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What are the terms used in Islamic Finance? Research Team | Posted On Thursday, April 09,2009, 01:35 PM

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What are the terms used in Islamic Finance?



1. Bai' al-Inah (Sale and Buy Back Agreement)

The financier sells an asset to the customer on a deferred-payment basis, and after that the asset is straight away repurchased by the financier for cash at a discount. The buying back agreement allows the bank to assume ownership over the asset in order to defend against default without explicitly charging interest in the event of late payments or insolvency. Some scholars think that this is not compliant with Shariah principles.

2. Bai' Bithaman Ajil (Deferred Payment Sale)

This idea refers to the sale of goods on a deferred payment basis at a price; it includes a profit margin agreed to by both parties. This is related to Murabahah; apart from that the debtor makes only a single installment on the maturity date of the loan. By the application of a discount rate, an Islamic bank can assemble the market rate of interest.

3. Bai muajjal (Credit Sale)

Bai muajjal means a credit sale, it is a financing technique adopted by Islamic banks that takes the form of murabaha muajjal. It is a contract in which the bank earns a profit margin on the purchase price and allows the buyer to pay the cost of the commodity at a future date in a lump sum or in installments. It has to particularly mention cost of the commodity and the margin of profit is jointly agreed. The cost fixed for the commodity in such a transaction can be the same as the spot price or higher or lower than the spot price.

4. Mudarabah (Profit Sharing)

Mudarabah is an agreement between the bank, or a capital provider, and an entrepreneur, whereby the entrepreneur can gather together the funds of the former for its business activity. The entrepreneur provides expertise, labor and management. Income made is shared between the bank and the entrepreneur according to predetermined ratio. In case of failure, the bank loses the capital, while the entrepreneur loses his provision of labor. It is this financial risk, according to the Shariah, that justifies the bank's claim to piece of the profit, the profit-sharing continues until the loan is repaid. The bank is remunerated for the time value of its money in the form of a floating rate that is pegged to the debtor's profits.

5. Murabahah (Cost Plus)

This concept refers to the sale of goods at a cost, which includes a profit margin agreed to by both parties. The purchase and selling value, other costs, and the profit margin must be clearly stated at the time of the sale agreement. The bank is rewarded for the time value of its money in the form of the profit margin. This is a fixed-income loan for the purchase of a real asset with a fixed rate of profit determined by the profit margin. The bank is not rewarded for the time value of money outside of the contracted term; but, the asset remains as a mortgage with the bank until the Murabaha is paid in full.

This kind of transaction is similar to rent-to-own arrangements for furniture or appliances that are very common in North American stores.

6. Musawamah

Musawamah is the negotiation of a selling price among two parties without reference by the seller to either costs or asking price. Where the seller may or may not have full knowledge of the cost of the item being negotiated, they are under no obligation to reveal these costs as part of the negotiation process. This difference in obligation by the seller is the key difference between Murabaha and Musawamah with all other rules as described in Murabaha remaining the same. Musawamah is the most familiar kind of trading negotiation seen in Islamic commerce.

7. Bai salam

Bai Salam means a contract wherein advance payment is made for goods to be delivered later on. The seller undertakes to supply various specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. It is necessary that the quality of the commodity planned to be purchased is fully specified leaving no ambiguity leading to dispute. The objects of this sale are goods and cannot be gold, silver, or currencies based on these metals, excepting this, Bai Salam covers almost everything that is capable of being definitely described as to quantity, quality, and workmanship.

8. Hibah (Gift)

This is a token given willingly by a debtor to a creditor in return for a loan. Hibah regularly arises in practice when Islamic banks voluntarily pay their customers a 'gift' on savings account balances, representing a part of the profit made by using those savings account balances in other activities.

It appears similar to interest, and may, in effect, have the same outcome, Hibah is a voluntary payment made at the bank's discretion, and cannot be 'guaranteed.' But, the opportunity of receiving high Hibah will draw in customers' savings, providing the bank with capital necessary to create its profits; if the ventures are profitable, then some of those profits may be gifted back to its customers as Hibah.

9. Ijarah

jarah means lease, rent or wage, generally, Ijarah concept means selling profit or use or service for a predetermined price or wage. Under this concept, the Bank makes available to the customer the use of service of assets / equipments such as plant, office automation, motor vehicle for a fixed period and price.

Advantages of Ijarah

Ijarah provides the following advantages to the Lessee :
  • Ijarah conserves the Lessee' capital because it allows up to 100% financing.
  • Ijarah gives the Lessee the right to use the equipment on payment of the first installment. This is significant as it is the access and use of equipment that generates income.
  • Ijarah arrangements aid corporate planning and budgeting by allowing the negotiation of flexible conditions
  • Ijarah is not considering Debt Financing therefore it does not appear on the Lessee' Balance Sheet as a Liability. This method of off-balance-sheet financing means it is not included in the Debt Ratios used by bankers to determine financing limits, this allows the Lessee to enter into other lease financing arrangements without impacting his overall debt rating.
  • All payments towards Ijarah contracts are treated as in service expenses and are therefore fully tax-deductible, leasing thus offers tax-advantages to for-profit operations.
  • Various types of equipment become obsolete before the end of their actual economic life. Ijarah contracts allow the transfer of risk from the Lessee to the Lessor in exchange for a higher lease rate, this higher rate can be viewed as insurance against obsolescence.
  • If the equipment is used for a comparatively short period of time, it may be more profitable to lease than to buy.
  • If the equipment is used for a short time but has a very poor resale value, leasing avoids having to account for and depreciate the equipment under normal accounting principles.

10. Ijarah Thumma Al Bai' (Hire Purchase)

Here, parties enter into contracts that come into effect serially, to form a complete lease/ buyback transaction. The first contract is an Ijarah that outlines the conditions for leasing or renting over a fixed period, and the second contract is a Bai that triggers a sale or purchase once the term of the Ijarah is complete. For example, in a car financing facility, a customer enters into the first contract and leases the car from the owner at an agreed amount over a specific period. When the lease period expires, the second contract comes into effect, which enables the customer to buy the car at an agreed to price.

The bank generates a profit by determining previously the cost of the item, its residual value at the end of the term and the time value or profit margin for the money being invested in purchasing the product to be leased for the intended term.

The combining of these three figures becomes the foundation for the contract between the Bank and the client for the initial lease contract. This type of transaction is similar to the contractum trinius, a legal plan used by European bankers and merchants during the middle Ages to sidestep the Church's prohibition on interest bearing loans. In a contractum, two parties would enter into three concurrent and unified legal contracts, the net effect being the paying of a fee for the use of money for the term of the loan. The use of concurrent unified contracts is also prohibited under Shariah Law.

11. Ijarah-Wal-Iqtina

A contract wherein an Islamic bank provides equipment, building, or other assets to the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee. The undertaking or the promise does not become an important part of the lease contract to make it conditional. The rentals and the purchase price are fixed in such manner that the bank gets back its principal amount along with profit over the period of lease.

12. Musharakah (Joint Venture)

Musharakah is a relationship between two parties or more, of whom donate capital to a business, and divide the net profit and loss pro rata, this is often used in investment projects, letters of credit, and the purchase or real estate or property. In the case of real estate or property, the banks assess an imputed rent and will share it as agreed in advance. All providers of capital are permitted to participate in management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by every partner strictly in proportion to particular capital contributions. This concept is different from fixed-income investing i.e. issuance of loans.

13. Qard Hassan (Good Loan)

This is a loan extended on a goodwill basis, and the debtor is only required to repay the sum borrowed. But, the debtor may, at his or her discretion, pay an extra amount beyond the principal amount of the loan as a token of appreciation to the creditor. Here the debtor does not pay an extra amount to the creditor; this transaction is a true interest-free loan. A few Muslims consider this to be the only type of loan that does not violate the prohibition on riba, since it is the one type of loan that truly does not compensate the creditor for the time value of money.

14. Sukuk (Islamic Bonds)

Sukuk is the Arabic name for a financial certificate but can be seen as an Islamic equivalent of bond, though the, fixed-income, interest-bearing bonds are not permissible in Islam. So, Sukuk are securities that comply with the Islamic law (Shariah) and its investment principles, which prohibit the charging or paying of interest. In the secondary markets financial assets that comply with the Islamic law can be classified in accordance with their tradability and non-tradability.

15. Takaful (Islamic Insurance)

Takaful is an alternative form of cover that a Muslim can avail himself against the risk of loss due to misfortunes, it is based on the idea that what is uncertain with respect to an individual may cease to be uncertain with respect to a huge number of similar individuals. Insurance by combining the risks of many people enables each individual to enjoy the benefit provided by the law of large numbers.

16. Wadiah (Safekeeping)

In Wadiah, a bank is deemed as a keeper and trustee of funds, person who deposits funds in the bank and the bank guarantees refund of the whole amount of the deposit, or any part of the outstanding amount, when the depositor demands it. The depositor, may be rewarded with Hibah or gift at the bank's discretion, as a form of appreciation for the use of funds by the bank.

17. Wakalah (Agency)

This occurs when a person appoints a agent to undertake transactions on his/her behalf, similar to a power of attorney.

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