28 Nov

Islamic Finance | CA Final SFM

Islamic finance refers to the means by which corporations in the Muslim world, including banks and other lending institutions, raise capital in accordance with Sharia, or Islamic law. It also refers to the types of investments that are permissible under this form of law.

A unique form of socially responsible investment, Islam makes no division between the spiritual and the secular, hence its reach into the domain of financial matters. Because this sub-branch of finance is a burgeoning field, in this article we will offer an overview to serve as the basis of knowledge or for further study.

Although they have been mandated since the beginning of Islam in the seventh century, Islamic banking and finance have been formalized gradually since the late 1960s, coincident with and in response to tremendous oil wealth that fueled renewed interest in and demand for Sharia-compliant products and practice.

Central to Islamic banking and finance is an understanding of the importance of risk sharing as part of raising capital and the avoidance of “Riba” (usury) and “Gharar” (risk or uncertainty).

Islamic law views lending with interest payments as a relationship that favors the lender, who charges interest at the expense of the borrower. Because Islamic law views money as a measuring tool for value and not an asset in itself, it requires that one should not be able to receive income from money (for example, interest or anything that has the genus of money) alone. Deemed “Riba”, such practice is proscribed under Islamic law (haram, which means prohibited) as it is considered usurious and exploitative. By contrast, Islamic banking exists to further the socio-economic goals of Islam.

Accordingly, Sharia-compliant finance (halal, which means permitted) consists of profit banking in which the financial institution shares in the profit and loss of the enterprise it underwrites. Of equal importance is the concept of “Gharar”. Defined as risk or uncertainty, in a financial context it refers to the sale of items whose existence is not certain. Examples of “Gharar” would be forms of insurance, such as the purchase of premiums to insure against something that may or may not occur or derivatives used to hedge against possible outcomes.

The equity financing of companies is permissible, as long as those companies are not engaged in restricted types of business, such as the production of alcohol, pornography or weaponry, and only certain financial ratios meet specified guidelines.

While Islamic finance has roots in the past but there is resurgence in past 30 years. Though Islamic finance is different from the conventional finance but it has same objective of providing economic benefits to the society.

Islamic Finance Banking or Sharia Complaint finance is banking or financing activity that complies with Sharia (Islamic law) and its practical application through the development of Islamic economies.

Since under Islamic finance money is considered as only a mean of carrying out transactions any earning on the same in form of interest (“Riba”) is strictly prohibited.

Sharia Board

To ensure that all Islamic finance products and service offered follow principles of Sharia Rules, there is a board called Sharia Board which oversees and reviews all new product offered by financial institutions.

Concept of “Riba”

In Islamic Finance, the meaning of “Riba” is interest or usury. As mentioned earlier in Islamic Finance money is considered as medium of exchange, store of value or unit of measurement only, hence “Riba” is considered haram i.e. unfair reward to the provider of capital for little or no effort or risk undertaken. Due to this reason, Islamic finance models are based on risks and profit/loss sharing contract (as clear from the financial products discussed above).

“Riba” is equated with wrongful appropriation of property belonging to others and hence Muslims are asked to accept principal only and forego principal even, if borrower is unable to repay the same.

In this backdrop in Islamic banking a link must be established between money and profit as an alternative to interest. This is in sharp contrast of conventional banking which is simply based on lender borrower’s relationship.

Since, interest is not allowed in Islamic Finance, depositors are rewarded by a share in the profit from the underlying business (after deduction of management fees) in which the funds of depositors have been channeled.

Thus, it can be said that money has no intrinsic value i.e. time value of money. The relationship between depositor and banker can be viewed as:

  • Agent and Principal or
  • Depositor and Custodian
  • Investor and Entrepreneur
  • Fellow joint partners

Islamic Finance Instruments


Mudaraba is an Islamic contract in which one party supplies the money and the other provides management expertise to undertake a specific trade. The party supplying the capital is called owner of the capital. The other party is referred to as an agent who actually runs the business.

In Islamic finance, mudaraba is a trust financing contract. Mudaraba may be conducted between investment account holders as fund providers and the Islamic bank. Mudaraba is a partnership where capital is provided, in cash or assets (no debt is accepted) by one party – the fund provider – and labour is provided by the other party – mudarib.

Both parties can appoint agents on their behalf.  A mudaraba contract could be terminated unilaterally except when a term has been agreed by both parties, in which case the mudaraba could only be prematurely terminated by mutual agreement.  In addition, if the mudarib has already started the business, in the mudaraba contract, it becomes binding until actual or constructive liquidation.

As mudaraba is a trust-based contracts, the mudarib is not liable for losses except in case of breach of the requirements of trust or misconduct. Guarantees against negligence or misconduct could be taken from the mudarib as long as they are not excessively used by the capital provider.  The contract should specify whether the mudaraba instrument is unrestricted or restricted (to specific location or type of investment as agreed between parties).  It should also indicate the distribution ratio of profit between both parties (which cannot be a lump sum or a percentage of capital).  The distribution ratio could be revised at future dates by agreement of both parties.


A Musharaka contract is an agreement where two or more parties (for example an Islamic bank and its clients) agree to contribute to the capital – in cash or in kind, no debt is accepted – of the partnership in equal or varying amounts to establish a new project or share in an existing one.

Musharaka could be constant, where the partners’ shares in the capital remain constant throughout the period as specified in the Musharaka contract or diminishing, where the Islamic bank agrees to transfer its share gradually to the other partner, so that the Islamic bank’s share diminishes and the other partner’s share increases until the latter becomes the sole proprietor of the venture.

In Musharaka contracts, all parties must provide work but equality of the share of work is not a requirement. Partners may appoint workers to perform the tasks that are not within their individual share of work and the cost will be charged to the partnership.  Partners are not allowed to borrow or lend money from the partnership’s funds except after securing agreement from the other partners.  Musharaka partners must share profit and loss.

For Musharaka contracts to be valid, they must specify, at the time of the contract, the share of each partner in the capital.  The latter must also be available at the time of contract.  The Islamic bank’s share in the Musharaka shall be measured at fair value at the time of contract and at historical cost, after contracting, at the end of each financial period until final settlement. For Musharaka financing transactions that continue for more than one financial period, the Islamic bank shall recognise its share of profits or losses, for a financial period, resulting from partial or final settlement of the Musharaka.

Islamic bonds, structured in such a way as to generate returns to investors without infringing Islamic law (that prohibits riba or interest).


Sukuk represents undivided shares in the ownership of tangible assets relating to particular projects or special investment activity. A Sukuk investor has a common share in the ownership of the assets linked to the investment although this does not represent a debt owed to the issuer of the bond.

In the case of conventional bonds the issuer has a contractual obligation to pay to bond holders, on certain specified dates, interest and principal. In contrast, under a Sukuk structure the Sukuk holders each hold an undivided beneficial ownership in the underlying assets.

Consequently, Sukuk holders are entitled to a share in the revenues generated by the Sukuk assets. The sale of Sukuk relates to the sale of a proportionate share in the assets.

Since the beginning of 2000, sukuk have become important Islamic financial instruments in raising funds for long-term project financing. The first sukuk were issued by Malaysia in 2000, followed by Bahrain in 2001.  Since then sukuk have been used by both the corporate sector and states for raising alternative financing.  While sukuk issuance was affected by the global financial crisis, since 2011, sukuk have been growing in popularity.


There are various types of Sukuk structures relating to the nature of the underlying asset. The most commonly used is where the Sukuk relates to a partial ownership of an asset (Sukuk al-ijarah). Other types of these bonds relate to partial ownership in in a debt (sukuk murabaha), project (Sukuk al-istisna), business (Sukuk al-musharaka), or investment (Sukuk al-istithmar).

By 2011 over more than $19 billion had been raised through 30 issues of Sukuk bonds on the London Stock Exchange.


Islamic financial institutions use ijarah contracts either as a lessor or a lessee.  Some jurists define ijarah as ownership of the right to the benefit of using an asset for a period in return for a consideration.

Ijarah is classified into operating ijarah, which doesn’t include a promise to transfer the legal title of the leased asset into the lessee at the end of the lease, and financial ijarah, which is concluded by passing the legal title of the leased asset to the lessee.

For the ijarah contract to be valid it must be preceded by acquisition of the asset to be leased by the institution (lessor).  The ijarah contract is a binding contract which neither party may terminate or alter without the other’s consent.

The duration of the ijarah contract must be specified in the contract and normally commences on the date of executing the contract unless a future date is agreed by both parties.  It is permissible that the Islamic bank requires the lease promisor (customer) to pay to guarantee the customer’s commitment to accept a lease on the asset and the subsequent obligations, provided no deduction to be made to this sum except for damages suffered by the bank as a result of the customer’s breaching his promise.

No rental will be due if the lessor fails to deliver the asset to the lessee on the date specified in the ijarah contract.  At the end of the ijarah agreements the lessee has one of three options; either to return the leased asset to the lessor or to renew the lease contract for another term or to purchase the leased asset for a price that is determined based on rental payments made by the lessee.


In Islamic finance, a sales contract where the bank buys a product on behalf of a client and resells the product to the same client by clearly mentioning the cost incurred in buying the product and the margin or the mark-up when reselling the product to the client.

Usually the bank pays for the product in full and allows the client to pay the bank back in installments. So, instead of having a classic loan as in conventional finance when the bank lends money to the client to buy products, in the murabaha case, the financial institution buys and resells the product with a mark-up to the client.

Murabaha is a very popular contract in Islamic finance, especially for the buying of commodities involving large sums of money where the client is unable to pay in advance or when the commodities supplier does not trust the client. It is Sharia-compliant because there is no interest rate on a differed payment the financial institution gives to the client.

Since the mark-up is fixed, banks are more comfortable in entering the murabaha arrangement than in profit and loss sharing options where the income for the bank is not guaranteed.


Istisna means asking someone to construct, build or manufacture an asset. In Islamic finance, istisna is generally a long-term contract whereby a party undertakes to manufacture, build or construct assets, with an obligation from the manufacturer or producer to deliver them to the customer upon completion. In practice, the key advantage of an istisna contract is that it can provide flexibility to the customer, where payments can be made in installments linked to project completion, at delivery or after project completion. In contrast to istisna, for salaam contract the payment has to be made in full, in advance.

Istisna is a contract of exchange, whereby the funding party agrees to deliver a commodity or an asset at a pre-determined future time at an agreed price.

Istisna is widely used by Islamic banks and financial institutions to finance the construction of real estate related activity like buildings, warehouses, showrooms, shopping malls, residential towers and villas, as well as manufacturing activity like aircrafts, ships, machines and equipment.

Istisna are based on a contract for a future delivery of manufactured or constructed asset(s). At the delivery date(s), which can be single or multiple, the obligor will deliver the asset(s). The investors do not intend to hold the assets, they will be on-sold to an ultimate buyer, which could be the obligor. The investors will receive the proceeds of this sale. Often Sukuk al-istisna is combined with a forward lease arrangement to enable investors to receive a return before the delivery of the asset(s).


Salam is a forward financing transaction, where the financial institution pays in advance for buying specified assets, which the seller will supply on a pre-agreed date. What is given in exchange for the advance payment of the price should not in itself be in the nature of money. For the payment in advance, the contracting parties stipulate a future date for the supply of goods of specified quantity and quality.

Salam may be considered as a kind of debt, because the object of the Salam contract is the liability of the seller, up to the agreed future date, to deliver the object for which advanced payment of the price has already been made. There is consensus among Muslim jurists on the permissibility of Salam, notwithstanding the general principle of the Sharia that does not permit the sale of a commodity which is not in the possession of the seller, because the object of the contract is that the goods are a recompense for the price paid in advance, just as the price is recompense paid for getting the goods in advance. The transaction is considered Salam if the buyer has paid the purchase price to the seller in full at the time of sale. The idea of Salam is to provide a mechanism that ensures that the seller has the liquidity they expected from entering into the transaction in the first place. Muslim jurists are unanimous that full payment of the purchase price is key for Salam to exist. However, Salam cannot take place in money or currencies as these are subject to rules, wherein exchange has to be simultaneous.

Because the Salam contract deals with the delivery of an asset which is not in existence, the Sharia highlights that strict rules must be adhered to in order to ensure that the right of all parties are protected. In fact, it is necessary that the quality of the commodity is fully specified leaving no ambiguity which may lead to a dispute. All the possible details in this respect must be expressly mentioned. Salam can be effected in those commodities only the quality and quantity of which can be specified exactly. The commodity should be generally available in the market at the time of delivery. And all goods that can be categorized as belonging to the same species can be the subject of Salam. However, Salam cannot take place between identical goods. Besides, the time and place of delivery of the goods should be precisely fixed; and the quality and the quantity of the goods should be clearly specified. The specification of goods should particularly cover all those characteristics which could cause variation in price.

Other rules applied to Salam contract, is that the seller in Salam need not be the manufacturer or producer of the asset. The seller may be an agent to deliver the asset. Furthermore, a Salam contract can stipulate that that, in the event of late delivery of the goods, the supplier pays a certain amount as a penalty to the buyer, which amount must be used for a charitable purpose; it cannot be taken into the buyer’s income. The buyer has also the right to demand security or collateral from the seller to ensure that the seller delivers the goods on the agreed date, the buyer has the right to dispose of the security and purchase the specified goods from the market; the buyer is entitled to deduct the advance payment from the proceeds of the security realised and return any surplus to the seller.

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