Key Islamic Banking Instruments and How They Work

Checklist Description
This checklist provides an overview of Islamic banking instruments, such as murabaha, bai salam, istisna, ijara, and mudaraba.

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Definition
The need to fully conform to shariah law has created both challenges and opportunities for financial institutions aiming to serve their growing Muslim client base. Requirements that money cannot be used for the purposes of making money (effectively forbidding the charging of interest), and the need for investments to deliver some form of collective or community benefit, have necessitated a high degree of innovation from Islamic financial institutions to develop a range of new products for customers seeking full compliance with shariah law. Among the leading Islamic banking products are:

Murabaha
A kind of cost-plus transaction in which the bank buys the asset then immediately sells it to the customer at a pre-agreed higher price payable by installments. This price is set at a level that takes account of the time value of money until the customers monthly payments cover the banks selling price, less any deposit paid. This facility is often used in the way that mainstream banking customers might seek a mortgage when buying property.

Bai Salam
A kind of forward sales contract which requires the buyer to pay in advance for goods that are to be supplied later. bai salam contracts are often used in manufacturing; a buyer would expect to receive a more attractive price when paying in advance with funds that can be used in the meantime by the producer.

Istisna
Istisna, another form of forward sales contract, is a longer-term financing mechanism under which a price is agreed before the asset described in the agreement is actually built. Sellers can then either create the asset themselves or subcontract, with buyers also having the option of paying the entire sum due either in advance or as installments during the manufacturing process. istisna, meaning asking someone to manufacture in Arabic, is a common form of financing in the construction industry.

Ijara
A form of shariah law-compliant leasing involving the rights over the use of an asset under which the bank buys the asset then leases it to the customer over a fixed period in return for a pre-agreed monthly price.

Provisions can be made for the customer to buy the asset at the end of the agreed period. Thought needs to be given to issues such as the provision of insurance, as the asset is effectively owned by the bank during the lease period.

Mudaraba
A form of investment partnership between a bank and a business that shares the risk and losses/profits between both parties at pre-agreed levels. A mudaraba transaction, bringing some of the benefits of a business loan to shariah-compliant business customers, effectively requires the bank to take a stake in the business, with clients investing their time and expertise in running the enterprise.

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Advantages

Islamic banking instruments permit Muslims to benefit from a growing range of financial products in compliance with shariah law.

Some products require a partnership between the client and the bank, encouraging both parties to take a longer-term view.

Islamic banking dictates that transactions should serve to provide some form of benefit to the community at large, rather than setting pure profit as the aim. Back to top

Disadvantages

With some financial aspects of shariah law open to interpretation, some instruments may be offered by some institutions, but not by others.

Some non-Muslim clients could find that the conditions imposed by Islamic banks prevent them from taking advantage of shorter-term opportunities. Back to top

Action Checklist

When entering into leasing-style arrangements, ensure that all grey areas are covered by the agreement, such as the insurance and maintenance costs of the asset.

Islamic banking is by definition more stable than conventional mainstream banking in that it outlaws involvement in speculation or short-term industry trends. However, clients must ensure that they are committed to operating within the boundaries set by shariah law before using Islamic banking services. Back to top

Dos and Donts

Do

Appreciate that the stability of the Islamic banking sector can come at the price of a slower pace of product innovation.

Recognize that the rapid growth in Islamic banking globally could present an attractive source of funds for businesses prepared to make a long-term commitment to operation under shariah principles.

Dont

Dont ignore the aim of Islamic banking to bring a wider benefit to society. Dont see Islamic banking institutions as financial services providers for Muslims only; such banks can be valuable long-term commercial partners for a range of individuals

ISLAMIC FINANCE

Malaysia: An Islamic Capital Market Hub

By Amadou Sy IMF Monetary and Capital Markets Department September 18, 2007 Malaysia accounts for about two-thirds of global Islamic bonds (sukuk) outstanding Shariah-compliant stocks comprise about 86 percent of domestic stock exchange Authorities had key role in developing Malaysia's Islamic capital market

Malaysia is a champion for the development of capital market-based instruments under Islamic law in the form of sukuk. It hosts the world's largest Islamic bond market, estimated at $47 billion. Malaysian Islamic capital markets (ICM) have been developing at a rapid pace since the 1980s. The country now accounts for about two-thirds of the global Islamic bonds

(sukuk) outstanding and represents the largest sukuk market in terms of outstanding size and number of issues. While sukuk account for 14 percent of Malaysian public sector bonds outstanding, they represent about half of the total stock of corporate bonds outstanding ($32 billion). Corporate sukuk are issued mainly by the infrastructure/utilities and property/real estate sectors (70 percent). The most common type (around 80 percent) of corporate sukuk are based on bai bithaman ajil (a sales contract where payment is made in installments after delivery of goods) and murabahah (synthetic loans/purchase orders). Shariah-compliant stocks account for about 86 percent of stocks listed in the domestic stock exchange and 65 percent of total market capitalization ($195 billion). Supportive role The Malaysian authorities have played a key role in the development of the ICM, including through the issuance of local and global benchmark Islamic instruments. The growth in size and scope of the Malaysian ICM has also been accompanied by changes in the institutional and regulatory framework, as well as the market infrastructure and tax framework. These developments have helped deepen the domestic capital markets and provide financing to the domestic private and public sector. Recent policy initiatives aim now at leveraging existing achievements in the domestic capital markets to strengthen Malaysia's position as a global ICM hub. In 2000, the 10-year Capital Market Master Plan provided the broad strategic position and future direction for the ICM market. The authorities also issued guidelines for Islamic securities. Global hub The Ninth Malaysia Plan, covering 2006-10, seeks to position Malaysia as a global hub for ICM products and services and, in particular, as a center for origination, distribution, trading, fund, and wealth management. And, the Malaysia International Islamic Financial Centre is being established as a one-stop contact point to facilitate the issuance of sukuk. In addition, the authorities have introduced a number of initiatives and measures to further open their Islamic markets, including supporting the entry of foreign intermediaries, more flexible exchange control policies, a facilitative tax regime, and more flexible immigration policies. More broadly, the authorities also aim at an increased role for Islamic finance in the domestic intermediation process. For instance, the Ninth Malaysia Plan allocates 200 billion Malaysian ringgit for developmental projects and 20 billion for private finance

initiatives. Malaysia will also ease rules to allow banks to conduct Islamic banking business in foreign currencies.