Islamic Financial Instruments

Participation Term Certificate (PTC): It was designed to replace the old debenture used in the financing of industrial investments. This was the earliest instrument designed to promote Islamic instruments of finance. It had the following distinguishing features:

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  • PTC was a negotiable instrument of financing;
  • It represented redeemable capital of the purchasing company;
  • During construction period, PTC earned a pre-production discount similar to the earnings of interest during construction;
  • PTC earned a prior return out of the profits of the firm up to a certain pre-specified upper limit;
  • The deficiency in profits, relative to this limit, would have to be made-up through the issue of additional PTCs;
  • Under situation of losses, PTCs would decline to the extent of the share of the financier in the losses and the said amount will have to be converted in ordinary shares of the company;
  • In subsequent years, when firm earns profits, 25 per cent of the profits will be required to be used for converting the converted PTC back to their original form;
  • The securities required under the PTC financing were analogous to those required under debenture financing, such as creation of registered mortgage of property etc.

Undoubtedly the instrument stipulated a complex system of profit and loss sharing. The complexity has to be understood within the context of the problem that was intended to be resolved through the application of this instrument. Moving away from an interest based system that required little or no information about the outcome of the business, to a system that posed greater demands on that account had to be complex in the beginning. With greater application and experience, it was hoped, simplifications will be introduced and the instrument will be made easier in use.

Despite such complexities, however, with exception of National Development Finance Corporation (NDFC), almost all the development finance institutions (DFIs) and nationalized commercial banks (NCBs), used PTC as the main vehicle for industrial investments. Indeed the bulk of rupee funds provided by these institutions during 1980-1984 for industrial financing were in the form of short and long term PTCs.

Although more akin in form to what is called in financial literature as preferred or redeemable capital, the method represented a significant advance toward the development of non-interest financing methods as it linked the return on financing to the profitability of the financed projects. There were, however, a number of serious objections to this method. One, a fixed charge was added to the outstanding amount of PTCs during the period of construction, which was tantamount to interest during construction. Two, although losses were to be shared in proportion to the ratio of PTCs to the total capital, priority was accorded to the payment of return on PTCs before any payment could be made to other shareholders. This conflicted with the Islamic concept of profit and loss sharing which requires payment in a specified ratio, and without any prior claims. Three, the manner in which losses were shared was not only complex but also uncertain in terms of its outcome. The requirements of conversion of losses into equity, and the prior claim enjoyed by re-conversion of such shares into PTCs were not in conformity with the standard PLS arrangements. Finally, the nature of securities required for financing was analogous to what is required under interest-based financing and hence it may render the arrangement suspect from the point of Shari’ah. Despite these shortcomings there were real risks involved for the financing institutions, as was borne out by the subsequent experience also, and it was for this reason that the advocates of the new system had welcomed it in the hope of future improvements.

Musharika: This instrument was basically developed by the commercial banks initially at their own but was subsequently revised under the guidelines of the SBP, issued during the period 1982-84. Undoubtedly, along with Mudaraba, Musharika represents the most desirable form of Islamic financing arrangements. Yet, in terms of ability to be an effective and efficient instrument for replacing the interest-based transactions, it poses formidable problems. The efforts made in this regard and the eventual fate the arrangement met explain this point.

The salient features of the Musharika Agreement, as practiced by the commercial banks, were as follows:

  1. It was a short-term financing arrangement specific only to the parties to the contract;
  2. Investment by the banks was made in the form of sanctioning a funding limit to the client and the degree of employment of funds was determined on the basis of daily product of outstanding balances due to the bank;
  3. All participative funds, including equity, reserves and other non-debt capital was included in the definition of capital qualifying for profits;
  4. Profit sharing ratio was determined through negotiations within the limits specified by the SBP;
  5. Profits for the purpose of sharing were to be determined after apportioning a share of net-income as management fee to the firm;
  6. Provisional profits, based on projected profits, were to be paid to the bank on quarterly basis, subject to final adjustment on the basis of actual profits or losses;
  7. Shortfall or excess profits were to be settled through the creation of a participation reserve fund, which would attempt to smooth out the payments to the bank;
  8. Losses, if any, were to be shared in strict proportion of bank's investment in the total capital of the firm;
  9. Against the apportioned loss of the bank, ordinary shares were to be issued, which qualified for re-conversion in Musharika investment under the original terms of the Agreement in case profits accrued in future;
  10. Standard securities in the form of pledging and hypothecation of stocks or mortgage of properties were required against Musharika financing;

Evidently, the Musharika also envisaged a complex arrangement of profit and loss sharing just as it was present in the case of PTCs. But in its design the seriousness to evolve a truly Islamic instrument is quite evident. It was indeed a departure from the traditional financing arrangement and thus entailed significant risk which banks assumed in undertaking business based on this arrangement.

Some of the features of the instrument that attracted criticism were: One, the profit sharing arrangement did not strictly conform to the requirements of Shari'ah particularly in the treatment of losses and payment of provisional profits and their adjustment through the participation reserve. Two, despite being a sharing arrangement, the actual agreement was cast within the framework of a creditor and debtor relationship, and was also protected as such in the law. Three, Musharika also demanded securities that were akin to relationship between a creditor and debtor. Finally, in the absence of a legal framework regulating the operation of Musharika, there was no standardization of the agreement and the terms and conditions of various agreements varied considerably.

Mudaraba: Mudaraba represents another of the most desirable forms of Islamic financing arrangements. In a novel approach, the business to be undertaken under Mudaraba was regulated through the promulgation of a separate statute, called the Mudaraba Companies (Floatation and Control) Ordinance 1980.

The salient features of Mudaraba companies and their operations are as follows:

  • Only registered companies or those established under specific laws were eligible to register as mudaraba companies;
  • Mudaraba can either be for a specific purpose or multi-purpose and can either be for a fixed term or for perpetuity;
  • On fulfillment of certain conditions, and with the prior approval of the Registrar, Mudaraba Companies may float mudarabas through the stock exchange, and the certificates of issue will be tradable securities;
  • Each mudaraba will be a separate business and its operations had to conform to those approved under the injunctions of the Shari'ah.
  • A Religious Board to be periodically constituted under the Ordinance will be empowered to declare whether the operations of mudaraba were in conformity with the provisions of Shari'ah or not.
  • Many disclosure requirements, similar to those applicable to listed companies, are applicable to Mudarabas, including statutory audit, annual meetings and investments and loans to and from the directors of the mudaraba company.

Evidently, the entire scheme was an elegant formulation of the simple relationship required under a mudaraba contract between the labor (dharib) and capital (rabbul ma’l). The management company was to be remunerated through a fixed management fee paid out of the net income of the mudaraba and the remainder was to go the mudaraba certificate holders, with adequate provisions for retained earnings to ensure future growth. Initial tax incentives available to mudaraba companies, however, were such that maximum distribution was allowed. No income tax was applicable to mudaraba if it distributed 90 per cent of its net income, which was exactly what was left after payment of management fee.

Unlike the evolution of PTC and Musharika, which was largely taking place within the public sector financial institutions, the mudaraba financing was purely a market driven phenomenon. So far some 50 mudarabas have been floated with a combined capital of Rs.8.2 billion, largely by independent management companies. The fortunes under the mudaraba have fluctuated greatly over the years. In more recent years, due largely to generally depressing stock market conditions, and with the exception of a few, mudarabas have performed poorly. Withdrawal of tax incentives, which have been recently improved, have also contributed to this poor performance.

Although it is difficult to take exception to any of the provisions of the Ordinance, particularly in view of the presence of Shari'ah Board guiding the operations of mudarabas registered under it, one cannot help observing that the legislation proved to be a limiting factor in the broader application of this instrument. Once the mudaraba was defined under the law, no other form of the instrument was apparently sustainable in law. Thus the much-talked about potential of the mode, namely the generation of employment opportunities, could not be exploited.

Other Instruments: Three main instruments discussed above represented the most serious efforts aimed at evolving Shari'ah compliant instruments of financing. Two other instruments namely Leasing and Mark-up, which are often cited as instruments of Islamic financing, are briefly mentioned in the following paragraphs:

Leasing, under certain conditions, is undoubtedly a Shari’ah compliant financing arrangement. The first leasing company was established in 1984 but its aim was not to further the process of Islamization in the country. Even when the process of establishment of leasing companies was formalized in 1987, the purpose was more to expand the scope of financial intermediation than to evolve a new instrument of Islamic financing. More importantly, the business of leasing companies was never regulated from the point of view of compliance with the requirements of Shari'ah nor the companies at their own voluntarily adhered to such requirements. It will, therefore, be inappropriate to evaluate this sector within the context of the progress of Islamization of the financial sector in Pakistan.

By the term Mark-up, we cover all instruments that depend on mark up or mark down in the price of underlying goods or properties. As shall be seen later, two approved modes of financing of SBP, namely sale or purchase on deferred payment basis or under buy-back arrangements fall within this category. This instrument was never used by any of the financial institution until it was included within the 12 modes of financing. More importantly, even in its approved form, it was outrightly rejected by the Shari'ah experts as being seriously failing to meet the requirements of Shari'ah. Needlessly to say that deferred payment financing, under certain strict conditions, is an acceptable and widely practiced mode of financing by the Islamic financial institutions. In our subsequent discussion, we have more to say on this instrument and its potential to be an effective vehicle to introduce the Islamic system of finance.


Source: Experiences in Islamic Banking: A Case Study of Islami Bank Bangladesh, Institute of Policy Studies. Republished with permission.