Islamic Modes of Financing Salam

Summary of the Previous Lecture In our previous lecture we covered one of the important modes of financing in under Islamic banking system, i.e. Murabaha and we covered the following; Principles of Murabaha Procedures Application of Murabaha

Learning Outcomes After this lecture you should be able to understand the two modes of Islamic financing; Salam and parallel Salam Istisna and parallel Istisna And the differences between the Salam and Istisna modes of financing

Salam: Forward Purchase A salam transaction is the purchase of a commodity for deferred delivery in exchange for immediate payment. It is a type of sale in which the price, known as the salam capital, is paid at the time of contracting while delivery of the item to be sold, known as subject matter of salam, is deferred. Uses: Purchase of commodities (financing for production of agricultural commodities/ minerals) Liquidity requirements of sugar mills, etc.

Salam: Shariah Legitimacy Allah says “O you who believe when you deal with each other, in transactions involving future obligations in a fixed period time, reduce them to writing” [2:282] Ibn Abbas reported, the Prophet (PBUH) came to Medina and found that people were selling dates for deferred delivery (salam) after a duration of one or two years. The Prophet (PBUH) said: “whoever pays for dates on a deferred delivery basis (salam) should do so on the basis of specified scale and weight” [Bukhari and Muslim]

Wisdom of allowing Salam Beneficial for both seller and purchaser: seller or the farmer can get capital to grow the crop and get better produce of the crop, while the buyer can be sure of its stocks and price. Three major problems Risk of default by seller Bank’s need to liquidate goods after delivery Seller’s inability to produce or procure commodity

Principles of Salam An exception to the possession A contract opposite to Murabaha Payment of full price at spot - otherwise selling debt for debt Allowed in fungible commodities Product of a particular origin can't be specified Quality and quantity decided in unambiguous terms

Principles of Salam The commodity should remain in the market throughout the period of contract (different opinions). The time of delivery should be sufficient to allow use of Salam capital conveniently A security/guarantee is preferred as safeguard to the risk of default Only commodity is delivered and not the money

Parallel Salam The disposal of commodity at the end of Bank can be through: Parallel Salam: MFI may sell commodity, before the date of delivery, to some other purchaser for the date of original delivery. The period in second contract will be shorter than the original contract, but price will be higher than the original contract. Unilateral Promise: Promise of purchase can be obtained from third party for delivery on the date of original contract. Price in this promise is set higher than parallel salam because the promisor has to pay nothing.

Rules of Parallel Salam and Third Party Promise Both the contracts i.e. Salam and parallel Salam must be independent of each other Parallel Salam is allowed only with third parties The third party giving unilateral promise should not pay the price in advance as this is not allowed in Sharia.

Bank Transacts Purchase of Wheat Contract against payment of agreed price. Commodity to be delivered in six months. Bank apprehends trend of depressed prices in the prospect OR requires liquidity. Bank’s position at disadvantage as compared to other purchasers contracting lower spot price but cannot undo the contractual obligation. Bank can keep the original contract and enter another Salam contract with a buyer expecting trend otherwise… can lower the price risk.

Istisna

Istisna Introduction Istisna is a sale transaction where commodity is transacted before it comes into existence. Definition It is an order to producer to manufacture a specific commodity for the purchaser.

Conditions of Istisna the subject of Istisna is always a thing which needs manufacturing Manufacturer use his own material Quality and Quantity should be agreed in absolute term Purchase price should be fixed with mutual consent

Price of Istisna Price of Istisna may be spot and deferred therefore Istisna is applicable where Salam is not applicable. Price of Istisna can be paid in installments. The installments may be tied up with different stages of manufacturing.

Right of Rejection When the required goods have been manufactured by the manufacturer, purchaser can exercise his right to reject the goods based on the defects in the manufactured goods

Revoking of Istisna The contract of Istisna can be cancelled unilaterally before the manufacturer starts working. After starting the work, Istisna cannot be cancelled unilaterally.

Difference between Istisna & Salam The subject of Istisna is always a thing which needs manufacturing. The price in Istisna does not necessarily need to be paid in full in advance. The subject can be any thing. The price has to be paid in full in advance.

Difference between Salam and Istisna Time of Delivery does not have to be fixed, but the stages of manufacture might be time bound The contract can be cancelled before the manufacturer starts working. Time of delivery is an essential part of the sale The contract cannot be cancelled unilaterally.

Security A security in the form of a guarantee, mortgage or hypothecation may be required for Istisna in order to ensure that the manufacturer shall deliver the commodity on the agreed date, In the case of default in delivery, the guarantor may be asked to deliver the same commodity, and if there is a mortgage, the buyer can sell the mortgaged property and the sale proceed can be used either to realize the required commodity by purchasing it from the market, or to recover the price advanced by him.

Time of Delivery It is not necessary in Istisna that the time of delivery is fixed. However, the purchaser my fix a maximum time for delivery after the appointed time, he will not be bound to accept the goods and pay the price. In order to ensure that the goods will be delivered within the specified period, some modern agreement of this nature contain a penalty clause to the effect that in case the manufacturer delays the delivery after the appointed time, the price shall be reduced by a specified amount per day.

Delivery of Manufacturing goods Before delivery, goods will remain at the risk of seller. After delivery, risk will be transferred to the purchaser. 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. If manufactured goods are delivered before agreed date, purchaser can refuse to accept the goods.

Parallel Istisna and its Applications After the execution of Istisna agreement with one party, buyer as a seller executes another Istisna agreement with third party,

Conditions for Parallel Istisna There must be two different and independent contracts, these two contracts cannot be tied up and performance of one should not be subject to the other. Parallel Istisna is allowed with third party only.

Parallel Istisna 2nd Istisna Purchaser 1st Istisna Manufacturer Istisna Sale Parallel Istisna 1st Istisna Manufacturer 2nd Istisna Purchaser Delivery of Commodity Islamic Bank Seller Islamic Bank Purchaser Delivery of Commodity

Potential of Istisna The client can get finance for raw material, working capital and other overhead expenses by the execution of Istisna agreement. House financing, import and export products can be easily designed on Istisna basis.

Istisna as Mode of Financing House Financing Project Financing BOT Arrangement Export Pre Shipment

Risks in Istisna Applications and their Solutions Ownership of Material The Islamic bank is not the owner of the materials in the possession of the manufacturer for the purpose of producing the asset. Security is available with the bank. Delivery Risk Islamic bank may be unable to received goods as scheduled due to late delivery of completed goods and may not be able to honor the parallel Istisna. Bank can reduce the Istisna price according to the Istisna agreement.

Summary of the Lecture In this lecture we discussed two modes of Islamic financing; Salam and parallel Salam Istisna and parallel Istisna Differences between the Salam and Istisna modes of financing