PERMISSIBLE FINANCING METHOD IN ISLAMIC BANKING
by Asst. Prof. Dr Rusni Hasasan [View Writer's Profile]
Islamic Law Department,
AIKOL,
International Islamic University Malaysia

Introduction

Islamic banking is a system that does not subscribe to riba or interest. Buying and selling is permitted, but lending with interest is not. In fact, it is the prohibition of interest that makes an Islamic banking system differs fundamentally from a conventional banking system. In this context we read, “But indeed Allah has permitted trade and forbidden riba” (2:275). The Quran also states that Allah has ordered Muslims to abandon and liquidate all remaining riba (regardless of how large or small), “O you who believe, fear Allah and give up what remains of riba, if you are indeed believers” (2:278). Thus, there is no ambiguity about the impermissibility of riba within the Islamic financial system. On the other hand, Islam permitted and encouraged trading by mutual goodwill, as stated in the Quran “But let there be among you traffic and trade by mutual goodwill”(4:29). Initially, a valid trade is concluded in Islam if the seller and buyer exchange an offer and acceptance, which specify the object of sale and price, and they both agree. Following that, any financing conducted through a valid trading by mutual consent is permissible. It is to the credit of Islamic banks that they have devised creative financial products based on “trading” principles which are established in the Shariah. For day-to-day banking activities, these trading instruments are not only practical but have also proven to be profitable for the Islamic banks. Some of the basic financing methods which are used by Islamic banking are as follows:

1. Cost-plus sales (murabahah)
2. Credit sales (bay’ bithaman ajil)
3. Leasing (ijarah)
4. Partnership (musharakah and mudarabah)
5. Islamic forwards (salam and istisna’)

1. Cost-plus sales (murabahah)

Murabahah is an exchange transaction in which a trader purchases items required by end user. The trader then sells those items to the end-user at a price that is calculated using an agreed profit margin over the costs incurred by the trader. In this sale, the buyer knows the price at which the seller obtained the object to be financed, and agrees to pay a profit over that initial price¹. To be in compatible with the principles of Shariah and Islamic finance, the murabahah transactions must comply with certain conditions. Murabahah transactions may be undertaken where the client of a bank or financial institutions, wants to purchase a commodity. This type of transaction cannot be affected in cases where the client wants to get funds such as for payment of salaries, settlement of bills or other liabilities. To make the arrangement valid, it is necessary that the commodity is really purchased by the bank and it comes into the ownership and possession of the bank so that it may assume the risk of the commodity so far as it remains under its ownership and possession. Afterward, the commodity should be sold to the client through a valid sale. In the event of a murabahah transaction, no money is loaned to the client. Rather, the financing party or bank purchases the asset, based on the requirement of the client and sell the asset to the customer at cost plus a declared profit.

Islamic principles of finance are based on a well established rule that “the benefit of a thing is a return of the liability for loss from that thing”². Hence, in a murabahah transaction, the bank or financier assumes the risk of purchasing the commodity before he sells it at a mark-up. This mark-up is considered as the reward of the risk the financier assumes. In other words, the bank is really engaged in buying and selling that entails certain risks. This lends the profit that the bank derived and the transaction legitimacy.

2. Credit sales (bay’ bithaman ajil)

It is very rare that the customer of the Islamic banks who uses murabahah transaction pays the price to bank immediately. In such cases, there would be no financing included, and the Islamic bank would simply be a middle-man or broker-agent (simsar).when a customer approaches an Islamic bank to finance a purchase through murabahah, the payment of the price is usually deferred and most commonly paid in installment; and this arrangement is known as bay’ bithaman ajil or bay’ al-muajjal. It is basically a trade-deal in which the seller allows the buyer to pay the price of a commodity at a future date in lump sum or installments. As compare to murabahah, the bank need not disclose the profit margin they may earn in bay’ bithaman ajil transaction. On the other hand, in murabahah it is a requirement that the bank makes known the profit margin to the customer. Another essential element that distinguishes it from murabahah and normal sale is the deferred payment.

The permissibility of bay’ bi thama ajil has been subjected to some controversies between the scholars especially on the issues whether the price charged by the seller can be higher than the spot price³. The main argument of those who are against bay’ bithaman ajil is that it opens the back door to riba. They argue that if we accept the difference between spot and future prices of commodities, we cannot logically reject riba or interest which is also an identical difference between the spot and future prices of a commodity. Thus, they argue that bay’ bithaman ajil is a “juristic trick” to circumvent the prohibition of riba⁴. However, this is certainly not the case. The legal difference between the two is very clear: one is a sale in which price can be increased for deferment; and the other is an increase in the amount of debt for deferment. Indeed, the majority of Muslim jurists allow the selling price in deferred sale to be set higher than the cash sale. However, this condition does not go without any condition. It is provided that in order to be compatible with the Shariah, the object of sale must come into the possession of the bank before being handed over to the other party. In addition, in case of default or delay of the payment by the customer, the price can no longer be raised. The price in which the customer has to pay the bank must be fixed, or else it will render the contract price uncertain and that may invalidate the contract.

3. Leasing (ijarah)

Ijarah is a well-accepted and attractive Islamic financing method for intermediate to longer-term financing of equipment, machinery or real estate. It is used as an alternative to installment sale. Unlike installment sale, the lessor retains legal title to the property being financed, assuring an effective security interest. Another advantage of leasing is that it allows flexibility in payment terms, whereby the parties may agree that the rate of rental will be determined from time to time.

In many respects, ijarah resembles conventional leasing practiced by the banks and finance institution. They can either be the operating lease (where the lessor takes back the equipment when the lease ends) or financial lease (where the lease payments is cover the value of the equipment or property and the title may pass to the lessee at the conclusion of the lease). However, one distinguishing factor between the conventional leasing and Islamic leasing is that the responsibility for the maintenance and insurance of the leased asset. In conventional leasing, the responsibility is with the lessee, but in Islamic leasing, the lessor should bear the responsibility. However, if the may transfer the responsibility and the maintenance risk to the lessee if the lessee is agreeable to the arrangement. The fact that both lessor and lessee have agreed to such variation in the contract, makes the ijarah contract valid.

Modern Islamic finance often combines leasing with purchase in a single contract. This arrangement is known as Ijarah Thumma al-Bay’ or Al-Ijarah Al- Muntahia Bi Al-Tamlik or Ijarah Wa Iqtina’. It is a combination of lease contract with an option granted to the lessee to acquire or purchase the leased asset. The transaction commences with the payment of rent by the lessee, similar with normal ijarah contract; but at the end of the lease period, the lessee will purchase the asset at an agreed price from the lessor, by executing a purchase contract (bay’)⁶.