ISLAMIC BANKING TRAINING MANUAL

Module-9

Salam and its application in Islamic Banking

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Contents
Salam ............................................................................................................................................... 3
Introduction ................................................................................................................................. 3
Definition ..................................................................................................................................... 3
Legitimacy of Salam ..................................................................................................................... 3
Basic terms of Salam ................................................................................................................... 4
Purpose of use: ............................................................................................................................ 4
Conditions for Bai Salam ............................................................................................................. 5
Benefits........................................................................................................................................ 6
Conditions of Parallel Salam ........................................................................................................ 7
Buy Back .................................................................................................................................. 7
Revoking Salam Contract............................................................................................................. 7
Agency Contract .......................................................................................................................... 8
In case of Default ......................................................................................................................... 8
Risk Mitigation in Salam .............................................................................................................. 8
DIFFERENCE BETWEEN SALAM AND MURABAHA: ...................................................................... 9
Sample Salam Shariah Process Flow ......................................................................................... 10
Sample Incentive Schedule........................................................................................................ 14

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Salam
Introduction
Basic principle for validity of a sale in Shari'ah is that:

 The commodity must be existing;

o Non-existing goods are not eligible for sale;
 The seller must have ownership of the commodity;
o Short sale (selling of what is not owned by seller) is not allowed;
 The commodity must be in the physical or constructive possession of the seller;
o Selling of what is not possessed by seller is not allowed;

All sale transactions should conform to these above mentioned rules;

There are only two exceptions to these principles in Shari'ah and they are:

 Bai’ Salam
 Bai’ Istisna'

Both these are sales of special nature and are exceptions to the general rules of sale.

Definition
In Salam, the seller undertakes to supply specific goods to the buyer at a future date in exchange
of an advanced price fully paid at spot. The payment is at spot but the supply of purchased goods
is deferred.

In other words, Purchase of a commodity for deferred delivery in exchange of immediate payment
according to specified conditions.

Legitimacy of Salam
The contract of Salam derives its legitimacy from the Quran, Sunnah and Ijma.
Hazrat Ibn Abbas (R.A) said I declare that a Salaf (Salam) contract in which the commodity is
guaranteed for future delivery has been permitted by Allah and read:

“O you who believe! When you transact a debt payable at a specific time, put it in writing.”

(Surah Al Baqara, verse 282)

It is reported that Hazrat Ibn Abbas (R.A) said that this verse is a revelation for the particular
purpose of making Salam permissible.

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  Hazrat Ibn Abbas (R.A) is reported to have said: The prophet (peace be upon him) had
come to Madinah and found that people were selling dates for deferred delivery after a
duration of one or two years on a Salam basis.

 The Prophet (peace be upon him) said:

“Whoever pays for dates on a deferred delivery basis (Salam) should do so on the basis of specified
scale and weight.”

 In Another version of Hadith, it comes:

Whoever pays on a deferred delivery basis should do so on the basis of a specified scale, weight
and date of delivery. (See Sahih Al Bukhari Dar Al Qalam 2/781).

The Scholars are unanimous on the legitimacy of Salam. According to Ibn Al Mundhir:

All authoritative fuqaha (jurists) unanimously agreed that Salam is considered permissible.

(Ibn Al Mundhir, Al-Ijma p.54)

Basic terms of Salam

Some basic terms which are used in a salam contract

There are four basic components in a Salam contract namely:

 ) ‫ (رب السلم‬Rabb ul-Salam. Buyer.

 )‫ (مسلم اليه‬Muslam ilaihi. Seller.
 )‫ (راس مال السلم‬Rass u maalis Salam. Price.
 )‫ (مسلم فيه‬Muslam fihi. Subject matter.

Purpose of use:
 Before prohibition of interest farmers used to get interest based loans for growing crops and
harvesting. After prohibition of interest, they were allowed to do Salam transactions. This
helped them to get money in advance for their needs.

 During the days of our prophet (peace be upon him), the merchants going with caravans used
to get interest based loans for purchasing the commodities. After prohibition of interest, they
were allowed to do Salam.

 This mode of financing can be used by the modern banks and financial institutions especially
to finance the agricultural sector.

• To meet the needs and requirements of small farmers who need financing to grow their crops
and to feed their families until the time of harvest. When Allah's messenger declared Riba as

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haram, the farmers could not take usurious loans. Therefore, the Holy Prophet (‫ )ﷺ‬allowed them
to sell their agricultural products in advance.

• To meet the need of traders for import and export business. Under Salam, it is allowed to sell
the goods in advance so that after receiving cash price, they can easily undertake the aforesaid
business. Salam is beneficial to the seller as he receives the price in advance and it is beneficial
to the buyer also as normally the price in Salam is lower than the price in spot sale.

Seller benefits from the Salam sale by covering his financial needs whether these are personal
expenses or expenses for productive or trading activity.

For Example: A sugar manufacturer places an order of 1000 metric ton of sugar cane to famers.
The farmers would deliver the required quantity of sugarcane on a certain future date on Salam
Basis. In this case, the sugar manufacturer will pay the sugar cane price in full in advance to the
farmers. The farmers will utilize these funds in sugar cane production and will deliver the required
quantity and quality of sugar cane on the agreed date to the buyer. Once the buyer accepts the
delivery of sugar cane, the Salam stands concluded. In case there was a natural calamity that
destroyed the crop or the grower could not yield the exact quality of sugarcanes as specified in
the contract, the grower shall arrange the same quantity and quality of sugarcane from the
market and deliver it to the buyer on agreed date at the agreed place.

The permissibility of Salam is an exception to the general rule that prohibits forward sale and
therefore it is subject to strict conditions, which are as follows:

Conditions for Bai Salam

The conditions for Bai Salam are as follows:

1) It is necessary for the validity of Salam that the buyer pays the price in full to the seller at
the time of affecting the sale. In the absence of full payment, it will be tantamount to sale
of a debt against a debt, which is expressly prohibited by the Holy Prophet (‫)ﷺ‬. Moreover,
the basic wisdom for allowing Salam is to fulfill the "instant need" of the seller. If the full
price is not paid in advance, the basic purpose of Salam will not be achieved.

2) All the parties should know the capital of Salam. It may be in form of fungible goods,
livestock and usufruct of an asset. Generally, they may agree in terms of cash.

3) Only those goods can be sold through a Salam contract in which the quantity and quality
can be exactly specified e.g. precious stones cannot be sold on the basis of Salam because
each stone differs in quality, size, weight and their exact specification is not possible. The
underlying commodity in Salam transactions has to be fungible and homogenous in
nature that is measurable by weight or volume.

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 4) Salam cannot be effected on a particular commodity or for a product of a particular field
or farm e.g. Supply of wheat of a particular field or the fruit of a particular tree since there
is a possibility that the crop may get destroyed before delivery and given such possibility,
the delivery remains uncertain.
5) All details in respect to quality of goods sold must be expressly specified leaving no
ambiguity, which may lead to a dispute.
6) It is necessary that the quantity of the commodity is agreed upon in absolute terms. It
should be measured or weighed in its usual measure only, meaning what is normally
weighed cannot be quantified and vice versa.
7) The exact date and place of delivery must be specified in the contract.
8) Salam cannot be affected in respect of items, which must be delivered at spot. For
example, if gold is purchased in exchange of silver, it is necessary that the delivery of both
commodities be simultaneous, thus gold or silver cannot become the subject matter of
Salam if the price is paid in the form of gold/silver.
9) The commodity for Salam contract should be available in the market at the time of
delivery. This view is as per the rulings of Shaafi, Maliki and Hanbali schools of thought.
10) The time of delivery should be at least fifteen (15) days to one month from the date of
agreement. Price in Salam is generally lower than the price in spot sale. The Salam period
should be long enough to affect the prices. But Hanafi Fiqh did not specify any minimum
period for the validity of Salam. It is all right to have an earlier date of delivery if the seller
consents to it.
11) Before delivery, goods will remain at the risk of seller. After delivery, the buyer bears all
the risk. Possession of goods can be physical or constructive. Transferring of risk and
authority of use and utilization / consumption are the basic ingredients of constructive
possession.
12) Since price in Salam is generally lower than the price in spot sale; the difference in the
two prices may be a valid profit for the Bank.
13) A security in the form of a guarantee, mortgage or hypothecation may be required for a
Salam in order to ensure that the seller delivers the goods.
14) The seller at the time of delivery must deliver commodities and not money to the buyer
who would have to establish a special cell for dealing in commodities.

Benefits
There are two ways of using Salam for the purpose of financing:

1) After purchasing a commodity by way of Salam, the financial institution can sell it through a
parallel contract of Salam for the same date of delivery. The period of Salam in the second parallel
contract is shorter and the price is higher than the first contract. The difference between the two
prices shall be the profit earned by the institution. The shorter the period of Salam, the higher the
price and the greater the profit. In this way, institutions can manage their short term financing
portfolios.

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2. The institution can obtain a promise to purchase from a third party. This promise should be
unilateral from the expected buyer. The buyer does not have to pay the price in advance. When
the institution receives the commodity, it can sell it at a pre-determined price to a third party
according to the terms of the promise.

Conditions of Parallel Salam

1. In an arrangement of parallel Salam, there must be two different and independent contracts;

i) one, where the bank is a buyer and

ii) The other in which it is a seller.

The two contracts cannot be tied up and performance of one should not be contingent on the
other. For example, if 'A' has purchased from 'B' 1,000 bags of wheat by way of Salam to be
delivered on 31 December, 'A' can contract a parallel Salam with 'C' to deliver to him 1,000 bags
of wheat on 31 December. But while contracting Parallel Salam with 'C', the delivery of wheat to
'C' cannot be conditioned with taking delivery from 'B'. Therefore, even if 'B' does not deliver
wheat on 31 December, 'A' is duty bound to deliver 1,000 bags of wheat to 'C'. He can seek
whatever recourse he has against 'B', but he cannot rid himself from his liability to deliver wheat
to 'C'. Similarly, if 'B' has delivered defective goods, which do not conform to the agreed
specifications, 'A' is still obligated to deliver the goods to 'C' according to the specifications agreed
with him.

Buy Back
i. The seller cannot use Salam arrangement as a buy back facility.
ii. The bank cannot purchase a commodity from a supplier on Salam basis and then resale
the same to the same seller.

2. A Salam arrangement cannot be used as a buy back facility where the seller in the first
contract is also the purchaser in the second contract. Even if the purchaser in the second
contract is a separate legal entity, but owned by the seller in the first contract; it would not
be tantamount to a valid parallel Salam agreement. For example, 'A' has purchased 1,000
bags of wheat by way of Salam from 'B' - a joint stock company. 'B' has a subsidiary 'C', which
is a separate legal entity but is fully owned by 'B'. 'A' cannot contract the parallel Salam with
'C'. However, if 'C' is not wholly owned by 'B', 'A' can contract parallel Salam with it, even if
some share-holders are common between 'B' and 'C'.

Revoking Salam Contract

i. Once agreed upon, neither party can revoke the Salam contract unilaterally.
ii. The parties can mutually revoke the entire or partial contract with mutual agreement.

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Agency Contract
i. If the bank has no expertise to sell the commodities received under Salam contract, then
the bank can appoint the seller as its agent to sell the commodity in the market to any
third party, subject to condition that Salam agreement and Agency agreement are
separate from each other.
ii. Price must be determined in agency agreement on which the agent will sell the
commodity. The Bank can award an incentive to the agent against good performance.

In case of Default
i. The buyer cannot stipulate any penalty in the contract.
ii. If the seller fails to perform his obligation, due to insolvency or any unseen genuine
reasons, the bank may relax the delivery time.
iii. If the total or partial quantity is not available on due date, the customer has an option to
wait until the seller can provide the same quantity or can revoke and claim the price
without any opportunity cost. However, the buyer can claim actual loss from the seller.

Risk Mitigation in Salam

Some of the risks that are present in Salam Financing for Banks are as follows:

Risk Details Mitigation

 Delivery Risk  Delay in delivery of goods  Wait until the goods are
from the customer. available.
 Bank can cancel the contract
and recover the Salam Price
 Bank can agree on
replacement of goods
provided that the market
value of the replaced goods
does not exceed the market
value of the original goods
that were subject matter of
Salam.
 Quality Risk  The Customer delivers  The Bank has the right to
defected /inferior goods. reject the delivery or bank
can accept the delivery at
discounted price (with
mutual consent).
 Price Risk  Market price of the  Parallel Salam or promise to
subject matter decreases purchase from a third party
after Bank enters into will mitigate the risk.
Salam agreement

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  Price risk is another issue  Proper and prudent
in a Salam transaction. determination of the
Under Agency quantity of Salam goods
arrangements, Bank can help in avoiding these
cannot force the risks. If all reasonably
customer(Agent) to sell
possible adverse events
the goods at a price that
are factored into
is above the market
price. Any decline in calculating the marked-
market price of good has down present market
to be borne by the Bank. value of the goods,
substantial risks can be
mitigated.
 Storage Risk  The goods once delivered  Obtain Takaful coverage for
by Customer will be at Salam goods
Bank’s risk before the  Minimize the time duration
same are sold to the between acceptance of
ultimate purchaser. delivery under Salam and
delivery to the ultimate
purchaser.
 Income/loss due to  In case of early  Financing only to low risk
early Termination of termination of contract customer with satisfactory
Contract with mutual consent, track record to be allowed.
Bank will receive the
principal amount only.
Hence, there is a risk of
loss of potential income.
 Operational Risks  Risk that relevant staff  Provide proper training.
checked documentation
and a proper knowledge
of Shariah Principles.

DIFFERENCE BETWEEN SALAM AND MURABAHA:

Salam Murabaha

 In Salam, delivery of purchased goods  In Murabaha, purchased goods are

is deferred, price is paid on spot. delivered at spot, price may be
either on spot or deferred.

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  In Salam price has to be paid in full in  In Murabaha price may be paid on
advance. spot or deferred.

 Salam is not executed in the particular  Murabaha is executed in particular

commodity but commodity is commodity.
specified by specifications.

 Salam cannot be effected in respect of  Murabaha can be executed in those

things, which must be delivered at things, subject to the conditions of
spot. e.g. Salam between wheat and hand to hand transfer and equal
barley. quantities.

Sample Salam Shariah Process Flow

To Shariah Compliance Department

From Islamic Banking Division – IB New Garden Town branch Lahore
Approval Date 22.12.2021
Client XYZ Sugar Mills Limited
Review Date 01 year from the approval date (in case of any deviation in the
procurement/purchase cycle/mode of payment of the customer, the
process flow should be immediately revised & written approval must be
obtained from RSBM)
Purpose Process Flow for Salam Finance Facility
Limit Amount PKR 300 Million – Regular Line

Company Introduction:
XYZ Sugar Mills Limited is a 12,000 tons crushing per day (TCD) capacity sugar mill located in the
in Sindh with a 13.5 MW power house. The company was incorporated in May 2009 and COD was
achieved in Jan 2013, on schedule and within budget. The company's initial capital structure was
highly conservative LTD 52%.

Facility Purpose:
To facilitate the working capital requirements of the company.

List of Credible Buyers/ Distributors:

ABC Ali Traders and ABD Traders are major local distributor parties and sugar also export to
Afghanistan parties.

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Documentation Flow:

 Master Salam agreement

 Master Agency Agreement After approval of limit
 Corporate guarantee along with list of Buyers

 Written Offer
At the time of transaction
 Acceptance of offer

 Notice of delivery (By customer) At the time of Delivery of Salam

 Goods Receiving Note (By Bank) Goods

 Instruction to sell along with Incentive

Schedule (By Bank) At the time of hiring the
 Receipt of Goods (By Customer) customer as agent

 Written confirmation of sale to third party At the time of sale of Salam

With Copy of Invoice(s). Goods to ultimate buyer

Transaction Structure:

The transaction structure is based on Salam (an Islamic mode of finance). Bank will give an order
to XYZ Sugar Mills Limited for supplying sugar, and upon delivery of sugar bank will appoint XYZ
Sugar Mills Limited as its agent for selling of Salam goods in market on Bank’s behalf.

Process Flow to be followed for Salam Transactions:

1. After necessary credit and Shariah approval the bank will enter into Master Salam
agreement and Master Agency Agreement with the customer.

2. The bank will obtain corporate guarantee from the customer, which will be triggered in
case of default of ultimate buyer. (list of ultimate buyers must be attach with corporate
guarantee).

3. The customer will provide the Bank a Written offer to offer sale of specific Salam goods
(Sugar). The lack of details leads to dispute which may makes the transaction invalid.
a. Description and Specification of Salam goods.
b. Quality
c. Quantity

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 d. Sale Price of Sugar
e. Date of Delivery
f. Place of Delivery

4. Upon receipt of Written Offer, the bank will review the request and will place the order
for specified and quantified sugar through Acceptance of Offer. If there are more than
one Salam goods then the Description, Specification, Quantity and Price of each item
should be mentioned in written offer.

5. The price of Salam goods must be paid on the spot at the time of acceptance of offer.
However, delay in payment by the bank may render the Salam transaction invalid.

Note: As per recently issued SBP instructions dated 27th August 2021 and SNBL guidelines
for exposure to sugar Mills in compliance of SBP directives, process regarding
disbursement shall be followed according to the scenarios mentioned below:

 In case where customer had already paid the full payment to suppliers or growers
against the purchase of sugarcane, Bank shall disburse the amount in the account of
the customer where funds available to the customer subject to an undertaking (i.e.
already with the Business / CAD) with each disbursement has been provided.

 In case payment to suppliers or growers against the procurement / purchase of

sugarcane has not been made fully or partially by the customer, bank shall disburse
the amount in the current account of the customer but shall be kept under Bank’s lien
for payment to the growers / suppliers of the sugarcane. Customer shall provide the
instructions letter (after acceptance of offer by the bank) to authorize the Bank to
directly pay to the growers / suppliers of the sugarcane by debiting their account. Any
residual amount after making full payment to the growers / suppliers shall be
available to the customer.

(In Salam contract price of goods must be paid immediately at the place where the
contract is concluded. However, as an exception to this ruling, payment may be
delayed because of operational delays for two or three days at most, further delay in
payment by the bank may render the Salam transaction invalid).

6. The purchase of Salam Goods should be made on discount of cost prices to mitigate the
risk of price fluctuation but this discounting shall be done on cost price of the Salam goods
(Sugar). The rate of discount will be decided by the Business /branch. This discount will
enable the bank to pay agency incentive and cover its profit after the final sale.

7. The client will deliver the Salam goods within 120 days from the date of written offer in a
form of 50 kg or 100 kg in a specified godowns.

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 8. On delivery date the customer will inform the bank that salam goods are ready to deliver
through Notice of Delivery. The specification of Salam goods (i.e. Sugar), location of
delivery and date should be clearly mentioned in the notice of delivery.

9. A representative of the bank will take the physical possession of Salam goods after
inspection on site. 100% physical possession of Salam goods is compulsory in each Salam
transaction. The representative of the bank should submit his inspection report to the
concerned credit team/branch. The credit team/branch should maintain the transaction
wise record of inspection reports. The date should be clearly mentioned in the inspection
report.

10. After the verification and physical possession of Salam goods the Bank will issue Goods
Receiving Note to Customer. The date should be clearly mentioned in the Goods
Receiving Notes.

11. The risk of goods will transfer to the bank after physical possession and issuance of Goods
receiving note. This risk will remain with the bank until the goods are sold to the ultimate
buyer.

12. Customer will arrange Takaful coverage for Salam goods on behalf of bank on priority
basis.

13. After the receipt of goods at customer’s premises, the Bank will appoint XYZ Sugar Mills
Limited as its agent for the selling of Sugar through Instruction to sell. At this point the
targeted sale price along with the agency incentive of XYZ Sugar Mills Limited will be
decided through incentive schedule. The minimum Incentive amount must be Rs. 500
whenever the goods will be sold-out. The date should be clearly mentioned in Instruction
to sell. The Sample Incentive schedule is attached below;

14. After the appointment of XYZ Sugar Mills Limited as Bank’s agent the bank will hand over
the Sugar goods to XYZ Sugar Mills Limited and XYZ Sugar Mills Limited will provide the
bank a Receipt of Goods. The date should be clearly mentioned in the Receipt of Goods.

15. Upon sale of Sugar XYZ Sugar Mills Limited will inform the Bank regarding the sale
through Written Confirmation along with copy of Sale invoice (commercial invoice) and
pay the sale price to the Bank after receipt of the sale proceeds.

Additional Requirements:

a. If the transaction security is pledge on sugar, the relevant pledge should be in place before
the disbursal. Further the pledge sugar should not increase or decrease due to the
delivery of salam goods.

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 b. The disbursal amount should be based on the actual costs incurred by the customer for
manufacturing of sugar. The purchase price should be made on discount on cost to
mitigate the risk of price fluctuation.
c. Customer will arrange Takaful coverage (Islamic Insurance) for Salam goods on behalf of
bank.
d. Credit in-charge / officer should ensure that the date must be mentioned at each
document of the transaction.

Sample Incentive Schedule

Soneri Bank Limited - Islamic Banking Division Sample Sheet

Salam Pricing Incentive schedule

Quantity in Bags 13,575 Profit Rate 7.66%

Disbursement Date 18-Apr-17 Market Price
Cost of Goods 33,333,333
Cushion 3,333,333 10% Discounting as approved in process flow
Purchase Price 30,000,000
Per Bag Price 2455.494168
Date of delivery 23-May-17
Transctional Cost -
Profit (for year) 2,298,000
Salam Selling Price 32,298,000

Target Selling Price Cost Profit Selling Price Incentive Payment Date
32,298,000 30,000,000.0 220,356.2 30,220,356.2 2,077,643.8 23/May/17
32,298,000 30,000,000.0 226,652.1 30,226,652.1 2,071,347.9 24/May/17
32,298,000 30,000,000.0 232,947.9 30,232,947.9 2,065,052.1 25/May/17
32,298,000 30,000,000.0 239,243.8 30,239,243.8 2,058,756.2 26/May/17
32,298,000 30,000,000.0 245,539.7 30,245,539.7 2,052,460.3 27/May/17
32,298,000 30,000,000.0 251,835.6 30,251,835.6 2,046,164.4 28/May/17
32,298,000 30,000,000.0 1,133,260.3 31,133,260.3 1,164,739.7 15/Oct/17
32,298,000 30,000,000.0 2,266,520.5 32,266,520.5 31,479.5 13/Apr/18
32,298,000 30,000,000.0 2,272,816.4 32,272,816.4 25,183.6 14/Apr/18
32,298,000 30,000,000.0 2,279,112.3 32,279,112.3 18,887.7 15/Apr/18
32,298,000 30,000,000.0 2,285,408.2 32,285,408.2 12,591.8 16/Apr/18
32,298,000 30,000,000.0 2,291,704.1 32,291,704.1 6,295.9 17/Apr/18
32,298,000 30,000,000.0 2,298,000.0 32,298,000.0 500.0 18/Apr/18

=CostPrice - = Cost x Units x

=TargetSellingPrice - = Target Selling
(Partial No of Days /
PartialPayment - Selling Price
Payment- 365

Notes
1) The days mentioned above are tentative.
2) Price cushion (margin) shall be maintained by by setting finaning target for the
customer in order to mitigate risk.

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