owned by the parties to
a contract.
c. Existence:
The issues of existence pre-supposes that the object of a contract should be in
existence at the time of contract. Thus, it is illegal, for example, to sell fetus or
something else that does not exist.
d. Precise determination / specification / quantification:
Finally, the subject matter of a contract (commodities/ goods/ services) should
be determined so precisely and clearly that the element of ambiguity and any
uncertainty is graded down up to the natural level.
3. Consideration
As far as consideration is concerned, we mean price / rent / fare or any other

compensation given in exchange of something. Islamic law allows it to be a
monetary price as well as non-monetary exchange. Non-monetary would mean that
it could be a commodity given in exchange like in the barter system.
Islamic prohibition against uncertainty requires that the consideration should be in

existence and determined at the time of the contract and cannot be left to be
determined on a later date nor can it be left subject to the determination by a third
party. In summary:
a. Specification:
The consideration should be very specifically defined in terms of medium and
currency.
b. Quantification:
The consideration should also be very specifically defined in terms of quantity
and details.

c. Ability to deliver:
Delivery, on the other hand, indicates that the object should be capable of
certain delivery. For example selling against a currency that is not used in the
market is not acceptable unless otherwise agreed.
4. Wordings of Contract - Offer & Acceptance
A contract is completed when offer from one party and acceptance from other
match. Expression of both offer and acceptance could be, according to Islamic law
of contract, verbally expressed like in 'express contracts' or implied expression
which has been described as 'contract by conduct' or 'implied contract'.
However, Islamic law of contract requires that the offer and acceptance should be
jointly connected with no unnatural gap between offer and acceptance. We mean by
unnatural gap, any delay that does not usually occur between offer and acceptance
in such types of transactions. The session in which offer and acceptance takes
place is called Majlis Al-Aqd in Islamic law.
To clarify the concept, assume that Ali (buyer) and Umair (seller) are bargaining for
a cell phone at 10:00 AM. After all discussions and bargaining Umair (seller) offered
that the price of the cellphone would not be less than Rs 5,000 Ali (buyer) leaves
the shop and does not buy the cellphone. After 3 hours he comes back and asks
Umair (seller) to give him the cellphone. The seller (Umair) has the right of not
selling the cellphone on the price he had demanded reason being the fact that no
contract was made in the morning and by his conduct Ali had withdrawn from the
negotiations.
The requirements for wordings of a contract are given below:
a. Use of present tense:

This means that the words should reflect a contract that is being contracted in
present not in future.
b. Non-contingent:
The effectiveness of a contract is not contingent upon any event in future. This
is also true for the compensation of the contract. The following example is
made to illustrate the concept:
On 10th January Khalid (seller) sells a PC to Hammad (buyer) with the
condition that the sale would be completed if he (Khalid) wins the tennis match
on 15th January. As sale has been attributed to an event in future it would not
be allowed.
c. Unconditional:
This is another requirement that should be kept in mind. As discussed,
according to Islamic law, a contract should not be conditional. The basic
purpose of the prohibition of conditional clauses is to avoid any conflict that
may occur between parties to a contract by clearly specifying every detail of a
transaction as well as the responsibilities of the parties to the transaction.
Such rules are normally violated through conditions which are known as
conditions which are against the contract. Keeping in view modern business
practices, the issue needs to be understood in detail. It is hoped the following
rules will help clarify the concept.
Rule No. 1:
A condition, which is not against the basic objective of the transaction i.e sale, is
a valid condition. For example a condition of free delivery to buyers premises.

Rule No. 2:
A condition, which seems to be against the basic objective of the contract, but
it is in the market practice and its voidness is not proved with the clear
injunctions of the Holy Quran and Sunnah is a valid condition. For example, a
condition that the seller will provide five-year guarantee and one year free
service.
Rule No. 3:
A condition that is against the basic objective of the contract and not in market
practice and in favor of one of the contractors or subject matter, is a void
condition. For example if Ahmed sells a car to Basheer with a condition that he
will use it on a fixed date every month.
Rule No. 4:
A condition which is against the basic objective of the contract, not in the
market practice and not in favor of any contractor is not a void condition. For
example if both Ahmed and Basheer decide to give to charity a certain
percentage of both subject matter and consideration upon completion of sale.
C. TYPES OF CONTRACTS IN ISLAM
Contracts can be categorized under two broad headings:
1. Compensation Contract (Uqood Muawadha)

2. Non compensatory or voluntary contracts (Uqood Ghair Muawadha)
1. Compensation Contract (Uqood Muawadha)

These contracts are meant for financial activities and some compensation is given
to the other party. These are sales contract, purchase contract, rent agreements
etc.
An important element of these contracts is that they become void if a void

conditions is put in as explained in the above discussion. Care should be taken that
no void condition becomes part of the contract.
2. Non compensatory or voluntary contracts (Uqood Ghair Muawadha):

These are not meant for financial activities, instead, they are for social services and
are non-remunerative. An example of such contracts is a loan contract (Qard) that
is non-remunerative.
These contracts do not become void if a void condition is included instead, the void
condition itself becomes ineffective.


Session 2: Sale
Session Checklist
A. What is a Sale?
B. Basic elements of Islamic Sale contract
C. Types of Sale
A. WHAT IS SALE (BAI)?
Sale is also a kind of contract. Let us start with the definition of sale (Bai):
Sale is defined in Shariah as the exchange of a thing of value (the asset) with another
thing of value (money) with mutual consent.
Islamic Sales Contracts are a type of Compensation Contract (Uqood Muawadha).
B. Basic Elements of Islamic Sales Contract
We have discussed earlier the basic rules of contract. Now coming to the application of
these rules to a sale contract, it is essential for you to remember that there are four
elements which should be present in an Islamic sales contract. These are:
1. Contract offer from one and acceptance from other (Aqd)

2. Subject matter goods / commodities to be sold (Mabe'e)
3. Price any thing given as consideration (Thaman)
4. Possession or delivery (Qabza)
You may learn them as CSPP.
Let us discuss these elements in detail:
1. Contract or transaction
A sale contract must have the following three essentials:
a. Offer and Acceptance (oral or implied)
In simple words, one person proposes to either sell his commodity to another
person or buy from him. Acceptance means that the person who has been
offered gives his approval of the proposal.
As discussed above, if buyer takes goods from the seller with an implied
understanding that payment would be according to what is written on the
goods it would be an 'implied sale' since there is no oral communication
between them.
Implied sale can be of two types:
i. Implied Credit Sale in which buyer takes goods from the seller with an
implied understanding that payment would be made later e.g. settlement
of the bill at the end of the month. (milk, newspaper etc.).

ii. Hand-to-Hand Sale-Exchange of money with goods without uttering Ijab-

o-Qobool as per procedure adopted in our daily life. For example taking a
packet of biscuits that has a tag of price of Rs. 20 from a shelf and giving
shopkeeper Rs. 20.
b. Counter parties (Buyer and Seller)

In order, for a contract to be valid, it is important that the Buyer and Seller are
legally eligible for conducting such transactions, hence, they should be:
i. Sane: They are mentally sound at the time of contract.
ii. Mature: Should be adult. Minors can only enter into an agreement if they
understand the nature of the transaction.
c. Conditions of contract:
i. Non-contingent sale:
The contract of Sale should be non-contingent which means it is not
dependent on any condition or event in future.
ii. Unconditional sale:

As we discussed, being a contract, a sale transaction should be unconditional.
A conditional sale can only be allowed according to the criteria discussed
above i.e. the conditions which are not against the contract.
iii. Sale should be immediate:

Sale must be instant and absolute. A sale attributed to a future date or a sale
contingent on a future event is void. This is one of the reasons why future
contracts are not acceptable in Shariah.
2. Subject Matter or Sold Good
Please recall the requirements of subject matter of a contract. In a sale transaction

the following conditions should be present:
a. Existing:
The subject matter of a sale must exist at the time of sale. Thus a thing which
has not yet come into existence cannot be sold. If a non-existent thing has
been sold, even with mutual consent, the sale is void.
b. Valuable:
The subject of sale must be a property of value. Islam consider Haram things
as un-valuable like liquor, pork etc. Thus a thing that has no value cannot be
sold or purchased.
c. Capable of ownership/title:
The subject matter should not be a thing which is not capable of
ownership/title e.g. Selling of a portion of land from area that is regarded as a
property of general public.
d. Capable of delivery / possession:

It means the subject matter (goods / commodities) should not be in a
condition in which it cannot be delivered or possessed.

e. Specific & quantified:

It means the subject matter should specifically be known and identified either
by pointing or by detailed specification that can distinguish it from other things
which are not sold. For example, pointing one car among hundred of cars, or
specifying its color, make, engine number and other details.
f. Title and risk of seller to the goods:

The subject matter of sale should be in the ownership of the seller at the time
of sale. The meaning of ownership is to have rights to the goods as well as
bearing the risk. Therefore selling something before acquiring its ownership
and risk is not allowed. This particular condition makes short sale
unacceptable in Islam.
3. Price
The detailed discussion on the issue may give you some rules for price. The price
of the goods should be:
a. Quantified
The measuring unit of the price should be known e.g weight, currency etc.
b. Specified & certain

For a sale to be valid, the price should be ascertained and specified e.g. the
total amount. If the price is uncertain, the sale is void.
4. Delivery or possession
Early discussion on ownership of the subject matter draws some clear guidelines
regarding the possession by seller and delivery to the buyer. The subject matter
(goods / commodity) of sale should be in the physical or constructive possession of
the seller when he sells it to another person. Possession can be held in two ways:
a. Physical Possession:
It means the seller has the asset with him physically.
b. Constructive possession:
This refers to a situation where the buyer has not taken the physical delivery
of the commodity, yet the commodity has come into his control and all the
rights and liabilities of the commodity are passed on to him including the risk
of its destruction.
C. TYPES OF SALE
Discussed above was a procedure for a valid sale transaction. According to this
discussion a sale can be valid or invalid in nature. Hence, there are four kinds of sale:
1. Valid (Sahih)
A valid sale is in which all the four following elements of sale contract are present:
Contract
Subject Matter
Price
Possession / Delivery

2. Void (Baatil)
Sale will be void if any one of the conditions of 'offer and acceptance', 'conditions of
Buyer & Seller', and 'sold goods conditions' are not complied with. In a void sale,
the buyer does not have title to subject matter and seller does not have title to price.
Both subject matter and price cannot be used lawfully. The produce of both shall be
unlawful.
3. Defective (Fasid)
Sale remain intact but will be void due to defect if the 'conditions of contract', 'sold
good conditions' and 'conditions of price' are not complied with. However, if the
defect is rectified the sale will become valid. In a Fasid sale, the buyer should not
possess the subject matter. If possessed with the consent of the seller, title or
ownership will pass to the buyer but usage of subject matter will be impermissible.
He must return it to the seller if the defect is not removed.
4. Valid but disliked (Makrooh)

Sale is valid but not liked in Shariah. A few examples are:
Sale after Juma Azan violation of commandment of Allah to attend Jumah
prayer without delay.
Sale of hoarded goods unethical and prohibited business practice.
Sale by intervention of a third party while two parties are negotiating.

Session 3: Khiyar
Checklist
A. What is Khiyar?
B. Types of Khiyar
C. What is Iqala?
A. WHAT IS KHIYAR ?
The term khiyar refers to the option or right of the buyer or seller to cancel a contract of sale.
B. TYPES OF KHIYAR
There are five types of khiyars or options available in a sale contract which are as
follows:
1. Khiyar-e-Shart (Optional condition): At the time of sale Buyer or Seller can put a
condition that the buyer has an option to cancel the sale within specified days.
e.g. money back guarantee within one month of Sale.
Specification of the days is necessary for this Khiyar. Within this period, the
buyer has the right to cancel / dissolve the sale without any reason or as per
specified condition.
2. Khiyar-e-Roiyyat (Option of canceling contract after inspecting goods): In this,

the buyer has the option that the goods can be returned after inspection if found
contrary to what was specified in the contract.
3. Khiyar-e-Aib (Option of canceling contract if a defect is found): In this type, the

goods can be returned if found defective. It is the responsibility of the seller to
supply goods free of error / defect or point out the defect to the buyer. In no way
is he allowed to cover the defect of the goods which will constitute a fraud.
4. Khiyar-e-Wasf (Option of canceling contract if goods are not of specified quality):

Where the goods are sold by specifying a certain quality by the seller and that is
absent in the goods.
5. Khiyar-e-Ghaban (Option of canceling contract if price is more or less than the

market price): Where the seller sells the goods at a price which is far expensive
than the market price, the buyer has the right to return it to the seller.

C. IQALA (CANCELLATION OF SALE CONTRACT)
Iqala: Is act of cancellation of a sale contract where both parties freely consent to cancel
the contract i.e. each party will give back the consideration (money and subject matter)
received by them.
Principally speaking, neither the buyer nor the seller has the sole right to cancel the
contract after its execution. However we often see that the buyer wants to cancel the
contract after buying goods; similarly, seller sometime wishes to reverse the sale
transaction. In such cases it is necessary that any one who wants to cancel the contract
should get the consent of the other. This mutual agreement between buyer and seller to
cancel the contract is called Iqala.
The price of the goods being returned under Iqala will remain unchanged.

Session: 4 Agent
Session Checklist
A. Concept of Agent (Wakeel)
B. Rights and Obligations of the Agent
A. CONCEPT OF AGENT (WAKEEL)
You must have noted in earlier sessions that the Islamic sale contract is valid only
when the goods to be sold are in possession of the seller, i.e. these have been
purchased or produced by him first.
Ideally the financier or the Bank should purchase the goods itself directly from the
supplier or through a third person appointed by it as employee before selling it to the
customer. However, in exceptional cases, where direct purchase from the supplier is
not practical, the Bank makes the customer its Agent to buy the goods on its behalf.
In all such situations a formal Agency Agreement must be signed between the two
parties outlining the rights and obligations of the agent.
B. RIGHTS AND OBLIGATIONS OF THE AGENT
1. The Agent is bound to act and perform as per specifications and guidelines given
by the Principal or financier.
2. As long as the Agent complies with the instructions of the Principal, all his actions
will be construed as coming from the Principal himself and the latter cannot disown
these actions. However if the Agent exceeds or breaks the mandate given to him,
he is fully accountable for his actions and may have to compensate the Principal
for any damage caused by such unauthorized action.
3. Agent can be any person capable of executing a transaction including the customer
himself.
4. The Agent may receive funds in advance from the Principal for making purchases.
5. In case the Agent fails to purchase the goods, he is bound to refund the amount to
the principal if received in advance.
6. From the moment the Agent purchases the goods, all risks relating to ownership
will be with the Principal until such time the goods are sold to an outside party. If
the customer is also the Agent, he will take over the risk when the Sale Agreement
is signed and ownership transfers to him from the Principal. At that time his role as
Agent will come to an end.
7. The Agency Agreement can be canceled by either party, by giving a notice as

specified in the agreement. Till such time that the notice of cancellation reaches the
Agent, all actions taken by him will be binding on the Principal.

8. Agent is entitled to a fee for his efforts and this must be clearly mentioned in
the Agency Agreement. In case the customer himself becomes an Agent, such fee
is usually not charged.
Agency contract would become more clear to you after you study the next chapter
which is Murabahah. We recommend that you go through this concept again after
reading Murabahah or where Agent's role is discussed.

Chapter 4:
Murabahah
35
Chapter 4: Murabahah
Session Checklist
A. Define Murabahah
B. Payment options in Murabahah
Before beginning, we want you to be clear on the word Murabahah itself. Many people
call it Mur'rabba some call it Mar'haba while a few call it Muraba. The actual word is
Murabahah as given above.
A. DEFINITION:
Murabahah is a sale in which costs and profits are disclosed to the end customer.
For example Shahid is selling a car to Ali on Murabahah basis for Rs. 200,000
which he has purchased for Rs. 180,000. Now, if Shahid tells Ali the cost he
incurred for acquiring the car i.e. Rs. 180,000, this sale is called Murabahah!
For more explanation consider Maria who went to a jeweller to buy a gold necklace
for her wedding. She selected a beautiful necklace worth Rs. 50,000. Maria was
surprised and asked the jeweller why such a delicate necklace costs Rs. 50,000.
The jeweller told her precisely that the actual cost of gold used in making that
necklace was Rs. 32,000. Gem stones worth Rs. 6,000 were used to beautify the
necklace, Rs. 7,000 were being charged for labour Rs. 5,000 were the Jeweller's
profit. If Maria agrees that a profit of Rs. 5,000 will be composite of total cost of
necklace which is Rs. 50,000, this transaction would be called a Murabahah.
Murabahah is a sale between a Buyer and a Seller in which the seller expressly tells
the purchaser how much cost he has incurred and how much profit he is taking in
addition to the cost. That is why Murabahah is also called 'cost-plus' transaction.
Thus buyer is fully aware of cost and profit the seller is taking in the sale.
Chapter 4: Murabahah 36
B. PAYMENT OF PRICE:
Different methods for payment of price of things purchased are present under
Murabahah. The price can be:
a) Prompt / on spot.
b) Deferred (to be paid in full on a particular date in future).
c) Deferred with installments (equal or unequal installments of price to be paid

during a particular period in future).
Payment methods break Murabahah into three types:
1. Murabahah with spot payment of price, called Murabahah Mu'ajjalah.
2. Murabahah with deferred payment of price, called Murabahah Muwajjalah.
3. Murabahah with payment of price in installments during a certain periods is also

called Murabahah Mu'ajjalah.
Session 2: Murabahah explained

Session Checklist
A. Know the Rules of Murabahah
B. Factors that distinguish Murabahah from other interest based modes
C. Know how a Murabahah transaction takes place?
D. Take practical steps in constructing a Murabahah transaction
E. Learn the limitations of Murabahah mode
Let us go through the rules of Murabarah first before we move on to other things
A. RULES FOR MURABAHAH

It is now quite clear from whatever has been discussed previously that Murabahah is a
particular kind of sale, therefore, all the rules and regulations that govern trading
activities are applicable in Murabahah as well.
Therefore the rules that are vital in trading should be kept in mind for Murabahah
transaction as well.
You are expected to learn by heart the following six important conditions: aide-memoire :
ESOP FR
1. Existence of goods
At the time of sale, the goods which are being sold must be in existence. We can
say that anything that may not exist at the time of sale cannot be sold. Its non-
existence at the time of sale that makes the transaction void.
2. Specification and Identification of goods

Murabahah can be done of only those things which can be specified, identified and
quantified. It cannot be done of anything which is not clearly specified, e.g. an apple
in a box which is unknown to one party. Thus goods to be sold must be specifically
known and identified to the buyer. For example, if a buyer is buying dates from a
vendor, he should know the quantity, type and quality of dates which he is about to
buy.
3. Ownership of goods
If the Bank is seller, the goods that are being sold should be in the ownership of the
Bank at the time of sale. Sale of goods that are not in the ownership of the seller is
void.
4. Possession of goods
The goods must be in physical or constructive possession of the Bank while selling it
to another person. Constructive possession means a situation where the possessor
has not taken physical delivery of the commodity yet, but it has come into his control.
In such a case, all rights and liabilities of the commodity are passed on to him
including the risk of its destruction. This means that the Bank being a seller will be
responsible for any damages as it is the holder of all rights and liabilities.
5. Finalization of sale
Please note that Murabahah must be instant and absolute and it should not be
dependent on anything in future. Thus a Murabahah associated to a future date i.e. a
Murabahah to be finalized on a future date or a Murabahah contingent on a future
event is void. For example if a person sells a car on Murabahah basis with a
condition that the sale will be finalized if a new tax policy is announced, will not be an
acceptable Murabahah transaction.
6. Risk of goods
Though point 3 explains the obligations of ownership, there exists a common
misconception about this aspect. One significant sign of ownership is that after
purchase of the goods the Bank must bear risk of goods until those are actually sold
and delivered to the customer. In other words, after purchase of the goods but before
selling of those to customer, the Bank shall bear the consequences of any damage
or defect. For example, 100 bales of Cotton are purchased by the Bank for a
customer. Unfortunately the whole consignment caught fire while the consignment
was still under ownership of the Bank. In this case the Bank will bear the loss as the
ownership was yet not passed on to the customer.
B. WHAT MAKES A MURABAHAH DIFFERENT FROM INTEREST-BASED FINANCING?
We would like to emphasize on the basic difference before going into details. The
foremost point to remember is that Murabahah is a sale and not merely a loan advanced
to a customer. There are some misconceptions about Murabahah that it came into
existence by merely replacing the word of "interest" by the word "profit" or "mark-up".
However, the fact is very different from this, let us repeat, Murabahah is a sale. Any
transaction which is not structured as a sale can not be a valid Murabahah. Here are
some points that make this clear:
1. Murabahah is only a mode to escape from "interest" and not an ideal instrument for
achieving the real economic Islamic objectives. Islamic economic system aims for
proper distribution of wealth in society, which can be best achieved through
Musharakah and Mudarabah. Therefore, this instrument should be used as a
transitory step taken in the process of the Islamization of the economy and should
only be used in those cases where Mudarabah or Musharakah are difficult to be used.
2. The second important point is that, Murabahah as a mode of financing has been
allowed by the Shariah scholars with some conditions. Unless these conditions are
fully observed, Murabahah is not permissible. In fact, it is the observance of these
conditions (see rules for Murabahah) which can draw a clear line of distinction
between conventional and Murabahah transaction.
3. Murabahah is not a loan given on interest. It is the sale of a commodity for a deferred
price which includes an agreed profit added to the cost.
4. As Murabahah is a sale and not a loan, therefore, it should fulfil all the conditions
necessary for a valid sale, especially those discussed in earlier chapters.
5. Murabahah cannot be used as a mode of financing except where the client needs
funds to actually purchase some commodities. For example, if he wants funds to
purchase cotton as a raw material for his ginning factory, the Bank can sell him the
cotton on the basis of Murabahah. But where the funds are required for some other
purposes, like paying the price of commodities already purchased by him, or the bills
of electricity or other utilities or for paying the salaries of his staff, Murabahah cannot
be effected as Murabahah requires a real sale of some asset. In other words
Murabahah has to be asset back.
6. The Bank must have owned the commodity before he sells it to the client.
7. The commodity must come into the possession of the Bank, whether physical or
constructive, in the sense that the commodity must be in his risk, even if it is for a
short period. The table below shows the sequence of events in a valid Murabahah
transaction.
Financier (after receiving a financing request Day Day 2 Day Day 4
from customer) 1 3
Placed an Order for desired commodity - - -
Took the delivery of that commodity - - -
Paid the price - - -
Informed the customer about availability - - -
Sold the commodity to customer - - -
C. HOW A MURABAHAH TRANSACTION IS STRUCTURED
Bilal owns a sugar mill. He is in need of funds urgently as he suffered some loss in
another business. He wants to buy sugarcane for his mill. For this, he approaches a
Bank. The Bank agrees to buy sugarcane for Bilal under Murabahah mode. We will see
how a simple Murabahah transaction takes place between Bilal and the Bank in the
following steps:
1. The Bank and Bilal enter into a Agreement to Murabahah whereby the Bank agrees to
buy sugar cane from the market and sell it to Bilal after having added 20% over cost
incurred. The sale is to be effected on an agreed date.
2. Now the Bank will acquires the required sugarcane from market and takes its
possession in a manner that all risk before selling it to Bilal are borned by the Bank.
3. The Bank will inform Bilal Sugar Mills about the availability of the sugarcane with the
Bank and the price.
4. Bilal will receive the sugarcane and Murabahah would be concluded.
5. Payment of price of the sugarcane would be according to agreed time line and other
terms and conditions.
D. PRACTICAL STEPS IN CONSTRUCTING A MURABAHAH TRANSACTION
1. Client and Bank sign an agreement to enter into Murabahah
Bank Client
Agreement to Murahabah
2. Bank gives money to supplier for purchase of goods
Bank Client
Agreement to Murabahah
Disbursement to the supplier

Supplier
Risk Transferred
3. Client pays the price of goods purchased under Murabahah
Bank Client
Payment from client to Bank
(Prompt or deferred in installments)
Murabahah under Agency Transaction- A Graphical Presentation:
You must have noticed that whatever has been discussed so far has relates to a simple
Murabahah transaction in which Bank directly purchases the goods and hands it over to
the customer. Practically speaking this kind of transaction is rare in Banking. It is not
easy for banks to trade in goods.
In such cases there is a method for Murabahah that is called Murabahah under agency.
In this method, Bank appoints its Agents to perform trading of goods on behalf of the
Bank. The agent acquires goods from market on Bank's behalf and takes its possession
on behalf of the Bank as well. This appointed agent may be any person including the
client himself.
This is graphically illustrated below:
1. Bank appoints Client as an agent to purchase goods on its behalf
Agreement to Murahabah
Bank Client
Agency Agreement
2. The Bank pays the cost of goods purchased directly to the supplier or to the client (as
he is the agent of the Bank).
Bank Client
Agreement to Murabahah
Agency Agreement
Payment
Supplier
3. The client purchases the commodity on behalf of the Bank and takes possession as
the agent of the Bank. Remember that the client is performing two roles here he is a
client as well as an agent.
Agent
Transfer of Risk Delivery of Goods
Bank Supplier
4. The client, then, informs the Bank that he has purchased the commodity and at the
same time makes an offer to purchase it from the Bank.
Bank Agent
Offer to purchase
5. As the client has possession of the goods as an Agent of the Bank, the sale is
concluded immediately after the Bank accepts the offer. On this, the ownership as
well as risk is transferred to the client.
Offer and acceptance

Bank Client
Transfer of Risk
6. Client pays the agreed price of goods purchased under Murabahah to the Bank
according to an agreed schedule. This is usually done on a deferred payment basis
which is called 'Bai Muwajjal'.
Bank Client
Payment
E. LIMITATIONS OF MURABAHAH MODE
Let us remind you that Murabahah, is a type of sale and not a loan, that is why it is
important that Murabahah fulfills all the conditions necessary for a valid sale.
Murabahah has certain limitations:
It cannot be used as a mode of financing except where the client needs funds to actually
purchase some commodities. For example, if a client wants funds to purchase cotton as
a raw material for his ginning factory, the Bank can sell him the cotton on the basis of
Murabahah. However where the funds are required for some other purposes, like paying
the price of commodities already purchased by him, or running expenses like bills of
electricity or other utilities or for paying the salaries of his staff, Murabahah cannot be
used because Murabahah is always asset based. The ownership of the subject matter is
a extremely essential element of Murabahah, thus financier must own the commodity
before he sells it to his client. The commodity should also come into the possession of
the financier, whether physical or constructive. This means that the commodity must be
in his risk, even for a short period. Therefore, if ownership is not possible with its gist
then Murabahah can not be used.
As Murabahah is a type of trade, all necessary conditions for trading must be observed in
it. Knowing the specifications is extremely vital. If there is any commodity where
specification cannot be identified, Murabahah cannot be used. For example, if a trader
wants to purchase on Murabahah basis 100 bales of cotton stored in a warehouse with
other bales, the Murabahah can not be performed unless the sold bales are identified
properly through batch number or any other way.
Similarly, industries where raw material is acquired from different sources cannot avail
Murabahah unless they are able to identify sources and quantify the goods. For example,
a packed milk producing company that purchases milk from different resources cannot
use Murabahah for purchasing milk unless a mechanism is put in place that clearly
identifies the sources.
Session 3: Profit Calculation

Session Checklist
A. Learn how profit is calculated in Murabahah
B. Benchmarking rate to a prevailing benchmark
C. Process flow of a sample Murabahah transaction
A. HOW PROFIT IS CALCULATED IN A MURABAHAH TRANSACTION
Profit in Murabahah can be calculated in three ways depending on the payment of

Murabahah price by the Customer. Please remember that the payment terms should be
negotiated with the Customer on execution of Murabahah Contract. To ensure
transparency in the transaction, it is compulsory for the concerned officer to define
payment period in clear terms. Any exception made to this rule has to be approved by
the Head Office.
We would like to draw your attention to another important point. This is that the payment
of Murabahah price by the Customer is not recorded or written as REPAYMENT. This is
done because an Islamic Bank is not involved in advancing loan. Murabahah being a
trading transaction, the Customer is only making payments of the goods purchased.
Following situations may arise at the time of calculation of Murabahah price. Let:
MP = Murahabah Price
CP = Cost Price
R = Profit Rate
P = Period
1. Bullet Payment
In cases the Murabahah price is being paid in one bullet payment (Cost Price + Profit),
the Murabahah price is calculated by the following formula:
MP = CP + CP x R x P/365
Example:
CP = Rs. 100mn
R = 15% p.a.
P = 365 days
MP = 100 + 100 x 15% 365/365 = Rs 115m
2. Repayment in equal Installments
In cases the Murabahah price is being paid in equal periodic installments and each
payment carries a portion of the Cost Price and Profit, the installment will be calculated
using an IRR based equal payment formula as follows:
Where:
Installment = ___CP X r.......
P = No. of periods
[1 (1/ (1 + r) P]
R = Profit Rate / No. of periods
(You are not suppose to learn this.)
Murabahah Price = Installment X n
Example:
CP = Rs. 100mn
R = 15% p.a.
P = 365 days
Payment frequency Four Equal Installments

Murabahah Price (Amount Due) Rs 27.38 mn at the end of every quarter
Contract Price (Murabahah Selling Price) Rs 109.52 mn (273.38 x 4)
3. Repayment in unequal Installments
If the Murabahah price is being paid in unequal periodic installments in such a way that
the profit portion of the selling price is paid over the life of the transaction equally and the
Cost Price is paid at maturity, the Murabahah Price is calculated as follows:
MP = CP + CP x R x P/365
The profit is calculated as follows:
Periodic profit = R x 1/frequency x CP
Interim Installments = Cost Price x Profit Rate x No. of days (days per period) / 365
Illustration:
Financing Amount = Rs 100mn

Profit Rate = 15% p.a.
Tenor = 1 year
Four Unequal Installments with bullet
Payment =
payment of cost price
Amount due at the end of first 3 quarters = Rs 3.75mn (15% x x 100)
Amount due at the end of last quarters = Rs 103.75mn (100 + 3.75)
Contract Price
= Rs 115mn (100 + 15)
(Murabahah Selling Price to the customer)
B. BENCHMARKING TO A PREVAILING BENCHMARK
Shariah Scholars allow using variable profit rate tied to a known benchmark. In other
words, any known benchmark can be used in a Murabahah transaction for calculating
the profit. This approach helps to manage profit rate in Murabahah transaction especially
in cases where a large and long exposure is intended to be taken. However, you must
consider the following guidelines:
1) Only a known benchmark should be used.
2) Floor (lower limit) and ceiling (upper limit) if applicable, are clearly defined.
3) Profit Rate of each Murabahah transaction should be fixed at the time of
disbursement which will not change after the execution of offer & acceptance. We
have discussed before, price once fixed cannot be changed.
4) New rate will only be applicable on each new disbursement. Please remember and
clarify to the customer that the rate of the whole facility would be floating but rate
would be fixed for each disbursement of the Murabahah facility.
5) You should also keep this fact in mind that though the Shariah scholars allow using
interest based benchmarks. This permission is given only for the interim period in the
absence of an Islamic benchmark. The activity is regarded as permissible but not
preferable. In case an Islamic benchmark is available, it should be used.
C. PROCESS FLOW FOR A SAMPLE MURABAHAH TRANSACTION
Now let us go through the real world Murabahah transaction process. This is what
happens in actual.
1) Customer and Bank agree to do business.
2) Credit Proposal for the limit clearly specifies the nature of procurement process of the
commodities/goods to be used as a subject matter of Murabahah, normally in a
separate section of proposal. It also discusses the Murabahah Process to be followed
while undertaking Murabahah financing with the customer.
3) Necessary approvals are obtained.
4) Legal documents are prepared.
5) The Bank and the Customer enter into a Main Murabahah Financing Agreement
(MMFA). Under the agreement, the Bank promises to sell and the Customer
promises to buy the agreed commodities/goods from time to time as per the terms of
the MMFA.
6) The Bank and Customer enter into an Agency Agreement. Under this agreement,
the Bank appoints the Customer as its agent to procure the specified
commodities/goods on its behalf.
7) Whenever the customer has a purchasing requirement he contacts the Bank.
8) The Bank negotiates tenor, rate and amount as per agreed guidelines with the
customer.
9) Customer requests the Bank (for purchasing of required goods) by sending Purchase
Requisition to the Bank. Customer also informs the following to the Bank.
a) Credit Period it requires
b) Agreed Profit Rate
c) Supplier Name and City in which the payment to the supplier is required and
request for issuance of pay order in favor of the supplier.
d) Expected date/period within which commodity/good will come in its possession.
10)The Bank reviews the documents and if found appropriate payment is made to the
supplier.
11)Once the payment process is completed, the Bank contacts the customer to get the
confirmation of possession of commodity/goods as per the information received from
the customer at the time of disbursement. As a buyer, Bank will check its agent
(customer) about the possession of good.
12)As soon as the confirmation is received from the customer, process for obtaining
Declaration of purchase and taking possession from the customer starts.
13)A representative of the Bank visits customer's premises for physical verification of
commodity/goods received on behalf of the Bank by the customer.
14)After verification, Declaration i.e offer and acceptance is executed on the site of
customer. The Bank's representative is also required to obtain any proof of purchase
in the form of receipt, temporary invoice, etc. Bank's proportionate ownership in the
purchase is also clearly specified on the Declaration.
15)The Bank's representative also obtains confirmation from the customer that the
commodity/goods are received from the same supplier to whom the payment was made.
Following guidelines should be strictly followed while executing a Declaration:
16)If the value of commodity/goods is exactly equal to the funds disbursed by the Bank,
then Cost Price, Murabahah Contract Price (Murabahah selling price) and
Proportionate Ownership is as follows:
Cost Price = Value of funds disbursed

Murabahah Price = Cost Price including Profit
Ownership Percentage= 100%
An illustration of the above is as follows:
BankIslami paid Rs. 50 million to a supplier to purchase machinery for M/s ABC &
Co on January 01, 2005.
BankIslami plans to sell the machinery to ABC for a total price of Rs. 55 million to
be received after one year.
Declaration would be executed as follows:
Cost Price = Rs. 50 million

Murabahah Contract Price= Rs. 55 million
Ownership Percentage=100%
17)In the above situation, no financing from the customer's side was involved. In other
words, the customer was not leveraged and was not using his own equity. In practical
world, this may not be always the case. Customer may like to use his funds in
addition to the ones provided by the Bank. As a matter of fact this may be preferable
from credit point of view. In such cases the proportionate cost price would be
calculated as follows:
Cost price of the tranche
x MP
Total disbursement
An illustration of the above is follows:
BankIslami paid Rs. 50 million to a supplier to purchase cotton for M/s ABC & Co
on January 01, 2005. The customer is intending to purchase cotton of Rs 75 m
using Rs. 25M from own sources.
BankIslami plans to sell the cotton to ABC for a total price of Rs. 55 million to be
received after one year.
ABC paid Rs. 25 million from other sources to the supplier.
Cotton was received by M/s ABC as per the following schedule.
Cotton valued Rs. 15 million on January 07, 2005

The Declaration of the above would be executed as follows:

On January 07, 2005
Murabahah Price = Rs. 16.5 million (15/50*55)
Ownership Percentage = 100% (15/15*100)
On January 09, 2005

Murabahah Price = Rs. 22 million (20/50*55)
On January 11, 2005

Murabahah Price = Rs. 5.5 million (05/50*55)
January 13, 2005

Cost price recovered to date = 15+20+5=40m
Cost price remaining = 50-40=10m
Murabahah Price = Rs. 11 million (10/50*55)
Ownership Percentage = 66.66% (10/15*100)
You may ask: Why cost price was not recovered proportionately? There
are two reason. Firstly, banks like to recover their funds quickly. If the
credit is of good quality, the Bank may like to defer recovery right upto
the end. Secondly, Sharia scholars prefer recovery of funds under
agency quickly.
18)Profit is accrued at the end of each month.
19)Payment of Murabahah Contract Price is done on the due date by the customer.
20)In case the customer unnecessarily delays payment, charity may be charged.
Session 4: Murabahah Risks

Session Checklist
A. Risks for banks in Murabahah
B. Securities in Murabahah
A. RISKS IN A MURABAHAH TRANSACTION
The most critical point for you to remember is that Murabahah is a sale transaction which
involves taking ownership of the asset being financed by the Islamic Bank. All risk
related to the ownership of the asset are borne by the Islamic Bank until the assets are
sold to the Customer usually against deferred payment. A Murabahah transaction where
the Bank does not assume ownership risk is not a valid transaction.
Islamic Banks face two types of risks while undertaking Murabahah financing. Other
risks such as liquidity, operational, rate etc. are ignored to keep the discussion focused
on Murabahah:
1. Asset(s) Risks
2. Credit Risks
1. Asset Risks
You remember under a Murabahah transaction, Bank sells the assets to the customer
after purchasing it from a supplier. In case the asset is destroyed before onward sale to
the customer, the Bank would be responsible for any kind of loss. Therefore, before
entering into a Murabahah with a Customer, the Bank should study the procurement
process of the asset(s). Proper steps should be taken to cover risks arising in the
procurement process.
Similarly, if the customer fails to purchase or decides not to purchase the asset from the
Bank due to any reason despite his promise to do so, the Bank would be left with the
asset. In this situation the Bank would sell the asset in the market and may recover
actual loss from the customer who defaulted on his promise. Let us review an example in
the following paragraph to clarify the point.
Suppose Saleem & Co approaches Awami Bank to purchase a generator under a

Murabahah transaction. After execution of the legal agreements, Awami Bank purchases
a generator from a supplier at a cost Rs. 100,000 and contact Saleem & Co. for
necessary actions. Due to some reasons, Saleem & Co fails to purchase the asset from
Awami Bank. Awami Bank has no choice but to sell the asset in the market. Any of the
following three situations may arise now:
1. Asset is sold at a price greater than Rs. 100,000 say Rs. 101,000
2. Asset is sold at a price equal to Rs. 100,000
3. Asset is sold at a price lower than Rs. 100,000 say Rs. 99,000
In scenario 1 and 2 the Bank would not be allowed to charge any amount from the
customer. The Bank is also not allowed to charge any liquidated damages. If charged,
the amount should be given to charity. However, in the third scenario, the Bank is
allowed to charge Rs. 1,000/- from Saleem & Co as the Bank has suffered actual loss
due to the default in promise.
How to manage Asset Risks?
The assets risk can be avoided if proper steps are taken at the time of credit evaluation.
A credit proposal should clearly specify the nature of procurement process i.e. the steps
required in procurement of the commodities/goods to be used as a subject matter of
Murabahah, in a separate section of the proposal. It should also discuss the Murabahah
Process to be followed while undertaking Murabahah financing with the customer.
A good understanding of the process would help the Bank to take appropriate measures
to minimize the attached risks which will vary from transaction to transaction and from
customer to customer.
2. Credit Risks
As in Murabahah the Bank allows the customer to defer the payment of price for a certain
time period, credit risk comes into play. The risk is the same which is faced by
conventional banks and financial institution and that is why it should be managed in the
same manner.
B. TYPES OF SECURITIES AGAINST MURABAHAH
As discussed before, the procedure of Murabahah financing comprises of different steps

carried out at different stages. In the earlier stages of the process, client does not incur a
debt, as he is only acting as agent of the Bank. It is only after the commodity is sold to
him by the Bank on credit that the relationship of a creditor and debtor comes into
existence.
You see in case the commodity is destroyed during the period of agency agreement, the
Bank can have recourse to the security only if it is proved that the incident took place due
to the negligence of the client. Reason being the fact that the asset was not sold to the
customer, therefore the Bank was the beneficial owner.
The above fact re-emphasizes the importance of obtaining the Offer & Acceptance i.e
Declaration along with the purchase evidence in Murabahahs booked by the Bank without
unnecessary delay.
It is important to know that any kind of security, which is acceptable in law can be taken to
secure Murabahah financing. Following is the exception list due to Shariah reasons:
1) Shares of conventional commercial banks, leasing companies, DFIs, NBFIs and

shares of companies which do not pass the Shariah Screening Criteria. The reason
Shariah scholars have not allowed to take these instruments as securities is their
impermissible nature i.e. the business of these companies is not permissible. Only
those commodities/properties can be used as a security, which are recognized as
Maal-Mutaqawwam1 in Shariah.
2) In case of Defense Saving Certificates, Special Saving Certificates, Conventional

TFCs and Bonds, Lien cannot be marked on the interest portion. Only principal
portion can be used to recover any amount outstanding. Financing against these
securities is disliked. Approval of the Shariah Advisor will be necessary before
accepting them as securities.
1 A thing which has a value according to Islamic Shariah
51
Chapter 5:
Salam
52
Chapter 5 Salam
Session Checklist
A. What is Salam? Its definition, purpose and rules.
B. Rules of valid Salam contract
C. Comparing Salam and Murabahah?
D. Parallel Salam?
INTRODUCTION
Salam is one of the permissible economic financing modes in Islam compared to others as
most of the other modes are trade based. Salam is a different types of sale that have been
discussed in early chapters.
As you have gone through in earlier sections on Islamic Contract of Sale, there are three basic
conditions for validity of a simple sale:
1. The asset (subject matter of sale transaction) must exist.

2. The seller must own the asset.
3. The asset must be in the physical or constructive possession of the seller.
These are mandatory conditions, however, according to Hadith there are two sale transactions
that deviate from the above established rules. They are:
1. Salam
2. Istisna
Both these sales are of special nature and are allowed by Shariah. We will discuss Salam in
this chapter and Istisna in the next Chapter.
A. WHAT IS SALAM?
Salam is a sales transaction where the seller undertakes to supply some specific goods
to the buyer at a future date against an advance price fully paid on spot but the supply is
deferred.
There are three basic elements, in a Salam transaction:
1. Specified goods
2. Supply of goods on future date
3. Price is fully paid in advance
Salam was allowed by the Prophet (SAWS) subject to certain conditions.
Chapter 5 Salam 53
Actually Salam was allowed to meet the needs of small farmers who needed money to
grow their crops and to feed their families till the time of harvest.
The background is that after the prohibition of Riba in Qur'an, they could not borrow
money on interest, hence they were allowed to sell their agricultural products in advance.
Salam is beneficial to the buyer and seller both The seller receives the price in
advance and the buyer gains since the Salam price is generally lower than the spot price
in the market.
B. RULES OF VALID SALAM CONTRACT
As discussed earlier, some conditions have been considered necessary for simple sale,
to eliminate ambiguity and uncertainty in delivery and possession.
After establishing the fact that Salam is an exception to the general rules of sale, one
can think that deferred delivery of goods in Salam remains a factor of ambiguity and
Gharar (excessive uncertainty) which is prohibited, so how it is dealt with? Hadiths that
allowed Salam have mentioned some conditions that should be observed to minimize
ambiguity and element of Gharar that are inherent in Salam. The Salam transaction is
allowed subject to these conditions:
a) Payment of price in full
b) Homogeneity of the product
c) General availability at the time of delivery
d) Generality of source
e) Exactness of date and place of delivery
f) Security
g) Settlement as per contract only
h) Cancellation of contract
We will now explain the above points one by one;
1) The Salam price must be paid in full at the time of effecting sale. We established
earlier that the delivery of goods in Salam is in future, it means the subject matter
(goods) is due on seller as an obligation and debt. If both price and delivery are kept
at the end of the delivery period, it would effectively mean selling of debt with debt.
This is prohibited in Islam.
As well, the basic wisdom behind permissibility of Salam is to fulfill the instant needs
of the seller. If the price is not paid in full by the buyer, this purpose is defeated.
2) Another important condition for validity of Salam sale is that Salam is not allowed in
every halal commodity. The commodities Salam is meant for must be homogeneous
and fungible in nature. We mean by 'fungible' that every unit of the item is identical,
same and substitutable by other. For instance, wheat is a commodity where each unit
of it i.e. every grain is identical to other in the sense that the difference between them
is negligible.
Heterogeneous item i.e. rare items, or those that are not precisely specifiable
because every unit of them is not identical to other, cannot be the subject matter of
the Salam contract because of significant difference between each units.
Fuqaha (Jurists) are of the view that Salam cannot be effected for heterogeneous
commodities since each unit of these commodities is different from others in size,
weight and value, and cannot be precisely and clearly specified and quantified before
hand. For example precious stones, cattle and trees etc.
Chapter 5 Salam 54
3) The commodity must be generally available in market at the date of delivery. If the
commodity is not easily available at the time of delivery. Salam would not be allowed.
For example, selling of a commodity in off-season. It is obvious that the seller may not
be able to deliver the commodity at the delivery time.
4) In Salam, one can not put a condition of buying a particular commodity or product of a
particular field or farm e. g. supply of wheat of a particular field or the fruit of a
particular tree. There is a possibility that the crop is destroyed before delivery and
keeping such possibility in view the delivery remains uncertain
5) The exact date and place of delivery by the seller must be specified in the contract.
6) A security in the form of a guarantee, mortgage or hypothecation can be taken in a

Salam in order to ensure that the seller delivers.
7) The seller at the time of delivery must hand over the commodity. Sometimes it
happens that the buyer does not want to take the delivery, instead, he wishes a
monetary settlement. Scholars are of the view that this a hidden way of taking
interest, therefore, seller must deliver the subject matter to the buyer and not money.
8) The Salam contract once established cannot be canceled unilaterally. Consent of

both parties is required. You must note that in no case can a seller hands over money
in place of commodity on the date of delivery.
Salam can be done for:
Purchase of homogeneous commodities for working capital.

Forward purchase of manufacturing inputs e.g. Cotton.
C. COMPARING SALAM AND MURABAHAH
Let us take a look at differences between Salam and Murabahah. Though both Salam and
Murabahah are sale based transaction, there are distinctive differences between the two:
Murabahah Salam
1. The buyer can pay the sale price on 1. The buyer must pay the full sale price
deferred basis or in installments. in advance.
2. The subject matter of sales i.e. goods 2. The commodity does not exist at the
must exist before sale is executed. time of sale.
3. The goods must be firstly in 3. The question of possession does not arise
possession of the seller. since the commodity is yet to be grown.
D. PARALLEL SALAM
Salam as a mode of financing has some limitations. While doing a Salam transaction with
customer, Bank purchases a commodity as a buyer. After given period it takes
possession of the commodities it purchased from a supplier. Practically speaking, it is not
possible for a Bank to have Salam contracts with suppliers, acquire the commodities and
maintain huge stocks for supplying to customers as Muslam ilaih (seller) when any
customer approaches it.
Having said that, Salam is still very useful instrument for banks. Shariah Scholars
keeping this in view, have allowed a new structure for Salam called Parallel Salam.
Chapter 5 Salam 55
In this structure of Salam, the financial institution makes an arrangement for the
commodities it will acquire by way of Salam from a supplier (Salam A). The Bank then
sells the commodities it acquired by Salam A to a customer through a parallel contract of
Salam (Salam B) for the same date of delivery. This is called parallel Salam. You must
remember that the Bank has to first acquire the goods through Salam A before it sells it to
the customer through Salam B.
For instance, BankIslami (BI) has entered in a Salam of 100 MT wheat with M/S Jawwad
and Co. the details are:
Transaction: Salam A
Transaction date: 1st, Jan, 2006
Commodity: Wheat (Code of wheat: W-12 pak),
Quantity: 100 M. Ton
Price: $10,000 (Paid on 1st, Jan, 2006 by the BI)
Delivery: 2:00 PM, 25th, Jan, 2006, in Karachi
Seller: M/S Jawwad and Co.
Buyer: BI
As per contract, M/S Jawwad will deliver the wheat to the Bank on 25th, Jan, 2006.
Fortunately, BankIslami found a customer, M/S Alwani & Co. Ltd. who is ready to buy
wheat from the Bank. BankIslami entered with M/S Alwani in a Salam contract in which it
undertook to provide them 100 M. ton wheat on a specific date. Immediately after signing
the agreement, M/S Alwani paid to the Bank full price for wheat it would take in future.
The details of the new contract are:
Transaction: Salam B
Transaction date: 2nd, Jan, 2006
Commodity: Wheat (Code of wheat: W-12 pak),
Quantity: 100 M. Ton
Price: $10,500 (Paid on 2nd, Jan, 2006 by the buyer)
Delivery: 2:30 PM, 25th, Jan, 2006, in Karachi
Seller: BI
Buyer: M/S Alwani & Co. Ltd.
Now, just analyze both situations. In the first, BankIslami is a buyer at price of $100 per
M. Ton. In the second transaction, it is a seller at price of $105 Per M. Ton. The period of
Salam in the second parallel contract is less and the price is higher than the first contract.
The difference between the two prices $500 is the the profit earned by BankIslami.
By arranging a parallel Salam, Bank successfully off loaded the commodity.
MAIN FEATURES OF PARALLEL SALAM
In an arrangement of parallel Salam, there must be two different and independent

contracts, one where the Bank is a buyer and the other in which it is a seller. The two
contracts cannot be tied up and performance of one should not be contingent on the
other.
This can be better understood through the following example.
Chapter 5 Salam 56
If 'A' has purchased from 'B' 1000 bags of wheat by way of Salam to be delivered on
1:00 PM, 31 December, 'A' can contract a parallel Salam with 'C' to deliver to him 1000
bags of wheat at 1:30 PM, 31 December. While contracting parallel Salam with 'C', the
delivery of wheat to 'C' cannot be conditioned with taking delivery from 'B'. Therefore,
even if 'B' did not deliver wheat on 31 December, 'A' is duty bound to deliver 1000 bags
of wheat to 'C'. He can seek whatever recourse he has against 'B', but he cannot rid
himself from his liability to deliver wheat to 'C'. Similarly, if 'B' has delivered defective
goods, which do not conform to the agreed specification, 'A' is still obligated to deliver
the goods to 'C' according to the specifications agreed with him.
Chapter 5 Salam 57
Session 2: How to use Salam

Session Checklist
A. Process flow of Salam
B. Risks in Salam and how they can be mitigated
C. What are the common mistakes in executing Salam
A. PROCESS FLOW OF SALAM
1) Customer 'A' approaches BankIslami with a request for Salam financing.
2) Full specifications of the commodity are finalised, sale price is fixed and the date of
delivery is agreed upon.
3) Collateral against Salam finance is agreed between the two parties and the
customer furnishes the collateral to BankIslami.
4) Salam agreement is signed between BankIslami and customer 'A' incorporating all
the details given in 2 and 3 above.
5) BankIslami pays the full sale price to customer 'A'.
6) BankIslami finalises a parallel Salam with customer 'B'. The commodity details and
the date of delivery remain the same as in the earlier Salam contract. The period of
the contract is normally shorter and the sale price is higher.
7) A separate Salam contract is signed with BankIslami as seller and customer 'B' as
buyer.
8) On due date, customer 'A' delivers the commodity to BankIslami.
9) On the same day, BankIslami delivers the same commodity to Customer 'B'.
10)If customer 'A' fails to deliver on due date or delivers commodity which is either
defective or not according to agreed specifications, BankIslami must purchase it
from the market and honour its commitment to customer 'B'.
B. RISK IN SALAM TRANSACTION
Being a Bank we should know the risk inherent in Salam transaction. They are as
follows:
1) The customer 'A' may fail to make delivery of the commodity due to natural disasters
like excessive rains, floods, storms, earth quakes, fire etc.
2) The customer may note that spot market prices is very high and instead of delivering
to the Bank, he may sell it in the market. Thereby defaulting from his commitments.
Chapter 5 Salam 58
3) In the above circumstances, when the Bank goes to the market to purchase the
commodity for delivery to customer 'B', two things can happen.
a) The price in the market may be high thus the profit margin of the Bank is reduced
or the Bank may actually suffer a loss.
b) The commodity may not be available in the market at that time.
To mitigate these risks, the Bank may take the following steps:
1) Take special care in the matter of collateral. All securities must be perfect and
should be readily encashable as far as possible. Funds should be paid to the
customer only after the collateral documents have been executed and are in Bank's
possession.
2) The commodity must be generally available in markets at the date of delivery. If the
commodity is not easily available at the time of delivery, Salam would not be allowed
as per Shariah.
3) Preferably, care should be taken that subject matter of the Salam contract is a
commodity which remains in the market right from the day of contract up to the date
of delivery. In other words the commodity is not seasonal.
C. COMMON MISTAKES IN EXECUTING SALAM
Financiers make some common mistakes while finalizing Salam contracts. These
mistakes are:
1) Since financiers have commodity in their hands and if for some reason a parallel
Salam cannot be done, they sell the commodity back to the seller at a higher price.
2) This is a buy-back and it is not permitted in Shariah.
Chapter 5 Salam 59
Chapter 6
Istisna
60
Chapter 6 Istisna
Session Checklist
A. What is Istisna'?
B. Main features of Istisna?
C. How does Istisna differ from Salam?
A. WHAT IS ISTISNA?
Istisna is simply a sale transaction where a commodity is transacted before it comes into
existence. Istisna is the second exception where a sale is allowed without existence of
the goods sold. The first one being Salam.
Istisna is an order to a manufacturer to produce a specific commodity for the purchaser.

It is necessary that the manufacturer uses his own material to manufacture the required
goods. If the manufacturer provide his services to produce the item and the material is
from ordering party then this transaction will not be an Istisna' transaction.
Istisna can be use for made-to-order commodities where a customer orders a specific
good with some specifications to be manufactured in a particular period of time and
delivered to him after completion.
Let us now review the main features and basic rules of Istisna.
B. MAIN FEATURES OF ISTISNA
1) Istisna is a particular type of sale hence it cannot be used generally. It relates ONLY
to goods that require manufacturing.
2) Istisna transaction has two stages in its execution:
a) The understanding or contract between buyer and seller for manufacturing a

particular good with all the specifications, determination of price and
manufacturing period.
b) Starting of work by seller (manufacturer) through purchasing of required goods

and material for manufacturing.
Istisna contract is not considered started by just establishing a contract. Instead, it starts
when the manufacturer buys raw material for making goods. Thus the contract can be
canceled unilaterally by the purchaser before the manufacturer starts the work. After he
starts the work, the contract cannot be canceled unilaterally.
Chapter 6 Istisna 61
On the other hand, if Istisna contract is established with a manufacturer who

already has the required material, the transaction is effected immediately after
manufacturer undertakes to manufacture goods and therefore, cannot be
canceled unilaterally.
3) It is necessary for the Istisna transaction that the price is fixed and necessary
specifications of the product are defined.
Following should be noted about price:
a) It is not necessary for buyer in Istisna to pay price in full or in advance.
b) Price can be paid according to any schedule mutually agreed upon by both
parties.
c) Similarly, the payment may also be made in installments.
4) To make the ordered goods, the manufacturer has the option to either use his own
material or procure them from the market.
5) All specifications should be mutually agreed upon between parties at the time of
contract. The buyer has a right to reject the goods after inspection if the goods do
not conform to the specifications agreed upon.
Time of delivery
Fixing of delivery time is not necessary in Istisna. If desired, the purchaser may fix a
maximum time for delivery after which the contract will become invalid.
In order to ensure that the goods are delivered within the specified period, some modern
agreements contain a penal clause to the effect that in case the manufacturer delays the
delivery after the appointed time, he shall be liable to a penalty.
Now the question arises, can such a penal clause be inserted in a contract of Istisna
according to Shariah? Although the classical jurists are silent about this question when
they discuss the contract of Istisna, yet they have allowed a similar condition in the case
of Ijarah of services. It is said that if a person hires the services of person to tailor his
clothes, the fee may be variable according to the time of delivery. The hirer may say that
he will pay Rs. 100 in case the tailor prepares the clothes within one day and Rs. 80 in
case he prepares them after two days.
On the same analogy, the price in Istisna may be tied up with the time of delivery and it
will be permissible if it is agreed between the parties that in case of delay in delivery,
the price shall be reduced by a specified amount per day.
C. COMPARISON OF ISTISNA WITH SALAM
Salam Istisna
1) Subject of Salam may be anything 1) The subject of Istisna is always
which fulfills the Salam conditions. something which requires
manufacturing.
2) Price should be fixed and paid in full 2) Price may be paid under any agreed
in advance. schedule. It can be tied up with the
time of delivery and if the
manufacturer misses the deadline the
price may decrease but this must be
decided beforehand and included in
Istisna contract.
3) Determining the time of delivery is an 3) Fixing the time of delivery is not

essential part of Salam. necessary in Istisna. However the
buyer may fix a maximum date of
delivery.
4) Salam contract, once effected, cannot 4) Contract may be canceled unilaterally

be canceled unilaterally. before the manufacturer starts work
i.e, before the raw materials are
purchased or work is performed on
materials in inventory. Once it is
done, it is assumed that the work has
started.
Session 2: Parallel Istisna

Session Checklist
A. What is Parallel Istisna?
B. What is the process flow in Istisna?
C. What is the scope of Istisna?
A. PARALLEL ISTISNA
Like Parallel Salam, there is a concept of 'Parallel Istisna'. The financier of an Istisna is a
person who orders a specific thing to be manufactured for him so that he can deliver it to
his customer. The contractor may not have the expertise of manufacturing or
construction. To get the job done, he can sub-contracts the job to a third party. This is a
simple example of a Parallel Istisna.
This will be clear from the following example:
Saad owns a land and seeks financing for construction of a house. Adil Associates
(financier) undertakes to construct the house on the basis of Istisna. In case Saad does
not own the land and wants to purchase that too, Adil Associates (financier) will provide
him with a constructed house adding the specified price of land in overall cost as well.
It is not necessary that Adil Associates constructs the house themselves. They can enter
into a parallel Istisna with a third party (other than the client) and order the third party to
construct the house.
In this case Adil Associates calculates their cost and fixes the price of Istisna with Saad
after adding a reasonable profit for them. When an agreement on price is reached, the
payment of installments by Saad may start right from the day when the contract of
Istisna is signed by the parties. In order to secure the payment of installments, the title
deeds of the house or land or any other property of the client may be kept by Adil
Associates as security until the last installment is paid by Saad. Adil Associates are
responsible to strictly conform to the specifications in the agreement for the construction
of the house. The cost of correcting any discrepancy would have to be borne by them.
B. PROCESS FLOW OF ISTISNA
1) A Customer named 'Ayub' approaches BankIslami with his request to finance for
manufacturing of some items.
2) BankIslami obtains full description of the work to be done with exact specifications.
3) BankIslami consults a contractor 'Bashir' and obtains cost estimates of the project.
4) BankIslami adds its profit and quotes an Istisna price to Ayub.
5) Upon agreement of the terms, including mode of payment and delivery date an
Istisna contract is signed with Ayub.
6) At the same time, a Parallel Istisna contract is separately signed with the contractor
'Bashir' containing all the terms agreed upon.
7) On the due date, contractor 'Bashir' delivers the manufactured goods to BankIslami,
which in turn hands them over to customer Ayub.
8) The difference in amount received from Ayub and the amount paid to the Bashir is
BankIslami's profit.
C. SCOPE OF ISTISNA
Istisna mode can be used in various situations such as:
1) Real Estate Finance e.g. construction of residential and commercial buildings.
2) Government projects e.g. dams, airports, seaports, dockyards etc.
3) Financing of plant / building / machinery in factories.
4) Hotels, Hospitals etc.
5) The modern BOT (build, operate and transfer) arrangements may be structured
through Istisna.
66
Chapter 7:
Ijarah (Leasing)
67
Chapter 7 Ijarah (Leasing)
Session 1:
Session Checklist
A. What is Ijarah?
B. Important features and basic rules of Ijarah.
C. Distinguishing factors of Ijarah.
A. WHAT IS IJARAH?
The literal meaning of Ijarah is "to give something on rent". In Islamic jurisprudence this
term is used in two different situations. Firstly, it means to employ the services of a
person on wages given in exchange of his hired services. This kind of Ijarah is not
discussed here.
The second type of Ijarah which is being used in Islamic Banking means to transfer the
rights of use of a particular property to another person in exchange for a rent claimed
from him. In this while, the ownership of the item remains with the Bank (lessor), only
the right of use is transferred to the person renting it (lessee). It is just like you take a
house on rent and you pay a rent to the owner of the house for use of his house, the
ownership remains with him.
B. IMPORTANT FEATURES AND BASIC RULES OF IJARAH
There are some basic rules for Ijarah. Let's take an example of Latif as a Lessor and
Usman as a Lessee to elaborate the concept of Ijarah.
1) Leasing is a contract in which the owner of an asset (Lessor) transfers the rights of its
use to another person (lessee) for an agreed period, at an agreed consideration and
the ownership of the leased asset remains with the Lessor. So if Latif, the owner of
an asset (lessor), gave Usman (lessee) that asset against a particular amount (rent)
to be paid by Usman for an agreed period of time, this activity would be considered
as Ijarah.
In this case Latif (lessor) transfers the right of use of his asset to Usman (lessee) for
an agreed period, but the ownership remains with him.
2) The leased asset must have a valuable use permissible in Shariah. Items which have
no value in Shariah can not be used e.g. gambling machines.
3) Since Ijarah is transfer of rights of use, therefore anything which is consumed cannot
be leased e.g. money, eatables, fuel, ammunition, etc., because their use is not
possible unless they are consumed.
Chapter 7 Ijarah (Leasing) 68

4) As the ownership is not transferred, all the liabilities animating from the ownership i.e.
insurance, transportation, duties etc., shall be borne by Latif (lessor) but the liabilities
relating to use of the property shall be borne by Usman (lessee).
5) The leased asset shall remain in the risk of the Latif (lessor) through-out the lease
period. Any damage or loss caused by factors which are beyond the control of the
Usman (lessee) shall be borne by Latif (lessor).
6) Usman cannot use the leased asset for any purpose other than the purpose specified
in the lease agreement.
7) Usman is liable to compensate Latif (lessor) for any damage to the leased asset
caused by any misuse or negligence on his part .
8) The period of lease must be determined in clear terms and the leased asset must be
fully identified and quantified by both; Latif (lessor) and Usman (lessee).
9) Rental must be determined at the time of contract for the whole period of lease.
Variable amounts of rent can be fixed for different periods, but these must be known.
For example, if a house is taken on lease, different amount of rent can be taken for
each year.
10)Latif (lessor) cannot increase the rent unilaterally.
11)The lease period shall commence from the date on which the leased asset has been
delivered to Usman (lessee) whether Usman has started using it or not.
12)If the leased asset has lost the function for which it was leased and no repair is
possible, lease shall terminate on the day on which such loss occurred. However, if
the loss of function is caused due to misuse or negligence of Usman, he will be liable
to compensate Latif (lessor) at a value that was prevailing in the market immediately
before the loss.
13)Usman (lessee) will bear the maintenance and operating costs of the asset during the
lease period.
14)Latif (lessor) will bear the cost of insurance of the asset and its annual renewals
during the lease period. In case of increase in premium by the insurance company
during the currency of the lease, Latif (lessor) will not be entitled to make a
corresponding increase in the rental amount unless otherwise agreed beforehand
with Usman.
15)All ownership related expenses at the time of purchase of vehicle shall be borne by
Latif (lessor).
16)Rent will start after delivery of the goods to Usman. Rent or any part of it may be
paid in advance i.e before the delivery of the asset to Usman. The amount so
collected by Latif (lessor) shall remain with him as 'on account' payment and shall be
adjusted towards the rent after its becoming due.

17)After completion of the tenor of lease i. e. expiry of the lease period the ownership of
asset will revert back to Latif (lessor). At that time Latif (lessor) will have the liberty to
go for any of these four options:
Take the asset back from Usman;

Renew the lease contract for another tenor;
Lease it out to another party;
Sell it to Usman or to any other person.
If you take example of a Bank as a lessor and customer as a lessee, the Bank has
the right to choose whatever option it wishes and the customer (lessee) has no right
to force the Bank (lessor) to sell it to him, nor can such a condition be imposed on the
Bank (lessor) in the lease agreement. However, on expiry of the lease, if the Bank
(lessor) wants to sell and the customer (lessee) desires to purchase, the asset may
be sold on mutually agreed terms and conditions. Please not that the desire of the
Bank to sell the asset to the customer cannot be part of the main Ijarah Agreement. It
has to be contracted separately.
For this purpose, the Bank (lessor) will give a side-letter to the customer (lessee)
promising the customer that he would have first option to purchase the leased asset.
This type of Ijarah in which there is a separate promise from the Bank (lessor) to the
customer (lessee) to give him first right to purchase the asset, is called 'Ijarah-Wa-
Iqtina'. Since Shariah does not permit two contracts in one agreement, this
arrangement does not form part of the main Lease Agreement;
18)If the customer (Lessee) breaches any condition of the Lease agreement, the Bank
(Lessor) may unilaterally terminate the agreement. However, if there is no
contravention, the agreement can only be terminated by mutual consent.
It would be interesting to know that rules governing Ijarah are similar to the rules
governing sale because in both cases something is transferred from one person to
another.
The only difference is:
In case of sale, title of property is transferred to Buyer. In case of Ijarah, title remains
with the Lessor only the use of the property is transferred to the Lessee.
Can you claim a Rebate on early rental repayments in Ijarah?
If Usman (lessee) opts to repay Ijarah rentals before due maturity date can he claim a
rebate on early payments? The answer is that he cannot claim any rebate or
concession on early payment as the rents and their frequency is governed by a
contract. However, Latif (lessor) may consider a concession at its own discretion. The
policies laid down by the Shariah Board would govern such practices in BankIslami.
Rollover of Ijarah
Now, If Usman faces severe financial constraints and gets in a position where he
cannot make rental payments within due date, Ijarah payment cannot be rolled over for
an extended period. If Usman's case holds merit, some additional time can be given to
him. This is done at the sole discretion of Latif (lessor).
In case Usman is unable to pay within this additional time too, then the leased asset can
be repossessed by Latif (lessor) and leased to another person.

C. DISTINGUISHING FACTORS OF IJARAH
While studying Ijarah you must be thinking about the difference between conventional
lease and Ijarah. In Pakistan, leasing is being done on a large scale by commercial
banks, leasing companies, investment companies and private enterprises mainly on the
basis of conventional leases. These conventional leases are of two types:
Sale & Leaseback - In this type of lease, Usman (lessee) purchases a car and later
decides to get it leased. He takes it to a leasing company which buys his car and
pays the money to Usman then lease the same car back to Usman. This method is
not recommended in Islamic Banking as it allows the lessee to get into camouflaged
ways to receive cash under the umbrella of Ijarah. For your information, most of
leasing in Pakistan is done as 'sale and lease back'. At BankIslami, the Shariah
Board only allows sale and lease back transaction where the monies so received are
to be used in retiring conventional funding.
Diret Lease - In this type of lease, the leasing company/Bank (lessor) purchases the
car (asset) from the supplier and becomes its owner and then it leases it to the
lessee. This type of lease is allowed in Shariah.
The main differences between conventional leasing and Islamic leasing (Ijarah) are
outlined in the next section.

Session 2:
Session Checklist
A. What is the difference between Conventional Lease and Ijarah?
B. Different types of Leases
A. DIFFERENCES BETWEEN CONVENTIONAL AND ISLAMIC LEASE
Conventional Finance Lease Ijarah
Commencement
In most cases of the 'financial lease' the Mostly the financial institution buys the
lessor i.e. the financial institution purchases asset for the lessee. Similarly, the correct
the asset through the lessee himself. The way, according to Shariah, is that the rent
lessee purchases the asset on behalf of the is charged after the lessee has taken
lessor who pays its price to the supplier. In delivery of the asset not from the day the
some lease agreements, the lease price has been paid. If the supplier has
commences the very day on which the delayed the delivery after receiving the
price is paid by the lessor, irrespective of price, the lessee should not be liable for the
whether the lessee has effected payment to rent of the period of delay.
the supplier and taken delivery of the asset
or not. In other words, the lessee's liability
for the rent starts before the lessee takes
delivery of the asset.
Expenses consequential to ownership
In most traditional financial leases, all the As the lessor is the owner of the asset and
expenses incurred in the process of he has purchased it from the supplier
purchase of the asset. For example, directly or through agent, he is liable to pay
registration charges, import expenses like all the expenses incurred in the process of
freight and customs duty etc. are paid by its purchase and its import to the country of
the lessee. the lessor. He can of course include all
these expenses in his cost and can take
them into consideration while fixing the
rentals.
Liability of parties in case of loss to asset
The agreements of the traditional 'financial The lessee is responsible for any loss
lease' generally do not differentiate caused to the asset by his misuse or
between the wear and tear or losses negligence. He can also be made liable for
caused by misuse or negligence of the the wear and tear, which normally occur
lessee and situations that are out of control during its use. However, he cannot be
of the lessee. The lessee is liable for costs made liable for a loss caused by factors
incurred due to events that are out of his beyond his control. In a lease based on the
control e.g. theft of the asset or damage in Islamic principles, both the situations are to
event of a natural disaster. be dealt with separately.

Conventional Finance Lease Ijarah

Penalty on late payment of rent
In most contemporary financial leases, an The lessee may be asked to undertake that
extra monetary amount is charged if rent if he fails to pay rent on due date, he will
payment is not paid on time. This extra pay certain amount to a charity. For this
amount is taken into income of the lessor. purpose the financier/lessor may maintain
a Charity Fund where such amounts are be
credited and disbursed for charitable
purposes, including advancing interest-free
loans to the needy and poor. The amount
payable for charitable purposes by the
lessee may vary according to the period of
default and may be calculated as a percent
or on lump sum basis. Under no
circumstances it can form part of the
lessor's income.
Termination of lease
In some agreements of the 'finance lease' it If the lessee breaches any term of the
has been noticed that the lessor is given an agreement, the lessor has a right to
unrestricted right to terminate the lease terminate the lease contract unilaterally.
unilaterally whenever he wishes to at to his However, if there is no breach on the part
sole discretion. of the lessee, the lease cannot be
terminated without mutual consent.
Insurance of the assets
The insurance expense of the asset is If the leased property is insured, it should
borne by the lessee. be at the expense of the lessor and not at
the expense of the lessee. Lessor can
however recover the insurance expenses in
the rentals.
Title of ownership at the end of lease period
It is understood between the parties that the The position in Shariah is that the asset
title of the asset will be passed on to the shall be the sole property of the lessor and
lessee at the end of the lease term. In other at the expiry of the lease period, the lessor
words, transfer of the asset at the end is shall be at liberty to do whatever he wishes
made a condition of the transaction. to. The lessee cannot force him to sell it to
him nor such a condition can be imposed
on the lessor in the lease agreement.
The agreement of Ijarah itself should not

contain a condition of gift or sale at the end
of the lease period. However, the lessor
may enter into a unilateral promise
completely separate from Lease
Agreement to sell the leased asset to the
lessee at the end of the lease period. This
promise will be binding on the lessor only.

B. TYPES OF LEASING
1. Operating Lease
Lease is basically meant for giving the right by a person to other to use an asset
against a compensation with the ownership not transferred.
This kind of leasing is called 'Operating Lease' where lessee wants to use the asset
only.
In other words, operating lease is a contract through which a person takes the right
to use some specific asset in return for some kind of consideration.
Islamic Leasing i.e. Ijarah is very close to operating lease. One has to make sure
that the essential elements of Ijarah are incorporated in the agreement to keep an
operating lease shariah compliant.
2. Finance Lease
This is also called capital lease. In simple words, the essence of transaction in
financial lease is funding not use of asset. In such transactions, the obligations of
the lessee are almost that of the borrower not an asset user.
In most cases the lessee takes over the ownership risks as well as the financial
risks of the transaction. Additionally, purchase of asset is made a part of the
contract. Failure to do so is categorized as a default event. This kind of finance
lease is not allowed in Shariah.
3. Sale & Lease Back
Sale and Lease Back is a form of Ijarah. Under this format, the Bank purchases an
asset from the customer and leases the same back to the same customer.
Frequently, this is being requested by the customer to ease their cash flow
problems e.g. payment of salaries, utilities, servicing banks' debts etc. It is mostly
considered a hide-way for interest based transactions and this is the reason that
majority of Shariah scholars frown on this practice. Sale and lease-back could be
allowed in very rare cases and with the approval of Shariah Board as has been
explained earlier.

Session 3:
Session Checklist
A. What is the process flow of Ijarah?
B. How profit is calculated in Ijarah?
C. What are the risks in Ijarah?
A. PROCESS FLOW OF IJARAH
1. Usman (the customer) approaches the Bank with the request for financing and
enters into a promise to lease agreement.
Request to purchase
Islamic Bank Customer
Promise to lease agreement
2. Bank purchases the item, receives title of ownership and makes payment to the
vendor.
Sale
Vendor Islamic Bank
Title of ownership
Payment
3. The Bank leases the asset to Usman and receives rentals. After full payment the
Bank sells the asset to Usman separately.
Lease agreement
Islamic Bank Customer
Delivery of asset
Payment of rentals
Transfer of title
B. PROFIT CALCULATION IN IJARAH
It is reminded once again that in Ijarah, all costs relating to purchase are borne by the
Bank. These include the base price of the asset, custom clearance and duties (in case
of imported asset), transportation, insurance, registration etc.

In the long term lease agreements it is mostly not in the benefit of the Bank to fixed
rent for the whole period of lease because the market conditions may change. For this
purpose, it is allowed to use discount rate or any other benchmark i.e. KIBOR to
determine the rental amounts. However, rental for the period should be fixed at the
start of the period. Any change in the benchmark rate during the period will not affect
the current rent. It can be used to calculate rent of the next month.
The constant rate is called as fixed rate. The variable rates are known as floating
rates since they can change from time to time.
While using floating rate as a benchmark, it is customary to define a cap and floor rate
meaning the highest or lowest amount below or above which the profit will not be
charged. This is to protect the interest of both parties in case there is a sharp fall or
increase in the rates.
Rental Calculation [for information only]
Rent can be calculated by using the following formula.
Rent = Asset Cost Paid by the Bank X r

[1 (1/ (1 + r) n]
Where,
n = No. of periods
r = Profit Rate / No. of periods
C. RISKS IN IJARAH
As we have discussed, the Bank must own the asset before it is leased to the
customer. Being the owner, all risks and rewards of the asset lies with the Bank.
Therefore, if the asset suffers any loss which cannot be regarded as the customer's
mistake/negligence, the Bank would be responsible for the repair or replacement of
the asset. The Bank cannot in any case claim any damages from the customer unless
the loss resulted from the customers negligent use. For this reason, at the time of
preparation of credit proposal for Ijarah facility, in addition to the credit risk, the
Relationship Manager should also analyze the asset risk.
Secondly, the leased asset will continue to remain in the Bank's ownership throughout
the lease period. Other problems which may arise are:
(i) A complicated and long drawn recovery process.
(ii) Failure of the lessee to reimburse any expenses paid by the Bank on his behalf.
To mitigate these risks, the Bank may at its discretion ask the lessee to furnish any of
the following securities:
Down payment as a portion of total asset cost

Lien on deposits
Bank guarantee
Personal guarantee(s)
In addition to above, the Bank may obtain any other security which is permissible in
Shariah.

77
Chapter 8:
Mudarabah
78
Chapter 8 Mudarabah
Session Checklist
A. What is Mudarabah?
B. What are the types of Mudarabah?
C. What are the rules of Mudarabah?
D. What are some issues in Mudarabah?
In this chapter we will be taking a look at Mudarabah which is one of the two modes of
financing considered ideal by Islamic scholars. The other being Musharakah.
A. WHAT IS MUDARABAH?
Mudarabah is a kind of partnership where one partner gives money to another for
investing in a commercial enterprise.
The investment comes from the first partner who is called "Rabb-ul-maal" while the
management of the business is an exclusive responsibility of the other, who is called
Mudarib'. The profits generated are shared in a mutually agreed in a predetermined
ratio.
As per rules described for Mudarabah, role of Rabb-ul-maal in Mudarabah, is to provide

'investment', while Mudarib performs the 'management' of the venture. Therefore,
Rabb-ul-Maal must hand over the management of the investment to Mudarib leaving
all decision making him without interference in the management.
As a financing technique adopted by Islamic banks, it is a contract in which the capital is

provided by the Bank while the business is managed by the other party (customer). The
profit is shared in pre-agreed ratios and loss is borne by the Islamic bank if any, unless
caused by negligence or violation of terms of the contract by the Mudarib The Bank
passes on this loss either to the depositors or charges it off against own revenues as
the case may be.
1. Mudarabah Capital
The capital in Mudarabah may be either in form of cash or in kind. In case the
capital is in kind, it has to be properly valued so that the valuation is known in clear
terms to the Rabb-ul-mall and Mudarib. The necessary element is that if the capital
is in form of assets then it should be clearly valued and its real value is known to
both Rabb-ul-Mall (Owner) and Mudarib (Manager).
Chapter 8 Mudarabah 79
B. TYPES OF MUDARABAH
Mudarabahs are mainly of two types, namely:
1. Restricted Mudarabah: (Mudarabah-al-Muqayyadah)
In this type of Mudarbah, the Rabb-ul-maal specificies a particular business or a

particular place for the Mudarib, which means that investment will be made only in the
specified business or business shall be eamed out at the agreed place. For example,
a Rabb-ul Maal may restrict Madarib to do auto-mobile business only. This kind of
Mudarabah is called restricted Mudarabah.
2. Unrestricted Mudarabah (Mudarabah-al-Mutlaqah)
In this type of Mudarabah, the Rabb-ul-maal gives full freedom to Mudarib to undertake
whatever business he finds suitable. This is called unrestricted Mudarabah. In an
Unrestricted Mudarabah, the Mudarib is authorized to carryout a vast range of activities.
Based on the same concept Islamic Banks can have restricted or unrestricted
investment accounts.
In Restricted investment accounts, the investment holder (or Rabb-ul-Maal) imposes

certain restrictions like where, how and for what purposes his funds are to be
invested. He is the sole decision maker for his investments
In Unrestricted investment accounts, the investment holder (Rabb-ul-Maal) does not

prescribe such conditions. The Islamic Bank or the Mudarib makes decisions like
where, how and for what purpose the funds of the investment holder can be placed.
For your information all deposit accounts in BankIslami are under the concept of
Mudarabah and are of unrestricted nature.
C. BASIC RULES AND MAIN FEATURES OF MUDARABAH
1) Rabb-ul-maal has the authority to:
Oversee the Mudaribs activities.

Work with the Mudarib if he consents, otherwise he is not allowed to participate.
2) Mudarib does not have the authority to:
Keep another Mudarib or a partner.
Mix his own investment in that particular Mudarabah without the consent of
Rabb-ul-maal
3) Different Capacities of Mudarib:
Since Mudarib is the one who performs all business related activities and keeps capital
of Rabbul Maal in his custody, jurists are of the view that Mudarib acts in the following
capacities and hence he possesses relevant rights and obligations. They are:
Ameen (Trustee)
As the money given by Rabb-ul-maal and the assets acquired for business are
held by him in trust, he cannot use them at his sole discretion. Instead, he
should perform everything according to Rabbul-Maal guidelines.
Wakeel (Agent)
In purchasing goods for trade, he is an agent of Rabb-ul-maal, so whatever he

does is considered as an act of Rabbul Maal.
Shareek (Partner)
In case the enterprise earns a profit, he is a partner of Rabb-ul-maal in the

earned profit and shares the profit in agreed ratio.
Zamin (Liable)
If the business suffers a loss due to his negligence or misconduct, he is
responsible to compensate the loss to Rabb-ul-maal. In othere words, the loss
is his liability.
Ajeer (Employee)
If the Mudarabah becomes void due to any reason the Mudarib has the right to
get a fee for his services.
D. SOME ISSUES IN MUDARABAH

1. Termination of Mudarabah
At the beginning of each Mudarbah, a contract period should be specified in

the contract between Rabbul Maal and Mudarib. The Mudarabah will stand
terminated when the period specified in the contract expires.
One form of termination could be that either of the two parties gives notice and
terminate the Mudarba at the end of notice period. In case Rabb-ul-maal has
terminated services of Mudarib, he will continue to act as Mudarib until he is
informed of the same. Until then, all his acts will form part of Mudarabah.
If all assets of the Mudarabah are in cash form at the time of termination, and
some profit is earned on the principal amount, it shall be distributed between
the parties according to the agreed ratio.
If the assets of Mudarabah are not in cash form, they will be sold and liquidated
so that the actual profit may be determined.
All payables and receivables of Mudarabah will be paid/recovered on

termination.
The agreed profit paid to Mudarib and Rabb-ul-Mal will also be taken into
account and when the total capital is withdrawn. The principal amount invested
by Rab-ul-Mall will be given to him first, remaining balance will be called profit
which will be distributed between Mudarib and Rabb-ul-maal according to the
agreed ratio. If no balance is left on withdrawl of capital Mudarib will not get
anything.
If the principal amount invested by the Rabbul Maal is not recovered fully, then
the interim profit paid to Mudarib and Rabb-ul-maal during the term of
Mudarabah will be taken into account in the payment of the principal amount to
Rabb-ul-Maal.
Session 2: Uses of Mudarabah

Session Checklist
A. Deposits How does the Bank work as a Mudarib?
B. Investments How does the Bank work as a Rabb-ul-maal?
C. Profit and Loss Distribution in Mudaraba
MUDARABAH IN THE MODERN CONTEXT
It has been discussed earlier that Mudarabah is a business venture which is considered one of
the most preferred Islamic financing mode.
The Islamic Banks and Financial Institutions utilize Mudarabah' in two ways. In one way they
act as Mudarib and in other way they function as Rabbul Mal.
Depositors in an Islamic Bank authorize the Bank to utilize their deposits on the basis of profit
and loss sharing. Such depositors may be termed as Rabb al-Mal and the Bank, as their agent
i.e. Mudarib.
On the other extreme, the Bank may invest in a business which is managed by someone else.
In this case it assumes the role of Rabb-ul-maal.
A. DEPOSITS HOW DOES THE BANK WORK AS A MUDARIB

Profit earned by the Bank is shared between the Bank (as Mudarib) and the
investment account holder (as Rabb-ul-maal) in a pre-agreed ratio.
The Bank does not bear any loss as Mudarib but remains responsible for any loss
due to the negligence. Otherwise all losses are on account of Rabb-ul-maal.
The Bank recovers from the depositors a management fee for managing their
monies. This is called Mudarib fee.
The Bank is bound to return the capital to the investors after adding profits or
deducting any losses or Mudarib share in profit at the time of winding up the
contract or on demand as the case may be.
B. INVESTMENTS THE BANK AS RABB-UL-MAAL

If Bank wants to enter in a Mudarabah transaction for financing, the Bank in this situation
would be Rabb ul Maal and the customer would be Mudarib .
In this case, the Mudarib (customer) requests Rabbul Maal for funds to invest in a
business. Profit earned from this Mudaraba venture, in which Bank has its own
investment through funding, is shared between the Bank (as Rabb-ul-maal) and the
customer (as Mudarib) in a pre-agreed ratio.
The Bank will bear all the losses unless the Mudarib violates the terms of agreement.
The Mudarib is bound to return the capital to the Bank after deducting any losses or
Mudarib fees at the time of winding up the contract.
C. PROFIT AND LOSS DISTRIBUTION IN MUDARABA CAPITAL
1) Remember that a Mudarbah will only be valid if the parties agree in the beginning on
a profit sharing ratio between them. Shariah has prescribed no particular proportion;
rather it has been left on the mutual consent of the contracting parties. They can
share the profit in equal proportions and they can also allocate different proportions
for Rabb-ul-Mall and Mudarib. However in rare cases where the parties have not
agreed on a ratio of profit, it will be calculated on 50:50.
2) The Mudarib & Rabb-ul-Mall cannot allocate a lump sum amount of profit for any one
of them nor can they determine the share of any party at a specific rate tied up with
the capital. The sharing ratio must be linked with profit that would be earned in future.
For example, if the capital is Rs.100,000/, they cannot agree on a condition that
Rs.1,000 out of the profits shall be the share of the Mudarib nor can they say that
profit equivalent to 20% of the capital shall be given to Rabb-ul-Mall. It is possible that
the total profit for the venture would be less then Rs. 1,000 or less then 20% of the
capital. Such condition would put the transaction at par with Riba based transaction
3) It is however permissable to agree that say 40% of the profit will go to the Mudarib
and 60% to Rabb ul Maal. Reason being the fact that profit sharing ratio is pre-
determined and is in relation to profits in future.
4) It is allowed that different profit sharing ratios are agreed in different situations. For
example, the Rabb-ul-Mall can say to Mudarib If you trade in cotton, you will get 50%
of the profit and if you trade in yarn, you will have 33% of the profit. Similarly, he can
say If you do the business in your town, you will be entitled to 30% of the profit and if
you do it in another town, your share will be 50% of the profit.
5) Compensation for Mudarib and Rabul Maal is profit earned by venture. Neither
Mudarib nor Rabbul Maal can take any fixed amount from the venture. Apart from the
agreed proportion of the profit, as determined in the manner described above, the
Mudarib cannot claim any periodical salary or a fee or remuneration for the work
done by him for the Mudarabah.
6) If the business incures loss in one transaction and gains profit in others, the profit
shall be used to offset the loss at the first instance, then the remainder, if any, shall
be distributed between the parties according to the agreed ratio. All losses shall be
set off against the profits before profit distribution commences. In other words profits
and losses are viewed together and cannot be treated seperately.
7) The Mudarabah becomes void (Fasid) if the profit is fixed in any way. In this case, the
entire amount (Profit + Capital) will be of the Rabb-ul-Mall. The Mudarib would be just
an employee earning Ujrat-e-Misl (market based remuneration).
Session 3: Process Flow and Risks
Session Checklist
A. What is the process flow of Mudarabah?
B. What are the risks in Mudarabah for ?
C. Where Mudarabah can be used by Islamic Banks?
A. PROCESS FLOW OF MUDARABAH TRANSACTION
You will now go through the details of how a Mudarabah works. Please keep all the steps
in mind carefully.
1) Two parties discusses the possibility of entering into a Mudarabah transaction.
2) The following details are agreed mutually:

What capital is the Rabb-ul-maal is bringing in and in what shape is it cash or
in kind?
Will it be a restricted or unrestricted Mudarabah?
If restricted, what is the mandate for Mudarib? Meaning what is the Mudarib
restricted from doing?
What is the period of the Mudarabah?
How the profit will be shared, i.e. Profit sharing ratio?
Will the Rabb-ul-maal get any interim profit, and if so, how much?
Can Rabb-ul-Mal terminate the Mudarabah unilaterally? How many days' notice
will be given?
How many days of notice will be required for termination of Mudarbah if either
party decides to terminate?
3) Once all the details are worked out, Mudarabah Agreement is signed by both parties.
4) On the completion of Mudarabah period, full accounting will be done and profit
shared as per agreed ratio.
B. RISKS IN MUDARABAH
Following is a brief description of some of the risks in Mudarbah;
Investment Risk:
Banks (as Rabb-ul-maal) do not have a recourse in case of genuine business loss. It
is to be noted that proving negligence of the Mudarib is also very difficult,
cumbersome and long drawn process.
Operational Risk:
Banks (as Rabb-ul-maal) have a very low degree of control over the management of
funds as they are managed by the Mudarib. Different business activites may require
vastly varied and even conflicting procedures.
Credit Risk:
Risk of contractual defaults if the Bank as Rabb ul maal is in spread business.
Market Risk:
Risk of price fluctuations specially if the Bank (as Rabb-ul-maal) invests funds in
securities or commodities.
C. HOW MUDARABAH CAN BE USED IN ISLAMIC BANKS?

Mudarabah can be used in the following areas:
Asset Side Financing

1. Short/Medium/long-term financing
2. Project financing
3. Small & medium enterprises setup financing
4. Large enterprise financing
5. Import financing
6. Import bills drawn under import letters of credit
7. Inland bills drawn under inland letters of credit
8. Bridge financing
9. LC without margin
10.Export financing (Pre-shipment financing)
11.Working capital financing
12.Running accounts financing / short term advances
Liability Side Financing
1. Current / saving / investment accounts

2. Inter-bank lending / borrowing
3. Term Finance Certificates & Certificate of Investment
4. T-Bills and Federal Investment Bonds / Sukok
86
Chapter 9:
Musharakah
87
Chapter 9 Musharakah
Session Checklist
A. What is Musharakah?
B. Types of Shirkah
Let us share with you that in the opinion of a vast majority of Islamic scholars,
Musharakah is the most ideal mode of finance as it conforms to the true spirit of Islamic
financial injunctions.
A. WHAT IS MUSHARAKAH?
Musharakah literally means sharing. This word has been derived from Shirkah
which means being a partner.
In Musharakah, a joint enterprise is formed for conducting some business in which
all partners share the profit according to an agreed ratio while the loss is shared in
the ratio of capital. Note that while profits can be shared in any agreed ratio, losses
are only allowed to be shared in the ratio of capital.
It is the most preferred financing mode in Shariah.
There is a Hadith Qudsi (Words of Allah from mouth of Prophet) about Shirkah which
says:Allah (SWT) has declared that he will become a partner in a business
between two Mushariks until they indulge in cheating or breach of trust.
1. What is Shirkah?
Shirk or Shirkah in Arabic means partnership. Assigning partners to Allah is referred to as

Shirk. Shirkah is a partnership in Arabic. Musharakah, commonly used now, means the
act or contract of striking up a partnership. In classical Islamic law, partnerships are
referred to as Shirkah. However, the concept of Musharakah is slightly limited in relation
to the concept of Shirkah, which is used in a wider sense. All modes of Sharing or
partnership are termed as Shirkah in the terminology of Islamic Fiqh, while the term
Musharakah is not found in the books of Fiqh. It is more commonly used in commercial
context.
The term Musharakah has been introduced recently by those who have written on the
subject of Islamic modes of financing and it generally refers to two particular type of
Shirkah namely:
Shirkat-ul-Milk
Shirkat-ul-Aqd
B. TYPES OF SHIRKAH
1. Shirkat-ul-Milk
This kind of Shirkah may come into existence in two different ways:
Chapter 9 Musharakah 88
a. Optional Shirkat-ul-Milk
If two or more persons purchase any item, it will be owned jointly by both of
them and the relationship between them with regard to that property is called
Shirkat-ul-milk.
Note that this relationship has come into existence at the option of the partners and
through their conduct..
b. Compulsory Shirkat-ul-Milk
This comes into existence without any effort/action taken by the parties.
For example, after the death of a person all his heirs inherit the property, which comes
into their joint ownership as a natural consequence of the death of that person.
In a Bank, Shirkat-ul-Milk is usually used in Diminishing Musharakah for fixed assets.
2. Shirkat-ul-Aqd
Shirkat-ul-Aqd is simply a partnership which has come into existence through a

mutual contract for commercial purposes. It can also be referred to as a joint
commercial enterprise or activity.
Shirkat-ul-Aqd is divided into three types:
a. Shirkat-ul-Amwal
b. Shirkat-ul-Aamal
c. Shirkat-ul-Wujooh
a. Shirkat-ul-Amwal
A partnership in which all partners invest some capital into a commercial venture.
Three partners opening a grocery store is a good example.
b. Shirkat-ul-Aamal
A partnership in which the partners jointly decide to offer some services to their
customers.
In this case the fee charged from the customers is distributed among the partners
according to an agreed ratio.
c. Shirkat-ul-Wujooh
The word Wujooh comes from Wajahat meaning goodwill, hence this is a partnership
in goodwill.
Here the partners contribute in the business not through the capital but through their
goodwill and reputation and share profit according to an agreed ratio.
Each of these three Shirkah i.e. Amwal, Aamal and Wujooh are further divided into
two sub-types:
i) Shirkat-al-Mufawada
ii) Shirkat-ul-Ainan
i) Shirkat-al-Mufawadal
The partners share capital, management, profit, and risk in absolute equal
amount. Every partner is a trustee, guarantor and agent on behalf of other
partners.
This type of partnership is rare these day, some types of partnerships though are
of such nature exsist even today in Pakistan i.e. a Hindu un-divided family.
ii) Shirkat-ul-Ainan
The partners share capital, management, profit, and risk in an agreed proportion
which may not be equal.
This is the most common type of Shirkat.
The following table graphically illustrates the types of Shirkat.
Shirkat
Shirkat-ul-Aqd
Shirkat-ul-Milk
Amwal Aamal Wujooh

Optional Compulsory
Mufawada Al-Inan Mufawada Al-Inan Mufawada Al-Inan
Session 2: Rules, Security and Termination

Session Checklist
A. Characteristics and rules of Musharakah.
B. Rights & Obligations of partners in Musharakah
C. Security in Musharakah
D. How a Musharakah can be terminated?
E. The differences between interest-based financing and Musharakah?
A. CHARACTERISTICS AND BASIC RULES OF MUSHARAKAH
Now let us review the basic rules of Musharakah:
1) Each partner has a right to take part in Musharakah management.
2) If the partners wish they can appoint a managing partner by mutual consent.
3) One or more of the partners may decide not to work for the Musharakah and work as
a sleeping partner.
4) The ratio of profit distribution must be agreed before the period of contract begins. It
may not be as per ratio of capital.
5) The ratio must be determined as a proportion of the actual profit earned by the
enterprise. Profit sharing cannot be fixed:
A percentage of a partners investment. For example, if Ali's investment in

Musharakah is 60%, then his profit sharing could not be set in relation to his
investment, i.e. he cannot say he would get 40% of his investment.
In lump sum amount. For example, if Ali says that he must get Rs. 10,000 from
the overall profit each month. This is not allowed.
6) The partners may be paid a provisional profit at any rate, but it must be adjusted from
final profit distribution later.
7) The partners may agree on any ratio of profit distribution, but the ratio of profit of
sleeping partner must not exceed his ratio of capital. For example, if Ali's investment
as a sleeping partner is 40% he can not get more than 40% of the profits.
8) In case the business incurs a loss, all partners will share the loss in the ratio of their
capital.
9) Share capital in a Musharakah can be contributed either in cash or in kind. In case if
a partner is contributing in kind, then market value of the goods must be determined.
This market value in terms of money will be added in overall capital and it will
become share of the partner in the capital of the venture.
B. RIGHTS & OBLIGATIONS OF PARTNERS IN MUSHARAKAH
We will take you through the powers and rights each partner can exercise in
Musharakah. It is important for you to remember that after entering into a Musharakah
contract, each partner has unless otherwise agreed:
a) The right to sell the mutually owned property since all partners are representing
each other in Shirkah and all have the right to buy & sell for business purposes.
b) The right to buy raw material or other stock on cash or credit using funds belonging
to Shirkah to put into business.
c) The right to hire people to carry out business if needed.
d) The right to deposit money & goods of the business belonging to Shirkah as
depositor trust where and when necessary.
e) The right to use Shirkah's fund or goods in Mudarabah.
f) The right of giving Shirkah's funds as hiba (gift) or loan. If one partner has taken a
Qard for the Musharakah business, then paying it becomes liable on all.
C. SECURITY IN MUSHARAKAH
In case of a Musharakah agreement taking place between the Bank and the client, the
Bank has the right and discretion to obtain adequate security from the client to ensure
that the capital is invested as per agreed terms and conditions and that the profit earned
is paid without any delay. Note that the security can not be used to set off against any
losses that may result due to the inherent nature of business or in course of business
conducted on as per agreed terms and conditions including situations which are called
'Forced Mejure'.
D. HOW A MUSHARAKAH CAN BE TERMINATED?
1) Each of the partners has the right to terminate the Musharakah at any time after
giving prior notice to other partners unless otherwise agreed. In that situation the
assets of Musharakah will be distributed as under:
If the assets are in liquid form, these will be distributed in the ratio of capital.
If the assets are non-liquid, there can be two situations;
a) The assets are liquidated and the proceeds distributed.
b) The assets can be distributed in their existing form after valuation. If the
assets cannot be distributed in their existing form e.g. Machinery, these will
first be liquidated and the proceeds distributed.
2) In case any of the partners dies during the currency of the Musharakah, his heirs will
have the option to:
a) Either liquidate their share, or

b) Continue with the business
3) In case any one of the partners becomes insane or otherwise incapable of conducting
commercial transactions, the Musharakah will stand terminated.
4) If one partner wants to terminate the Musharakah but other partners want to continue,
it can be done by mutual agreement. You must remember the following while doing
so :
Termination of Musharakah with one partner does not mean termination with
other partners.
Value of outgoing partners share must be determined.
If assets are not liquid, their valuation must be done to pay out the shares of
outgoing partners.
E. DIFFERENCES BETWEEN INTEREST-BASED FINANCING AND MUSHARAKAH
We will now look at the differences between interest-based financing and Musharakah:
Interest based financing Musharakah

1) Return is pre-determined and has 1) Musharakah does not offer a fixed
nothing to do with the profitability of rate of return. The return is based on
the venture. the actual profit earned by the joint
venture.
2) The financier cannot suffer loss, 2) In Musharkah, the financier can suffer
unless the borrower defaults. loss if the joint venture fails to
produce fruits.
3) Results in concentration of wealth. 3) Results in distribution of wealth.
Session 3: Diminishing Musharakah
Session Checklist
A. What is Diminishing Musharakah?
B. Step-by-step procedure of Diminishing Musharakah
C. Where Musharakah can be used as a Mode of Financing?
D. What are the risks for banks in Musharakah Financing?
E. Comparison of Musharakah and Mudarabah
In this section, we introduce you to Diminshing Musharakah which is one of the most popular words.
A. DIMINISHING MUSHARAKAH UNDER SHIRKAT UL MILK
Diminishing Musharakah is usually done under Shirkat ul Milk.This type of Musharakah is

primarily used for Real Estate Financing. It involves the Bank taking share in the
ownership of a specific asset along with the customer and then gradually transferring
complete ownership to the customer.
There are three different components of Diminishing Musharakah:
I) Joint ownership of the Bank and the customer.
II) Customer as a Lessee uses the share of the Bank and pays rents.
III) Gradual redemption of the share of the Bank by the customer until he acquires full
ownership.
It is quite clear from the above mentioned components of the Diminishing Musharakah
transaction that this product comprises of three modes In the first step it is Musharakah,
in the second step it is Ijarah and in the third step it is a Sale. You must note that rules
pertaining to each one of the mode should be followed while undertaking the transaction.
In the first step i.e. Musharakah, the Bank takes ownership in the asset and thus all the
risks and rewards of the ownership stays with the Bank as well as during the currency of
the transaction. It is, therefore, suggested that a complete analysis of the ownership
related risks should be done before undertaking the project.
In the second step i.e. Leasing or Ijarah portion of the transaction, all the rules and
regulation of the Ijarah transaction are applied. Any mistake or irregularity in
understanding and implementation of Ijarah can make the transaction defective from
Shraiah point of view.
In the third and last step, Sale of Bank's share to the Customer takes place. This is done
according to Shirkat ul Milk as in this type of Shirakat it is allowed to sell a partner's share
to another partner or a third party at a pre-agreed price.
Please note that Diminishing Musharakah cannot be followed under Shirkat ul Aqd. In
Shirkat ul Aqd, a partner cannot sell his/her share to another at a pre-agreed price,
instead the portion should be sold at market price at the time of sale. Nevertheless, since
our current discussion is limited to Diminishing Musharakah under Shirkat ul Milk we will
restrict ourselves to this particular mode and will not go into other details of Shirkat ul
Aqd.
In the discussion to follow, we will take you through step-by-step procedure of

Diminishing Musharakah.
B. STEP-BY-STEP PROCEDURE OF DIMINISHING MUSHARAKAH
1) Ali, the Customer, approaches the Bank with the request for financing.
2) The Bank enters into a Shirkartul Milk (Joint Ownership) agreement with Ali and both
of them pay their respective shares to the seller of the asset.
Bank Property Client

Payment of agreed share
3) Ali pays rent for the use of Bank's share in the property (as in the case of Ijarah i.e.
second step).

Rental Payment
4) The Bank's share in the asset is divided into several units as per mutual agreement.
Ali purchases these units over a period of time. Thus the Bank's share gradually
decreases and at the same time the customer's share increases. This is done as
mentioned in third step which is based on Sale transaction.
Gradual sale of share in property
RentalPayment
5) Ownership of the asset is then transferred to Ali upon full payment of Bank's share.
Ownership transformed
C. WHERE MUSHARAKAH CAN BE USED AS A MODE OF FINANCING
Musharakah can be successfully used in the following areas:
Project financing
Working capital financing
Import Financing
Export Financing
Running finance
Saving account
Certificates of Investments
Term finance certificates
Treasury Bills
Inter bank lending/borrowing
D. RISKS FOR BANKS IN MUSHARAKAH
The main risk for Banks relate to in-adequate, in-proper or at times fradulent disclosure
on part of the customer to the Bank. Tempered books of accounts, and representations
which are without reasonable basis are some of the additional risk factors. However all of
these risk factors directly relate to in-ability of the Banks to understand the clients
business. As a Bank officer, it is important for you to understand the business of the
client before you even think about Musharika.
E. COMPARISON OF MUSHARAKAH AND MUDARABAH
Musharakah Mudarabah
1. All partners invest. 1. Only Rabb-ul-Maal invests.
2. All partners may participate in the 2. Rabb-ul-maal has no right to

management of the business and can participate in the management which
work for it. is carried out by the Mudarib only.
3. All partners share the loss to the 3. Only Rabb-ul-maal suffers loss if
extent of the ratio of their investment. Mudarib has worked with diligence.
The Mudarib does not invest
anything, Mudarib earns
remuneration for his efforts in case of
profit only.
4. The liability of the partners is normally 4. The liability of Rabb-ul-maal is limited
unlimited. to his investment unless he has
permitted the Mudarib to incur debts
on his behalf.
5. As soon as the partners mix their 5. The goods purchased by the Mudarib
capital in a joint pool, all assets are solely owned by Rabb-ul-maal
become jointly owned by all of them and the Mudarib can earn his share in
according to the proportion of their the profit only in case he starts the
respective investment. All partners business and generate revenue with
benefit from the appreciation in the profit.
value of the assets even if profit has
not accrued through sales.

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HOW TO USE THIS STUDY PACK:

Chapter # Name of Chapter Page #

1 Islamic Economic System

3 Chapter 3 Islamic Sales Contract

Session 2: How to use Salam

7 Chapter 7 Ijarah (Leasing)

Profit and Loss Distribution in Mudaraba 73

Chapter 1: Islamic Economic System

Session 1: What is Shariah?

The regulations of Shariah can be divided into two groups:

Regulations on worship and ritual duties

Throughout this document, we will be referring to Shariah regulations governing the

Chapter 1: Islamic Economic System 2

Chapter 1: Islamic Economic System 3

There are two sources of Shariah.

(a) Quran, The book of Allah

It is complete and comprehensive. The Almighty says: "Nothing have We

It is Allahs eternal miracle revealed to Prophet Muhammad (peace and

Chapter 1: Islamic Economic System 4

(b) Sunnah / Ahadith

It in fact signifies the importance of delegated legislation to the Muslim community.

(b) Qiyas - Analogy

Chapter 1: Islamic Economic System 5

Chapter 1: Islamic Economic System 6

Session 2: Essentials of Islamic Economics

A. What are the objectives of Islamic Economics?

B. How Islamic economics compares with Capitalism & Socialism?

C. Concept of Wealth in Islam

D. How the wealth is distributed in Islam?

A. WHAT ARE THE OBJECTIVES OF ISLAMIC ECONOMICS?

B. COMPARISON WITH CAPITALISM AND SOCIALISM

Chapter 1: Islamic Economic System 7

C. CONCEPT OF WEALTH IN ISLAM

Wealth in all its possible forms is created by Allah.

Therefore, primarily wealth is the property of Allah.

Allah may forbid use of wealth in a particular way.

D. DISTRIBUTION OF WEALTH IN ISLAM

Let us review the objectives of distribution of wealth in Islam.

1. Establishment of a practicable Economic System

Islam accepts the following within certain limits:

Laws of demand and supply

2. Enabling every one to get what is rightfully due to him

Chapter 1: Islamic Economic System 8

3. Eradicating the concentration of wealth

Prohibition of hoarding, interest, gambling, , Uqood Fasidh (Unlawful contracts) and

Encouragement of Sadaqah, Laws of Inheritance and Mehar etc.

Quran says in Surah Al Hashr:

Chapter 1: Islamic Economic System 9

Session 3: Economic Activities in Islam

A. The Importance of Risk and Profit Sharing.

B. Why is Trade permissible?

C. Why is investment in business permissible?

A. THE IMPORTANCE OF RISK AND PROFIT SHARING (essential element of

Chapter 1: Islamic Economic System 10

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Chapter 2 : Riba and its prohibition Arguments and rationale

B. What the Holy Book Qur'an says about Riba?

C. Prohibition of Riba in Hadith

B. WHAT THE HOLY BOOK QUR'AN SAYS ABOUT RIBA?

1. First Revelation about Riba in Qur'an

2. Second Revelation about Riba in Qur'an

3. Third Revelation about Riba in Qur'an