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Saturday, 1 May 2010

How Islamic banks fund projects


ISLAMIC finance uses both debt and equity to fund transactions.

Some experts see equity financing as being closer to the syariah's original aim of promoting equality in sharing risks and rewards, but others say debt instruments play a similarly important role.
The global financial crisis has prompted debate about the use of excessive debt and speculation to fuel growth.
It has also renewed calls for Islamic finance to use more equity- based structures such as musharaka and mudaraba to reduce its reliance on debt funding.

POPULAR EQUITY STRUCTURES: MUSHARAKA
A partnership where profits are shared as per an agreed ratio, whereas the losses are shared in proportion to the capital/investment of each partner.
All partners to a business undertaking contribute funds and have the right, but not the obligation, to exercise executive powers in that project, which is similar to a conventional partnership structure and the holding of voting stock in a limited company.
It is often used in investment projects, letters of credit and the purchase of real estate.

MUDARABA
A limited partnership where thebank appoints the obligor as its limited partner to invest money in specific or general activities.
The losses are borne solely by the bank in the absence of fraud or negligence by the obligor, but profits are shared in an agreed ratio.
Customers can use mudaraba financing for overdraft requirements, short-term financing and bridge or project financing needs.

WAKALA BIL ISTITHMAR
An investment agency where the bank appoints the obligor as its investment agent to invest the finance money in specific or general activities.
Any losses are borne solely by the bank in the absence of fraud or negligence by the obligor and the rates of return are variable.

POPULAR DEBT STRUCTURES: MURABAHA
The bank acquires assets from a vendor at cost and on-sells the assets to the obligor at a mark- up and on deferred payment terms. The economics of this product are similar to a fixed-term loan and the mark-up is almost invariably benchmarked against a conventional index such as Libor.
Because of its fixed-price nature, it is seen as more suitable for short tenures.
The assets are usually charged as security for the obligor's payment obligations under the murabaha contract.
Used to purchase goods, for working capital and share finance.

IJARA
A leasing structure where the bank acquires assets from a vendor at cost and leases the assets to the obligor for the duration of the financing.
Part of the rent payable is benchmarked as per the murabaha contract and the amount of rent due can be altered by the use of periodic notices.
The obligor usually undertakes to buy the assets back from the bank at maturity or on default, and the value to be paid for the assets is equal to the outstanding amount of the financing at the date of such purchase.
The structure is suitable for longer tenures and may be offered with floating rates of rent.
The assets are typically charged as security for the obligor's payment obligations under the ijara contract.
Used to buy ships, aircraft, industrial equipment and real estate.

MUSHARAKA MUTANAQISA
A diminishing partnership where the bank acquires assets jointly with the obligor from a vendor.
Their shares in the assets are proportionate to their capital contributions.
The bank leases its share in the assets to the obligor and the rent payable is benchmarked.
The obligor undertakes to purchase the bank's share in the asset over time or as a bullet at the end of the financing.
This is the most flexible product as the principal payments (pursuant to the purchase undertaking) may be amortised and the rates may be floating.
Used to finance the purchase of houses, plants and machinery.

(MyPaper) 

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