1. Islamic Modes of Financing Salam

2. 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

3. 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

4. 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.

5. 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]

6. 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

7. 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

8. 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

9. 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.

10. 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.

11. 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.

12. Istisna

13. 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.

14. 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

15. 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.

16. 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

17. 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.

18. 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.

19. 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.

20. 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.

21. 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.

22. 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.

23. 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,

24. 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.

25. 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

26. 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.

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

28. 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.

29. 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