Islamic Modes of Financing

Salam
 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
 Learning Outcomes
After this lecture you should be able to understand
the two modes of Islamic financing;

1.Salam and parallel Salam

2.Istisna and parallel Istisna

3.And the differences between the Salam and

Istisna modes of financing
 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.
 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]
 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

1. Risk of default by seller

2. Bank’s need to liquidate goods after delivery

3. Seller’s inability to produce or procure commodity

 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

 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

 Parallel Salam
The disposal of commodity at the end of Bank can be
through:
a. 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.

b. 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.
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.
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.
Istisna
 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.
 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

 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.
 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
 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.
 Difference between Istisna &
Salam
Istisna Salam

• The subject of Istisna is • The subject can be any

always a thing which thing.
needs manufacturing.
• The price has to be paid
• The price in Istisna does in full in advance.
not necessarily need to
be paid in full in advance.
 Difference between Salam and
Istisna
Istisna Salam
• Time of Delivery does not • Time of delivery is an
have to be fixed, but the essential part of the sale
stages of manufacture
might be time bound
• The contract can be
• The contract cannot be
cancelled before the
cancelled unilaterally.
manufacturer starts
working.
 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.
 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.
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.
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,
 Conditions for Parallel Istisna
a. 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.

b. Parallel Istisna is allowed with third party only.

 Parallel Istisna
1st Istisna 2nd Istisna
Manufacturer Purchaser

Parallel
Istisna Sale Istisna

Delivery of Delivery of
Commodity Commodity

Islamic Bank Islamic Bank

Purchaser Seller
 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.
Istisna as Mode of Financing

• House Financing

• Project Financing

• BOT Arrangement

• Export Pre Shipment

 Risks in Istisna Applications and
their Solutions
RISKS SOLUTIONS

Ownership of Material
The Islamic bank is not the owner of Security is available with the bank.
the materials in the possession of
the manufacturer for the purpose of
producing the asset.
Delivery Risk
Islamic bank may be unable to Bank can reduce the Istisna price
received goods as scheduled due according to the Istisna agreement.
to late delivery of completed goods
and may not be able to honor the
parallel Istisna.
 Summary of the Lecture

In this lecture we discussed two modes of

Islamic financing;

1.Salam and parallel Salam

2.Istisna and parallel Istisna

3.Differences between the Salam and

Istisna modes of financing