I ISLAMIC BANKING & FINANCE: PRINCIPLES AND PRACTICES I Contents I Introduction to Islamic Economics and Finance 1. INTRODUCTION 14 1.1 Quran 15 1.2 Sunnah 15 2. ISLAMIC ECONOMICS 17 2.1 Real Owner 17 2.2 Man and his Position 18 2.3 Wealth and Resources 18 2.4 Economic Trust and Relationship 19 2.5 Economic Activities 20 2.6 Trade and business 20 2.7 Role and Nature of Money 20 2.8 Debt in Islam 21 2.9 Zakat and Charity 22 2.10 Savings in Islam 22 2.11 Reward 24 3. ISLAMIC FINANCE 24 3.1 Shariah 25 3.2 Fiqh 25 3.3 Features of Islamic Finance 25 3.3.1 Prohibition of Riba 26 3.3.2 Prohibition of Gharar 27 3.3.3 Prohibition of Maysir 27 3.3.4 Unlawful Goods and Services 27 3.3.5 Justice and equity based 27 3.4 Sources of Law and Islamic Commercial Law 28 3.4.1 Primary sources 28 3.4.2 Secondary sources 28 3.5 Madhahib - Schools of Islamic Legal Thought 28 3.5.1 The Hanafi School of Law 28 3.5.2 The Maliki School of Law 29 3.5.3 The Shafi’i School of Law 29 3.5.4 The Hanbali School of Law 29 4. HISTORY AND DEVELOPMENT OF ISLAMIC FINANCE 29 4.1 During 650 AD - 750 AD 29 4.2 During 750 AD - 1900 AD 30 4.3 During 1900 AD - 2000 AD 30 4.3.1 Single versus Dual Banking Systems 32 4.4 2000 AD till date: 32 4.4.1 Islamic Banking in West 32 Islamic Finance Structures 1. INTRODUCTION 36 2. ISLAMIC CONTRACT 37 2.1 Prerequisites of Shariah contracts 37 3. TYPES OF CONTRACTS 39 3.1 BARTER TRADING (Bay al-Muqayada) 39 3.2 GENERAL SALE (Bay’ al-mutlaq) 40 3.3 EXCHANGE SALE (Bay’ al-Sarf) 40 3.4 MARKUP-SALE (Murabaha) 40 3.4.2 Important principles of a Murabaha 41 3.4.3 Structure of a Murabaha contract 42 3.4.4 Mechanism of a Murabaha Transaction 42 3.4.5 Applications of Murabaha Contract 42 3.5 DEFERRED PAYMENT SALE (Bay’ Bithaman Ajil - BBA) 43 Islamic Banking and Finance: Principles & Practices 3 Contents I 3.5.1 Important principles of BBA 43 3.5.2 Structure of a BBA contract 44 3.5.3 Mechanism of a BBA Transaction 44 3.5.4 Applications of BBA 44 3.6 Monetization (Tawarruq) 44 3.6.2 Important principles of Tawarruq 44 3.6.3 Structure of Tawarruq 45 3.6.4 Mechanism of Tawarruq Transaction 45 3.6.5 Applications of Tawrruq 46 3.7 ENA 46 3.7.1 Structure of Ena contract 46 3.8 SALAM SALE (Bai’ Salam) 46 3.8.1 Important principles of Salam 47 3.8.2 Structure of a Salam contract 48 3.8.3 Mechanism of Salam Transaction 48 3.8.4 Applications of Salam 48 3.9 MANUFACTURING FINANCE (Istisna) 48 3.9.1 Important principles of Istisna 49 3.9.2 Structure of an Istisna contract 50 3.9.3 Mechanism of an Istisna Transaction 50 3.9.4 Applications of Istisna 50 3.10 PARTNERSHIP (Musharaka) 50 3.10.1 Important principles of Musharaka 51 3.10.2 Different types of Partnership at a glance 52 3.10.3 Structure of Musharaka & Diminishing Musharaka contract 53 3.10.4 Mechanism of a Musharaka Transaction 53 3.10.5 Applications of Musharaka 53 3.11 VENTURE CAPITAL (Mudaraba) 54 3.11.1 Important principles of Mudaraba 54 3.11.2 Structure of Mudaraba contract 55 3.11.3 Mechanism of a Mudaraba Transaction 56 3.11.4 Applications of Mudaraba 56 3.12 ISLAMIC LEASE (Ijara) 56 3.12.1 Important principles of an Ijara 57 3.12.2 Structure of an Ijara contract 59 3.12.3 Mechanism of an Ijara Transaction 59 3.12.4 Applications of Ijara contract 59 3.13 PLEDGE (Rahn) 59 3.13.1 Important principles of Pledge 60 3.13.2 Structure of Rahn contract 61 3.13.3 Mechanism of a Rahn Transaction 61 3.13.4 Applications of Rahn 61 3.14 GUARANTEE (Kafala) 61 3.14.1 Important principles of Kafala 62 3.14.2 Structure of Kafala 63 3.14.3 Mechanism of a Kafala Transaction 63 3.14.4 Applications of Kafala 63 3.15 WAKALA 63 3.15.1 Important principles of Wakala 64 3.15.2 Structure of Wakala 64 3.15.3 Mechanism of a Wakala Transaction 64 3.15.4 Applications of Wakala 65 3.16 HAWALA 65 3.16.1 Important principles of Hawala 65 3.16.2 Structure of Hawala 66 4 Islamic Banking and Finance: Principles & Practices Contents I 3.16.3 Mechanism of a Hawala-1 Transaction 66 3.16.4 Application of Hawala 66 3.17 WADIA 66 3.17.1 Important principles of Wadia 67 3.17.2 Structure of Wadia 67 3.17.3 Applications of Wadia 67 3.18 Set-off (Muqassa) 67 3.18.1 Important principles of Muqassa 68 3.18.2 Structure of Muqassa 68 3.18.3 Applications of Muqasa 68 3.19 URBOUN 68 3.19.1 Nature of Urboun 69 3.19.2 Benefits of Urboun 69 3.19.3 Structure of Urboun 69 3.19.4 Applications of Urboun 69 3.20 WAAD (Promise) 69 3.20.1 Structure of Waad 70 3.20.2 Applications of Waad 70 3.21 QARD 70 3.21.1 Important Principles of Qard Contract 70 3.21.2 Structure of Qard 71 3.21.3 Applications of Waad 71 Islamic Retail Products 1. INTRODUCTION 75 2. HOME FINANCE 75 2.1 Diminishing Musharaka (Musharaka Mutanaqisa) 75 2.1.1 Structure of Home Finance based on Musharaka Mutanaqisa 77 2.1.2 Calculations 78 2.3 Markup-Sale (Murabaha) 80 2.3.1 Structure of Home Finance based on Murabaha 80 2.3.2 Calculations 81 2.4 Islamic Lease (Ijarah and Ijarah Muntahia Bittamleek) 82 2.4.1 Structure of Home Finance based on Ijarah Muntahia Bittamleek 83 2.4.2 Calculations 84 2.5 Manufacturing Finance (Istisna and Parallel Istisna) 85 3. VEHICLE FINANCE 86 3.1 Markup-Sale (Murabaha) 86 3.1.1 Structure of Vehicle Finance based on Murabaha 86 3.1.2 Calculations 87 3.2 Islamic Lease (Ijarah Muntahia Bittamleek) 88 3.2.1 Structure of Vehicle Finance based on Ijarah Muntahia Bittamleek 88 3.2.2 Calculations 89 4. PERSONAL FINANCE 89 4.1 Service Ijarah (Ijarah) 89 4.1.1 Structure of Personal Finance based on Services Ijarah 90 4.2 Monetisation (Tawarruq) 90 4.2.1 Structure of Personal Finance based on Service Ijarah 91 4.3 Ena 91 4.3.1 Structure of Personal Finance based on Ena 91 5. ISLAMIC GOODS FINANCE 91 5.1 Markup-Sale (Murabaha) 91 5.1.1 Structure of Goods Finance based on Murabaha 92 5.1.2 Calculations 92 Islamic Banking and Finance: Principles & Practices 5 Contents I 5.2 Negotiation Markup-Sale (Musawwama) 93 5.2.1 Structure of Goods Finance based on Musawwama 93 5.2.2 Calculations 94 6. CREDIT CARD 94 6.1 Ujrah based Credit Card 94 6.1.1 Structure of Ujrah based Credit Cards 95 6.2 Tawarruq based Credit Card 95 6.2.1 Structure of Tawarruq based Credit Cards 96 6.2.2 Calculations 96 7. ISLAMIC BANK ACCOUNT 97 7.1 Current Account 98 7.1.1 Structure of Islamic Current Account 98 7.1.2 Calculations 98 7.2 Islamic Saving Account 98 7.2.1 Structure of Islamic Saving Account 99 7.2.2 Calculations 99 7.3 Investment Account 100 7.3.1 Structure of Islamic Investment Account 100 7.3.2 Calculations 101 Islamic Corporate Products 1. INTRODUCTION 105 2. ISLAMIC BANK GUARANTEE 105 2.1 Parties involved in Bank Guarantee 107 2.2 Types of Guarantee 107 2.2.1 Financial Guarantee 107 2.2.2 Tender Guarantee (Bid-Bonds) 107 2.2.3 Performance Guarantee (Bond) 107 2.2.4 Advance Payment Guarantee 107 2.2.5 Retention Guarantee(Retention Bond) 108 2.2.6 Shipping Guarantee 108 2.3 Structure of an Islamic Bank Guarantee 108 2.4 Mechanism of an Islamic Bank Guarantee 108 2.5 Islamic Bank Guarantee and Fee 109 3. ISLAMIC LETTER OF CREDIT 109 3.1 Types of Letter of Credit 109 3.1.1 Murabaha Letter of Credit 109 3.1.2 Wakala-Murabaha Letter of Credit 109 3.1.3 Musharaka Letter of Credit: 110 3.1.4 Cash based Letter of Credit: 110 3.2 Structure of an Islamic Letter of Credit (Murabaha LC) 110 3.3 Mechanism of Islamic Letter of Credit (Murabaha LC) 110 3.4 Calculations: 111 4. ISLAMIC CORPORATE FINANCE 112 4.1 Murabaha Finance (Markup Sale) 113 4.1.1 Structure of Corporate Finance based on Murabaha 113 4.1.2 Mechanism of Corporate Finance based on Murabaha 113 4.2 Manufacturing Financing (Istisna Sale) 113 4.2.1 Structure of Corporate Finance based on Istisna 114 4.2.2 Mechanism of Corporate Finance based on Istisna 114 4.3 Supplier Financing (Salam Sale) 115 4.3.1 Structure of Corporate Finance based on Parallel Salam 115 4.3.2 Mechanism of Corporate Finance based on Parallel Salam 115 4.4 Calculations 116 6 Islamic Banking and Finance: Principles & Practices Contents I 5. WORKING CAPITAL FINANCE 117 5.1 Commodity Murabaha 117 5.1.1 Structure of Working Capital Finance based on commodity Murabaha 117 5.1.2 Mechanism of Working Capital Finance based on commodity Murabaha 117 5.2 Mudaraba (Trust Financing) 118 5.2.1 Structure of Working Capital Finance based on Mudaraba 118 5.2.2 Mechanism of Working Capital Finance based on Mudaraba 118 5.3 Wakala based finance 118 5.3.1 Structure of Working Capital Finance based on Wakala 119 5.3.2 Mechanism of Working Capital Finance based on Wakala 119 5.4 Calculations: 119 6. SYNDICATE FINANCE 121 6.1 Ijarah Syndication 121 6.1.1 Structure of Ijarah Syndication 121 6.1.2 Mechanism of Ijarah Syndication 121 6.2 Murabaha Syndication 122 6.2.1 Structure of Murabaha Syndication 122 6.2.2 Mechanism of Murabaha Syndication 122 6.3 Calculations 123 7. CURRENT ACCOUNT 125 7.1 Structure of Islamic Current Account 125 7.2 Mechanism of Current Account based on Qard 125 7.3. Calculations 125 Islamic Treasury Products 1. INTRODUCTION 129 2. LIQUIDITY MANAGEMENT 129 2.1 Commodity Murabaha Instrument 131 2.1.1 Structure of Commodity Murabaha Instrument 131 2.1.2 Mechanism of Commodity Murabaha Instrument 131 2.1.3 Calculations 132 2.2 Tawarruq Instrument 132 2.2.1 Structure of Tawarruq Instrument 133 2.2.2 Mechanism of Tawarruq Instrument 133 2.3 Islamic Agency Instrument 133 2.3.1 Structure of Islamic Agency Instrument 134 2.3.2 Mechanism of Islamic Agency Instrument 134 2.4 Sukuk Instrument 134 3. RISK MANAGEMENT 135 3.1 Islamic Profit Rate Swap 135 3.1.1 Structure of Islamic Profit Rate Swap 136 3.1.2 Mechanism of Islamic Profit Rate Swap 136 3.2 Forward FX 136 3.2.1 Structure of Waad based FX 137 3.2.2 Mechanism of Waad basedFX 137 3.2.3 Calculations 137 3.3 Spot FX 137 3.3.1 Structure of Spot FX 138 3.3.2 Mechanism of Spot FX 138 3.3.3 Calculations 138 3.4 Currency Swap 138 3.4.1 Waad based Currency Swap 139 3.4.1.1 Structure of Waad based Currency Swap 139 3.4.1.2 Mechanism of Waad based Currency Swap 139 3.4.2 Murabaha-Tawarruq based Currency Swap 139 Islamic Banking and Finance: Principles & Practices 7 Contents I 3.4.2.1 Structure of Murabaha-Tawarruq based Currency Swap 139 3.4.2.2 Mechanism of Murabaha-Tawarruq based Currency Swap 139 3.5 Islamic Option 139 3.5.1 Structure of Islamic Option 140 3.5.2 Mechanism of Islamic Option 140 Islamic Funds 1. INTRODUCTION 143 2. ISLAMIC INVESTMENT FUNDS 143 3. FUNCTIONING OF AN ISLAMIC INVESTMENT FUND 145 3.1 Islamic Fund as a Company 145 3.2 Islamic Fund as a Trust 145 3.3 Islamic Fund as a Partnership 145 4. STRUCTURE OF AN ISLAMIC FUND 145 4.1 Parties involved in Islamic Fund 145 4.2 Structures of Islamic Fund 146 4.2.1 Mudaraba structure 146 4.2.2 Wakala structure 146 4.2.3 Musharakah structure 146 5. SHARIAH SCREENING METHODOLOGY 147 5.1 Main Components of Shariah Screening 147 5.2 Global Shariah Indices at a glance 149 5.3 The One Third Rationale 150 6. PURIFICATION PROCESS 150 6.1 Purification 150 6.2 Purification Method 151 6.3 Calculation Timing 151 6.4 Profit Returns on Borrowed Money 151 6.5 Method of Calculation 151 6.5.1 Method adopted by AAOIFI 151 7. BASIC TERMINOLOGIES OF AN ISLAMIC FUND 152 7.1 Units / Shares 152 7.2 Special Purpose Vehicle (SPV) 152 7.3 Net Asset Value (NAV) 152 7.4 Trading day 152 7.5 Public Offering Price (POP) 152 7.6 Load / Fee 152 7.7 Redemption 153 7.8 Dividend / Income 153 7.9 Capital Gains 153 8. BASIC MODEL OF AN ISLAMIC FUND 153 8.1 Mechanism of Mudaraba based Fund 153 8.2 Mechanism of Wakala based Fund 154 8.3 Mechanism of Musharaka based Fund 154 9. TYPES OF ISLAMIC FUNDS 155 9.1 Open-ended fund 155 9.2 Close-ended fund 155 9.3 Exchange traded fund (ETF) 155 9.4 Equity fund 155 9.5 Ijara Fund 155 9.5.1 Specific Shariah guidelines for Ijara fund 156 9.6 Commodity Fund 156 9.6.1 Specific Shariah guidelines for Commodity fund 156 9.7 Murabaha Fund 156 8 Islamic Banking and Finance: Principles & Practices Contents I 9.7.1 Specific Shariah guidelines for Murabaha fund 157 9.8 Mixed Fund 157 Sukuk- Islamic Bonds 1. INTRODUCTION 159 2. RECOGNITION OF SUKUK BY PROMINENT INSTITUTIONS 159 2.1 Islamic Fiqh Academy 159 2.2 Accounting &Auditing Organization for Islamic Financial Institutions 159 3. SUKUK - ISLAMIC BOND 159 3.1 Sukuk - a brief history 159 3.2 Sukuk- Definition and Derivation 161 3.3 Special Purpose Vehicle 162 4. SUKUK CATEGORIES 162 4.1 Asset based Sukuk 162 4.2 Debt based Sukuk 162 5. DIFFERENT TYPES OF SUKUK 162 5.1 Sukuk al- Musharaka 162 5.1.1 Structure of Sukuk-al Musharaka 163 5.1.2 Mechanism of Sukuk-al Musharaka(shirkat-al Aqd) 163 5.1.3 Key features of underlying Structure 164 5.1.4 Required Documentation 164 5.2 Sukuk al- Mudaraba 165 5.2.1 Structure of Sukuk-al Mudaraba 165 5.2.2 Mechanism of Sukuk-al Mudaraba 165 5.2.3 Key features of underlying Structure 166 5.2.4 Required Documentation 167 5.2.5 Calculations: 167 5.3 Sukuk al- Ijarah 167 5.3.1 Structure of Sukuk-al Ijarah(Purchase and lease back) 168 5.3.2 Mechanism of Sukuk-al Ijarah (Purchase and lease back) 168 5.3.3 Key features of the underlying Structure 169 5.3.4 Required Documentation 170 5.3.5 Calculations 170 5.4 Sukuk al- Wakala 170 5.4.1 Structure of Sukuk-al Wakala 170 5.4.2 Mechanism of Sukuk-al Wakala 171 5.4.3 Key features of underlying Structure 171 5.4.4 Required Documentation 172 5.5 Sukuk al- Murabaha 172 5.5.1 Structure of Sukuk al-Murabaha 172 5.5.2 Mechanism of Sukuk al-Murabaha 173 5.5.3 Key features 173 5.5.4 Required Documentation 173 5.6 Sukuk al- Istisna 173 5.6.1 Structure of Sukuk al-Istisna 174 5.6.2 Mechanism of Sukuk al-Istisna 174 5.6.3 Key features of underlying Structure 175 5.6.4 Required Documentation 175 5.7 Sukuk al- Salam 176 5.7.1 Structure of Sukuk al-Salam 176 5.7.2 Mechanism of Sukuk al-Salam 176 5.7.3 Key features of underlying Structure 177 5.7.4 Required Documentation 177 5.8 Sukuk al-Muzaraa (Sharecropping) 177 5.9 Sukuk al-Musaqa (Irrigation) 178 Islamic Banking and Finance: Principles & Practices 9 Contents I 5.10 Sukuk al-Mugharasa (Agricultural) 178 5.11 Sukuk al-Manfaah 178 5.12 Sukuk al-Intifa 178 5.13 Sukuk Melkiyyat al-Khadamat 178 5.14 Sukuk al-Khadamat al-Mawsufah-fi-al-Zimmah 178 6. KEY ISSUES RELATED TO SUKUK PRACTICES 179 6.1 Ownership 179 6.2 Guarantee 179 6.3 Tradability 179 6.4 Redemption 179 7. KEY DOCUMENTS RELATED TO SUKUK 180 TAKAFUL 1. INTRODUCTION 183 2. CONVENTIONAL INSURANCE 183 2.1 Uncertainty (Gharar) 183 2.2 Gambling (Maysir) 183 2.3 Interest (Riba) 185 2.4 Contract of Indemnity 185 2.5 History of Conventional Insurance 185 3. TAKAFUL- THEORY AND LAW 186 3.1 Taawun and Tabarru 187 4. SHARIAH GUIDLINES FOR TAKAFUL 188 4.1 Takaful Model 188 4.2 Contractual Relationship 188 4.3 Takaful Accounts 188 4.4 Takaful Participants 188 4.5 Commitments of the Participants 189 4.6 Conditions in Takaful Policies: 189 4.7 Commitments of the Takaful Company 189 4.8Takaful Indemnity 189 4.9 Takaful Surplus 189 4.10 Expiry of the Takaful Policy 190 5. BASIC CONCEPTS OF TAKAFUL 190 5.1 Takaful Contribution 190 5.2 Takaful Amount 190 5.3 Risk Insured Against 190 5.4 Takaful Participants 190 5.5 Takaful Account 190 5.6 Takaful Surplus 190 6. TAKAFUL- BUSINESS MODELS 191 6.1 Mudaraba Model 191 6.1.1 Structure of Mudaraba Takaful Model 191 6.1.2 Mechanism of Mudaraba Takaful Model 191 6.2 Wakala Model 192 6.2.1 Structure of WakalaTakaful Model 192 6.2.2 Mechanism of Wakala Takaful Model 192 6.3 Waqf Model 192 6.3.1 Structure of Waqf Takaful Model 193 6.3.2 Mechanism of Waqf Takaful Model 193 6.4 Hybrid Model 193 6.4.1 Structure of Hybrid Takaful Model 194 6.4.2 Mechanism of Hybrid Takaful Model 194 7. TAKAFUL PRODUCTS 194 10 Islamic Banking and Finance: Principles & Practices