Islamic modes of financing

1. Islamic modes of financing

2. There are basically three modes of Islamic financing are: Participatory modes: 1.
Mudarabah 2. Musharakah 3. Diminishing partnership Sale modes: 1. Murabahah 2.
Istisna 3. Salam • Rent based modes: 1. Ijarah (Leasing) 2. Tawaruq

3. Mudarabah: •It simply means equity finance. •This is a contract between two parties
a capital owner and investment manager. Profit is distributed between two parties in
accordance with the ratio that they agree upon at the time of contract. •Financial loss is
borne by the capital owner. The loss to the manager being the opportunity cost of his
own labor which failed to generate any income from him.

4. Capacities of Mudarabah: •Amen (Trustee). •Wakeel (Agent). •Shareek (Partner).

•Ajeer (Employee). Collective Mudarabah: It means a joint pool created by many
investors and handled over to a single Mudharib who is normally a juristic person.
Relationship: It creates two different relationships: •Relationship between investors
which is Shirkah or Partnership. •Relationship of all the investors with Mudharib which is
Mudharabah. Mudarabah:

5. Musharakah: •This contract is similar to that of the Mudarabah with the difference
that in the case of musharakah both partners participate in the management and
provision of capital and also share the profit and loss equally. •Profits are distributed
between partners in accordance with agreed ratio but the loss must be distributed in
proportion to the share of each in the total capital.

6. Rules of Musharakah: •Assets of musharakah are jointly owned in proportion to the

capital of each partner. •Ratio of the profit distribution must be agrees at the time of
the execution of the contract. •Profit is based on the agreement of the parties but loss is
always subject to the ratio of investment. Management of Musharakah: •Each partner
has right to take part in management. •the partners may point a managing partner by
mutual consent. Application of Musharakah: •Investment accounts- depositors are
sleeping partners and bank also invest its own funds. •Stock companies. •Bank invests
its funds with an importer/exporter. Musharakah:

7. Diminishing Partnership: This is a contract between the financer (the bank) and a
beneficiary in which the two agree to enter into a partnership to own an asset as
described above but on the condition that the financier will gradually sell his share to
the beneficiary at an agreed price and in accordance with an agreed schedule.

8. It is a particular kind of sale and not a mode of financing in its origin. Where the
transaction is done on a “cost plus profit” basis i.e. the seller discloses the cost to the
buyer and adds a certain profit to it to arrive at the final selling price. Murabahah:

9. Banking Murabahah: •The sequence of their execution is extremely important to

make the transaction Shariah complaint. •It is a bunch of contracts completed in steps
and ultimately suffices the financial needs of the client. Steps in Murabahah: •A mutual

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 understanding to conduct a business at a later stage. •Client specifies a property
belonging to a third party bank can accept or refuse. • Bank takes undertaking from
client to purchase the property subsequently to the banks purchases of the property.
•Client becomes the agent of the bank to purchase a property on the behalf of the bank.
•Property is purchased by the bank either directly or via its agent (client) and liability is
assumed by the bank. •Client purchases property from the bank. This is the Murabahah
bit. Murabahah:

10. Ijarah: The term Ijarah is used in two situations: •To employ the services of a person
on wages. •Paying rent for the use of an asset or property defined as “LAND” in Islamic
Economics It literally means “To give something on rent”.

11. Ijarah as a mood of financing: •Ijarah is Islamic alternative to Leasing. •Risk and

rewards of ownership lie with the owner. •Late payment penalty cannot be charged to
the income of the Lessor. Rules of Ijarah: •Since owner of the leased asset remains with
the lessor. •All the rights and liabilities relating to ownership are borne by the lessor.
•The lessee is responsible for damage to the asset caused by fraud or negligence. •Rent
may only be charged after delivery of the asset to the lessee in a usable condition.
•Insurance is a cost related to ownership of the assets and must be borne by the lessor.
Applications of Ijarah: •For long and medium term fixed asset financing like plant,
equipment, generators and etc. •Retail products like care financing, durable financing
and etc. Ijarah:

12. Istisna: •In this contract the customer give an order to the producer to manufacture
a specific commodity for the purchase. •It is also defined as “It is sale transaction where
commodity is transacted before it comes into existence”. •Price must be fixed but need
not to be paid in advance.

13. It is defined as “Price is in cash but the supply of goods is deferred”. It is also defined
as “Seller undertakes to supply specific goods to the buyer at a future date in exchange
of an advanced price fully paid at the spot”. Purpose of Salam: •To meet the need of
small farmers who need money to grow their crops and to feed their family up to the
time of harvest. •To meet the need of traders for import and export business. Salam:

14. To purchase a commodity on credit and sell at the spot to a third party at a loss with
the objective of acquiring cash. Tawaruq:

Prohibition of Reba:
Islamic law prohibits Muslims from paying interest on debt. Local groups are helping
entrepreneurs find alternatives. 
Bille of Minneapolis, a practicing Muslim, faced a quandary when he decided to start a small
bus transportation service. Bille needed a loan to get the business going, but traditional
Islamic law prohibits him from paying interest, or reba, on debt.

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Until recently, options have been limited for Muslim entrepreneurs like Bille. But in May,
because of new efforts by Twin Cities groups, Bille was able to obtain interest-free financing
for his firm, which transports immigrants to English classes.

Bille financed a 34-person school bus with $15,000 borrowed from the Neighborhood
Development Center in St. Paul. The group built a $2,000 profit into his repayment plan.
Bille pays no interest, and the center still earns an annual return because the profit replaces
interest.

"I prefer to stay out of business than participate with interest," said Bille. Without the
alternative financing, he would have needed to save enough money to buy the bus, or try to
borrow money interest-free from friends, he said.

Twin Cities Muslims have spent the past year educating government officials, lenders and
civic leaders about the need to accommodate Islamic beliefs through alternative financing.
Banks say strict regulations have kept them from stepping up to meet the need.

Muslim and financial leaders agree that it's not just a personal or religious issue; it's also a
community and economic concern. They say a lack of acceptable financing has slowed
Islamic entrepreneurial efforts and stunted business expansion in the Twin Cities. Some say
the void has prevented Muslims from expanding their wealth, which has lessened their
economic impact on the region.

Nationally, the Islamic community is growing in numbers and affluence. The 6 million
Muslims living in the United States (out of 1.2 billion worldwide) have a per capita income of
$35,000 to $45,000, well above the national average of $24,000 to $27,000, according to
Islamic Horizons magazine.

An estimated 75,000 Muslims live in the Twin Cities (up from about 45,000 five years ago),
with 100,000 living in Minnesota.

Nonprofit groups have seen the need for alternative financing during business training
classes, especially among recent Somali immigrants, who tend to be more observant of the
Islamic religion. Minnesota has one of the nation's largest populations of Somali refugees,
estimated to be as high as 40,000 people.

Mike Temali, executive director of the Neighborhood Development Center in St. Paul,
started Reba Free Investments earlier this year to provide small-business financing. He saw
Muslim immigrants become discouraged about starting a business because they couldn't get
a loan.

Several local Islamic financing programs have recently begun or are in the planning stages:

-- Phillips Community Development Corp. and the Minneapolis Community Development

Agency each recently financed one Islamic business owner with administrative fees
replacing interest. Both seek ways to make the programs acceptable to more orthodox
Muslims.

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-- The Minneapolis Consortium of Community Developers has provided two fee-based
financings to Islamic businesses as a pilot program. The nonprofit group wants to establish a
micro-venture capital fund within two years that would cater to the needs of Muslims and
others. It is also exploring other funding options.

-- Dalsan Auto Dealer, a Somali used car dealership in Minneapolis, opened a year ago to sell
cars and provide interest-free financing to customers.

-- Nationally, a few companies such as American House Finance Lariba and MSI Financial
Services offer car and equipment leasing and interest-free financing for houses and
businesses to people living in Minnesota. Some local efforts also are focusing on Islamic
home ownership.

-- A Twin Cities group is working to form an Islamic credit union.

-- Banks such as Wells Fargo & Co. and University Bank are exploring how they can help
Islamic businesses and encourage home ownership.

"There is a big need to do this,'' said Wafiq Fannoun, a consultant for many Twin Cities
nonprofit groups and banks on how to provide Islamic financing. "The Muslim community in
the Twin Cities has been trying to do this for 10 years.

"Many Muslims in Minnesota have no choice but to get a traditional bank loan. We all do it
out of need. This is the system. I can't change it overnight, but this is a start."

Hamdy El-Sawaf, executive director of the Islamic Center of Minnesota, said Islam is the
world's fastest-growing religion but Muslims still struggle for greater social understanding.

INTEREST FORBIDDEN

Muslims from Africa, Asia, India, the Middle East and Eastern Europe follow a religion
founded 1,400 years ago. Islamic law, or Shari'ah, is based on the Koran, the holy book of
God, and the teachings of the Prophet Mohammed. It strongly influences Muslim life.

Islamic law strictly forbids the giving or receiving of interest. Muslims believe in maintaining
economic harmony in any financial transaction. It is not acceptable for a well-off person to
benefit from lending money to someone less fortunate. Money is shared as a way to help
the community prosper.

That belief can affect how Muslims finance a house, a car or an education, how they start a
business, how they pay bills and how they use credit cards.

The payment of interest is either a major or minor obstacle, depending on how orthodox a
Muslim is. Many traditional Muslims in the Twin Cities don't own a house or have a bank
savings account. If they have a savings account, they typically donate the interest to charity.

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Financing agreements acceptable under Islamic law include buy-sell and buy-lease
agreements, interest-free loans, cost-plus-profit contracts, stock investments and
partnerships.

Osman Ali took advantage of a buy-sell agreement when he started a business in May to
deliver about 400 meals a week and cater events for Tariq's, a Somali restaurant in
Minneapolis. The Neighborhood Development Center bought a 1995 Dodge Caravan and
equipment and resold it to Ali at a profit for $5,323 with monthly payments of $443.64 for
one year.

But other Twin Cities Muslims, faced with few options, have used their savings and relied on
the generosity of family and friends, much as other immigrant groups have done. Others,
especially the Somali community, pool their money in a group setup somewhat like an
investment club.

One of those is Halimo Yusef, who opened a clothing shop called Beautiful Woman a year
ago at the Karmel Souk, a Somali mini-mall in Minneapolis. Yusef, her Somali partner and
the owners of four other shops there formed a financing pool: Each shop contributes $1,000
a month and one receives the $5,000, she said. The next month, the $5,000 goes to another
shop until all five have received the pot. Then it repeats.

Yusef uses the infusion of interest-free money to restock her store with clothing, toiletries
and housewares from Chicago, New York and overseas. But to break even or expand, she
needs more money to buy more merchandise.

"In general, immigrant communities are very resourceful and tend to draw money from
their extended families," said Ed Lambert, executive director of the Minneapolis
Consortium, an association of nonprofit community development corporations in the
Minneapolis area. "But there are plenty (of Muslims) who do not have the kind of extended
family that can provide that kind of support."

In seeking financing from other sources, Muslims may find obstacles in the form of state and
federal laws. In addition, many of the nonprofit groups trying to help them face funding
issues.

For example, Muslims didn't have access to the Neighborhood Development Center's
program earlier this year because it ran out of money. The center had been banking on
receiving money from the Minnesota Department of Trade and Economic Development's
urban initiative program, but it ran into a legal snag. State law prohibits state loan funds to
be used to buy equipment and lease it to a business, said Bart Bevins, who administers the
department's Urban Initiative program.

Bevins believes a legislative amendment may be proposed next year. In the meantime, the
Neighborhood Development Center last month received a $100,000 grant from the
Minneapolis Foundation for Reba Free and hopes to receive money from several other
sources, Temali said.

BANKS HELD BACK

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Nonprofit groups, rather than banks, have led Islamic financing efforts in the Twin Cities
because banks say they're bound by regulations. Changing regulations to accommodate
Muslims would radically alter the banking industry, which traditionally is slow to adopt
innovations.

"It's new territory for the regulators," said David Reiling, president of University Bank in St.
Paul. "They're not going to invent anything and they're not going to say you can do it. Once
someone does it and if there aren't any blatant regulation violations, they will monitor it
closely and see how it works."

Banks have increased outreach and education to ethnic groups such as Latinos and Asians,
but Islamic financing is a bigger risk because it requires a new financing structure, not just a
new name for the same old product. But Muffie Gabler, Wells Fargo's vice president of
community development for the Midwest, points out: "This is something that we need to be
aware of and deal with because these are emerging markets ... and that's the growing part
of our customer base."

One answer to the financial difficulties facing Muslims may be the Islamic Credit Union of
Minnesota, which a group of Muslims is trying to form to develop a financial system within
Islamic guidelines. It would be the first Islamic credit union in the nation.

The group, which has been focused on educating Muslims about what a credit union is, is
collecting fund-raising pledges and earlier this year launched a Web site at www.icumn.org
and printed educational pamphlets to hand out at Islamic events, said Fawzi Awad, one of
the organizers. He wants to have a credit union proposed to the state this fall, but has not
yet approached state or federal regulatory agencies.

"We don't want to be viewed as establishing something different from the norm, but we
want to create something we believe in," Awad said. "This could be a solution to some of
the issues we deal with in society."