Nature and Market for Islamic Financial Products (IFP) in banking sector
Now on celeberation of Eid Millad un Nabi on 30th Oct, we can say that significant developments have taken place in Islamic finance during last 50 years. The Islamic finance has moved from providing retail and commercial banking during 1970s to advanced treasury services, balance sheet management and innovative asset management more recently. Though the Islamic financial services industry currently represents approximately only 1% of global assets, it has been growing by more than 30% annually over the last 10 years however it has slowed down a bit in 2020 due to corona epidemic.
Financial products, in general, refer to the instruments that help save, invest, and get insurance or borrowing facilities.
As per the Islamic law, the lender must share in the profits or losses arising out of the enterprise for which money was lent. Moreover making money from money is not acceptable by Islamic law. Money is only a medium of exchange, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else. The Islamic law also prohibits uncertainty, risk or speculation (Gharar).
The reason for existence of a financial system is to transfer funds from savings surplus units (SSU) to savings-deficit units (SDU) in the economy which assist intermediation between savers and investors.
Deposit products satisfy people’s need of money in crisis period, as the customers can save some money or fund through such products (e.g. current account, savings account, term deposit and savings bond). These products are based on revenue sharing which is usually calculated ex post on a monthly basis. Islamic financial institutions are engaged in mobilizing savings from group of Muslim savers by offering Shariah compliant products that also vary with respect to other dimensions of return, risk, liquidity, maturity, safety and stability.
There are primarily three types of deposit products available: Wadi’ah, Mudarbah, and Qard al-Hasanah. Wadi’ah deposits include current accounts (giro wadi’ah) while Mudarabah deposit products are based on revenue-sharing between depositor and bank, including savings products that can be withdrawn any time and time deposit products. Qard al-Hasanah, on the other hand, is unremunerated deposit products; usually for charitable purposes. These Islamic deposit products allow no trade-off in the matter of Shariah-compliance.
Credit products satisfy people’s borrowing needs and are based on profit-sharing, either at a mutually agreed-upon ratio or at a mutually agreed-upon fixed rate. These products are backed by collateral as collateral-free lending would normally be considered as containing a speculative element, or moral hazard. People can spend more money, than they can earn through credit products (e.g. loans, hire purchase, leasing and mortgage).
In this category IFPs can be categorized as 1) profit sharing financial products and 2) Advance purchase financial products.
Profits sharing products may include active partnership (Musharakah) or passive partnership (Mudaraba). In case of Musharakah capital is provided by the bank in return for a share in the realized profit (or the loss if a loss occurred). In diminishing musharaka, the bank is entitled to receive, in addition to its share in realized profits, an extra payment that is specifically assigned for the purpose of reducing its share in the company’s capital until this is fully paid off by the partner.
Mudarabah on the other hand is a contract between two parties; a capital-owner (who contributes capital) and an investment manager (who provide entrepreneurship). Profit is shared between parties on a pre-agreed ratio at the time of contract. These two modes provide an alternative banking and if implemented on a national level are likely to result in much fairer distribution of wealth in society with a far reaching effect on the economy. Other forms of credit products include Qard Hasan, Wakalah and Hawalah.
Qard Hasan is a charitable loan free of interest and profit-sharing margins. The loan is repaid in installments and a modest service charge is permissible. In case of Wakalah, a bank is authorized to conduct business on customers’ behalf. Hawalah, on the other hand is an agreement by the bank to undertake some of the liabilities of the customer in return for a service fee. The customer pays back the bank when the liabilities mature.
Advance purchase financial products include Murabahah, Ijara, Ijarah muntahia bittamleek, Istisna, and Salam. Murabahah is a spot sale contract where the client (the bank’s customer) orders the purchase of a certain commodity that is available either in the domestic or the foreign market at a specified cash price which include a profit margin (mark-up) in favor of the bank. If the customer’s creditability is satisfactory, the bank buys the commodity. The bank accepts payment for the commodity in installments, which usually stretch over one year or more. When Murabahah purchase is made by means of importation from foreign markets, letters of credit and foreign conventional banks are involved, necessary shariah precautions are taken to avoid payment of interest at any step.
Ijarah is an Islamic alternative to Leasing. Literally, Ijarah mean to give something on rent. Therefore Ijarah is a leasing contract under which a bank buys and leases out equipment required by its clients for a rental fee. The bank (lessor) and the client (lessee) mutually agree on the leasing period, and terms of payment. Risk and rewards of ownership lie with the bank i.e. any loss to the asset beyond the control of the client (lessee) should be borne by the bank (lessor). Maintenance and insurance of the leased asset are the bank’s responsibility, whereas the lessee has to bear the running costs as well as any repair costs in the case of misuse.
Ijarah muntahia bittamleek can be understood as a lease ending with ownership. It is a financing contract which implies a promise on the part of one party (the bank) to gift or to sell the leased asset at a nominal price at the end of the lease term to the client (lessee). As shariah law does not allow for the combination of leasing and ownership in one single contract, this second transfer of ownership contract should be signed only after the termination of the lease term as promise by the bank (lessor).
Istisna is a manufacturing contract in which a party orders another to manufacture and provide a commodity, the description of which, delivery date, price and payment date are all set in the contract. For example, a household that wishes to build a house, or a firm that needs to construct a building, or to manufacture equipment with particular specifications, would approach the bank for this purpose. After assessing the economic viability of the operation and the creditability of the customer, an istisna contract is signed between the two parties. As this type of contract is of a binding in nature, the customer submits a down payment and undertakes to pay the remaining part of the manufacturing price, as mutually agreed with the bank, in installments over a given period of time. The Islamic bank would then sign a parallel istisna contract whereby it extends finance to a firm that agrees to manufacture the requested object according to specification and to deliver it at an agreed future date. Islamic banks in the Arab Gulf countries have used this type of contract successfully to finance big operations, particularly in the construction sector and infrequently in the industrial sector.
Salam is a contract to sell a prescribe commodity where price is paid in advance at the time of contracting against delivery of the purchased goods or services at a specified future date. Salam is permissible in shariah to meet the instant cash needs of a seller who undertakes the future delivery of the commodity. Thus, banking finance is extended to firms or individuals against their commitment to deliver commodities at future dates. To hedge the salam operation banks also practice parallel salam. This involves making counter deals with other parties whereby they obtain immediate cash payments against a commitment to deliver commodities of similar quantity and quality to those in the salam contracts at some future date. Islamic banks in Pakistan, Sudan, and in some Arab Gulf countries have practiced Salam transactions.