Sharia Financing and Liquidity Management (2)

II. SHARIA FINANCING



Generally Sharia Financing can be Categorized as follows: [1]
1. Sales and Purchase Methods: Murabahah, Salam, Istisna'

2. Investment Methods: Mudharaba, Musharaka

3. Other Methods: Ijara, Hawala, Ar- Rahn, Qard Hasan

2.1 Sales and Purchase Method

The condition of this method is the existence of goods, to be sold and purchased. Under this method, the bank will purchase and sell goods. The profit is generated from the difference of sell price and purchase price. There are 3 kinds of financing operate under this system, namely Murabaha, Salam, and Istisna’


2.1.1 Murabaha (Cost-Plus Financing)
Murabaha is the most popular and most common mode of Islamic financing. It is also known as Cost plus financing. The seller is obliged to tell the buyer his oust price and the profit he is making. This contract has been modified a little for application in the financial sector.

The Murabaha mode of finance operates in the following way: The client approaches a bank to get finance in order to purchase a specific commodity. The bank purchases the commodity on cash and sells it to the customer on a profit. Since the client has no money, he buys the commodity on deferred payment basis through instalment. Thus, the client got the commodity for which he wanted the finance and the bank made some profit on the amount it had spent in acquiring the commodity.

The Murabaha can be used in various and diverse sectors. In consumer finance for purchase of consumer durable such as cars and household appliances, in real estate to provide housing finance, in the production sector to finance the purchase of machinery, equipment and raw material etc.

However, probably the most common and the most popular application of Murabaha is in financing the short-term trade for which it is eminently suitable. Murabaha contracts are also used to issue letters of credit and to provide financing to import trade.

2.1.2 Salam (Pre-Paid Purchase)
This term refers to advance payment for goods, which are to be delivered later. Normally, no sale can be affected unless the goods are in existence at the time of the bargain. But this type of sale forms an exception to the general rule provided the goods are defined and the date of delivery are fixed. The objects of this type of sale are mainly tangible things but exclude gold or silver as these are regarded as monetary values. Barring these, salam covers almost all things which are capable of being definitely described as to quantity, quality and workmanship. One of the conditions of this type of contract is advance payment; the parties cannot reserve their option of rescinding it but the option of revoking it on account of a defect in the subject matter is allowed.

Salam is most often used when a manufacturer needs capital to manufacture a final product for the buyer. In return for paying in advance, the buyer receives a more favorable price (i.e. splits the profit margin with the manufacturer). It is also applied in the agricultural sector where the bank advances money for various inputs to receive a share in the crop, which the bank sells in the market.


2.1.3 Istisna (Progressive Financing)
A contract of acquisition of goods by specification or order where the price is paid progressively in accordance with the progress of a job. An example would be for the purchase of a house to be constructed, payments are made to the developer or builder according to the stage of work completed. This type of financing along with salam are used as purchasing mechanisms, and murabaha is for financing sales.

2.2 Investment Method

The condition of investment method is the existence of a project to be financed , the owner of the capital and agent who run the project. The profit from the project will be shared base on a pre determined ratios among the parties involved. There are 2 types of financing operate under this method, namely Mudaraba and Musharaka.


2.2.1 Mudaraba (Trust Financing)
The term refers to a form of business contract in which one party brings capital and the other personal effort. The party supplying the capital is called owner of the capital. The other party is referred to as worker or agent who actually runs the business. As a matter of principle the owner of the capital does not have a right to interfere in to the management of the business enterprise, which is the sole responsibility of the Agent. However, he has every right to specify such conditions that would ensure better management of his money. The proportionate share in profit is determined by mutual agreement. In case of loss, the capital owner shall bear the monetary loss and agent shall lose the reward of his effort. The owner of the capital could be individual or joint.

As a financing technique adopted by banks, it is a contract in which all the capital is provided by the bank while the business is managed by the other party. The profit is shared in pre-agreed ratios, and loss, if any, unless caused by negligence or violation of terms of the contract by the agent is borne by the Islamic bank. The bank passes on this loss to the depositors.

2.2.2 Musharaka (Partnership Financing)
This is a classical partnership agreement. All parties involved contribute to towards the financing of a venture. All providers of capital are entitled to participate in the management but not necessarily required to do so. The profit is distributed among the partners in predetermined ratios, while the loss is borne by each partner in proportion to his contribution.

In practice, there are two kinds of Musharaka namely permanent musharaka and diminishing musharaka. In permanent musharaka the bank participates in the equity of a project and receives a share of profit on a pro rata basis. The period of contract is not specified. So it can continue so long as the parties concerned wish it to continue. This technique is suitable for financing projects of a longer life where funds are committed over a long period and gestation period of the project may also be long.

Diminishing musharaka allows equity participation and sharing of profit on a pro rata basis but also provides a method through which the equity of the bank keeps on reducing its equity in the project and ultimately transfers the ownership of the asset on of the participants. The contract provides for a payment over and above the bank share in the profit for the equity of the project held by the bank. That is the bank gets a dividend on its equity. At the same time the entrepreneur purchases some of its equity. Thus, the equity held by the bank is progressively reduced. After a certain time the equity held by the bank shall come to zero and it shall cease to be a partner.

Musharaka is increasingly used to finance domestic trade, imports and to issue letters of credit. It could also be applied in agriculture and Industry.

2.3 Other Method

Belongs to this method are all types of financing which do not operate under sales and purchase method and investment method.


2.3.1 Ijara (Leasing)
Ijara technically defines as sale of a definite usufruct in exchange for a definite reward. Commonly used for wages, it also refers to a contract of land lease at a fixed rent payable in cash. It also refers to a mode of financing adopted by banks. It is an arrangement under which a bank leases equipment, a building or other facility to a client against an agreed rental. The rent is so fixed that the bank gets back its original investment plus a profit on it.

Under this scheme of financing the bank purchases an asset as per specification provided by the client. The period of lease may be determined by mutual agreement according to nature of the asset. During the period of the lease, the asset remains in the ownership of the lessor (the bank) but its right to use is transferred to the lessee. After the expiry of the lease agreement, this right reverts back again to the lessor.

Derivative form of ijara is Ijara wa Iqtina (Lease to Purchase). It is the same as ijara except the business owner is committed to buying the equipment at the end of the lease period. Fees previously paid constitute part of the purchase price. This type of lease to purchase agreement is commonly used for home financing.


2.3.2 Hawala (Facforing)
Technically, a debtor passes on the responsibility of payment of his debt to a third party who owes the former a debt. Thus the responsibility of payment is ultimately shifted to a third party. As financing, the bank will finance the debtor and will collect its funds back from the third party. The transfer of fund will be made in full amount, therefore a commission may be charged for such service.

In the bank’s practice Hawala is used for settling international accounts, by book transfers. This obviates, to a large extent, the necessity of physical transfer of cash. Whereas the application as financing is not yet broadly used since there are still argue about determining the commission for the service.

2.3.3 Ar-Rahn (Collateralised Borrowing)
Refers to an arrangement whereby a valuable asset is placed as collateral for debt. The collateral may be disposed of in the event of default. The bank cannot collect interest on the debt but it is allowed to charge maintenance cost of the collateral to the customer.

2.3.4 Qard Hasan (Benevolent Loans)
Most of the banks also provide interest free loans and free of charges to their customers. If this practice is not possible on a significant scale, even then, it is adopted at least to cover some needy people. Hence, it is referred as Qard Hasan (benevolent loan), which signifies the benevolent nature of the act of lending. The practices of various banks in this respect differ. Some banks provide the privilege of qard hasan only to the holders of investment account with them. Some extend to all bank clients. Some restrict it to needy students and other economically weaker sections of the society. Yet some other banks provide interest free loans to small producers, farmers and entrepreneurs who are not qualified to get finance from other sources. The purpose of these loans is to help them start their independent economic life and thus to raise their incomes and standard of living.

[1] Antonio, Muhammad Syafii, Bank Syariah: Dari Teori ke Praktek , Gema Insani Press, Jakarta: 2001