CONTRACTS IN ISLAMIC FINANCE

Category: Notary Services
Written by David J. O. Tuhusula on 05/10/2022
The author’s views are entirely their own and may not always reflect the views of Putranto Alliance.

In Indonesia, the development of the sharia economy is very rapid, considering that most of the Indonesian population is Muslim. In addition, Indonesia’s President, Joko Widodo, also inaugurated the Sharia Economy Brand, a symbol of togetherness in all activities related to the sharia economy and finance in Indonesia. Of course, sharia principles are also things that are adhered to and important to pay attention to, considering that this also contributes to increasing the added value of the sharia economy in Indonesia.

ABOUT ISLAMIC FINANCE / BANKING

Islamic finance is a form of banking that is consistent with the principles of Islamic law, for example, the prohibition of interest (riba) payments and excessive uncertainty (gharar) or gambling (maysir). Conversely, stakeholders should share risks and rewards, and the transactions should have real economic purposes without undue specification. Islamic banking involves banking, leasing, sukuk (Islamic bonds), equity markets, investment funds, insurance, and microfinance. However, banking and sukuk assets account for about 95% of Islamic finance assets.

As opposed to conventional banking, there are some differences when it comes to Islamic banking:

Conventional Banking

Islamic Banking

Money is treated as a commodity aside from as a medium of exchange and store of value. Because of that, it can be sold at a price higher than its face value, and it also can be rented out.

Money is not treated as a commodity, although it is used as a medium of exchange and store of value. As a result, it can’t be sold at a price higher than its face value or rented out.

The basis for charging interest on capital is time value.

Profit on the trade of goods or charging on providing service is the basis for earning profit.

Interest is charged even if the organization suffers losses using banks’ funds. Hence it is not based on profit or loss sharing.

Banks based on Islamic principles operate based on profit/loss sharing. In case of the businessman has suffered losses, the bank also shares these losses based on the mode of finance used (Mudarabah, Musharakah).

While disbursing cash finance, running finance, or working capital finance, no agreement for exchanging goods & services is made.

The execution of agreements for exchanging goods & services is a must while disbursing funds under Murabaha, Salam & Istisna contracts.

Because money is used as a commodity, it may lead to inflation in the future.

Islamic banking links with the economic system’s real sectors by using trade-related activities. Because money is linked with tangible assets, it contributes directly to economic development.

Within Islamic banking, all banking businesses based on sale or lease must have an underlying asset, contrasting with conventional banking, where the asset’s importance lies only in collateral security. However, the asset is not necessarily a part of the loan transaction.

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ESSENTIAL CONDITIONS OF ISLAMIC CONTRACT VALIDITY

Agreements/contracts, in general, require several conditions to be fulfilled to be considered valid. Generally, the elements are: (i) the offeror and offeree, (ii) the offer and acceptance, and (iii) the subject matter and consideration. Subjectively, it’s necessary to have prudence and sound judgment and be considered an adult according to Indonesian law. Islamic agreement differs from an agreement based on the common law would be the insistence on the session of contract (majlis al-‘aqd), where both the offer and acceptance must simultaneously take place at the same time in the same place to avoid ambiguity and disagreements in the future. With technological advancement, however, the concept of flexibility has been introduced as a source of Islamic jurisprudence.

Because the objective of Islamic finance is social and economic justice, the Islamic financial instruments are geared with the following principles: the prohibition of riba (interest), gharar (uncertainty), and maysir (speculation). That is to say, an offeror is allowed to withdraw their offer before the offeree accepts it following the principle of khiyar al-majlis, the right to revoke the concluded offer and acceptance. As such, prices must be determined at the start to avoid gharar. Concerning flexibility and acting as the only exception, the price can be paid in the future in some contracts.

Concerning the object of the contract, the Qur’an also specifically prohibits all things related to alcohol, pork, gambling, and other things that can be considered as a disruption to public order or morals (such as pornography); while concerning the activities of banking and finance, the prohibited things include:

  • Transactions where the parties involved are not competent
  • Sale of something non-existing (or otherwise having a weak existence)
  • Sale of something that’s not easily deliverable
  • Sale of debt to someone other than the debtor
  • Sale with Jahalah’ (subject matter or price unknown)
  • Sale with two different prices
  • Contingent and future sales
  • Sale before taking possession
  • Sale with Haram’ money or consideration
  • Hoarding (sale containing harm to society)
  • Sale of Haram’ or Najis’ subject matter
  • Sale of grabs to the producer of wine
  • Sale with the wrong condition
  • Combining a sale with a loan

TYPES OF CONTRACTS IN ISLAM

Some of the major Islamic banking/finance products that most often be offered to customers are:

  1. Mudaraba (direct equity participation):

    An investment contract in which one party (Rabul-Mal) contributes capital while the other party (Mudarib) makes efforts to generate a profit from such contribution. In the finance context, it’s described as a contract in which the capital is provided by the depositor/fund provider, and the bank acts as the Mudarib, with the profits of the Mudaraba then being shared in pre-agreed ratios. Should there be losses, unless it’s a result of negligence or breach of contract by the Mudarib, the depositor bears them.

  2. Musharaka (partnership/joint ventures)

    Musharaka refers to two or more persons coalescing their money or work to earn a profit or appreciation in value and sharing the resulting profit and loss. The losses are generally shared according to the proportionate share. However, it’s also possible for the profit to be shared in any ratio should they be active/working partners in the arrangement. If one of them happens to be an inactive or “sleeper” partner, the said partner cannot have a higher profit-sharing ratio than the share they contributed.

  3. Murabaha (cost plus profit mark-up)

    A form of sale contract in which a seller sells its goods/assets at a cost that’s inclusive of an agreed profit. The price for the sale may be paid on the spot or deferred to be paid in a lump sum or instalments. In this sale contract, the goods/assets are purchased after a customer has requested the bank to purchase the goods/assets to sell the same to the customer on Murabaha (cost + profit) basis on deferred payment. .

  4. Ijarah (leasing)

    Ijarah Ijarah is leasing an asset under a specified permissible benefit, taking the form of usufruct, and obtained for a specified period in return for rental payment.

  5. Sukuk (Islamic bonds)

    Sukuk is an asset-backed Islamic investment instrument, using the basis of sharia as structure, and registered in the holders' name. Funds for Sukuk are raised based on the value of the underlying asset, with any increase/decrease in the value reflected in the value of the Sukuk itself. A Sukuk certificate is proof of partial ownership or beneficial interest in an asset/enterprise. Sukuk can also be bought from the issuer (primary market) or its holders (secondary market) either directly or via a middleman (broker).

  6. Istina & Salam (long-term and short-term project financing)

    Istina is a form of advanced sale for a specific commodity that has yet to be manufactured/constructed/processed. In this kind of sale, the buyer may choose to perform an advance payment. However, it’s important to note that advanced payment is considered unnecessary. Istina itself is only considered valid if the price is fixed (with the consent of both parties). Salam is the advance sale of specific goods that will be supplied at a later date, hence needing advance payment. Contrasting to Murabaha, the agreed-upon price is paid in full in advance, and the delivery of the goods is deferred.

  7. Wakalah

    Wakalah is a contract where the principal appoints an agent to act as their substitute, that is, to perform on their behalf. In this contract, the principal is called Aseel or Muwakkil, while the agent that represents them is called Wakeel. The profit and/or loss earned/sustained during the time of this contract belong to the principal, whereas the agent may take a fixed remuneration for their service.

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RISKS OF ISLAMIC FINANCE OPERATION

Despite being different from conventional banking, it is inevitable that the method also poses unique risks of its own just as well, which include:

  1. Sharia compliance risk arising from the fact that the products offered to customers may not be certified to be compliant with Sharia principles;
  2. Displaced commercial risks arise from the fact that the returns to Profit Sharing Investment Account (PSIA) holders are supposed to depend on the profitability of their investments. PSIA holders would expect similar returns to those offered by conventional banks. Hence the shareholders may need to forego their part of the profits; and
  3. Equity investment risks emanating from profit-sharing financing instruments are unique to Islamic banking.

The Islamic finance industry also poses additional risks related to its business model and the nature of the industry itself. For example, managing liquidity risk is more difficult for Islamic banks or Islamic financial institutions when there are limited or no Sharia-compliant financial markets and the Lender of Last Resort facility. Not to mention that the transaction requirement having to be underpinned by assets would result in complex transactions and corporate structures that include non-financial corporations.

Such differences result in the rise of specific policy issues in regulation and supervision, consumer protection, monetary policy and liquidity management, and tax policy. To deal with these issues, jurisdictions have cooperated in establishing specialized institutions to develop regulation standards, governance, auditing and accounting standards, financial market instruments, and short-term liquidity infrastructure.

HOW CAN WE HELP

Our experienced advisors are ready to assist you should you decide to take a step to invest using the systems of Islamic banking/finance. Our careful approach and meticulous work ensure that we will go above and beyond to provide what you may need related to Islamic banking/finance for your future endeavors in business.

REFERENCES

FAQs

Indonesia is a country with the single largest population of Muslims in the world, contributing around 12.7% of the world’s Muslim population. In contrast, in-country, at least 87.2% of the population identifies as Muslim.

Even with that as a fact, there’s no specific obligation for the people of Indonesia to use Islamic banking/finance; the same as in Indonesia, there’s no moral obligation for Muslim people in Indonesia to use the service of Islamic banking/finance.

This is because the common norm of Indonesia is to promote freedom of expression and activity (within reason). As such, people of Indonesia or otherwise foreigners in Indonesia are not obligated to use the service of Islamic banking/finance.

The word riba in itself means excess, increase, or addition – where should it be linked to sharia terminology, it would be described as the existence of an excess compensation without due consideration. As a concept of Islamic banking/finance, it is mainly understood as “charged interest.” For example:

  • Rolling over a term loan with an increase over and above the principal amount and thereby obtaining interest
  • Periodic increase in payment
  • Allowing additional time against the additional amount in deferred payment sale


Another form of riba, according to most Islamic jurists, is the simultaneous exchange of goods of unequal quantities or qualities.

Gharar is translated to delusion, risk, or uncertainty – in the sense that it is an ambiguous situation with the potential of creating a disagreement or dispute once the details/facts are known. Examples of gharar include the sale of fish still in the sea or the sale of unborn animals.

Whereas maysir or otherwise known as qimar, can be translated as gambling, an activity that’s strictly prohibited due to the inherent aspect of uncertainty and chance. In the modern-day, prize bonds and lotteries are prime examples that would fall under the category of maysir or qimar.

In Quran, receiving and/or paying interest is considered a major sin because it promotes inequality, increasing the gap between the rich and the poor in society. In contrast, anyone who receives it is expected to donate that money to charitable causes. Whereas under Sharia law, riba is considered exploitative, the law itself tries to ensure equity in exchange.

However, depending on the interpretation, riba itself may only refer to excessive interest, while to some others, the entire concept of riba is considered harmful and thus unlawful.

Some modern scholars argued that there is a broad spectrum of interpretation on what point an interest could become exploitative while also noting that interest should be allowed up to the value of inflation to compensate lenders for the time value of their money while at the same time trying to avoid obtaining excessive profit.

Thank you for sharing

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