ISLAMIC LETTER OF CREDIT (LC)

Class Lecture

Islamic Financial System (Fin-5402)

ISLAMIC LETTER OF CREDIT (LC)

Islamic letter of credit (ILC) is a written undertaking given by the Islamic bank to the seller (beneficiary) at the request and on the instruction of the buyer (the applicant) to pay at sight or at a determinable future date, a stated sum of money within prescribed time limit and against stipulated documents which must comply with  term and condition. An Islamic ban may offer ILC under the some Shari’ah contract namely

1.      Murabahah (cost-plus profit),

2.      Musharakah (partnership) and

3.      Wakalah (agency).

RIBA IN THE SUNNAH

Narrated from Abu Said Al Khudri, the Prophet S.A.W. said:  “gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt, like for like, and hand-to-hand. whoever pays more or takes more has indulged in Riba. the taker and giver are alike (in guilt).

1.      Murabahah Islamic Letter of Credit

A document of trust signed by the importer, the strength on which the bank allows the importer to obtain release of the merchandise but making a lump sum payment at a later date

Under the principle of Murabahah (cost plus profit) where the customers is unable to pay the purchase price, the bank issues the ILC and pays the purchase price to the exporter. The bank immediately sells to the customer at a mark up for a deferred payment. The model of murabahah letter of credit as follow:

Modus Operandi of MURABAHAH in Islamic Letter of Credit

1)The customer inform the Islamic Bank of his ILC requirement and requests the Islamic bank to purchase or import the goods indicating that he would be willing to purchase the goods from Islamic Bank upon negotiation of the ILC on the principle of Murabahah concept.
2) The Islamic Bank appoints the customer as its agent to purchase the required goods on his behalf.
 3)The Islamic Bank establishes the ILC and pays the proceed to the negotiating bank utilizing its own funds.
4) The Islamic Bank sells the goods to the customer at a sale price comprising its cost and profit margin under the principle of murabahah for settlement on deferred term
5) The customer takes possession of the goods and disposes of them in the manner agreed.

Customer Informs The Bank Of His LC Requirement And Request Bank To Purchase The Goods. The Bank Retains The Legal Title To The Goods BUT Relinquishes Physical Possession To The Buyer Or Importer.
Buyer/Importer Acts As Trustee Or Agent Of The Bank
Buyer/Importer Dispose The Goods And Repays The Bank

 SP = FV [1 + {r x t)]
---------
36500
Note:
Sp = Selling Price
Fv = Invoice Value
R = Mark-up Rate Or Annual Rate Of Return
T = Tenor

1.      MUSHARAKAH

a.       Islamic bank issues the ILC and both the bank and customer contribute to the purchase price under ILC, and later share.

b.      The procedures of the sale of the asset based on the pre-agreed profit sharing ratio. Losses are born proportionate to the capital contribution. 

Modus Operandi MUSHARAKAH ILC:

1. The customer informs the Islamic bank of his ILC requirement and negotiates the terms of musharakah financing for his requirement.
2. The customer places with the Islamic bank a deposit ofr his share of the cost of goods to be purchased or imported as per the musharakah agreement which the Islamic bank accepts under the principle of wada’ah yad dhamanah.
3. The Islamic bank establishes the ILC and pays the proceeds to the negotiating bank, utilizing the customer’s deposit as well as its won shares of financing.
4. The Islamic bank releases the documents to the customer.
5. The customer takes possession of the good and disposes of them in the manner agreed.
6. The Islamic bank and the customer share the profit from the venture as provided for in the agreement

Advantages

1.      Customer shares the profit from the venture as provided in this agreement

2.      The absolute return on the investment depends on the profitability of the venture.

3.     WAKALAH

1.      Islamic letter of credit, the customer must pay in advance the full value of the item in question prior to the issuance of the ILC.

2.      Furthermore, the Islamic bank will receive a commission or service fee upon the service rendered to the customer. 

Modus Operandi On WAKALAH ILC 

1. The customer informs the Islamic bank of his ILC requirements and requests the Islamic bank to provide the facility
2. The Islamic bank may require the customer to place a deposit to the full amount of the price of the good to be purchased or imported, which the Islamic bank accepts under the principle of Wadiah Yad Dhamanah
3. The Islamic bank established the ILC and pays the proceeds to the negotiating bank, utilizing the customer’s deposit, and subsequently release the documents to the customer
4. The negotiating bank claims reimbursement from the Islamic bank as per the reimbursement instruction.
5. The Islamic bank charges the customer fees and commission for its services under the principle of al-ujr based on the Wakalah principle.

Advantages:

1.      To ensure buyer receives merchandise on time and payment made upon receipt of complied document.

2.      From islamic point of view, zakat fund of the islamic banks will help the muflis. So, there will be no auction of assets of the muflis unless he surrenders himself.

3.    Therefore, this explicitly shows the beauty of islamic banking system in protecting its ummah.