An evaluation of the suitability of the Istisna contract to financing small enterprises - Essay Example

?An evaluation of the suitability of the Istisna contract to financing small enterprises Grade 15th December An evaluation of the suitability of the Istisna contract to financing small enterprises Introduction The 21st century continues to see new inventions in many sectors of the economy. The modes of operations continue to diversify as years progress. The development of Islamic banking has immensely transformed the banking sector. These banks offer services based on religious teachings and laws. The banks continue to provide innovative financial products aimed at filling the existing gaps in the financial industry. These banks have used a philanthropic approach, adopted from Islamic teaching, to offer high quality services to customers. One of these approaches has been the Istisna contract. Based on the Sunnah of the prophet Muhammad (PBUH) this contract has transformed the banking industry immensely (Mahlknecht, 2009). The use of this contract may be enormously beneficial to people seeking comprehensive funding for small businesses. The contract and its use by Islamic banks The Istisna contract falls under the category of manufacturing contracts. It was created by the Islamic Financial Institution in line with the Istisna believes. The contract is strongly related to the shariah. In Arabic, the word Istisna means making a request to someone to build, construct or manufacture something for another. This contract is based on the principle meaning of the word. The contract, therefore, involves agreements for sale and purchase between two individuals. The items under discussion in the contract agreements of Istisna are non-existent. This can be termed as the greatest difference between the Istisna and other financial contracts within the industry (Warde, 2000). This has led to the identification of the Istisna as a exceptional sale agreement. Within the scope of the Istisna contract, the agreement is normally based on trust between the parties. The asset in the agreement normally has to be constructed or manufactured in a later date. The parties normally agree on the date in which the finished product should be delivered. The process of creating an Istisna contract needs to be handled with considerable care. The Shariah law dictates that a commodity intended for sale must in the hands on the seller when the sale is being made (Mahlknecht, 2009). The seller must also posses the ownership of the product intended for sale. A product to be sold must also have been gained through acceptable means by the Islamic law. The Istisna contract, however, seems to offer a slightly different ideology. In the Istisna contract, the products being sold are normally, not in their final form. The core aspect of the contract becomes the religious values attached to the agreement. All elements of the contract are based upon trust and belief in the ability of the manufacturing party to deliver items. The quality and quantity of the product is expected to meet the agreed upon standards. In the contract, the parties agree on the specifications of the goods to be manufactured as well as the date of completion of the manufacturing process. The cost price of the items can also be another element agreed upon by the contracting parties. All these elements are done through agreements made by the contracting parties. Within the scope of the Istisna contract, the Islamic financial institutions are requested by customers to manufacture a product. The product is manufactured by the financial institution on behalf of the customer. Upon completion of the construction, the product is then delivered to the customer for payment. Trust becomes essential as the customer may not be able to cater for the payment of the products delivered. An important note to make here is that the contract terms cannot be changed once they have been agreed upon. This becomes essential in ensuring that each party delivers its part of the bargain. Failure by either party, though, immediately makes the contract obsolete. The Istisna contract, however, has a remedial procedure in the event of faulting by either party. The terms of the contract can be changed through giving notice from either of the party. This can only occur before the manufacturer commences the work of manufacturing. Once the work has commenced the contract cannot be changed by either party without the consent of the other. The elements agreed upon can also be the causes for any form of contract termination. Failure by either of the parties to honour the specifications laid down by the contract can lead to a breach of contract. As stipulated by the common law, breach of a contractual agreement surmounts to termination of the contract without prior notice. This part of law applies equally to Istisna contract. Being a religious contract, the law permits that in the event of failure to deliver a commodity of the agreed time, the contract shall not be terminated. The delay in the case of Istisna is charged on the manufacturer. The buyer is allowed to pay a lower price than the agreed as a compensation for the delay. The rise of numerous Islamic banking organisations can be linked with the use of Istisna as a source of finance. The Istisna contract has been adopted by several Islamic Financial institutions as a method of financing businesses. It has been extensively applied in the housing sector by Islamic banks (Warde, 2000). Customers have continued to seek financing through Istisna contracts to enable them finance housing projects. In the contract agreement, the client seeking to construct a building may have land in which he/she desires to construct a house. The Islamic banks have created several options to finance projects of such nature. These contracts continue to get attractive to customers as the terms are agreed upon. The setting does not contain any bank regulations governing the agreements. Any agreement made between a bank and its customer normally differs from the other customers’ agreements. The terms of the contract seem attractive to the customer due to the level of confidentiality exhibited by the personalised contracting. The client provides the piece of land where a building needs to be set up. An agreement is made between the customer and the bank for the bank to undertake construction of the desired building on behalf of the client. This, as opposed to other construction agreements, the bank funds the building process. Within the agreed timeline, the construction of the house should be complete. Once it is complete, the bank hands the house back to the owner. At this point, the owner pays the agreed upon the amount of money to the bank. The payment modes in most cases have been through instalments. This, however, cannot be the only specified mode of payment. In some other cases, the customer can pay a lump sum amount and settle the entire cost at an instance. The time for payment can also be deferred according to the agreement between the parties. In the case of Istisna, everything is agreed upon by the contracting parties. There are no predetermined aspects of the agreement. Payments may begin when the contract is signed or may start once the construction has been completed. In the Istisna contract, the regulations are lenient for both parties. The bank is not obligated to undertake the construction under itself. The regulations allow for the manufacturer to contract another firm or a third party to undertake the construction. The financier, though, has to calculate the estimates of constructing by him to be able to decide the best method to use. To ensure the payment for the product, the financier keeps the documents of ownership for the house until when all the payments have been made in full (Mahlknecht, 2009). The financier is responsible for the full construction of the building. This construction, however, has to conform to the stipulated specifications agreed upon by the contracting parties. The application of Istisna is not only limited to construction of buildings. It continues to be used to fund small enterprises, by Islamic banks. Businesses continue to use the mode as a source of finance for projects which the companies cannot afford. Installation of manufacturing plants within many organisations has been funded using the Istisna contract. In other related development, there has been the use of BOT agreements. These agreements involve Buying, operating and Transferring of projects. This is a modern method which has been adopted into the Istisna. Governments in different countries have entered into Istisna contracts to allow the construction of highways. Using the BOT agreement, a government agrees the terms with a builder. The builder constructs a highway and is allowed to operate and collect toll for a specified time. Through the toll, the builder repays the construction costs. The price in these scenarios is the rights to collect toll on the project (Mahlknecht, 2009). Once the toll collection period is over, the highway ownership returns to the government. During the time when the builder collects the toll, the project is regarded as owned by the constructor. This has been the modern way through which banks have continued to utilise the Istisna contracts. Small enterprises and their importance Small enterprises can be defined by Longenecker et al 2008, as privately owned businesses with a small number of employees. The enterprises are mostly small in size though some become relatively large with time. The definition of these businesses varies from country to country based on the level of industrialisation in a country. In developed nations large privately owned corporations may fall under small enterprises. The case becomes different when applied to developing and third world countries. Most small enterprises are involved in medium levels of manufacturing. In most cases, they act as subcontractors to the large multinational corporations. Over the years, the role of medium sized enterprises continues to increase. In the modern times, they have continued to play an influential role of assisting large manufacturing companies with performing small duties. Huge corporations, for example, may hire a medium enterprise to carry out some services like cleaning or offer catering services to employees of the large company. They have continued to offer support to the large companies. Many small enterprises are privately owned because it may be extremely expensive to set up a large firm. The legal requirements for setting up large companies also encourage businessmen to venture into small enterprises. The amount of cash required to set up a small enterprise can be raised through personal savings. This has continued to encourage many people to establish these kinds of businesses whenever a chance to start a business comes around. Starting of a small enterprise may not require external sources of funding, unless where the entrepreneurs wishes to borrow a loan from a financial institution like banks, SME Finances etc. This capital accumulation may be of expense when the bank loan rates are extraordinarily high (Longenecker, et al 2008). The entrepreneur may wish to accumulate his own cash to amount up enough for capital which can assist him to start up a small enterprise. This may be done by small savings from the owners’ earnings. Family members and sometimes friends may to some extent help a potential entrepreneur with the capital to come up with the venture he wishes to start-up. Another way a small business may acquire its capital is through a franchise. Franchising can be termed as a way through which owners of business can reap benefits from the economies of scale of gigantic corporations. These corporations act as franchisers in such scenarios. The franchisee comes up with an idea or a business opportunity which is then financed by the franchiser for the opportunity to be a successful business in the economy. Partnership is another way a small enterprise may obtain its capital. A partnership can be defined as an incorporated form of business organisation or structure. General partners form part of the management team and become fully liable into business debts. There exist another class of partners known as individual partners. These investors maintain indirect investments into a partnership enterprise. Their liability is limited to the extent of the investment owned. In partnerships, losses and debts are shared equally amongst all existing partners. The case of limited liability companies works in the opposite direction to this as there is no sharing of debts or losses between the owners. Companies can be said to be individual entities capable of incurring own losses independent of the investors. Small enterprises are advantageous to run. This is, for example, that their costs of starting can be extremely low and can also be run on a part time basis. This means that the entrepreneur does not need to use all his time in the business. The entrepreneur can run numerous income generation activities using the available time. Increased earnings would position an individual at an improved economic status. He may wish to apportion his time properly hence will get time for his personal dealings. Independence is another advantage of owning a small business. The business owner is placed at liberty to undertake any new opportunities that may arise. Within the corporation setting, a management decision needs to be arrived at whenever a new venture needs s to be started. The process of decision making also gets lengthy in corporations. Within the small enterprises, no consultations are made regarding business decision. In the event they are made it occurs out of personal will of the owner. Small businesses have been known to have immense contributions to the economic growth of a nation. This comes in numerous ways. Small business creates a surmountable volume of employment to citizens within a country. Small enterprises provide almost 18% of the employment opportunities in the developing countries. In the developed world, though, the figures are higher than in the developing or third world countries. This can be attributed to the high levels of income common in the developed countries. The level of infrastructure development in these countries also contributes immensely to the growth of small businesses in developed countries. In the United States of America, for example, the small enterprises control about 48% of the employment. Small businesses contribute immensely towards the gross national production (GNP). GNP finances the state hence it can perform other tasks with the revenue earned. Small business owners are advantageous in terms of customer goodwill. Many customers or clients feel that small enterprise owners offer better customer service compared to large enterprises since there is direct contact with the customer. The entrepreneur will provide personal attention to their customers. Small businesses continue to play a great role in bringing services, offered by multinational companies, to the customers. The appeal created by small enterprises on customers continues to drive huge companies into seeking the assistance of small businesses to reach their client. This has played a major role in increasing the customer base for the multinational companies. These companies have resorted to utilise the small enterprises which have a better appeal to the public as compared to the multinational companies. Problems of micro finance in the interest-based system Micro finance has been defined as the provision of financing to low income earners in support of business (Armendariz and Morduch, 2010). The element has been attributed to the provision of business financing to the poor and near poor. The aim of micro financing has always been identified as providing access to appropriate financial services to the poor individuals. This financing is aimed at being sustainable and affordable. In the developing countries micro financing has been extensively used to provide financial services to groups and businesses. The system has been used mainly to finance small and medium enterprises in these countries. The use of micro financing is limited in developed countries. This can be attributed to the high levels of income in developed nations. Individuals in these countries can be able to raise substantial amounts of money to be able to finance businesses from other sources. The micro financing system has been extensively used to provide financing for small businesses in the modern times. However, great levels of challenges continue to be faced by these institutions due to the setting of the program. The process of interest based micro financing continues to become a nightmare to the owners of small enterprises. Minimum amount borrowed The problems face d by micro financing for small and medium businesses are numerous. Traditionally, this system of financing was not provided by banks. The bankers did not offer banking services to the poor and middle class individuals. Banks were reluctant to offer their services to these people. The ability for these businesses to service loans granted by banks were doubted. Banks considered it extremely risky to lent money to individuals running small and medium sized enterprises. Banks did not see the reason for lending small sums of money. This meant that there was a minimum amount of money which a person could borrow as loan from a bank. This led to the people viewing loans as belonging to the rich people. The accessibility of financing can be termed as an influential factor in the growth of the business. In the olden days, banks could not avail credit to small businesses. Micro-financing institutions The development of micro financing institutions has however eased the pressure on banks to offer services to small businesses. These sources of financing maintain a close monitoring of the business and keep on checking the progress of the business. This can sometimes make the owners feel like their business is being interfered with. Though the micro finance institutions aim at ensuring the success of the business, the negative impact of their actions seems adverse (Armendariz and Morduch, 2010). The institutions have failed miserably to achieve the target. The mode of operation adopted continues to discourage people from seeking funding from micro-finance institutions. They offer limited amounts of capital, and assign officers to monitor how the business is being conducted. Most people do not appreciate the idea of being directed on what to do with their businesses. Most people start businesses seeking to be free to do what they wish. Through the micro finance officers appear to be limiting the freedom of business executives. Repayment The terms of repayment for a loan can be a significant source of discouragement for small business owners. The conditions which exist in the banking sector regarding money lending are not friendly to small businesses. The interest rates at times seem to be extremely high for the small businesses to be able to cover. Since the lending rates are high, the small businesses are not able to service the loans from business profits. The lending rates offered by banks drive people away to seek financing elsewhere. The only available options are micro finance institutions. These institutions offer lower, affordable, and reliable source of business financing to small enterprises. They charge lower interest rates and also offer business advice. This has led to the overcrowding of the lending institutions. The institutions have at times received requests for financing which are extremely high for them to handle. The financing institutions seek to make profits from the lending business. Many of these institutions have collapsed as they also lack the great financial muscle to lent money to many people. With sources of financing being cut short, many small businesses have collapsed due to the lack of funding. The reliability of the financing institutions has come under immense criticisms. Group targets In most cases, the interest based system seems to target group businesses. This locks out the existing businesses from accessing credit financing. The small businesses which are owned by individuals become ineligible to receive any services. This can be termed as a discriminatory regulation that should be discouraged. The progression of groups is always slow than that of individuals. Financing group businesses has left out the individual or partnership small enterprises from the possible recipients of financing. Privately owned small and medium businesses continue to face a surmountable challenge in deciding where to source for funds. The micro-financing institutions consider lending to such businesses risky (Armendariz and Morduch, 2010). While the lending institutions consider lending to individuals risky, owing to their ability to repay, the individuals also fear borrowing from these institutions as there have been cases of collapse of the institution. This puts businesspeople in a situation of dilemma of considering the available options of funding. The option of using banks as sources for funding becomes inevitable under such circumstances. Lack of public appeal The system has not been accepted fully among the target population for the micro-financing. The availability of informal money lending institutions continues to have a negative effect on the acceptance of micro-finance from registered institutions. Majority of the targeted persons opt to use the informal money lenders. This has been mainly due to the fact that these lenders are persons whom the people can reach personal agreements with. The attractiveness of this venture lies in the ability for an individual to negotiate his own terms of repayment. Informal money has made the micro-financing system to be viewed by business owners as aiming at oppressing the people, leading to the collapse of their businesses. This stereotype creates a surmountable challenge of convincing individuals to source funding from micro-financing institutions. Suitability of the Istisna contract in supporting the activities of Small Enterprise According to Mahlknecht, 2009, the Istisna contract can be used to solve the existing problems in micro-financing of small and medium enterprises. The shortcomings of the interest based micro-financing continue to mitigate the growth and expansion of small enterprises. Ways of dealing with the challenges faced by the businesses when seeking financing continue to be elusive to the business personalities. The products businesspeople expect to get when seeking funding from financial institutions seem unsatisfactory to their desires. The integration of Istisna contract into the banking industry may just be the solution that continues to elude the business class. There are numerous aspects of the contract that make it suitable for financing small enterprises. Personalisation of the financing services One of the greatest problems of the other available financing options has been the personalisation. Individuals continue to move away from financing institution because the institutions insist on lending to groups. This drives the people seeking funding into other places. The Istisna contract can be characterised by being an agreement between two parties. The activities of small enterprises can be well supported by this contract. Business owners seeking funding can be able to receive personalised banking services. This comes in the way that the Istisna contracts are negotiated between the contracting parties. This can put a businessperson in a comfort zone as he can stipulate his desired mode of payment and time for payment. The contract does not involve groups and thereby, it can be said to be personal. Although there are regulations governing the Istisna contract, the ability to discuss and negotiate personal terms makes the contract more accommodating to businesspersons than the micro-finance institutions. Clear terms The terms employed by other lending institutions at times contain many clauses and sub-clauses, making a contract extremely difficult to understand. These contracts also come already drafted by lawyers for the lending institutions. In most of the cases, the aim of these institutions always lies in making profits. The desire for profits drives the lending institutions into drawing contract best suiting their course. Businesspersons at time feel oppressed by the terms. People have been known to enter into contracts with financiers only to realise later that the terms contained hidden meanings. Such scenarios have resulted into the collapse of many businesses. With the Istisna contract, most of the terms are negotiated between the business personality and the institutions. This makes an Istisna contract clear and understandable to the contracting parties. A person has the ability to clearly understand the contract when he/she is part of the negotiating team. The clear terms of the Istisna contract can be termed as an advantage over the other financing options. Friendly Financial institutions normally give people seeking funding forms to fill. Upon filling the forms, the document created becomes a binding contract between the institution and the person seeking financing. This mode of conducting business continues to scare people away from such institutions. The persons do not get an opportunity to peruse through the contractual terms. Many people see this as being unfriendly to the businessperson. An amicable decision can only be arrived at when proper negotiations have taken place. In these micro-financing institutions, the only explanation offered concerns the benefits one might reap from the funding. There are no explanations regarding possible remedies should the person become unable to pay. This has made these institutions to be regarded as extremely unfriendly. The Istisna contract offers an individual seeking financial services a chance to negotiate with a representative of the financier. Most of the terms in the Istisna contract are based on agreement and trust. In arriving to this point a degree of friendship develops between the businessperson and the financier. This also develops an element of trust between the contracting parties. Reliability Cases of collapsing of financing institutions continue to increase with time. The stability of these institution cannot be established when one is seeking financial assistance. Some of these institutions have been known to be owned by fraudulent individuals seeking to collect capital for other ventures. This can be attributed to the limited information provided by the institutions regarding financial status. Once the institutions collapse the individuals cannot recover any lost assets as clear litigation channels are not available at times. The Istisna contract can be characterised with being binding to both parties. Within the scope of the contract, the financier has an obligation to deliver the agreed upon product within the agreed time. The contract also stipulates the possible remedies in the event of the financier failing to meet the set standards. This makes the Istisna contract reliable as a source of funding. The business person can take legal action once a financier fails to deliver according to the contractual terms. Comprehensive Financing institutions fund small enterprises based on the judgement of the capability to repay. Most institutions conduct an assessment of the business seeking funding. This normally aims at establishing the size and the ability for the business to service loans that may be granted. This continues to make micro-financing institutions to reject funding proposal for many businesses. This is always based on the ability of the business to pay loans. The assessment of the institutions may be wrong hence denying financing to a viable business venture. The Istisna contract does not include such restrictions. It comprehensively funds proposals based on the agreed terms and not the size of business. The contract also provides funding for an entire project making it comprehensive. Most micro-financing institutions require the owners of a business to raise a percentage of the needed amount (Armendariz and Morduch, 2010). This is extremely difficult as the people seek funding as a result of the inability to raise the funds. This continues to be a discouragement for individuals who may have brilliant ideas and lacking capital to actualise the ideas. The Istisna contract comprehensively supports business ventures fully. All the owners have to do in the Istisna contract is to repay the money owed. The financing institutions cover for the costs as requested in the contract terms. Business ideas The Istisna contracts can be used by businesspeople to gain new ideas. In the modern mode of BOT, the financing organisation is allowed to run a business for a period of time so as to recover its money. Once the financier recovers the entire amount the business goes back to the owner. The management system employed by the financier may be beneficial to the owner once he takes over. The owner can learn new and profitable methods of conducting business as applied by the financier in recovering costs incurred (Longenecker, et al, 2008). This element of the Istisna contract can immensely reduce the collapse of small businesses. Most small enterprises collapse as a result of the owners lacking efficient knowledge pertaining to the business venture. Though micro-finance institution offer educative services to business owners through their officers, the officers at times seem to interfere with the running of the businesses. In the Istisna contract, the owners are not obliged to do what the financier was doing. The owners can adopt their own system to run the business. This ensures retaining of the independence by the business owner. Conclusion Islamic banking has immensely diversified the products available in the banking industry. Operations have integrated a religious aspect into the banking industry while maintaining an appeal to people of all religions (Warde, 2000). The adoption of shariah compliant, Salam and Istisna modes of funding continues to impress numerous people. These funding modes have tremendously changed the way banks lent money to customers. The Istisna contracts have been extensively employed by many financiers in numerous fields. They can be linked to a lot of development projects initiated in the developing countries. The Istisna contractual funding can immensely benefit small enterprises if well adopted. It can be identified as a possible solution to the various challenges faced in the field of micro-financing of small enterprises. The Istisna contract presents numerous advantages over other sources of funding in the financial industry. References Beatriz Armendariz & Jonathan Morduch., 2010. The Economics of Microfinance second edition, Massachusetts: The MIT Press, Cambridge, Longenecker, Justin G.; Carlos W. Moore, J. William Petty, Leslie E. Palich., 2008. Small business management : launching and growing entrepreneurial ventures. (14th ed.) Manson: Cengage learning. Mahlknecht, Michael, 2009. Islamic Capital Markets and Risk Management. London: Risk Books Warde, I., 2000. "Islamic Finance in the Global Economy". Edinburgh: Edinburgh University Press. Read More