Assignment Title

Project 1
Assignment Question :
1. Debt Financing is a straigh-forward form of lending made by a banker to its customer based on
an agreed profit margin over a determinable period of financing. Equity-based Financing on the
hand is a sharing of risks and potential profits between bankers and their customers. It is noted
from the Islamic banking Annual Performance Reports produced by authorities such as IFSB,
E&Y, KFH, and others, that Islamic banks are not in favour of offering Equity-Based Financing
to their customers. Provide your discussion and rationales on this action of the bank.

Answer :

Islamic banking operates under the principles of Shariah, which prohibits the charging or earning
of interest (riba). As a result, Islamic financial institutions have developed alternative
mechanisms to provide financing that comply with Islamic law. While debt financing is
commonly offered by Islamic banks, equity-based financing is less prevalent. There are several
reasons for this phenomenon, which I will discuss along with the rationales behind Islamic
banks' preference for debt financing.
Compliance with Shariah principles: Debt financing aligns more closely with Shariah principles
as it involves a straightforward lending arrangement with a predetermined profit margin. This
structure allows Islamic banks to provide financing while avoiding interest-based transactions,
which are considered exploitative in Islamic finance.
Risk management: Equity-based financing involves sharing risks and potential profits between
the bank and the customer. Islamic banks are generally more risk-averse due to their
responsibility to safeguard depositors' funds and ensure compliance with Shariah principles.
Debt financing allows banks to mitigate their exposure to business risks by ensuring regular
repayment of principal and profit margin.
Transparency and predictability: Debt financing provides greater transparency and predictability
for both the bank and the customer. The profit margin and repayment schedule are agreed upon
upfront, making it easier to assess the financial obligations and plan for repayment. Equity-based
financing, on the other hand, introduces uncertainties regarding the future profitability of the
financed project or venture, which may make it more challenging to determine the bank's returns.
Lack of collateral requirements: Debt financing typically involves collateral as security against
the loan, providing an additional layer of protection for the bank. Islamic banks often require
collateral to mitigate the risk of non-payment. In equity-based financing, the bank becomes a
shareholder in the venture and relies more on the project's success for generating returns, which
may entail a higher degree of risk and potentially lower collateral protection.
Expertise and resources: Debt financing is a more straightforward and familiar mechanism for
Islamic banks, requiring less specialized expertise and resources compared to equity-based
 financing. Debt financing aligns with conventional banking practices to a considerable extent,
making it easier for Islamic banks to implement and manage effectively.
It's important to note that while debt financing is more prevalent, Islamic banks do offer equity-
based financing in certain cases, especially for larger and more complex projects where the
sharing of risks and rewards is deemed beneficial. However, the overall preference for debt
financing stems from the desire to comply with Shariah principles, manage risks effectively,
maintain transparency, and utilize available resources efficiently.
2. Explain with an example what do you understand by (a) Salam contract (b) Describe major
differences between Salam contract and Istisna’ contract as being practiced in Islamic banking
system
Answer:
a.) Salam contract is a term used in Islamic finance and commerce. It is a type of forward
contract or sale transaction in which a buyer pays the seller in advance for the delivery of a
specified commodity at a later date. The seller undertakes to deliver the commodity at the
agreed-upon future date.
The key characteristic of a Salam contract is that the buyer pays the full price of the
commodity upfront, while the delivery of the actual commodity occurs at a later date. This
type of contract is commonly used in Islamic finance to facilitate financing for businesses
engaged in agriculture or other industries that involve the production or procurement of
goods.
The purpose of a Salam contract is to provide capital to the seller (usually a producer or
farmer) in order to finance their production or operational needs. It allows the seller to
receive funds in advance to cover costs, while the buyer accepts the risk of delayed delivery
and potential price fluctuations. The contract ensures a fair transaction by specifying the
quality, quantity, and delivery date of the commodity.
Salam contracts comply with Islamic principles, which prohibit charging or paying interest
(riba). Instead, the price of the commodity is agreed upon at the time of the contract, and the
payment is made in advance. This structure aligns with the concept of providing financing
without exploiting the time value of money.
It's important to note that the Salam contract is just one of several types of contracts used in
Islamic finance, each designed to comply with Islamic principles while meeting the
financing needs of individuals and businesses.
A Salam contract, also known as a Salam sale or Salam agreement, is a type of Islamic
contract that involves the advance payment for goods to be delivered in the future. Here's an
example of a Salam contract:
 Parties involved:
Seller: Ahmed
Buyer: Khalid
Terms of the Salam contract:
1. Subject Matter: Wheat
 Ahmed will sell 1,000 kilograms of wheat to Khalid.
 Quality and specifications of the wheat are agreed upon by both parties.
2. Price: $10,000
 Khalid will pay the full price of $10,000 to Ahmed at the time of the contract.
 The price is determined and agreed upon by both parties.
3. Delivery: After six months
 Ahmed will deliver the 1,000 kilograms of wheat to Khalid after a period of six
months.
 The specific date of delivery is agreed upon by both parties.
4. Ownership and Risk:
 Ahmed bears the risk of any damage or loss to the wheat until the delivery is made.
 Upon delivery, the ownership and risk will transfer from Ahmed to Khalid.
5. Payment Default:
 In case of payment default by Khalid, Ahmed has the right to terminate the contract.
 Khalid will be liable for any losses incurred by Ahmed due to the default.
6. Termination:
 The contract cannot be terminated unilaterally, except in case of default or mutual
agreement.
7. Legal Framework:
 The contract will be governed by the principles of Islamic Shariah law.
This example illustrates a basic Salam contract where Ahmed, as the seller, receives the
payment upfront for the delivery of wheat to Khalid after a specified period. The contract
ensures the rights and obligations of both parties and adheres to the principles of Islamic
finance. It allows the buyer to secure the goods in advance and the seller to receive payment
in advance, providing financial stability to both parties.
b.) In the Islamic banking system, both Salam and Istisna' contracts are used as forms of
financing. They have distinct characteristics and serve different purposes within the
framework of Shariah-compliant transactions. Here are the major differences between Salam
and Istisna' contracts:
 Nature of the Contract:
Salam Contract: Salam is a forward sale contract where the buyer pays the price of the
goods upfront but receives the goods at a later specified date. It is commonly used when
the goods are not yet available for immediate delivery.
Istisna' Contract: Istisna' is a contract for the manufacturing or construction of goods,
whereby the buyer provides specifications for the desired product, and the seller agrees to
 produce or construct it. It involves the creation of a new asset or the customization of an
existing one.
 Payment Structure:
Salam Contract: In Salam, the buyer pays the full price of the goods upfront at the time
of the contract. The seller may use the funds received for any purpose, including the
production of the goods.
Istisna' Contract: In Istisna', the payment is typically made in installments according to
the progress of the manufacturing or construction. Payments are made at different stages
or milestones agreed upon in the contract.
 Delivery Timing:
Salam Contract: The delivery of the goods in Salam takes place at a future date
specified in the contract. The buyer may not receive the goods immediately but has the
assurance that they will be delivered as agreed.
Istisna' Contract: In Istisna', the delivery of the finished goods occurs upon completion,
as stated in the contract. The buyer expects to receive the custom-made or newly
constructed asset.
 Usage and Purpose:
Salam Contract: Salam is commonly used in financing agricultural or industrial projects.
It allows farmers or producers to obtain upfront financing to cover their production costs
or purchase necessary inputs.
Istisna' Contract: Istisna' is primarily employed in financing manufacturing,
construction, and infrastructure projects. It enables buyers to customize and acquire assets
tailored to their specific requirements.
 Risk and Responsibility:
Salam Contract: The risk of damage or loss to the goods during the production period
lies with the seller until delivery. The buyer bears the risk after the delivery.
Istisna' Contract: The risk associated with manufacturing or construction rests with the
seller until the goods are delivered. Once the goods are handed over to the buyer, the risk
transfers to the buyer.
 Transferability:
Salam Contract: Salam contracts are generally non-transferable. The buyer cannot sell
or assign the rights and obligations under the contract to a third party.
Istisna' Contract: Istisna' contracts are usually transferable. The buyer has the option to
assign the contract to another party with the consent of the seller.

It's important to note that the specifics of Salam and Istisna' contracts may vary based on
the interpretations of Islamic scholars and the requirements of individual financial
institutions. The mentioned differences outline the general characteristics of these
contracts in the Islamic banking system.
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