Modes Of Financing

Different Ways of Project Financing in an Islamic Bank 1) Mudharaba (Trust financing) - In order to understand the system lets consider the following scenario – a businessman comes up with a project of 6 months that requires Dhs. 50,000. The businessman claims that he would get a return of Dhs. 100,000 which means a profit of Dhs. 50,000. The Islamic bank would then analyze the nature of the business, whether it is viable and if the return is profitable. Both the parties then decide on a ratio that would be shared between them. Suppose the Islamic bank suggests that it will get 3 parts of the profit whereas the businessman will get 2 parts, 60%: 40%. If this deal is approved by the businessman the bank would then go ahead with the requested transaction. In the modern bank the interest is negotiated whereas in the Islamic bank the profit ratio is determined. The businessman would then be granted Dhs. 50,000 for 6 months. If the entrepreneur works for the business in that particular time period even his salary (e.g average salary of a person can be Dhs. 2000) will also be included in the amount lent by the bank. Therefore, at the end of 6 months a salary of Dhs. 12000 (6 x 2000) will be taken into account. However if the businessman has employed other people then the amount for his salary will not be considered. The remaining Dhs. 38,000 of Dhs. 50,000 would be used for the buying of materials and paying the administration. If at the end of 6 months the businessman gets a profit of Dhs. 50,000, his total return would be Dhs. 100,000 from which Dhs. 50,000 is given back to the bank. The remaining Dhs. 50,000 is shared by the entrepreneur and the bank on the ratio that had been determined prior to the commencement of the business project. So the Islamic bank would get 60% of the profit, i.e. Dhs. 30,000 and the businessman 40%, Dhs. 20,000 + Dhs. 12,000 (salary for his labor). Here also, greater the profit, greater the share for both the parties, but if the businessman goes in loss, the complete loss is borne by the Islamic bank. The bank in turn passes the loss to the depositor. Technically, even the businessman suffers a loss as his time, ideas and efforts were wasted. He had been paid for his labor but not for other charges. In the system of Mudharaba the bank has no right to interfere with the management of the business of the entrepreneur. The bank can evaluate and assess the progress of the business but cannot intervene with the management. For example if a businessman wants to construct a 10 storey building, the Islamic bank cannot ask him to build 12 instead of 10. 2) Musharaka (Participation financing) – This form of trading is also known as partnership. In this case, the bank has the authority to interfere with the management of the system. The bank can suggest ideas and guide the businessman to apply techniques that would bring them a greater profit. In Musharaka, the businessman has got part of the capital it takes from the Islamic bank. The amount is invested by each party depending on the ratio of investment. The profit is again shared on a predetermined ratio. For example, if each party has invested 50% amount then 50% profit goes to both parties. The loss is also shared on a predetermined ratio, but this ratio is different from the sharing of profit

as the bank bears a greater loss, e.g. if the both invested 50% and there is a loss then the bank bears 60% of it, while the depositor would have a loss of 40%. 3) Murabaha (Cost-plus trade financing) – Suppose a person wants to purchase a particular piece of machinery from Japan and it costs around Dhs. 100,000. To process this transaction through a modern bank the person would open a Letter of Credit or a Trust Receipt and keep the money in the bank. The bank would then buy the machinery from Japan and would charge a fixed interest on the time taken to purchase the equipment. In comparison, the Islamic bank would buy the machinery from Japan on behalf of the depositor. The Islamic bank has a right to take service charges or commission. This profit is called Ijara and is negotiable. 4) Mudharaba with Murabaha - If a person lacks financial resources to purchase that machinery (refer point 3), he can combine the Mudharaba system with Murabaha to process this transaction. For instance, the person who has no financing power asks the bank to purchase machinery worth Dhs. 100,000 from Japan and claims to make a profit of say Dhs. 2000 by selling it in Dubai. This kind of transaction would be called as Mudharaba as the bank purchases the equipment for the businessman who promises to make a profit of Dhs. 20,000 on it. The profit would be shared on a pre-determined ratio. The bank can demand 60% profit and leave the 40% for the businessman since the bank is financing the project by 100% and not a single pie is contributed by the businessman. After the machinery is sold he returns Dhs. 100,000 to the bank as capital along with 60% profit of 12,000, so Dhs. 8000 will remain with the businessman. This system is known as Mudharaba along with Murabaha. 5) Musharaka with Murabaha – The businessman partly contributes in the purchase of the machinery (refer point 4). For example, he has Dhs. 50,000 and the rest of the Dhs. 50,000 is given by the bank to purchase the machinery that costs Dhs. 100,000. The shares in profit are agreed upon beforehand. 6) Ijara (leasing or rental financing) – Suppose a person wants to rent a car for Dhs. 200,000. The Islamic bank agrees to rent the car to the person depending on the lifespan of the vehicle. Suppose a car can last for 5 years and the Islamic bank demands a profit of Dhs. 100,000. The cost price and profit when added (200,000 + 100,000) would give a total of Dhs. 300,000. This total is divided equally between 60 months, so the bank rents the car to the businessman at Dhs. 5000 per month. Initially, the businessman was not interested in buying the car but after 3 years if he is willing to buy back the car, this kind of trading would be called as Ijara ending with sale. Islamic banking not only allows renting but also provides the facility of buying back. In modern banks, the car would be registered by the name of the person who wants to rent it and will be given to the bank hypothetically. The modern bank will never buy back the car. According to the Islamic financial and banking system, if a person does not want to buy the car, it will remain with the bank. A businessman taking loan from an Islamic bank has the option of buying back the car or keeping it with the bank. 7) Qarz-e-Hasan – Qarz means loan and Hasan, beautiful. This is a form of loan that is given to the poor without charging any interest. There is no equivalent of Qarz-e-Hasasn or interest-free loan in any system of modern banking. In Islamic banks some percentage

of profit is kept separately for Qarz-e-Hasan. In the Islamic banks in Malaysia, this percentage is 10%. This loan encourages the poor people to do business. For example, a person takes loan of Dhs. 500 from the bank for a year. If he earns some profit after a year he can give some part of the profit to the bank if he wills but he is not forced to return a single pie extra than the money he has borrowed. It is quite unfortunate that many banks today operate under the label of Islam but are not truly Shariah compliant. An easy way to determine whether the Islamic bank is following the principles of Quran and Sunnah is to observe how it actually works in practice. Some Islamic banks simply rename the word interest with profit. The truth can be exposed by asking the bank if the profit amount (not the percentage amount) is fixed, or if the customer profit is declared before the bank’s actual profit is announced. If either of this is the case then the profit is just another kind of interest or Riba. Who is he that will lend to Allah a goodly loan so that He may multiply it to him many times? And it is Allah that decreases or increases (your provisions), and unto Him you shall return. [Surah Al-Baqarah 2:245]. The example of those who spend their wealth in the way of Allah, is like a grain of corn that grows seven ears, each of which contains a hundred grains. Allah multiplies for whoever he wishes. And Allah is All Sufficient for His Creatures’ needs and All-Knowing [Sura Al Baqarah 2:261]. Is there any business in this world today that offers us a profit of 70,000%? But Allah has promised us a profit of 70,000% i.e. 700 times more profit and Allah does not stop at this. He will give us many-fold times more but for us to do business with Allah we need to have Taqwa, faith, righteousness and God consciousness. Surely the best bank that one can invest in is the bank of Allah (SWT).