Bai al Salam by alicejenny

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									   Lecture Three

Financial System
                 Brief History of
            Islamic Financial System
   In 1963 Interest free savings bank (Mit Ghamr Saving
    Bank) was first introduced- invested in trade and industry in
    return of share of profits.
   During the 1970s and early 80s Egypt Nasr Social Bank,
    Dubai Islamic Bank, Faisal Islamic Bank of Sudan and
    Islamic Banks in Bahrain, Malaysia, Nigeria Indonesia, and
    the Philippines were established
   Islamic windows of the conventional banks: As of 2007 20
    branches of 10 conventional banks are operating under
    Islamic system. Examples- HSBC Amanah fund, ANZ
    International Murabhah ltd, Standard Chartered Sadiq
   1975 IDB was established through the Conference of
    Islamic Finance Ministers in 1973 – Fee and Profit Loss
    sharing Basis.
                 Brief History of
     Islamic Financial System in Bangladesh
   Islamic Finance started its journey in Bangladesh in 1980s
    with the establishment of the Islami Bank Bangladesh Ltd
    (IBBL) on March 13, 1983. It was the first Islamic bank in
    South and Southeast Asia. Now the leading private bank
    in Bangladesh.
   At present there are 7 full fledged Islamic banks operating
    in Bangladesh – IBBL-1983, Al-Barakah Islami Bank Ltd -
    1987 (Now known as ICB Islamic Bank), Al-Arafah Islami
    Bank Ltd- 1995, Social Investment Bank Ltd- 1995, Shamil
    Bank of Bahrain- 1997, Shahjalal Islami Bank Ltd- 2001,
    Exim Bank Ltd- 1999 (Islamic operation from 2004), Bank
    Al-Falah- 2007.
        Definition of Islamic Finance
   Islamic financial system is a product of Islamic economic
    system which is based on the Islamic principles and
    philosophy (Shariah). The basic framework for an Islamic
    financial system is a set of rules and laws, collectively
    referred to as the shariah, governing social, economic,
    cultural, and political aspects of the Islamic society. It
    differs from the western worldview in the following ways:
       Priority in emphasis on Islam's teaching of Justice and Equity as
        demonstrated by the enforcement of distributive justice
       A spiritual framework that values human relations above material
       A balance between individual self-interest and the common good
       Maximum profit and satisfaction are not the sole objectives, which
        in effect minimizes waste
       Recognition and protection of private property rights while
        encouraging reciprocal responsibilities.
   Differences Between Islamic
Finance and Conventional Finance
Bank       Goods & Services         Client


Bank                              Client
       Money & Money (Interest)
       Differences Between Islamic
    Finance and Conventional Finance

   CFS is based on interest where as IFS is based on
    profit/loss or rent sharing.
   CFS Deals with only the financial assets such as money or
    paper, IFS deals with real assets.
   CFS is based on predetermined return on both sides of the
    balance sheet, IFS is based on profit sharing on deposits
    (liability) side and profit/loss on the asset side.
   CFS does not involve itself in trade or business- just lend
    money in return of payment of interest. IFS actively
    participate in legal trade, production, and services through
    valid contracts as an investment partner. Similar role like
    an investment bank.
     Principles of Islamic Financial
    The basic principles of the Islamic financial system
    are based on the following characteristics
   Prohibition of interest (riba)
   Risk sharing
   Share of the profits
   Money as “potential” capital
   Prohibition of speculation (Gharar)
   Sanctity of contracts
   Shariah-approved activities.
     Differences between Profit and
   Profit is related to buying and selling (trading) of goods
    and services. Interest is related to purely debt and time.
   Profit is the integrated investment of capital, labor and time
    spent by the investors. In case of interest, the lender does
    not need to invest his labor.
   Profit is unidentified and uncertain, interest is predefined
    and certain.
   Profit is earned once only but interest may be taken
    several times.
   Profit is subject to having loss, interest has no uncertainty
    of loss.
      Challenges of Implementing
       Islamic Financial System
    The Islamic Financial System requires careful
    implementation of the following aspects:
   Supportive legal framework
   Overall risk management
   Ethical values
   Shariah body/council
   Standard Islamic financial institution
   Uniform accounting standard
         Major Contracts Used in
             Islamic Finance
   Murabahah: Buying and selling of goods based on
    cost-plus pricing
   Mudhrabah: Profit-sharing partnership
   Musharakah: Joint-venture partnership
   Ijarah: Leasing
   Wakalah: Agency
   Bai-al-Salam: Forward sale contract
   Istisna’a: Supply contract
   Qardul Hasanah: Benevolent loan
            (Bai-al-Bithman Ajil)
   It is a type of sale where the seller express the
    cost of the sold commodity, and sell it to
    another person by adding some profit of mark-
    up thereon.
   Two aspects are important for this type of
     Production cost + Mark-up

     Disclosure of actual cost
                 Basic Features of
                Murabahah Contract

   Murabahah is not as loan given on interest, rather it is a
    contract of sale of a commodity for a deferred payment
    which will include a cost plus added profit.
   It must follow the basic Islamic concept of contract (fiqh-
    al-muamalat). Two fundamental concepts are:
       The subject of sale must be present at the time of sale. Example:
        selling of inexistent good or service such as unborn calf, crops
        before ripe, fish in the pond, etc are prohibited.
       The subject of sale must be under the ownership of the seller at
        the time of sale. Example: forward contract on short selling is
              Basic Features of
             Mudarabah Contract
   Mudarabah is a special kind of partnership where one
    partner provide money to other partner(s) for investing in
    commercial enterprises. The investment comes from the
    fund provider who is called “rab-ul-maal” while the
    management and work is an exclusive responsibility of the
    other, called “mudarib”.
   Single-tier and Two-tier Mudarabah: Single tier
    mudarabah is a mechanism by which the investor directly
    deals with the entrepreneur, where as under the two-tier
    mudarabah, investors pull their funds with an intermediary
    who subsequently deals with entrepreneurs.

   Musharakah means sharing. In the context of
    business it refers to a joint venture in which all
    the partners share the profit or loss of the joint
    venture. Profit may be shared according to a
    previously agreed ratio but losses (if any) has
    to be shared according to the proportion of the
    contributed capital.
   The basic characteristics of Musharakah contracts
    include the followings:
       Each partner is an agent of the other partners in all
        aspect of the partnership business
       Partners must have-a) free will, b) sound mind and c)
        maturity of age
       Rate of profit to be shared must be predetermined.
       Capital may be invested in any proportion by the
       Loss (if any) must be borne according to the share of
        capital contribution.
          Differences between
       Mudarabah and Musharakah
   In case of mudarabah investment is the sole responsibility
    of rab-ul-maal, where as under musharakah investment
    comes from all the partners.
   For mudarabah management is carried out by the
    mudarib only, as for musharakah all partners can
    participate in the management.
   In case of mudarabah any loss incurred is born by the
    rab-ul-maal only, where as under musharakah losses are
    born by the partners according to their shares of
   For mudarabah there is a limited liability of the investors,
    where as for musharakah, the partners have unlimited
                  Al-Ijarah (Leasing)

   Ijarah means to give something in exchange for a rent
    income. In Islamic term it refers to a contact whereby the
    owner of something transfer its utility to another person for
    an agreed period, at an agreed consideration.
   The bank will lease an item to the customer for a pre-
    agreed period and then the customer will pay the balance
    of the price for the item and be the owner of the item.
   There are two concepts of ijarah:
       The first concept is drawn from Islamic jurisprudence. Here it
        refers to employment of the service of a person on wages given to
        him as a consideration for his hired services. Example Mr. A has
        employed Mr. B in his office as a manager on a monthly basis.
       However, in Islamic finance, it refers to the useful rental assets
        and properties and not to the services of human beings.

   It refers to the delegation of a duty to another
    party for specific purposes and under specific
    conditions. Under this concept, the bank act as
    an agent in completing a particular transaction
    in return of a service charge for the service it

   It is an order sale used mainly to finance assets
    under construction. This allows the bank to
    disburse payments according to the stage of
    completion. As a financier, the bank rarely order
    the assets for its own use rather for its customers.
    Once completed the asset is handed over through
    ijarah, murabahah, mudarabah or mushrakah
   Istisna'a is a technique similar to Bai al Salam and
    is used to provide advance funding for construction
    and development projects.
               Istisnah (cont.)

   The key practical difference to Bai al Salam is that,
    instead of buying a finished asset with delivery
    deferred, the financier pays an amount to fund the
    manufacture, development, assembly, packaging or
    construction of an asset to an agreed specification.
    On completion, it will typically sell the asset to the
    customer or lease it back to the developer under an
   The financier's return usually takes the form of a
    premium on resale, typically calculated by reference
    to a benchmark, such as an inter-bank offer rate
    (IBOR), plus a margin.

   Bai Al-Salam (future delivery) Refers to an
    agreement whereby payment is made immediately
    while the goods are delivered at a later date. It is
    equivalent to an advance payment.
   Bai al Salam can be used to provide working
    capital. The key difference to Murabaha is that,
    while the financier still buys an asset, delivery is
          Bai-al-Salam (cont.)

   Usually, the financier will receive a discount
    for advance payment, typically calculated by
    reference to a benchmark, such as IBOR,
    plus a margin.
   Financier may at the same time enter into a
    parallel but separate Bai al Salam with a
    third party to resell the asset for an increased
    price (also calculated by reference to a
    conventional benchmark such as IBOR), or it
    may simply sell the asset on delivery.

   Charitable loans free of interest and profit-
    sharing margins, repayment by installments.
    A modest service charge is permissible.
    Unremunerated deposit products, usually for
    charitable purposes.


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