Financing in Islamic Banks.

Question: If the Islamic banks do not lend money on interest then what modes of financing can be used for the following:

 

Trade and industrial finance 

 Financing the budget deficit 

 Acquiring foreign loans

As a matter of principle, all the financial transactions between the parties are lawful in the eyes of Islamic Shariah. Islamic Shariah provides several interest-free modes of finance that can be used to satisfy various business needs of the customer. These modes can be clubbed into two main categories.

The 1^st may include modes of advancing funds on a profit-and-loss-sharing basis. ( Mudarabah, Musharakah ).

The 2^nd may include the modes of finance in which are used for the purchase/hire of goods and services on a fixed return basis. (Murabaha, Istisna, Salam & Ijara). 

A)      Modes for financing trade and industry:

Muarabaha, Musawama, Ijara and Salam are particularly suitable for trade while istisna is especially suitable for manufacturing or construction industry. Murabaha can be used for the financing of all purchase of raw materials and inventory. For the procurement of fixed assets including plant and machinery, building etc. either Diminishing Musharakah or Ijara can be more feasible. 

B)      Modes for the financing a budget deficit:

It is noted that in an Islamic state, all the efforts should be made to avoid the budget deficit.

However, in case of unavoidable circumstances, the budget deficit may be kept to the possible minimum limit. Sometimes the budget deficit is seen as a result of either extravagant expenditure or inefficient effort to generate tax revenue due too political, economic reasons or otherwise. There is a need to win public confidence about these needs and to create transparency in government expenditure. This can serve better in keeping budget deficit to minimum level. In case of unavoidable deficit, government-owned enterprises can obtain finance by way of Mudarabah, Musharakah or Sukuk, just like private companies do. 

C)      An alternative to foreign loans:

Seeking Islamic solution to foreign borrowing, arrangements could be made to attract foreign as well as domestic funds.

Islamic Banking how is interest free?

Q: If banking were to be based on interest-free transactions how would it work in practice?

Islamic banks like other banks is an institution whose main business is to mobilize funds from savers and user these funds to finance the economic activities of businessmen. While a conventional bank uses the rate of interest for both obtaining funds from savers and lending these funds to businessmen. An Islamic bank performs these functions using various financial modes which are compatible with the Shariah. For mobilizing resources, it uses either the contract of Mudarabah or Wakalah with the funds owners. Under in first contract, the net income of the bank is shared between fund owners and fund providers according to a predetermined profit sharing formula. In the case of loss, the same is shared by fund providers in proportion to the capital contribution. As far as the nature of investment deposits are concerned, these could be either general investment deposit or specific investments’ accounts in which deposits are made for investment in particular projects. In addition, there are current accounts are in nature of an interest free loan to bank. The bank guarantees, the principle in case of current accounts but pays no profit on such accounts.

Under the Wakalah contract, clients give funds to the bank that serve as their investment manager. The bank charges a predetermined fee for its managerial services. The profit on to the fund after deducting such a fee. On the assets side, the bank uses a number of financial instruments none of which involves interest.