Step two: common Islamic products (page 1 of 2)

By Kaushiq Kodithodika, Advent

A Shariah-compliant portfolio may be made up of:

- Islamic-based permitted (halal) investments
- Qualifying 'conventional' securities and cash

The Islamic-based permitted investments are covered by a number of standard contract types.
advent.com

Standard Contracts

Mutual Investment Contracts

The principal transactions within this group are the mudaraba and musharaka. In the mudaraba arrangement, the bank will provide funds to the entrepreneur who will supply labour or expertise. The bank may invest its own funds in which case it is the investor (Rab ul-Mal), or it may act as agent (mudarib) on behalf of other bank clients who wish to invest funds in which case the bank aggregates the investment funds and places them with the entrepreneur. Profits will be shared according to a pre-defined ratio while losses are borne purely by the investor(s).

The musharaka is a similar partnership arrangement, but the bank does not act alone in investing in the project. In a musharaka there are other direct investors, which may include the entrepreneurs themselves. Profits are shared according to a pre-agreed ratio, but losses are shared on the pro-rata of the capital investments.

This sharing of profits in an agreed ratio enables the bank to take a higher proportion of profits in order that its investment may be returned earlier, enabling the bank to exit the arrangement earlier than other investors. This arrangement (called a diminishing musharaka) can be used by a client to finance the start-up of a business or the purchase of real estate where the bank's share of the ownership gradually reduces.

Finance Contracts

This group of transactions are used by banks to provide assets, or the use of assets, directly to their clients. The most common types are the murabaha (cost plus sale), the ijara (lease), and the salam and Istisna'a forward finance transactions.

The murabaha is the most common Islamic form of financing. In this the bank acquires an asset on behalf of the client, and in turn the client will buy the asset back from the bank over time. The client and bank agree at the time of contract on the amount of profit that the bank will make. This contract can be used at a retail level, say to buy a car, or at a corporate level, for example to acquire real estate. In its reverse form murabaha is used as a method of time deposit. In this arrangement, it is the bank that does the "buying" and the investor that "sells." Most commonly the investor "buys" a stated commodity which is then "sold" to the bank for selling price plus profit. The bank's payment will be deferred for an agreed time. In this way the investor deposits money with the bank which is then repaid plus profit at a given time in the future, avoiding interest.

The ijara lease is similar to a conventional lease in form but presents some significant differences. The bank acquires the asset (plane, manufacturing equipment, etc.) and gives the client the right to use the asset (called usufruct) in return for agreed lease payments. Ownership of the asset remains with the bank, which is also responsible for its maintenance.

In an ijara wa iktina, payments contain an element of capital repayment so that at the end of the agreed lease period the capital amount is fully repaid and ownership transfers to the client. The salam and Istisna'a contracts are considered exceptions under Shariah because they involve the purchase of something that at the time of the contract does not exist.