What Are Hybrid Islamic Financing Contracts?

The classical Islamic finance contracts have been described in the Jurists’ writings over centuries. They are the product of simple two-party relationships. Today, financing is provided by intermediary institutions that collect resources from those who have surpluses and pour them into business and industry. Thus, on the basis of the characteristics or salient features of the classical Islamic financial contracts, contemporary Islamic banks, in cooperation with Shariah scholars, have developed a host of hybrid financing contracts that suit their role as mediators and the industry of financial intermediation.

Financial intermediation is a relatively new industry that has been developed in Western countries over the past three centuries. When a merchant sells at a deferred price or a lessor leases an asset, she is providing financing to the purchaser or the lessee. By contrast, a financial intermediary is a corporation that specializes in getting the savings of those who have them and channeling them to businesses that need them for investment. In other words, financial intermediation is a specialty of those who recruit deposits and provide funding, while merchants and producers deal with the daily decisions of a production line and buying and selling of goods and services.

How Do Hybrid Islamic Finance Contracts Work?

Today’s Islamic banking specializes in financial intermediation that requires suitable or appropriate tools that serve its specialty without transgressing the Shariah limits. This is the role of Islamic financial engineering, whose products are the Islamic hybrid financial contracts. In other words, the hybrid Islamic finance contracts constitute the empirical and practical backbone of Islamic banking and finance in the world today, an industry that started in the mid-1970s and has been growing at an average of over 14 percent annually over the last three decades.

There are eight major hybrid Islamic financing contracts that are practiced in Islamic banks today: murabahah to the purchase orderer, installment sale, mudarabah investment deposit, three-party istisna`, leasing to the purchase orderer, compound Salam, Buy Back, and Tawarruq.

What Is Murabahah to the Purchase Orderer?

Murabahah to the purchase orderer is a sale in which the price is equal to the known cost plus a known profit or mark-up. This cost and profit are fully disclosed to the person who made a purchase order. Murabahah to the purchase orderer is a combination of a request to buy with a promise to re-buy, a cash-buy by the Islamic bank, and a deferred payment sale contract to the client. It begins with an order to buy from a customer to the bank with a promise that she will buy the same from the bank. The order defines the commodity, quantity, cost, and supplier.

Once the bank approves financing, the two parties agree on the bank’s profit margin. A power of attorney or delegation of authority is then issued by the bank to the customer. As an agent of the bank, the customer contracts a cash purchase with the supplier and takes physical delivery; after delivery, a second purchase contract between the bank and its customer is concluded in which the goods are sold to the customer at cost and the agreed profit. The price is deferred and the date of payment is scheduled. It looks long, but all these steps are prepared and signed together with a condition that the execution of the second purchase contract is effected only after delivery.

Murabahah is a hybrid contract of sale financing characterized by the following:

1. The bank owns the commodity even for a short period of time. This is what legitimizes, from a Shariah point of view, the bank’s profit.
2. The bank bears liability in regard to this ownership for the duration of ownership; this makes it concerned about the truthfulness of the transaction as it becomes a real purchaser/owner, not only a mere financier.
3. The transaction has an order to purchase, a promise to buy, an agency contract, and two sale contracts.
4. It is necessary that there ought to be real goods circulating from one hand to another.
5. Size of financing cannot exceed the exact amount of cost plus profit.
6. Rescheduling of payment for an increment and discounting are not permissible, so there will not be accumulation or creation of layers of debts.
7. For the bank, the transaction begins with cash out and ends with money in.
8. Murabahah creates a debt on the customer similar to the loan debt in conventional banks.
9. The Murabahah debt is subject to collaterals, guarantees, mortgages, and other default risk mitigation measures.
10. It is simple, easy to understand, and neat.

Murabahah is the most popular mode of financing in Islamic banks today. In certain Islamic banks, it occupies 80–90 percent of their total financing.

Installment sale is exactly a murabahah in which the price is paid in installments. A large majority of Islamic banks do not distinguish between murabahah and installment sale. Malaysia and Brunei are the exception. The central bank of Malaysia defines it as an independent Islamic finance contract and calls it by the abbreviation of its Arabic name, BBA (Bay Bithaman Ajil). It is used very often in combination with Buy-back arrangements to provide personal finance.

What Are the Main Types of Hybrid Islamic Financing Contracts?

Mudarabah investment deposit is a mudarabah financing contract between an Islamic bank and a depositor. The bank invests the deposit in its financing business, and the profit will be divided between the fund owner and the bank, being the manager, according to an agreed-upon ratio.

Mudarabah deposit contract adds three conditions to the simple mudarabah that is known in classical literature. It mixes funds from all depositors together, it mixes funds of depositors with funds of the manager, and it provides certain procedures for early withdrawal.

Mudarabah investment deposit is the Islamic alternative to the time deposit in conventional banks. It does not give a pre-fixed rate of return. Therefore, depositors choose between Islamic banks on the basis of past performance. In this regard, they are closer to investment in open mutual funds; a key difference, though, is that mudarabah deposits are usually set for an agreed period of time.

Islamic banks usually offer mudarabah deposits for different maturities, including three months, six months, a year, and three years, with different ratios of profit distribution. They also offer a variety of withdrawal facilities similar to passbook and small savings accounts.

Usually, two broad categories of mudarabah deposits are normally offered: general mudarabah and restricted mudarabah. While general Mudarabah deposits are used by the bank in any and all of its financing business at the bank’s discretion, restricted mudarabah deposits are invested in special projects that are designated and selected by the customer and are usually offered through the private banking department for large deposits only.

Three-party istisna`, sometimes called financing istisna`, is an istisna` contract between a bank and a purchaser or customer put together with a second istisna` contract between the bank and a contractor or manufacturer that is identified by the customer.

It is essentially a project financing tool whereby a corporation wants to build a project or purchase machinery and equipment. The project is put together by the corporation in a detailed blueprint. The plans are submitted to an Islamic bank for financing, and two independent istisna` contracts are put together in one document among three parties: the bank, the contractor, and the customer.

The customer has an agency agreement that delegates to the customer authority of acceptance of delivery in regard to the contract between the bank and the contractor. Obviously, all specifications of the project, price of each istisna` contract (which includes the cash price between the bank and contractor and deferred or installment price between the customer and the bank), dates of payment of each contract, dates of delivery of each stage, and the mark-up are stipulated in the contract.

Financial istisna` contracts are often used for large projects, with a syndication of a group of Islamic banks or Islamic and conventional banks together. Financial istisna` is also used as an alternative to lending to the government. Also, the Islamic Development Bank (an intergovernmental Islamic bank with 57 member Muslim countries) uses this financing hybrid contract in its development project financing.

While the indebtedness created in simple istisna` financing is in kind, i.e., in the form of manufactured goods to be delivered or projects to be built, the debt created by the financing istisna` is in monetary terms because the in-kind debt of one contract is offset by that of the other. This makes financing istisna` less risky and easier to handle than simple istisna` or salam contracts.

Leasing to the purchase orderer is a financing contract consisting of a cash purchase of equipment by proxy through the purchase orderer and a lease to the same. It begins like a murabahah to the purchase orderer but ends as an operational or financial lease.

Furthermore, if the contracted products or goods are to be manufactured or built, it may begin as an order to make an istisna` contract with the supplier or contractor and end as a lease-to-own contract.

Leasing to the purchase orderer is a form of financing that is similar to “Build and Transfer,” with a few minor differences that are necessitated by the Shariah requirement of defining the real ownership at each stage of construction.

The lease contract component may be signed at any time regardless of whether the leased property is already in existence or not, or in the possession of the lessor or not, as long as the postulate that no rentals are earned for any period during which the property is not made available for the lessee to derive its usufruct is maintained. Additionally, the lessor must be the owner of any rental-generating property, wholly or partially. In other words, property cannot be sold and rented at the same time.

Lease to the purchase orderer may end by giving the property as a gift to the lessee (when installments include cost plus rentals), when the lessee opts to buy the asset at a predetermined price, by extending the lease to a new period, or by giving the property back to the lessor.

Lease to the purchase orderer is practiced by Islamic banks in house and car financing as an alternative to the conventional mortgage or lease. Accordingly, each of the equal installments consists of an ever-declining rental of the share of property that the lessee does not own and ever-increasing amounts to buy segments of the bank’s property.

Payment may be accelerated by virtue of a lessor’s open offer to sell to the lessee her share of the property. Delinquent payments do not reduce the rent of the following period.

In compound salam, Islamic banks attempt to avoid the in-kind debt of the classical salam financing. They conclude a reversed salam contract with another customer in which the Islamic bank will be the seller of the same goods it is buying in a previous salam. But since the reverse salam financing would bring back funds financed (as salam requires payment at the time of contract), the banks do not like to counter a salam by another salam.

Instead, Islamic banks counter a salam financing by a murabahah with another customer of the same goods and quantity as the salam financing contract. This way, they can use their resources in financing producers against in-kind debt of goods to be delivered in the future, through Salam, and financing consumers through Murabahah on future delivery and future payment of the same goods.

The components of a compound salam are as follows:

1. A salam financing with a producer (say, a farmer) for future delivery and immediate payment to the farmer;
2. A murabahah sale to a grain wholesaler for the same goods, quantity, specifications, and delivery date against future payment (i.e., financing the wholesaler); and
3. An agency agreement to delegate the wholesaler to take delivery directly from the farmer.

Finally, although the in-kind debt of one contract is offset by that of the other, each contract, on its own, can afford having any and all kinds of collaterals and guarantees. The Islamic bank can also take collateral for the final monetary debt of the final purchaser.

Buy back is essentially practiced by Islamic banks in Malaysia and Brunei for providing personal financing. It is a cash buy of goods owned by a customer and deferred sale of the same goods at a higher price to the same customer. A version of this contract is done as buy lease-to-own back.

While the Shariah counselors of most Islamic banks do not approve of this hybrid financing contract because it is merely lending for interest hidden under a different name, some scholars argue that it may be the lesser of two evils when compared with interest lending. Therefore, they accept it in cases of need for cash to pay off an interest-based loan.

Tawarruq is a financing hybrid that aims at providing cash or personal finance to a customer. Similar to “buy back,” it adds certain goods or assets between the provision of cash to the customer and the customer’s repayment of a larger sum in the future.

Tawarruq consists of a murabahah to the purchase orderer plus another agency contract in which the customer authorizes the bank, on behalf of the customer, to sell the same goods purchased on Murabahah for cash and hand the money to the customer.

Tawarruq is exercised on local goods, such as cars or common stocks, or on international commodities in the international exchange markets. In the latter case, a number of spot commodity contracts will be used depending on the amount of financing.

Tawarruq increases the cost of financing by adding broker commissions to buy and sell. It unlinks Islamic financing from the real exchange and production market because, although commodities are purchased and sold, they are not intended in the transaction, and they go back to the market without giving a signal to producers to replace them. Tawarruq also inflates the spot market with unreal transactions.

While Tawarruq is not practiced in Malaysia, it is common in several Islamic and conventional banks in the Gulf region, especially in the context of Islamic transactions departments in conventional banks in Saudi Arabia.

However, the majority of Islamic banks and their Shariah counselors consider Tawarruq to be pure interest lending hidden under a different name and do not include it within the Islamic hybrid financing contracts. Yet, a few Shariah scholars, especially in Saudi Arabia, approve of it on the ground that it is a series of sales, whereby each one of them is permissible.

Tawarruq has been practiced since 1999 by Islamic banks and Islamic departments of conventional banks in Saudi Arabia. The Shariah scholars’ council of the Muslim World League, a Saudi Arabian organization, issued an opinion in late 2003 suggesting that the Tawarruq financing, as practiced by banks, is merely an interest transaction that is not permitted in Shariah.

At the same time, it upheld a previous opinion that permits the same if it is practiced individually and consists of two separate contracts of buying deferred and selling cash, provided it is not organized by a third party like a banker.

• 👉 Read also:
  Principles of Islamic Finance: A Complete Guide
• Types of Classical Islamic Financing Contracts
• 4 Things You Need to Know about Islamic Finance (IMF)
• What is the Difference Between Islamic Loan and Riba?
• An Introduction to Islamic Finance
• Sharing Risk in Islamic Finance is The Future

Reference:

This series is based on a paper published by Dr. Monzer Kahf in 2006.