Guide to uses of Salam in Islamic banking

In-Depth Analysis

Last week we shed light on how Islamic banks use the Murabahah contract to first purchase and then on-sell any defined commodity or asset to their customers at a profit margin agreed with them. The profit earned by the Islamic banks from several Murabahah transactions then become the banks' aggregate gross earnings which are made available for periodic distribution among the depositors and shareholders of the banks. This week's discussion will revolve around the usage of the Salam contract by Islamic banks as a profit-making tool. Remember, the point of discussion is how an Islamic bank can make money without indulging in interest-based lending. As you may have grasped so far, a Salam contract is a fixed price sale contract used for the trade of a non-existent commodity or goods purely based on its description with the entire purchase price paid upfront by the buyer for the delivery to be made by the seller in a prefixed future date and place. It is to be noted that the Salam contract was primarily developed to provide much-needed financial assistance to farmers for the sale of farm produce which takes some time to be grown and delivered but their monetary necessities for sustenance cannot wait for that long. The core objective of Salam has been to prevent farmers from getting into the interest-bearing debt trap to meet such needs but instead receive the 100% sale price in advance. Under Salam, an Islamic bank provides the entire upfront downpayment to the farmer who is the seller of such produce, by entering into a Salam contract with him. When the goods are delivered by the seller, these are sold by the Islamic bank in the market at a higher price in order to recover its capital plus the profit which goes into bank's gross income ledger for the benefit of depositors and shareholders. In addition to the crop financing as explained previously, Islamic banks also use the Salam contract at the corporate and retail banking levels to provide upfront cash to customers in need of liquidity. Certainly such customers are not farmers. Some Islamic banks use complex products such as Tawarruq for granting cash to retail customers which are not looked upon with favor by most scholars. Due to the element of a 100% upfront payment of the purchase price by the buyer, these scholars consider Salam to be the natural fit for situations where the customers are in need of cash. It is important for readers to understand that, unlike various types of loan money lent by conventional banks to customers, all Islamic sales contracts (except Salam) do not provide cash to customers. For example, in the case of a Murabahah contract which we have already covered in detail, the bank buys the required goods from the supplier and delivers it to the customer. Hence the customer does not receive cash but goods. Similarly, we will come to know when discussing Ijarah that the Islamic bank delivers a movable or immovable asset to the customer and not money. Our next subject of discussion, namely the Istisna contract, too has the same aspect. In view of the foregoing, these scholars prefer Islamic banks to use the Salam contract should they be required to fulfill the cash needs of customers. Now the question arises as to how retail customers (mostly the salaried class) can provide the farm produce to the Islamic bank and that too in piecemeal spread over a period of 3-5 years (or more). To address this need, some Islamic banks have made an arrangement with the suppliers of the agreed commodity to sell the small quantities to their retail customers so that they can fulfill their monthly delivery commitment toward the Islamic bank in terms of the Salam contract in a timely fashion. On the other hand, third-party buyers provide a unilateral undertaking to the Islamic bank that they will buy the quantities delivered by the retail customers at a price higher than the Islamic bank's cost. As Islamic banks enter into scores of Salam contracts on a daily basis, most of the banks have streamlined the process of purchasing the Salam commodity and its onward disposal on one particular day of the month for all Salam customers. While the scholars who support such arranged Salam transactions consider it better than the so-called Tawarruq practice and approve Salam retail products as a better alternate to provide cash to clients, another set of scholars are not pretty much convinced. The jury is still out if the Salam contract can be used by Islamic banks to meet the cash needs of retail customers. What do you think?