Islamic Banking and

Financial Markets
Module 3
Financial instruments of Islamic banks
Dr. Mustafa Disli

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Balance sheet
Assets Liabilities

Assets are the resources controlled by an enterprise as a

result of past events, from which future economic
benefits are expected to flow to the enterprise.
Liabilities are the present obligations of the enterprise,
arising from past events, the settlement of which is
expected to result in an outflow of resources embodying
economic benefits.
Equity is the residual interest in the assets of the
enterprise after deducting all its liabilities.

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Balance sheet
A typical non-bank Traditional banks Modern banks

3
Balance sheet
A typical non-bank Modern banks
Banks use much more leverage
than other businesses and earn
a spread between the interest
income they generate on their
assets (loans) and their cost of
funds (customer deposits).

Leverage = total company debt/

shareholder's equity.

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Balance sheet
Conventional banks Islamic banks

Asset-backed
Transactions: Savings/
Murabaha, Demand
Ijarah, Deposits:
Istisna, Wadiah
Salam

Investment
Profit Sharing
Accounts:
Transactions:
Mudaraba
Mudaraba,
Musharaka

Property Equity

5
Murabaha

Islamic banks Sale at a specified profit margin. This term,

however, is now used to refer to a sale agreement
Asset-backed
Transactions: Savings/ whereby the seller purchases the goods desired by
Murabaha,
Ijarah,
Demand
Deposits: the buyer and sells them at an agreed marked - up
Istisna,
Salam
Wadiah
price, the payment being settled within an agreed
time frame, either in installments or as a lump
sum.
Investment
Profit Sharing
Accounts:
Transactions:
Mudaraba
Mudaraba,
Musharaka

Property Equity

6
Steps in Murabaha transaction

Price inquiry Step 1: The potential purchaser asks the

Client Vendor vendor to quote a price for the goods
Price quote
required.

Step 2: With this quotation, the purchaser

Price quote vendor
Islamic contacts the bank, promising to buy the
Client goods from the bank if the bank buys the
Bank same from the vendor and resells them to
Promise to buy at
cost-plus-profit the client at the quoted cost plus a profit to
be agreed upon mutually.

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Steps in Murabaha transaction

Cost-plus contract Payment

Client Islamic Vendor Vendor

Sale Item/Commodity
Bank Sale Item/Commodity

Step 3: The bank purchases the product from the vendor by making payment. Since the
bank is still the owner of the product, a Murabaha contract is drawn up between the client
and the bank indicating the mark - up to be charged and other relevant details. The
contract is finalized by agreeing on the mode of payment; that is, a lump sum or through
installments. In addition to the contract, the bank also accepts the goods or other assets as
collateral against the credit risk or the risk of default in payment by the client.

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Murabaha vs Musamawa transaction

‒ Musawama is a general kind of sale in which the price of the

commodity to be traded is stipulated between the seller and the
buyer without any reference to the price paid or cost incurred by the
seller. Thus it is different from Murabaha in respect of the pricing
formula.
‒ Unlike Murabaha, the seller in Musawama is not obliged to reveal his
costs. All other conditions relevant to Murabaha are valid for
Musawama.

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Features and Conditions of Murabaha
1. The sale item should be owned by the Islamic bank (seller-buyer relationship, not
borrower-lender relationship)

2. Default event: Islamic bank has only recourse to the item purchased (no penalty allowed)

3. Islamic bank is allowed to ask for securities other than the item financed

4. Mark-up = f(item financed, length of time contract, collateral, creditworthiness client)

5. Murabaha resembles a conventional debt security

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Murabaha: Example 1

• Mr. ABC asked an IFI to arrange a machine for him on a deferred sales
basis.
• As agreed upon, both parties agreed to charge 10% per
annum profit and payment would be due after one year.
• Suppose goods value was QAR 1,000,000, and it was agreed to sell to
Mr. ABC at QAR 1,100,000
• Mr. ABC pledged to purchase once the goods have been arranged by
the bank and paid QAR 50,000 as a security deposit.
• Once the goods are arranged by the bank, ABC fails to execute the sales
agreement, causing the bank to incur a loss of QAR 20,000.
What is the amount of the claim on ABC? 11
Murabaha: Example 2

• Ms. XYZ came to an agreement with a local Islamic bank on a

Murabaha arrangement in which the bank will charge ten percent on
the cost to purchase cotton for her textile mill.
• The bank authorized Ms. XYZ to buy goods of her choice from her
trusted supplier, and paid Ms. XYZ QAR 500,000 for the discharge of
liability to be refunded QAR 550,000 after one year.
Explain the validity of this arrangement.

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Murabaha: Example 3

• Mr. ABC entered into a Murabaha agreement with the

bank. According to the terms, the bank will charge 10% per
annum on the sale of Murabaha.
• The customer was authorized by the bank to select products from his
supplier of convenience. The customer purchased products in his
name and had them delivered to the customer's premises.
Explain the validity of this arrangement.

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Murabaha vs conventional debt

‒ Murabaha is a sales contract in which the price is increased for

deferment of payment; the latter is an increase in the amount of a
debt for deferment. The first is permitted, but the second is not.
‒ Exposure to risk:
• Conventional loan is exposed to credit risk.
• Murabaha is exposed to price and credit risk
‒ Price risk: when the product is acquired for the client because the client retains an
option to decline to take delivery of the product (non-binding Murabaha)
‒ Murabaha: Use of LIBOR (interbank offered rate) rate as a benchmark
‒ Mark-up is determined by LIBOR
‒ Islamic banks argue that there is no Islamic benchmark
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 Reverse Murabaha (Tawarruq)

1. The customer approaches the bank for cash financing ($5,000)

Islamic
3. The asset is sold to the customer for $6,000 Customer
bank
5. Payment of $6,000 is made to the bank per the agreed installment plan

2. The bank 4. The customer

purchases the Tawarruq is a structure that facilitates cash financing sells the
commodity commodity in the
equivalent to the open market or to
client’s need for the same vendor
cash (i.e., $5,000) to realize cash (i.e.,
$5,000)

Commodity
dealer 15
Reverse Murabaha (Tawarruq)

Criticism:
‒ Customer has no real intention of buying underlying commodity that
supports the financial transaction
‒ Tawarruq leads to a debt markt, and a debt instrument does not
represent real assets.

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Ijara

Islamic banks Ijara means to transfer the usufruct of a particular

property to another person in exchange for a rent
Asset-backed
Transactions: Savings/ claimed from him.
Murabaha, Demand
Ijara, Deposits:
Istisna, Wadiah
Salam

Investment
Profit Sharing
Accounts:
Transactions:
Mudaraba
Mudaraba,
Musharaka

Property Equity

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Ijara financing
3. The bank leases the machine to the customer at monthly rental
terms for the agreed duration
Islamic
4. The customer pays the monthly rental Customer
bank
5. The machine is returned to the bank upon expiry of the duration

2. The bank 1. The customer

purchases the identifies the
machine/ machine/
equipment from equipment
the dealer to be leased
Machine/
Equipment
Dealer
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Ijara risks

• Risk 1 Credit Risk: The risk that the lessee is unable to service the
lease rental as and when it is due.
• Risk 2 Market Risk: The risk that if default occurs, the bank has to re-
rent the property on the open market at a lower price than agreed.

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Ijara wa Iqtina financing
3. The bank leases the machine to the customer at monthly rental
terms for the agreed duration
Islamic
4. The customer pays the monthly rental Customer
bank
5. Ijara wa Iqtina = hire-purchase agreement: regular ijara contract + sale
agreement (promise by the lessor/owner to sell the leased asset to the
lessee at the end of the original lease agreement)

2. The bank 1. The customer

purchases the identifies the
machine/ machine/
equipment from equipment
the dealer to be leased
Machine/
Equipment
Dealer
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Ijara & Murabaha: Similarities Ijara & Murabaha: Dissimilarities

Asset-based financing Ownership transfer: Yes with Murabaha, No with

Ijara

Paid in installments Consumable (Murabaha) & Non-consumable (Ijara,

Murabaha) goods

Predetermined cashflows (Murabaha) & Cashflows

can vary (Ijara)

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 Ijara Conventional lease

Rent can only be charged after delivery of leased Rent charged once the contract is signed even if
assets delivery is delayed

Penalty of late payment of rental is given to charity Penalty of late payment of rental is taken into
income

Transfer of asset at the end of lease period to lessee Transfer of asset at the end of lease period to lessee
is not included in the agreement is part of the agreement

All rights and liabilities of ownership lies with the IFI, All risks and rewards of assets transferred to lessee
while usage related rights and liabilities lies with
customer being user.

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Ijara popularity

‒ Ijara mostly do not require credit evaluation.

• It is easier to lease than borrow for short-term needs.
‒ Gives more freedom of changing equipment as technology advances.
‒ Easier to get finance through leasing for companies without credit
standing; these kinds of companies may not be able to borrow from
banks or the public and if they do, have to pay high rate of interest.

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Istisna

Islamic banks Istisna is a deferred manufacturing or construction

contract between the buyer and the contractor,
Asset-backed
Transactions: Savings/ whereby the client needs to construct,
Murabaha,
Ijara,
Demand
Deposits: manufacture or assemble a specified asset
Istisna, Wadiah
(property, equipment, machinery, etc) through an
Salam
agreed schedule of payment related to the
progress and performance of the contractor and
Profit Sharing
Investment
Accounts:
date of completion.
Transactions:
Mudaraba
Mudaraba,
Musharaka

Property Equity

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 Istisna financing
Istisna agreement, including the
duties and responsibilities of both
buyer and contractor, with
detailed specification of the assets
and date of completion

Istisna contract
Buyer Contractor
Construction of required assets
Specify the Performs as per
required assets to the Istisna contract
be manufactured terms and
On completion conditions within
gets ownership the agreed time
and possession of frame
finished project
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 Parallel istisna financing
Istisna contract exists on both sides: between the customer and the bank, and between the bank and
the manufacturer.
The customer who wants the project or asset enters an Istisna contract with the bank per the
customer’s specifications. The bank then enters into a parallel Istisna contract with a manufacturer to
meet those same specifications.
The performance of Parallel Istisna contract must not be conditional on the completion of first Istisna’a
contract.

Payment + mark-up Payment

Buyer Sale contract Purchase contract

Islamic bank Contractor
Delivery of asset Delivery of asset

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Features and Conditions of Istisna

1. Contract of Istisna is binding upon parties involved provided certain conditions fulfilled
including specifications of underlying subject matter (commodity), price and delivery date

2. Istisna cannot be executed with a customer who is the purchaser of underlying subject matter
from IFI and in the same acts as manufacturer for the production/supply of subject matter.

3. Istisna sale cannot be executed for a product already manufactured and or constructed.

4. Penalty clause can be stipulated for the delay in completion to compen-sate the purchaser,
however, penalty on default in payment by the purchaser is not allowed.

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 Istisna: Examples

Mr. ABC entered into a contract of Istisna with an Islamic bank to

supply ten tons of rice @ QAR 5/- per Kg

Explain the validity of these arrangements.

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Istisna risks

• Risk 1 Credit Risk: The risk that the customer is unable to honor the
payment obligations for deferred instalments when the work is
already in progress.
• Risk 2 Operational Risk: The risk that the partner lacks technical
expertise and the project fails.

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Salam

Islamic banks Salam is a contract involving the purchase of a

commodity for deferred delivery in exchange for
Asset-backed
Transactions: Savings/ immediate payment according to specified
Murabaha,
Ijara, Istisna,
Demand
Deposits: conditions, or the sale of a commodity for
Salam Wadiah
deferred delivery in exchange for immediate
payment.
Investment
Profit Sharing
Accounts:
Transactions:
Mudaraba
Mudaraba,
Musharaka

Property Equity

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Salam vs conventional forward contract

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Salam and Parallel Salam

Salam sale Parallel

salam Salam by the purchaser as
well as a seller of goods is
allowed subject to the
condition that performance
Delivery of Delivery of of any one of the Salam
commodity commodity contracts is not conditional
on the performance of any
other Salam contract.

Islamic bank Islamic bank

purchaser seller 32
Salam risks

• Risk 1 Credit Risk: Settlement/delivery risk where the goods are not
delivered or not delivered on time.
• Risk 2 Market Risk: The risk that if there is a default then the bank has
to purchase the goods on the open market at a higher price than the
agreed price in the Parallel Salam contract.

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Salam Shariah compliance

‒ Salam was permitted as a special case by the Prophet (pbuh) because pre-
payment of the price allowed farmers to buy seeds and raw materials, and for
personal consumption in order to be able to produce the fruits and crops. The
prohibition of riba meant that farmers and traders could not take usurious loans
and, therefore, they were permitted to sell agricultural products in advance.
‒ The basic wisdom behind the permissibility of salam is to fulfil the instant needs
of the seller.
‒ Similarly, the traders of Arabia who were engaged in importing and exporting
goods were permitted to sell their goods in advance as a means of financing
business.

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Features and Conditions of Salam
1. The buyer pays the price in full to the seller at the time of effecting the sale (purpose : fulfill the
instant needs of the seller – otherwise: similar to selling debt for debt, which is forbidden)

[Link] can be affected in those commodities only the quality and quantity of which can be specified
exactly (purpose : eliminate disputes on quality/exact measure should be known)

3. Salam cannot be effected on a particular commodity or on a product of a particular field or farm

(purpose : the delivery becomes uncertain)

4. The exact date and place of delivery must be specified in the contract

5. Salam cannot be affected in respect of things which must be delivered at spot

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 Salam: Examples

1) Ms. XYZ entered into a Salam contract with an IFI to provide 50

laptops with complete specifications after two months @ QAR
5,000/- each for spot payment.
2) Mr. ABC entered into a salam contract to supply 1,000 tons of apple
to a local IFI for a price of QAR 7/- per Kg. IFI made the payment to
the seller immediately. It is stipulated that fruit shall be provided
from archard # 6.
3) Mr. ABC sold the total produce of Orchard # 11 to a local juice
manufacturer for QAR 200,000 to be delivered after harvesting.
Explain the validity of these arrangements.
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Sidenote: Selling debt for debt

‒ A type of credit sales in which on due date, the debtor seeks

extension with the promise to pay something in addition to the
original price.
• Amount of debt sold to the debtor for some profit
‒ Application to salam: If the buyer does not pay at the signing of contract (for
example: $100) but promise to make the payment at delivery (for example:
$105).
• This is not allowed.

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 Istisna Salam

The subject of Istisna is always a thing which needs Salam can be effected on anything, no matter
manufacturing whether it needs manufacturing or not, provided that
the subject matter is fungible.

Payment for Istisna can be made in staggered basis It is necessary for Salam that the price is paid in full
advance, while it is not necessary in Istisna

The contract of Istisna can be cancelled before the The contract of Salam, once effected, cannot be
manufacturer starts the work cancelled unilaterally

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Salam vs. Istisna: example

Ms. XYZ entered into a contract of sale with an Islamic bank to sell a
unique set of furniture to be gifted to a prime customer of bank for
QAR 50,000 with a delivery date of two months after signing the deal
subject to make 50% advance payment, is a valid Istisna sale but same
cannot be a valid Salam sale due to uniqueness of underlying goods.
This is a condition in Salam sale that only fungible goods can be the
subject matter of sale which is not required under Istisna sale contract.

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Mudaraba

Islamic banks Mudaraba financing, known as “trust financing,”

is based on the principle of profit sharing.
Asset-backed
Transactions:
Murabaha,
Savings/
Demand
Mudaraba financing is a commercial activity in
Ijara, Istisna,
Salam
Deposits:
Wadiah
which an Islamic bank entrusts funds to an
entrepreneur. Profits are distributed between the
bank and the entrepreneur on the basis of a
Investment
predetermined ratio. All losses are borne by the
Profit Sharing
Transactions:
Accounts: supplier of the funds (the bank) as long as there
Mudaraba
Mudaraba has been no negligence on the part of the
Musharaka
entrepreneur.
Property Equity

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 Mudaraba
Fund manager/ Investor/
entrepreneur/ silent partner
working partner (rabb-al-mal)
(mudarib) Entrepreneurship Capital

Project

Profit

Loss
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 Types of Mudaraba
Restricted Mudaraba Unrestricted Mudaraba

The investor specifies a particular business or project The investor gives the working partner permission to
where the investment funds are to be used; the funnel the funds into any type of business or project
working partner should not use the funds for any that best suits the financial goals of both partners.
other business or project.

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 Two-tier Mudaraba

Deposits from Capital Capital Investments by

Islamic bank fund managers/
investors/ silent
(mudarib) entrepreneurs/
partners
(rabb-al-mal) (rabb-al-mal) working partners
Profit and Loss Profit and Loss (mudarib)

The first agreement is between The second agreement is between

the bank and depositors the bank and the entrepreneur

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 Two-tier Mudaraba (Example)
$1M $1M
Depositors Islamic bank Entrepreneur
60:40 70:30
(Profit sharing) (Profit sharing)
Project’s income: $1.5M
Total Profit: $0.5M
Profit Depositors & Bank: ??? Profit Entrepreneur: ???
Profit Depositors: ???
Profit Bank: ???

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Features and Conditions of Mudaraba
1. Control: the investor does not have any management rights over the mudarib, who is free to select
the projects in which to invest or the manner in which to invest. (unrestricted Mudaraba)

2. Control: the investor does not have any management rights over the mudarib, but the investor impose
some upfront restrictions on the agent to participate in a particular project or in a particular fashion.
(restricted Mudaraba)

3. Profits are shared between the investor and the agent, any loss in the investment or business is
borne solely by the capital-owner.

4. The capital-owner cannot require any guarantee such as security and collateral from the entrepreneur in
order to insure its capital against the possibility of an eventual loss

5. Salam cannot be affected in respect of things which must be delivered at spot

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Mudaraba risks

• Risk 1 Displaced Commercial Risk: The risk that the bank may retain
investment account holder’s funds by increasing the rate of return
thus giving away its share of the profit.
• Risk 2 Credit Risk: The risk that the entrepreneur/partner defaults and
goes bankrupt.

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[EXERCISE: MUDARABA]

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Musharaka

Islamic banks Musharaka financing is a type of partnership

financing in which one of the partners is an Islamic
Asset-backed
Transactions: Savings/ bank.
Murabaha, Demand
Ijara, Istisna,
Salam
Deposits:
Wadiah
Profits and losses are shared among the partners
according to a predetermined formula.
Profit sharing need not be based on the
Profit Sharing
Investment proportion of shares owned, but liability is limited
Transactions:
Accounts:
Mudaraba to the contributions of the shareholders.
Mudaraba
Musharaka

Property Equity

48
 Musharaka
1. The bank and customer enter into a Musharaka contract
(e.g., a construction project based on 50/50 capital contribution)
Islamic Bank Partner/Client

50% Capital 50% Capital

Joint venture

40% 60%
Profit

50% 50%
Loss
49
[EXERCISE: MUSHARAKA]

50
 Types of Musharaka
Consecutive partnership Diminishing partnership
(Consecutive Musharaka) (Diminishing Musharaka)

Each partner keeps its share in the partnership until the One partner is allowed to buy the other partner’s share of
very end of the joint venture. equity step by step until the whole equity of the other
Partners are often allowed to withdraw or transfer their partner is transferred. It’s called a declining
shares (unless the initial contract specifically states that all balance partnership because one partner’s equity balance
partners shall remain in the partnership until the date of declines gradually.
maturity).
If one of the partners withdraws from the contract, the
whole partnership doesn’t terminate.

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[EXAMPLE REAL ESTATE PURCHASE: DIMINISHING MUSHARAKA]

• Assume that a potential buyer is interested in purchasing a home

worth US$150,000.
• The buyer approaches an Islamic financial institution for the purchase
of the property and puts down 20% of the price (US$30,000) as a
down payment.
• The financial institution provides the other 80% of the price
(US$120,000).
• This agreement results in 20% of the home ownership belonging to
the client and the remaining 80% to the financial institution.

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[EXAMPLE REAL ESTATE PURCHASE: DIMINISHING MUSHARAKA]

53
Musharaka risks

• Risk 1 Credit Risk: The risk that the entrepreneur/partner defaults and
goes bankrupt.
• Risk 2 Operational Risk: The risk that the partner lacks technical
expertise and the project fails.

54
Sources of funds

Islamic banks Islamic banks are deposit-taking institutions but do not pay
interest on deposits.
Asset-backed
Transactions: Savings/
Murabaha, Demand Sources of Funds:
Ijara, Istisna, Deposits:
Salam Wadiah • Shareholder investments (Equity),
• Savings and demand deposits,
• Investment accounts (general or special)
Profit Sharing Investment
Transactions: Accounts:
Mudaraba Mudaraba
Musharaka Islamic banking depositors are seeking safe custody of their
funds and convenience in using their funds. Islamic banking
Property Equity
depositors may also expect to earn some profit on deposit
balances, but this profit is not guaranteed.
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Wadiah savings accounts

Islamic banks In this type of contract, someone gives his

property to a trustee for safety reasons and
Asset-backed
Transactions: Savings/
doesn’t expect to receive any return for the use.
Murabaha, Demand
Ijara, Istisna, Deposits: In the Wadiah contract, the trustee (=bank) is
Salam Wadiah allowed to use the asset while the asset is in its
possession — with the condition that the property
should be returned when demanded.
Profit Sharing Investment
Transactions:
Mudaraba
Accounts:
Mudaraba
In the Amana contract, the trustee (=bank) cannot
Musharaka use the asset; it must simply safeguard the asset.

Property Equity

56
Wadiah
1. The depositor signs a contract with bank and deposits
a certain amount of money
Depositor Islamic bank
2. Permission is given to the bank to make use of funds

3. The bank uses the

money in various
forms of investments

4. Hiba (gift) is paid to depositor, which is based on the bank’s discretion

Profit
57
Investment accounts

Islamic banks Investment accounts operate on the principle of

Mudaraba (profit sharing), with banks accepting
Asset-backed
Transactions: Savings/
deposits from investors.
Murabaha, Demand
Ijara, Istisna, Deposits: The ratio for sharing profits and losses identifies
Salam Wadiah
the only return guarantee the account holder
receives from the bank.
Profit Sharing Investment
Transactions: Accounts:
Mudaraba Mudaraba
Musharaka

Property Equity

58
 Mudaraba
1. The depositor deposits a certain amount of money with the bank for a
specific period (e.g., 1 year, with an agreed 70/30 profit-sharing ratio)
Investor Islamic bank

2. The bank uses the

money in various forms of
investment or financing

70% 30%
Profit

100%
Loss
59
 Types of Mudaraba
Restricted Mudaraba Unrestricted Mudaraba

The investor specifies a particular business or project The investor gives the working partner permission to
where the investment funds are to be used; the funnel the funds into any type of business or project
working partner should not use the funds for any that best suits the financial goals of both partners.
other business or project.

60
 Composition of assets

Ali, S. S. (2011). Islamic

banking in the MENA
region. Washington,
DC: World Bank and
Islamic Development
Bank.

61