1. Murabaha (Financing on a “Cost-Plus” Basis)

A murabaha, although typically used as a finance method, “is actually a sale contract.”In a typical murabaha transaction, the financial institution acts as a middle-man and purchases a good requested by its customer; the financial institution then turns around and sells the good to the customer at the acquisition cost plus a profit. The customer agrees to pay for the good over a stated period in installments, but if there is a default (unlike in traditional financing) the customer is only liable to the financial institution for the contracted sale price (not any fees or interest calculations otherwise available in typical financing arrangements).

A key component of murabaha financing is the requirement that the financial institution actually own the good before transferring title to its customer.This is because the financial institution assumes some risk to justify its profit, making the profit more than just disguised interest. The customer could always refuse to accept the good obtained for it by the financial institution, causing the financial institution to find an alternative buyer with the accompanying costs of storage, marketing, and overhead.As a result, murabaha financing is available to trusted customers of a financial institution41 and to those that provide some form of guarantee or collateral.

2. Ba’i Bithaman Ajil (Deferred Payment Financing)

Ba’i bithaman ajil involves a credit sale of goods on a deferred payment basis. At the request of its customer, the financial institution purchases an existing contract to buy certain assets on a deferred payment schedule and then sells the goods back to the customer at an agreed upon price, including a profit. The payments by the financial institution to the original supplier of the goods are progressive, as the goods are manufactured or purchased. The financial institution’s customer “can repay in lump sum or make installment payments over an agreed-upon period.”

3. Istisna (Commissioned Manufacturing)

Similar to ba’i bithaman ajil transactions, istisna contracts involve the payments by a financial institution to a developer or contractor as a job (typically involving construction or manufacturing) is completed.

4. Ijara (Lease Financing)

Ijara is a leasing arrangement whereby the financial institution “purchases an asset and leases it to a Client.” Most typically used with regard to equipment, the financial institution owns the asset throughout the lease period and the customer pays the financial institution a rental fee.The customer may purchase the asset either during or at the end of the lease period, but the customer is not required to do so. There are differences between a conventional lease and ijara, in that with the ijara:

1) a lease/hire begins the day the asset is delivered to the client (not the date the contract is signed as with the [conventional lease]), 2) the lessee is not liable for the full rent if the asset is destroyed (the bank takes out insurance on the asset and factors in the cost of insurance at the time the rent is fixed), and 3) the purchase at the end of the contract cannot be made binding.

Even with these slight differences, the ijara is fairly similar to traditional lease financing.

5. Musharaka (Partnership Arrangement)

Musharaka means “partnership” and typically involves a business undertaking where the financial institution provides a percentage of the capital needed by its customer with the understanding that the financial institution and customer will proportionately share in profits and losses in accordance with a formula agreed upon before the transaction is consummated.The customer contributes to the business undertaking by providing some capital and sweat equity represented by its management efforts and “know-how.”

6. Mudaraba (Venture Capital Transactions)

Like musharaka transactions, mudaraba involve business undertakings where the financial institution provides capital to an entrepreneur, but in the mudaraba transaction the financial institution provides all of the capital and the customer provides only sweat equity and know-how. The financial institution is guaranteed an agreed upon percentage of the profits and bears all of the risk of monetary loss. The entrepreneur serves as the financial institution’s agent for investing and utilizing the funds in the venture.

Often, a manager, called a Mudarib, is appointed to manage the business venture at the base of the mudaraba:In many cases the bank acts as a Mudarib for a fee. The bank also acts as a Mudarib in relation to its deposits in investing the depositors’ money in various schemes assuming the role of the capital provider. The Mudarib may be held liable for losses from actions that are beyond those originally provided for in the contract.

Just as with traditional venture capitalism, this is a “high risk” mode of financing. As such, a financial institution must use “extraordinary efforts to carefully scrutinize [the] feasibility and projections” provided by the customer along with undertaking stringent credit analyses and risk assessments.In part due to the increased risk and in part due to the capital requirements, “under the most optimistic accounts, mudaraba schemes represent less than 10% of [worldwide Islamic] banking operations.”

7. Qarde Hasan (Benevolent Financing)

Qarde hasan financing occurs when the financial institution provides a loan free of charge, typically with the intent to provide financial assistance to ailing institutions or to provide humanitarian assistance to individuals. In exchange, the customer provides an unconditional obligation that the financial institution will be repaid, and often collateral is required. The financial institution may also “charge a small fee to cover its administrative costs.

“Arising out of the communal aspect existing in the Islamic approach to economics, qarde hasanah “are for the benefit of the individual and the society at large.” Essentially, qarde hasanah represent loans to deserving persons and entities with the only requirement being repayment of the principal and administrative fees. Such loans “do not constitute a significant source of financing by Islamic banks” and fall into the charitable activities of these institutions.

The financial tools set forth above serve to promote the growth of principal without implicating the forbidden use of riba. Notably, not all of these tools will be available in the banking system of the United States, but some are remarkably similar to financial vehicles already approved by banking regulators, and as such, easily can be utilized in conformance with existing regulations.

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ShariaFinancing.com CEO
Asif Dada

Experience working with major global banks, underwriters, capital markets and investment brokers. Responsible for issuing over 200 million dollars in bonds and other debt issues. Managing investment portfolios of up to 100 million dollars. Working with rating agencies such as Moody's and major investment premium insurers to enhance ratings and marketability of investment products.