Why contracts decide whether finance counts as Islamic
Islamic finance contracts are the named agreements, each with its own rules, that replace the interest-bearing loan in Sharia-based dealing; they cover lending, sale, lease and partnership. The word on a brochure does not make a product Islamic. The structure of the agreement, the order in which things happen and who owns what at each moment are what a scholar examines.
Underneath all of them sit a few principles. Interest, known as riba, is avoided. Excessive uncertainty (gharar) and gambling (maysir) are avoided. The money may not finance prohibited activities such as alcohol, gambling or pork. Within those limits, the contracts allow trade, hire, partnership and benevolent lending.
A reader in India should keep one fact in view: the country has no licensed Islamic bank, because banks work on interest under the Banking Regulation Act, 1949. These contracts are therefore known mostly through co-operatives, funds and charities, or through foreign products, and not through high-street Indian banks.
Lending contracts: qard and the pledge that secures it
The simplest contract is the loan itself. A central bank glossary describes qard as a loan repaid in an equivalent amount of the same fungible asset. In everyday terms the borrower returns what was received. When the loan is made out of kindness it is called qard hasan, a benevolent loan in which only the principal comes back; the lender may recover actual administrative costs but earns no profit.
A lender may ask for security. That is the role of rahn, the pledge or collateral that backs a debt. The creditor holds an asset, such as jewellery, as a guarantee, and the pledge does not by itself create any profit for the creditor.
Money is also placed with a financial institution under non-remunerative contracts. The IFSB working paper on money-laundering risk notes that non-remunerative funds come from qard or wadi’ah contracts, which are deposits or loans without a return, while remunerative funds come from profit-sharing investment accounts.
Sale-based contracts: murabaha, salam and istisna
In a murabaha the financier buys an asset and sells it on to the customer at the original cost plus an agreed mark-up that the buyer is told about. The price can be paid later or in instalments. The working paper adds the key condition: the bank must hold the asset before it sells it. A sale of something the seller does not yet own is not a valid murabaha.
Salam turns the timing around. The buyer pays in advance and the goods are delivered later, a pattern that has been used for crops. Istisna is a contract for something to be made or built, so it fits a manufacturer or a developer who needs funds during production. The IFSB paper describes it as a sales-based financing contract for developers or manufacturers.
These three share a feature that sets them apart from a loan. The financier takes ownership, even briefly, and the customer pays a price for a real thing. Critics sometimes say the result looks like interest on paper, which is why scholars insist the steps are genuine, not staged.
A worked picture helps. A customer needs a machine. In a murabaha the financier first buys it from the supplier, then sells it to the customer for the cost plus a disclosed margin payable in instalments. In an ijara the financier buys it and rents it out. In a musharakah the financier and the customer jointly fund the purchase and share what the machine earns. Three routes, one machine, three different sets of rights and risks.
Lease contracts and the ownership question
Ijara is the Islamic form of a lease. The definition in the central bank glossary describes a contract giving use of an asset or a service for an agreed period in return for payment. The financier remains the owner and takes the risks that ownership brings, such as damage not caused by the user.
A variant, ijara muntahia bittamleek, ends with the asset passing to the user. The customer pays rent for a fixed term and, at the end, becomes the owner by a transfer that the contract spells out.
Because ownership stays with the financier during the lease, the arrangement differs from a loan secured on an asset. If the asset is destroyed or fails through the owner’s fault, the owner bears part of the loss. This is a practical test for whether a product is a lease or only a loan renamed. A lessee should therefore ask who pays for major repairs and insurance, since the answer shows where the risk of ownership really sits.
Partnership contracts: musharakah, mudarabah and diminishing shares
In a musharakah, all partners provide capital and share profit by an agreed ratio. Loss follows capital: someone who contributed a quarter bears a quarter. A diminishing musharakah is a variant in which the customer gradually buys out the financier’s share, so that ownership shifts over time.
A mudarabah splits the roles. One party supplies the money and the other manages it. Profit is divided as agreed. The glossaries agree that the financial loss lies with the capital provider, unless the manager’s misconduct, negligence or breach of the terms caused it.
Both contracts are called profit-and-loss-sharing. The financier cannot demand a fixed return, and that is why they are seen as the closest in spirit to Islamic ideals, and the reason an institution using them must be able to judge the business it funds, since it shares the outcome.
- Lending: qard, qard hasan, and rahn as security.
- Sale: murabaha at cost plus a disclosed margin, salam with advance payment, istisna for manufacture or construction.
- Lease: ijara, and ijara muntahia bittamleek with transfer of ownership.
- Partnership: musharakah, diminishing musharakah and mudarabah.
Support contracts: wakalah, takaful and sukuk
Some agreements do not provide money directly but support the others. Wakalah is an agency contract in which a principal authorises an agent to carry out a task that can be delegated, with or without a fee. It can be the basis on which an operator is appointed to handle other people’s money.
Takaful applies the idea of mutual assistance. Participants pool contributions in a common fund that pays benefits on pre-agreed events. The operator manages the pool, usually under a wakalah or a profit-share contract.
Sukuk are certificates of undivided ownership in assets, according to the IFSB working paper. They are sometimes called Islamic bonds, but the holder owns a share of an asset instead of being owed a loan. The instrument is mentioned here only to complete the picture. Unlike a bond, its value depends on the underlying assets, which is why the description of those assets matters to any buyer.
Reading Islamic finance contracts before you sign
Ask three questions of any product that calls itself Islamic. What is the contract type? Who owns the asset and when? How is the price or return set? A clear answer names one of the contracts above and shows the sequence of steps. A vague answer, or a fixed return promised on a partnership, is a warning.
Remember also that the standards bodies publish detailed rulebooks. The AAOIFI website, for example, offers its Shari’a standards as a downloadable file. A short summary is no substitute for those documents, which set out each contract in detail and are written for specialists.
Whether a given product complies is decided by qualified scholars or a Sharia board, not by the name of the contract. Whether it is legal in India is a separate question for the relevant Indian regulator. A careful reader asks both, and asks for each answer in writing from the scholar or the regulator, so that the reply can be filed with the contract. Keep copies of the signed contract, the schedule of payments and any document that shows the financier’s purchase of the asset, since these papers prove which structure was really used.