Tuesday, July 19, 2005

Modern Islamic finance: The Contract (‘Aqad) Approach

The nature of Islamic finance today is largely fashioned by Islamic finance jurists who hold the authority in determining the Shariah value of financial products. Shariah status is given by virtue of contract validation according to which a financial instrument that uses a contract deemed valid by Islamic finance jurists shall receive Shariah legitimacy.

Since the Holy Quran has condemned interest and enjoins profit creation via trading (bay’), the Islamic finance jurists have resorted to apply the explicit meaning of al-bay i.e trading in determining Shariah legitimacy of financial instruments. By trading, they usually make reference to sale of goods and services. For example, a contract of sale consists of the followings pillars:

1) Buyer and seller
2) Object of sale
3) Price
4) Offer and acceptance

A valid contract must ensure that each of the above pillars does not contain the following prohibitions:

1) Interest as riba
2) Ambiguities (gharar)
3) Gambling (maisir)
4) Prohibited commodities such as liquor, pork etc.

As an example, both buyer and seller must be rational. Object of sale is a permissible property (mal-mutaqawim). The seller must also hold ownership (milkiyah) before making the sale. Price must be determined on the spot. The offer and acceptance is made explicit by way of written document or verbal statement. These requirements must be strictly observed to avoid ambiguities (gharar) in the contract. Some sale contract become invalid (bathil) if it is inclined to gambling such as selling fish in the water or determining price using stones or arrow. As long as the contracting parties have fully observed the legal requirement concerning their transaction, the contract of sale is deemed valid (sahih).

The contract approach therefore looks at the explicit or external (zahir) property of contracts. It does not give qualification to the role of intention (niyyah) of the contracting parties. In doing so, the Contract Approach has given birth to a number of products where profits are created by virtue of time value. It opens Islamic banking to a variety of credit sales and credit-based transactions. These are:

a) Al-murabahah (sale with lumpsum deferred payment)
b) Al-bai-bithaman Ajil (BBA) (sale with installment payment)
c) Bay’ al-‘inah (sale-buyback with installment payment)
d) Tawaruq (installment sale + cash sale)
e) Bay’ al-dayn (sale of debt at discount)
f) Ijarah Thumma Al-bay AITAB (interest-free financial leasing)

In 2004, BBA and murabahah constitute 49.9 percent and 7 percent of total Islamic bank financing respectively while AITAB accounting for 24 per cent.

Table 1 Islamic Banking System 2004 Malaysia


Bai bithaman ajil 49.9
Murabahah 7.0
Ijara Thumma Al-bay 24.0
Mudarabah/Musyarakah 0.5
Istisna 1.2
Others 17.4
Source: Bank Negara Malaysia 2004

In other words, total credit financing has accounted for 80.9% of total Islamic financing. This essay concludes that the Contract Approach has led Islamic banking into offering credit-based products (CBP) as a means to generate profit. The implications are examined in the next essay.


Blogger hazim said...

in my opinion,the contract approach of islamic finance is the outcome of the point of departure of malaysia's islamic financial system development. what i mean here is that when the first time an islamic financial institute was established it was aimed to reduce the immobility of muslims' wealth who were reluctant to use conventional banking and investment services.as the result, the lembaga tabung haji was established. looking at huge pooling of wealth in tabung haji it makes sense to establish an alternative finacial system so that muslim's wealth can be expanded.in doing so, contract approach becomes the main object of islamic finance because it gives ways to product generation which is anologous to conventional products in term of features.so it is easier to be marketed.
the way i see this is that the point of departure is sort of partial.it is aimed to recude muslims'(mainly malay)wealth immobility so that wealth distribution range will some how become smaller nationally.whether it is achieved, is a point to ponder. it should be set in wider perspective of liberating muslim from usuriuos economy practice by any mean.some even thinks that today islamic finance practice makes it harder to establish the latter. among others is Umar Vadilo(in his book: return of gold dinar)wallahualam.-Ahmad Hazim Alias

1:53 AM  
Blogger siti hajar samsu said...


in my view, the contract approach('Aqad)in the modern islamic finance is the best way to distinguish between islamic finance practice and the conventional one. As it is seems nearly the same with conventional product in term of features..it means that by doing so 'aqad approach become the main goal in islamic finance today.And im strongly agree with what has been said by bro. Ahmad Hazim.
To discuss further, in the context of ummah and our next generation, this approach will help muslims do their financial business in a proper way which is follow shariah principles and at the same time rewards from Allah s.w.T.However, in a way to give a best services and better understanding among muslim or non muslim out there the principles and the guideline should be very clear, and the most importanat thing it is necessary to have an act in the matter of inforcement.Moreover, modern islamic environment gradually changed concurrent with new globalize phenomenon. Therefore, such condition must take into account in away to make islamic products more attractive and marketable.

and i think in broad perspective...islamic finance specifically this approach leads muslim as a whole runs from usurious, gharar or maisir even some might thinks that islamic finance practice today makes it so difficult to achieve what we most desired. Wallahualam..by Siti Hajar Samsu

7:47 PM  
Anonymous Anonymous said...

To enable the Islamic banking to remain competitive with its counterpart, it has to somehow devise some way to stay in the front run, if not in the business itself. Due to its status of being a private body, Islamic banking as one that conducts business must therefore generates profit that is competitive with the conventional banking. However, Islamic banks are prohibited from generating profits through the current system of riba, i.e. interest. So, how do Islamic banks get profit needed to stay in the business? The solution to all problems returns solely to Allah SWT, i.e. through His Revelation (Wahy) as well as His Prophet’s Sunnah. The Islamic Syariah has provided many rulings and contracts that legalize human’s actions which are also in conformity with reason. One of these contracts is the contract of sale (al-Bay’) which the Quran has stated that instead of riba, Allah Has legalised sale (al-Bay’). Following the Mazhab Safi’I, a transaction is valid if all its conditions are properly met and at the same time, it does not contain the prohibited elements of riba, gambling, ambiguities and prohibited commodities like alcohol and pork. As a result, Islamic banking has come up with products which are based on credit-sale and credit-based transaction. Although this may set Islamic banking with the conventional one apart from each other, on this basis however, Islamic banking is still lacking in that it seems to use the contract approach on its explicit property without really putting greater weight on its implicit element which is the most important thing in Islam, i.e. intention (niyyah). The most important essence in Islam is in upholding justice, especially in eleviating the misery of people. However, by resorting to credit-sale and credit-based transaction, the Islamic banking seems to make people suffer where consumers felt burdened by the huge amount that they have to pay at the end of their contract. Viewed from this perspective, one question arises.. where does the name Islamic go? Then, it will only be Islamic in name but not in its true spirit.This will not be the case if Islamic banking returns to the basic Shariah objective, i.e. justice. One way for this to be achieved is instead of profit maximization, the main objective of Islamic banking should be the circulation of wealth. The Islamic banks should be the capital provider to people who need the capital to do their business and the contracts available according to Islamic Syariah are of course Mudharabah and Musyarakah. While for people with consumption needs, the Islamic banks should provide the loan on Qardhul-Hassan basis. In these ways, wealth should be circulated in the system and not only pooled in few hands (in order that it may not (not) merely make a circuit between the wealthy among you- Quran 59:7).
There must an argument from the Islamic banks as to how they will survive in this competitive and profit-driven world since Islamic banks only comprise not more than a quarter of the share in the banking industry and its capitalization is still not large enough to absorb any economic shocks. Also, the natures of Mudharabah and Musyarakah are long-term contracts in that both contracts require longer time for the profits from the business venture to materialize. But then again, the wait is really much worth it since transactions under the blessings of Allah which are exposed to much risks will be in the end rewarded handsomely, not only in this Dunya but also in Akhirah. It is after all up to the Islamic Banks’ true Niyyah in involving in this Industry in the first place.
As an end word, all the above stems from the fact that Islamic Banking starts as a private organization competing in this market world, with business as its main engine of operation which requires competitive profit to be remain lucrative in this industry that mainly dominated by conventional banks. Therefore, whether it is late to suggest this or not since Islamic Banking have already 22 years to prove itself, Islamic banks perhaps should be under government hands in their fragile years until their capital bases are strong enough to be release on its own to face this dynamic world while maintaining the Islamic spirit of justice and brotherhood.
Nur Edzalina Haji Idris

10:47 PM  
Blogger octa enriqco said...


I am agreeing with sister hajar and brother hazim, there are both my colleagues. In this era globalization we should know how to choose in what kind of systems that we want to save our money. Manage our financial in Islamic way is the best way that we can do so far. It means that as a Moslem we should act like a Moslem. Don’t wait until we get trap by the conventional rule. Since Allah has prohibited riba (interest) we should follow and support this concept together as Moslems and makes everyone knows (especially non Moslems) that in Islam there are a lot of keys to success in life here and after. And we have to make the rules as foundation of this system clearly and easy to understand for all people, so people will enjoy and feel the benefit of this. Further more I hope by this Islamic finance system we can reduce and diminish the poverty and decreasing in equality income. Therefore by the lower poverty and high in distribution of income will affect to the economic growth which is will improve stability and happiness in citizen.

Octa Enriqco A

10:47 PM  
Blogger eghutapea said...

It has been wellknown that Murabahah as a product of IB (Islamic banks) was not a genuine form of financing in Islamic tradition. PLS modes of finance are the original ones, namely Mudharabah, Musyarakah, Muzara’ah, and Muqarradah.

Murabahah (in differed payment sense) is accepted as a kind of product for this time being, by realizing that there are so much precondition needed to fulfill in implementing the PLS into the reality. Because, at the same time we have to make available a kind of banking institution that operates under the shariah principles to serve the needs of ummah. So, Murabahah is allowed only in the spheres where PLS cannot work and that too with certain condition. This allowance should not be taken as permanent rule for all sorts of transaction of IB. IB should have advances toward PLS in gradual phases and should have increased the size of PLS.

If we learn from the experience among the countries in implementing PLS. Sudan is the only country that has Islamic banking industry with significant portfolio in PLS. They made it after had a big problem in the first stage in implementing that idea. Notice that in Sudan case, portfolio allocation is regulated by Bank of Sudan as banking authority and banking system is totally Islamic. With the same environment, Islamic banking system in Iran has different picture with their assets portfolio is dominated by debt-based products (originated from trade transaction). Then, it is not surprisingly if Islamic banking industry in country with dual banking system is struggling with the problem of majority of credit-based products in its portfolio. Under such environment it is quite hard to reach the ideal picture of Islamic banks.

I just want to argue that the unsatisfying current condition of IB practices is not merely a result of contract approach. To me, the dominance of credit-based product in IB is a result of a wider, more complex and fundamental problem on the environment where the IB operates. Sorry to say that the unsatisfying picture of IB for this time being is a result of our wants. Meaning to say that they behave because we required to did so. This picture is a result of our preference in doing banking activities regardless of how good we are as muslim in our ritual activities.

How do I say so?
Let me start with simple question: who are the stake holders of Islamic banks? Did we play our role in the way that fit and proper to the nature of business of Islamic banks?
We are the depositor of IB: did we ready to get lower return (compare to interest rate) because business is slowing down or even to bear the loss in case of normal business loss happened in IB assets side (as a result of PLS principle)?
We are the customer that using financing from IB: did we want to share profit from doing business if that profit-shared is higher than interest rate in the market?
Did our government prepare the regulation to let IB operates according to its nature of business? (in the sense that banking regulation should be different since the nature of business between IB and conventional bank is quite different: i.e. IB should be allowed to involve in trading of goods or the regulation on capital requirement should be different)
As academician and researcher: did we give assistance to IB with useful research to find the right methodology in determining the just price in murabahah or help IB to solve the problem in implementing PLS?

Developing IB in the conventional atmosphere is akin of laborious task where we have to struggle with flawed condition. Social control is the best way to keep IB on the right track. Critics with constructive idea on how to make it right will accelerate the development of IB as we wish. Otherwise, blaming without helping is akin of phenomenon on the stadium of soccer game.

“…wa tawaa shaubi al-haq, wa tawaa shaubi al-shabri” (QS. Al-Ashr)

Wallahu ‘alam bissawab

Erwin Gunawan Hutapea-G.0422765

8:45 PM  
Blogger iryani said...

Nowadays, the Islamic banking institutions in Malaysia are trying to give the best alternative financing to the society. Competing with the major and formal conventional baking institutions is something not simple to tackle. Since these major conventional banking existed before the Islamic banking, therefore people are more familiar and comfortable to use these baking services. Seeing this, Islamic banking institutions are facing major task as to overcome the situation. By introducing an Islamic instruments which is something that mainstream banking does not offer, can help to change people perception towards it services. Interfering by Muslim’s jurists to give and ensure the validation of Islamic instruments should convince the Muslim’s customers to use the services. The jurists are guided by the Shariah rules and regulations which is command in Islam. The contract of aqd introduced by Islamic baking has been leading to variety of Islamic instruments services. This can be seen as major breakthrough in banking institutions as it can provide the people relatively new services compare to mainstream. Therefore, the using of BBA, bay’ al-inah and so on can help people to choose from these services to fulfill theirs satisfaction and needs.


6:39 PM  
Blogger noor anum sarah bt johar ariffin said...

In this sense, “Islamic banks” or “Islamic financial institutions” try to ensure that all their contracts adhere to Islamic legal requirements as well as state requirements.In this domain also, the Muslim
needs to ensure that the contract he signs with the lessor or lessee agrees with
the conditions of the lease contract (‘aqd al-’ij¯arah or ‘aqd al-’¯ıj¯ar) in Islamic
jurisprudence. Those conditions are put in place to ensure that the contract would not contain elements of Rib¯a or Gharar, which are forbidden in Islam.It is sometimes asserted that in the beginning, that is in mid seventies, Islamic banks tried to practice profit-sharing with their clients but it did not work for a number of reasons. No documentary evidences is, however,available tosupport this claim. Whatever the history, currently the practice of profit-sharing is insignificant.Despite a claim that it is increasing, Islamic banking remains dominated by murabaha followed by leasing. Islamic banks have also been dealing in real estate,bullion and currencies. Most of the losses sustained by Islamic banks in the past originated in the latter dealings.

11:26 PM  
Blogger weni said...


The contract ('Aqad) Approach is the outcome of the progressing of Islamic banking. Most of them are based on a variety credit of sales and credit based on transactions such as murabahah, Al-Bai-Bithaman-Ajil, Bay al inah, Bay al dayn, AITAB AND tawaruq.

They create much profit to Islamic banking. It goes without saying, they are one of the biggest assets. We could see from Prof.Saiful data of their percentage in Islamic banking.

Since the Holy Qur'an has condemned interest and enjoins profit creation via trading (bay'), many people, muslim and non muslim people join with Islmaic banking. The point of view of Musilm is because as a muslim they want to apply their religious and from the point of view non muslim join with islamic bank because they just pay with a lower price compare if they make credit transactions with conventional bank.

However, there are two things that we have to give attention toward islamic aqad (contract). THey are:
a. Are the Islamic aqad products are really free from riba or interest since they create profit from the time value of money?
b. The Islamic aqad products is the conventional contract products with the different name.

Based on my point of view in this case, the Islamic aqad products are still contain the term of riba or interest in their system and application. Furthermore like I said before, they creat money from the time value of money. It is just the same with conventional product but with different name. Whereas The Holy Qur'an has been condemned the riba or interest and enjoin profit via trading.

However, in its application, the Islamic banking still use the same system with conventional to get profit. Even though the Islamic aqad products give much profit toward islamic banking but actually they are still products based on riba or interest. Take for example like murabahah and BBA(installment payment). They create profit based on time value.

I just want to emphasize in this blog that the Islamic banking have to use their own tools in creating profit for their company based on Islamic aqad products. They must be have their own ways to reduce or to eliminate the Islamic aqad products from the interest or riba. This is because if they keep maintain using the system like the system in conventional banking, they had already cheated the people, especiaaly the muslim people. They must aware of this and they have to cooperate with shariah advisor to create the new islamic aqad products that are really free from riba or interest. If not, Allah will give them punishment. Thank you.

12:11 AM  
Blogger muhammad said...


Role of 'aqd' in Islamic contract is crucial to distingusish with 'conventional' contract.In fact, in conventional contract, there is also offer,acceptance,object and intention to create legal relation as to validate the contract.The unique characteristics of Islamic contract is it should not have engaged with riba, gharar and things that are 'haram' from Islamic point of view.

Item stipulated in normal conventional contract such as 'the Bank', 'lender' and 'contract awarder' is clearly defines in the contract.In fact, facility and security quantum is being clearly stipulated in the letter of offer to the borrower.Ironically, in Islamic Banking in the case of Bay al Inah or particularly Mudharabah Overdraft for example, the borrower has to come out with their own assets, which is free from encumbrances to be used for 'aqd' purposes.This creates difficulty for borrower, especially petty trader to meet such requirements.As a result, Islamic Bank may loose its potential customer due to unnecessary red tape.

Another debatable issue is some of them, especially Non Muslim will questioned on the purpose of asset to be use of aqd.The only concrete answer is to 'validate' the 'Islamic' contract without any necessary purpose on the assets.Transactions are soley based on 'niyyah'.This transactions can be clearly seen in Al Bainah contract.

As an implication to this, this can be consider as 'hiyal' or tricks to Almighty God.

For me, particularly for working capital financing best alternative to this is al Ijarah & Al Musyarakah based product which insist on risk sharing principle.

12:52 AM  
Blogger kamruzzaman said...

The way I see almost all financial transactions are contract based in this modern day and age, except that conventional banking contracts are Islamically invalid because they have elements of interest and usury. It is fair enough that the Contract approach allows for Islamic banks to generate profit. but is it accceptable for Islamic banking institutions to take such an approach?

Let consider this example, a man Mr Salam wants to buy a house. So he looks around and finds a house he likes to buy. Goes to Islamic Bank Alif and agrees contractually to finance the house on Bait bithaman ajil. The bank goes and buys the house from the original owner Mr Kalam (transfer of ownership to the bank) and the bank resells the house at a much higher price on an installment basis to Mr Salam.

Whats wrong with this senario? Mr Kalam when selling the house to the bank obviously wants to sell it for a good price, to get more than what he paid for it or at least to sell it at market value. So Mr. Kalam will get a profit from the sale of his home. The bank now resells the house to Mr Salam also for a profit which hikes the price of the house even higher. From a purely Islamic basis this can be seen as burdensome to the buyer Mr Salam. It is justified because of the contract approach whereby both parties agree to the conditions stipulated in the contract.

Now let’s compare this to the conventional banks approach. Mr Sam wants to buy so he gets a loan from the conventional bank and has to repay with interest. Signs a contract and gets his loan approved and buys a house with the same price as Mr Salam. Mr Sam pays added interest its true but the amount that he pays is the same as Mr Salam at the end of the day or nearly equal for the same house.

Therefore is being Islamic about the process or is it about the end result? If we can justify the contract method as valid because of the process then the Muslim consumers will indeed suffer, since the Islamic banks will make easy prey on the muslims to obtain profit (if you look at it pessimistically). Otherwise we would have to concede that it is ALL about the process of obtaining the house whether there is riba or not.
The intention of the allowing contract based approaches is to facilitate a trader to better able sell his wares and trade amongst his fellow merchants and buyers. The bank is not a merchant, it deals with money. However from an Islamic perspective I guess you could say that the bank is indirectly a merchant that trades in many wares, houses, cars and businesses. The end result however is not really different from conventional banking.

I think Prof has elaborated on this in Time Value of Money and Murabahah/BBA profits and how there is no ‘iwad for the higher mark ups in BBA financing.


9:00 AM  
Blogger Md.khademul Islam said...

In my point of view, the product of Islamic bank such as BBA, Al-murabahah, Bay’ al-‘inah, Tawaruq, Bay’ al-dayn, AITAB have got popularity by it’s islamic validity. Muslimes want to earn money by the islamic way not conventional system. The Islamic bank earned profit by selling and buying contract which is permissible in Islam. Prof has given the measurment which sell is Islamic or not . I think thre is some problem in practical field but we can follow in most of the case. This is happy news for Mulim Ummah that we can earn profit by avoiding the interest system. The malaysian islamic banking model provides many cntract as a result local muslim can expand their money by sharia law. But all produtcts are still confusing about their implemetation. Some of my friend have given opposit argument that are not islamic rule. I don’t think so. This is because at least they are following the buing and selling contract and they are not follwing the fixed income. Finally , I think if islamic banks can implement the islamic business system accuratly, they can earn more profit.

Md.khademul Islam,G0429917

10:31 PM  
Blogger nira said...

This comment has been removed by a blog administrator.

7:54 AM  
Blogger nira said...

The fundamental basis of sale contract consists of one piece of property being exchanged for another. Offer and acceptance are also referred to as the fundamental basis of sale, since they imply exchange. As for the object, it must be in existence, deliverable and known to the purchaser. These conditions are applicable to many types of sales except in few contracts such as bay' al-salam and istisna'.

Ever since the inception of Islamic banking in Malaysia, the contract approach has been the fundamental element in outlining the Islamic banking business and its products. This is because the main focus and concentration of the so called pioneers is on the compliance of Shariah in the implementation / operation of the Islamic banking business.

Hence, it is not a surprise to see the trending of bias towards contract approach in conducting Islamic banking business. I think that this was contributed by the secularism in our education system. Why am I saying that?....

This is because although we have the SAC to ensure the compliance of Shariah in our Islamic banking business, however, the bias is still towards the Shari' dimension and the Tabi' dimension is being left out. This is because the SAC consists of the economists/financiers/bankers and the ulama', on which each rep is analyzing / focusing on one's area of expertise. An ulama' will focus on the Shari' matters while the economists/financiers/bankers will look at the Tabi' perspective. This is the result of secularism adopted from the colonials.

Hence, decisions made by the SAC did not look from holistic point of view but rather in separation between the Shari' and Tabi' concerns. Therefore, this could be the reason for practice of contract approach which has led into the adoption of credit-based products in our very own Islamic banking system. Wallahualam.

8:00 AM  

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