SESSION 2

NON
FINANCIAL
CONTRACTS IN
ISLAMIC
BANKING
 2

At the end of this module, you should

be able to achieve the following:
➢An Overview of Islamic Financial
Intermediation;
➢Understand the Contracts in Islamic
Finance; and
Beginning with ➢Understand the Non-Financial
the end in mind Contracts in Islamic Banking.
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2 3

Presentation
outline
 SECTION 1

ISLAMIC FINANCIAL
INTERMEDIATION
An Overview of Islamic
Financial Intermediation
➢ Financial intermediation in Islamic
banks has a fundamental difference
from that in conventional banks.
➢ In Islamic financial intermediation
interest is replaced with profit and
loss sharing. Instead of the debit–
credit framework
➢ Islamic banks use the Mudarabah
concept.

5
Islamic Financial Intermediation Model

Two-Tier Mudarabah: This model

includes two tiers of Mudarabah.
a) The first tier is on the liability
side of the bank’s balance sheet.
b) The second tier is on the asset
side of the bank’s balance sheet.
 7
The Conventional Financial Intermediation
The Islamic Financial Intermediation 8
 SECTION 2
MOST COMMON
CONTRACTS IN
ISLAMIC FINANCE
 ➢ Shari’ah-compliant contracts are like any valid conventional contract, 10
with the addition of certain Shari’ah rulings.
➢ Shari’ah-compliant valid financial contracts have the following
requirements:
1. Two or more independent parties, with their mutual consent and
for their mutual benefit.
2. All contracting parties should be adults under Shari’ah and be
mentally sound.
3. The subject matter of the contract should be acceptable in
Shari’ah.
4. The item of exchange should exist, be owned and be in physical
Contracts in or constructive possession of the seller.
5. The contract should be devoid of Riba, Gharar and Maysir.
Shari’ah Law 6. The contract should be linked to a real asset or enterprise.
7. There should be an offer and an acceptance related to the
product and price.
8. Transfer of ownership should follow the exchange of the asset and
the payment.
Common Islamic Finance Contracts
11
 1. Deposit Contracts: 12
✓ Qardh.
✓ Wadiah or Wadiah wadhamana.
✓ Mudharaba.
✓ Wakala.
2. Financing contracts:
✓ Musharakah & Musharakah Mutanaqisa,
Contracts in Mudharaba
Usage ✓ Murabaha, Musawamah, Bai Bithamanin Ajil.
✓ Tawarruq.
We will look ✓ Ijarah.
briefly at some of ✓ Salam & Istisnaa.
the examples of 3. Other contracts:
each of the ✓ Sarf.
modes in the ✓ Kafala
coming slides ✓ Rahn
 SECTION 3
NON FINANCIAL
CONTRACTS IN
ISLAMIC BANKING
 14

➢ Islamic finance draws its value propositions

from the application of a diverse spectrum of
Shari’ah contracts in financial transactions that
provide for different risk and return profiles.
➢ The strict adherence by Islamic financial
institutions to Shari’ah principles under such
distinct contracts preserves the sanctity and
An Overview of validity of Islamic financial transactions.
Non-Financial ➢ We will learn the Non-financial Contracts in
Islamic Banking in the following slides.
Contracts in IB
 SECTION 2 (A)
MUDARABAH CONTRACT
 16

➢ Mudarabah is a contract between a capital provider

(rabbul mal) and an entrepreneur (mudarib) under which
the rabbul mal provides capital to be managed by the
mudarib and any profit generated from the capital is
shared between the rabbul mal and the mudarib according
to a mutually agreed profit sharing ratio (PSR) whilst
financial losses are borne by the rabbul mal provided that
such losses are not due to the mudarib’s misconduct,
negligence or breach of specified term.
An Overview of ➢ Rabbul maal trust their capital with the Mudarib, hence
the name of ‘trust financing’.
Mudharabah ➢ Mudarabah can also be called a passive partnership, since
one party is involved actively while the other is not.
Contract
 There must be two or 17
Components of a more parties to the
contract of
Mudarabah 1 Mudharabah
Funds
i.e.
Provider
Contracting
Contract Parties (Customer) & Funds
Manager (the Bank).

Offer and Acceptance.

✓They should be clear. The capital should be:
✓Corresponding to 3 2 ✓ Known to both
Offer and Acceptance. parties involved.
✓ With the quantum
and type of the
Profit/Loss currency specified.
Profit/Loss is:
✓ Recognized.
✓ Determined.
✓ Distributed. 4
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The following basic principles should be taken into consideration

while determining the net profit of the Common Mudarabah Pool:
➢ Profit or loss account of any investment pool can be ascertained
through liquidation of pool.
➢ Since actual liquidation of the CMP is not possible, Shari’ah
allows a constructive liquidation of the pool by following proper
accounting policies and standards.
Profit ➢ No profit can be realized unless the capital deployed for
investment remains intact, as profit is the surplus generated
Calculation in through investment of the Mudarabah capital.

Mudarabah ➢ Through constructive liquidation of the CMP, the net profit, if

any, can be ascertained in the following manner:
 a. Total income from the CMP’s Shari'ah compliant financing 22
and investment activities in which the funds of the CMP have
been used should be calculated.
b. The following items should then be deducted from (a).
i. Direct expenses relating to financing & investment
activities of the CMP such as taxes, transportation
expenses of the goods, insurance of the goods and leased
assets etc.;
Profit ii. Provisions for bad and doubtful transactions/
investments; and
Calculation in iii. Depreciation of the fixed assets in the CMP such as
Mudarabah assets leased on operating lease basis, if any.
The result of the above equation will be the net profit of the CMP
(Cont.’) available for distribution between the shareholders and the
depositors.
 Provisions & Reserve Related to Mudarabah
➢ Islamic banks allocate a percentage of their profit
to a reserve fund before sharing it with depositors
and distributing to shareholders.
➢ The purpose of this fund is aimed at smoothing
the profit distributed to account holders between Investment Risk
Profit Equalization
high-profit and low or no-profit years. Reserve Reserve
➢ Strict accounting rules need to be followed in The allocation for this
The allocation for this
allocating profit to the reserve funds, as this affects reserve from the Mudarabah reserve from the
both the bank, its account holders and finally the profit is made before Mudarabah profit is done
shareholders. allocating any amount to the after the share of the
➢ The approval of the account holders, mainly the Mudarib and aims to Mudarib has been allocated
investment account holders, who are the Rabbul maintain the level of return and it aims to protect
Maal, is required for the reserve allocation. for investment account investment account holders
holders. from future losses.
Islamic banks usually maintain two
kinds of reserves.
Examples of Products under Mudarabah Contract Offered 24
by an Islamic Bank

Mudharabah
Capital Pool

Saving Investment Placement Mudharabah Project

Accounts Accounts Sukuk Financing
 SECTION 3 (B)
INTRODUCTION TO AGENCY
AGREEMENT (WAKALAH)
 26

➢ Wakalah refers to a contract in which a party,

as principal (muwakkil) authorizes another
party as his agent (wakil) to perform a
particular task in matters that may be delegated,
with or without imposition of a fee.
➢ The inherent nature of wakalah is based on
An Overview of delegation or authorization of the wakil by the
Wakalah muwakkil resulting in the wakil having fiduciary
duties (amanah) towards the muwakkil within
what has been authorized to him.
 Components of a Wakalah Contract 27

1. Contracting Parties 2. Contractual Expression

The Principal Offer (ijab) and
and Agent. Acceptance
(qabul).

3. Subject Matter
To perform a particular task.
 28

Export Letter of
Collections of Bills
Credit (LC)

Financial Contracts
Funds Transfer (Murabaha, Ijarah,
Services Musharakah,
Tawarruq, etc.)

Examples of
Products under
Wakalah Contract
Offered by an
Islamic Bank
 SECTION 3 (C)
INTRODUCTION TO
KAFALAH CONTRACT
 30

➢ Kafalah (Guarantee) refers to a contract

where the guarantor conjoins the
guaranteed party in assuming the
latter’s specified liability.
➢ The specific inherent nature of kafalah
is to provide assurance on the
fulfilment of an obligation of the
An Overview of guaranteed party’s liability.
Kafalah ➢ Kafalah is binding on the guarantor.
 Components of a Kafalah Contract 31

1. Contracting Parties 2. Contractual Expression

The Guarantor Offer (ijab) and
(Kafil), the Acceptance
Beneficiary (qabul).
(Makful Lahu) &
the Guaranteed
Party (Makful
‘anhu).

3. Subject Matter
Debt liability & Delivery of a
physical asset.
Examples of Products under Kafalah Contract Offered 32
by an Islamic Bank

1 Bid Bonds.

2 Advance Payments.

Letter of 3 Performance Guarantees.

Guarantee
 SECTION 3 (D)
INTRODUCTION TO WADIÁH
CONTRACT (SAFEKEEPING)
 34

➢Wadi`ah (Safekeeping) refers to a

contract where an asset is placed
with another party for safekeeping.
➢The inherent nature of wadi`ah is
An Overview trusteeship, referred to as wadi`ah
of Wadiáh yad amanah in which any of the
contracting parties may terminate
the contract unilaterally.
 Components of a Wadiáh Contract 35

1. Contracting Parties 2. Contractual Expression

Comprising a Offer (ijab) and
Custodian (wadi`) Acceptance
and a Safekeeping (qabul).
Depositor (mudi`).

3. Subject Matter
Wadiáh Asset.
Examples of Products under Wadiáh Contract Offered an Islamic 36
Bank

Safe Current
Custody Accounts
THANK YOU