an
Introduction
to
Islamic Finance


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Foreword 6
Some Preliminary Points
9
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Musharakah 17
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Distribution of Profit
23
Ratio of Profit
24
Sharing of Loss
24
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OR
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OU
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Termination of Musharakah without Closing the Business
29
Mudarabah 31
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Musharakah & Mudarabah as Modes of Financing
37
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Securitization of Musharakah
39
Financing of a Single Transaction
42
Financing of the Working Capital
43
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Risk of Loss
52
Dishonesty 54
Secrecy of the Business
55
Clients' Unwillingness to Share Profits
56
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House Financing on the Basis of Diminishing Musharakah
59
Diminishing Musharakah for Carrying Business of Services
63
Diminishing Musharakah in Trade
63
Murabahah 65
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SR
Some Basic Rules of Sale
66
Bai' Mu'ajjal (Sale on Deferred Payment Basis)
70
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TN
Murabahah as a Mode of Financing
72
Basic Features of Murabahah Financing
73
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TS
Different Pricing for Cash and Credit Sales
76
The Use of Interest-Rate as Benchmark
81
Promise to Purchase
83
Securities against Murabahah Price
88
Guaranteeing the Murabahah
90
Penalty of Default
91
No Roll Over in Murabahah
98
Rebate on Earlier Payment
99
Calculation of Cost in Murabahah
100
Subject Matter of Murabahah
102
Rescheduling of Payments in Murabahah
103
Securitization of Murabahah
103
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Ijarah 109
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1. The Commencement of Lease
114
2. Different Relations of the Parties
115
3. Expenses Consequent to Ownership
116
4. Liability of the Parties in Case of Loss to the Asset
117
5. Variable Rentals in Long Term Leases
117
6. Penalty for Late Payment of Rent
120
7. Termination of Lease
120
8. Insurance of the Assets
121
9. The Residual Value of the Leased Asset
121
10. Sub-Lease
123
11. Assigning of the Lease
124
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NOS
Salam and Istisna'
128
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Conditions of Salam
129
Salam as a Mode of Financing
133
Some Rules of Parallel Salam
134
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Difference Between Istisna' and Salam
136
Difference Between Istisna' and Ijarah
136
Time of Delivery
137
Istisna' as a Mode of Financing
138
Islamic Investment Funds
140
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Conditions for Investment in Shares
143
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Murabahah Fund
149
Bai'-Al-Dain 150
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The Principle of Limited Liability
152
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The Performance of the Islamic Banks --A Realistic
Evaluation 161
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Over the last few decades, the Muslims have been trying to
restructure their lives on the basis of Islamic principles. They
strongly feel that the political and economic dominance of the
West, during past centuries, has deprived them of the divine
guidance, especially in the socio-economic fields. Therefore, after
acquiring political freedom, the masses are striving for the revival of
their Islamic identity to organise their collective life in accordance
with the Islamic teachings.
In the economic field, it was the biggest challenge for such
Muslims to reform their financial institutions to bring them in
harmony with the dictates of Shari`ah. In an environment where the
entire financial system was based on interest, it was a formidable
task to structure the financial institutions on an interest free basis.
The people not conversant with the principles of Shari`ah and
its economic philosophy sometimes believe that abolishing interest
from the banks and financial institutions would make them
charitable, rather than commercial, concerns which offer financial
services without a return.
Obviously, this is totally a wrong assumption. According to
Shari`ah, interest free loans are meant for cooperative and charitable
activities, and not normally for commercial transactions, except in a
very limited range. So far as commercial financing is concerned, the
Islamic Shari`ah has a different set-up for that purpose. The

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principle is that the person extending money to another person
must decide whether he wishes to help the opposite party or he
wants to share his profits. If he wants to help the borrower, he must
rescind from any claim to any additional amount. His principal will
be secured and guaranteed, but no return over and above the
principal amount is legitimate. But if he is advancing money to
share the profits earned by the other party, he can claim a stipulated
proportion of profit actually earned by him, and must share his loss
also, if he suffers a loss.
It is thus obvious that exclusion of interest from financial
activities does not necessarily mean that the financier cannot earn a
profit. If financing is meant for a commercial purpose, it can be
based on the concept of profit and loss sharing, for which
musharakah and mudarabah have been designed since the very
inception of the Islamic commercial law.
There are, however, some sectors where financing on the basis
of musharakah or mudarabah is not workable or feasible for one
reason or another. For such sectors the contemporary scholars have
suggested some other instruments which can be used for the
purpose of financing, like murabahah, ijarah, salam or istisna.
Since last two decades, these modes of financing are being used
by the Islamic banks and financial institutions. But all these
instruments are not the substitutes of interest in the strict sense, and
it will be wrong to presume that they may be used exactly in the
same fashion as interest is used. They have their own set of
principles, philosophy and conditions without which it is not
allowed in Shari`ah to use them as modes of financing. Therefore
the ignorance of their basic concept and relevant details may lead to
confusing the Islamic financing with the conventional system based
on interest.
The present book is a revised collection of my different articles
that aimed at providing basic information about the principles and
precepts of Islamic finance, with special reference to the modes of
financing used by the Islamic banks and non-banking financial
institutions. I have tried to explain the basic concept underlying
these instruments, the necessary requirements for their acceptability
from the Shari`ah standpoint, and the correct method of their
application. I have also dealt with the practical issues involved in the
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application of these instruments and their possible solutions in the
light of Shari`ah.
In my capacity as chairman / member of the Shari`ah
Supervisory Boards of a number of Islamic banks in different parts
of the world, I came across the points of weakness in their
operations caused mainly by the lack of clear perception of the
relevant rules and principles of Shari`ah. This experience
emphasized the need for the present book in which I have tried to
discuss the relevant subject in a simple way which may be easily
understood by a common reader who had no opportunities to study
the Islamic financial principles in depth.
This humble effort, I hope, will facilitate to understand the
basic principles of Islamic finance and the main points of difference
between conventional and Islamic banking. May Allah Ta`ala accept
this humble effort, honour it with His pleasure and make it
beneficial for the readers.



Muhammad Taqi Usmani
Karachi
04.03.1419 A.H.
29.06.1998 A.D.
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Before the details of Islamic modes of financing are discussed, it
seems necessary to explain some points concerning the basic
principles that govern the whole economic set-up in an Islamic way
of life.
Belief in Divine Guidance
The foremost belief around which all the Islamic concepts revolve is
that the whole universe is created and controlled by One, the only
One God. He has created man and appointed him as His vicegerent
on the earth to fulfil certain objectives through obeying His
commands. These commands are not restricted to some modes of
worship or so-called religious rituals. They, on the contrary, cover a
substantial area of almost every aspect of our life. These commands
are neither so exhaustive that straiten the human activities within a
narrow circle, leaving no role for human intellect to play, nor are
they so little or ambiguous that they leave every sphere of life at the
mercy of human perception and desire. Far from these two
extremes, Islam has a balanced approach to govern the human life.
On the one hand, it has left a very wide area of human activities to
man's own rational judgment where he can take decisions on the
basis of his reason, assessment of facts and expedience. On the other
hand, Islam has subjected human activities to a set of principles
which have eternal application and cannot be violated on superficial
grounds of expediency based on human assessment.

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The fact behind this scheme is that human reason, despite its
vast capabilities, cannot claim to have unlimited power to reach the
truth. After all, it has some limits beyond which it either cannot
properly work or may fall prey to errors. There are numerous
domains of human life where 'reason' is often confused with
'desires' and where unhealthy instincts, under the disguise of
rational arguments, misguide humanity to wrong and destructive
decisions. All those theories of the past which are held today to be
fallacious, claimed, in their respective times, to be 'rational' but it
was after centuries that their fallacy was discovered and their
absurdity was universally proved.
It is thus evident that the sphere of work delegated to human
'reason' by its Creator is not unlimited. There are areas in which
human reason cannot give proper guidance or, at least, is susceptible
to errors. It is these areas in which Allah Almighty, the Creator of
the universe, has provided guidance through His revelations sent
down to His prophets. On the basis of this approach it is the firm
belief of every Muslim that the commands given by the divine
revelations through the last Messenger are to be followed in
letter and spirit and cannot be violated or ignored on the basis of
one's rational arguments or his inner desires. Therefore, all the
human activities must always be subject to these commands and
must work within the limits prescribed by them. Unlike other
religions, Islam is not confined to some moral teachings, some
rituals or some modes of worship. It rather contains guidance in
every sphere of life including socio-economic fields. The obedience
from servants of Allah is required not only in worship, but also in
their economic activities, even though it is at the price of some
apparent benefits, because these apparent benefits may go against
the collective interest of the society.
The Basic Difference between Capitalist and Islamic
Economy
Islam does not deny the market forces and market economy. Even
the profit motive is acceptable to a reasonable extent. Private
ownership is not totally negated. Yet, the basic difference between
capitalist and Islamic economy is that in secular capitalism, the
profit motive or private ownership are given unbridled power to
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Document Outline

• An Introduction to Islamic Finance
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