Application of Salam in Malaysian Banking System

Islamic banking is flourishing in the world today. Malaysia is a leading country of it in the world. In Malaysia, there are various types of Islamic Banking products used. However, Salam has never been used as a mode of financing in the country, though it is utilized for sukuk or Islamic bond. Salam is an exceptional contract in Islamic law which has been legalized to facilitate the people, especially the poor famers. It has been stated here that Malaysia is an agricultural nation and farmers here are looking for modes to finance their productions and hence application of salam contract in Malaysia would be vital. But so far, the Banks are hesitant to use this product because of risk factors. The main objective of this paper is to analyze and formulate a feasible way to implement salam contract in Malaysia.

Keywords: salam, Islamic Banking, agriculture, salam assistance

1. INTRODUCTION

Islamic banking is a booming industry in the world today. And it is universally accepted by all groups of people now, irrespective of their faith. The range of products utilized in different parts of the globe vary based on custom and needs of the community in that particular area. In Malaysia, we apply extensive range of equity mode of financing such as musharakah and mudharabah, while somehow neglecting the debt financing modes like salam. Salam in its own right can play a significant and, in many ways, a leading role in the Islamic banking system, especially when the major parts of goods in a commercial transaction involves agricultural goods.

Salam financing is appropriate in the agricultural sector particularly for the seasonal food crops. Due to the market uncertainties and volatile prices, the investment in agriculture sector is classified as a hazardous venture. But under Salam contract the market peril is to a great extent reduced by virtue that the Bank would pay the customers or suppliers in advance. As such salam financing can act as a complement to the existing Islamic banking products and AGRO Bank Malaysia have hinted they may adopt this in the near future.

When salam is mentioned, the foremost thing which the majority of the people assume would be about the risk involved in it. Particularly, bankers are concerned about the price risk, delivery risk, operational risk and last but not least the natural calamity. Bankers are hesitant to employ salam because of the perils involved in it. But what we shall bear in mind here is the legal maxim which says, “algurum bil gunm” or no pain, no gain. We have to comprehend that innovation can possibly curb the risk and that in Islamic banking; the gate for innovation is always open.

The application of salam as a form of financing would indeed equilibrium the bank’s aim of maximizing profit as well as achieving its’ role as a communal institution helping the deprived. This is because; most of the producers of the agricultural goods are in want of hard cash. They are inadequate and are in huge need of what ever form of cash they may get to gain income for their families by growing crops. Hence, implementing salam in this nation would undeniably assist the people in necessitate and at the same time will be a lucrative product for the bank, provided that the product is designed in such a way to stabilize the interest of both parties.

It is believed that necessity is the mother of invention and through innovation everything is possible. So with this optimistic view, with the grace from Allah (SW), it is tried here to find a feasible way to implement salam in Malaysian Islamic banking industry. In the course of doing this, salam in theory and in practice would be discussed, but the main focus would be on the product we innovate and the documentations involved in it. We would also be looking at the possible legal issues which may be involved in the implementation of this product and also the solutions to resolve it.

2. CONCEPTION OF SALAM

Literally salam or salaf means pre-payment. Salam is a transaction in which the price is paid immediately for goods which are to be delivered later, but which are specified in the contract. It is a contract for delivery of future goods with pre-payment. The purchaser pays the seller in cash and fixes a certain time for the delivery of the goods. For example, in exchange for RM1000 to be paid immediately 500 kg of rice would be supplied after it is harvested. The purchaser pays RM1000 in cash and the time for delivery of the rice is fixed.

Salam technically is a sale whereby the seller undertakes to supply some specific goods to the buyer at a future date in exchange for an advanced price fully paid on the spot.

Here the price is paid in cash, but the supply of the purchased goods is deferred. The buyer is called “rabb-us-Salam”, the seller is “Muslam ilaih”, the cash price is “ra’s-ul-mal”, and the purchased commodity is termed as “muslam fih”, but for the purpose of simplicity, the English synonyms shall be used for these terms.

In Shariah terminology, when a Salam contract is effected, all the fuqaha are unanimously agreed that the commodity in question is known as a “debt” on the seller.

Bay al-Salam has its legitimacy from the Quran, Sunnah and Ijma’ (consensus of the Islamic Jurist). The Prophet S.AW, allowed Salam subject to certain conditions. The basic purpose of this sale was to meet the needs of the small farmers who needed money to grow their crops and to feed their family up to the time of their harvest as after the prohibition of riba they could not take usurious loans. Therefore, it was allowed for them to sell the agricultural products in advance of which part of the said payment shall be utilized to capital their cultivation.

Similarly, the traders of Arabia used to export goods to other places and to import other goods to their homeland. They needed money to undertake this type of business. They could not borrow from the usurers after the prohibition of riba. It was, therefore, allowed for them that they sell the goods in advance and the cash received by them will ease their burden to undertake the aforesaid business.

Salam was beneficial to the seller, because he received the price in advance, and it was beneficial to the buyer also, because normally, the price in Salam used to be lower than price in spot sales.

In pre-Islamic period Salam was practiced without specifying the measure, weight and the date of delivery. The contract as such contained elements of gharar and was then prohibited. The Prophet S.A.W was reported to have said:

“Whoever pays money in advance (for fruit or gains to be delivered later) should pay it for a known specified measure and weight (of fruits or grain) and for a specific time of deliverey”. Hadith “whoever engages in a salam, let him specify a known volume or weight, and a known term of deferment” (authenticated by the six major narrators on the authority of ‘Ibn `Abbas). In addition, jurists ruled that this exception to the prohibition of Gharar is permitted based on need, especially in agriculture, where a farmer may need advance payment of the price to finance his activities.

In Surah Al-Baqarah (2:282) Allah says that:

يَا أَي�?ّهَا الَّذ�?ينَ آمَن�?واْ إ�?ذَا تَدَايَنت�?م ب�?دَيْن�? إ�?لَى أَجَل�? م�?ّسَمًّى �?َاكْت�?ب�?وه�? وَلْيَكْت�?ب بَّيْنَك�?مْ كَات�?بٌ ب�?الْعَدْل…

“O Believers, when you contract a debt for a fixed; term, you should put it in writing. Let a scribe write with equity the document for the parties …”

According to Ibn Abas, the said Quranic verse 2:282 also refers to Salam. He says that according to analogy if postponement of payment is allowed then postponement of the delivery can also be allowed. Dain is a deferred undertaking similarly Salam is also a deferred undertaking as long as the goods are clearly specified and known.

Thus the prohibition of the Prophet S.A.W that a man should not sell what he does not have does not apply to Salam. The prohibition applies only to those goods where the buyer is incapable of delivering it; it is a thing which he actually does not have and is not able to produce. There is therefore uncertainty and the possibility of conflict and harm. Salam is an undertaking where a person is capable to fulfill at a certain specified time in future.

On the wisdom of its legitimacy, Ibn Qudamah said “ Because people had a need for Salam and because farmers. Market gardeners and tradesmen needed money for their living expenses and to spend on their business to bring them to fruition and so faced the financial need, Salam was made permissible so that they can benefit from it as the buyer having the benefit of its permissibility.

The classical jurists recognized the economic need for this contract primarily to allow farmers access to capital i.e. price of Salam, with which they can buy seeds, fertilizer and other material to harvest their corps. However, they also recognized that Salam includes an element of speculation, since the Salam seller benefits if the spot price at delivery time is lower, and the buyer benefits if it is higher. Further, Salam also includes price discounting for time i.e. an element of interest since the prepaid Salam price will be generally lower that the expected spot price at the time of delivery.

The above recognitions have actually prompted classical jurists to stipulate numerous conditions on Salam in order to minimize the elements of gharar and eliminate elements of riba therein. Therefore, the practice of Salam is subjected to some strict conditions that shall be summarized in the next heading of this assignment.

3. ESSENTIAL ELEMENTS OF SALAM

There are certain elements as of an ordinary sale that must be fulfilled for the validity of Bai Al-Salam as summarized below:-

4. ADDITIONAL CONDITIONS OF SALAM

1. It is necessary for the validity of Salam that the buyer pays the price in full to the seller at the time of affecting the sale because in the absence of full payment by the buyer, it will be tantamount to a sale of debt against debt, which is expressly prohibited by the Holy Prophet S.A.W. Moreover, the basic wisdom behind the permissibility of Salam is to fulfill the instant needs of the seller. If the price is not paid to him in full, the basic purpose of the transaction will be defeated. Therefore, all the Muslim jurists are unanimous on the point that the full payment of the price is necessary in Salam. However, Imam Malik is of the view that the seller may give a concession of two or three days to the buyers, but this concession should not form part of their agreement.

2. Salam can be effected in those commodities only whose quality and quantity can be specified exactly. The things whose quality or quantity is not determined by the specification cannot be sold through the contract of Salam. For example, the precious stones cannot be sold on the basis of Salam, because every piece of precious stones is normally different from the other either in its quality or in its size or weight and their exact specification is not generally possible.

3. Salam cannot be affected on a particular commodity or on a product of a particular field or farm. For example, if the seller undertakes to supply wheat of a particular field, or the fruit of a particular tree, the Salam will not be valid, because there is a possibility that of that particular field or the fruit of that tree is destroyed before the delivery, and in the presence of this possibility the delivery remains uncertain. The same rule is applicable to every commodity whose supply is not certain. It is necessary that the quality of the commodity (intended to be purchased through Salam) be fully specified leaving no ambiguity that may lead to dispute. All the possible details in this respect must be expressly mentioned.

4. It is also necessary that the quantity of the commodity be agreed upon in unequivocal terms. If the commodity is quantified in weights according to the usage of its traders, its weight must be determined, and if it’s quantified through measures, its exact measure should be known. What is normally weighed cannot be specified in measures and vice versa.

5. The exact date and place of delivery must be specified in the contract.

6. Salam cannot be effected in respect of those things that must be delivered at the spot. For example, if gold is purchased in exchange of silver, it is necessary, according to Shariah, that the delivery of both be simultaneous. Here, Salam cannot work. Similarly, if wheat is bartered for barley, the simultaneous delivery of both is necessary for the validity of sale, therefore, the contract of Salam in this case is not allowed.

All the Muslim jurists are unanimous on the principle that Salam will not be valid unless all these conditions are fully observed, because they are based on the express hadith of the Holy Prophet S.A.W The most famous hadith in this context is the one in which the Holy Prophet S.A.W has said:

“Whoever wishes to enter into a contract of Salam, he must effect the Salam according to the specified measure and the specified weight and the specified date of delivery.”

However, there are certain other conditions, which have been a point of difference between the different schools of the Islamic jurisprudence of which some of these conditions are discussed below:

1. It is necessary, according to the Hanafi school, that the commodity (for which Salam is effected) remains available in the market right from the day of contract up to the date of delivery. Therefore, if a commodity is not available in the market at the time of the contract, Salam cannot be effected in respect of that commodity, even though it is expected it will be available in the markets at the date of the delivery. However, all the other three schools of Fiqh (i.e. Shafi’i, Maliki, and Hanbali) are of the view that the availability of the commodity at the time of the contract is not a condition for the validity of Salam. What is necessary, according to them, is that it should be available at the time of delivery, only. This latter view can be acted upon in the present circumstances.

2. It is necessary, according to the Hanafi and Hanbali schools that the time of delivery is, at least, one month from the date of agreement. If the time of delivery is fixed earlier than one month, Salam is not valid. Their argument is that Salam has been allowed for the needs of small farmers and traders, therefore, they should be given enough opportunity to acquire the commodity, and they may not be able to supply the commodity before one month. Moreover, the price in Salam is normally lower than the price of spot sales. This concession in the price may be justified only when the commodities are delivered after a period that has a reasonable bearing on the prices. A period of less than one month does not normally effect the prices. Therefore, the minimum time of delivery should not be less than one month.

Imam Malik supports the view that there should be a minimum period for the contract of Salam. However, he is of the opinion that it should not be less than fifteen days, because the rates of the market may change within a fortnight.

The view is, however, opposed by some other jurists, like Imam Shafi’i and some Hanafi jurists also. They say that the Holy Prophet S.A.W has not specified a minimum for the validity of Salam. The only condition, according to hadith, is that the time of delivery must be clearly defined. Therefore, no minimum period can be prescribed. The parties may fix any date for delivery with mutual consent.

This view seems to be preferable in the present circumstances, because the Holy Prophet S.A.W has not prescribed a minimum period. The jurists have prescribed different periods that range between one day to one month. It is obvious that they have done so according to the expediency and keeping in view the interest of the poor sellers. But the expediency may differ from time to time and place to place. Likewise, sometimes it is more in the interest of the seller to fix an earlier date. As far as the price is concerned, it is not a necessary condition of Salam that the price is always lower than the market price on that day. The seller himself is the best judge of his interest, and if he accepts an earlier date of delivery with his free will and consent, there is no reason why he should be forbidden from doing so.

Certain contemporary jurists have adopted this view considering it more suitable for the modern transactions.

5. DELIVERY OF THE COMMODITY OR THE SUBJECT MATTER

The seller is obliged to deliver the subject matter on the agreed date. If the commodity is delivered before the due date, the buyer has the right to refuse taking possession of the commodity if that is detrimental to him. The jurist also advocate that the buyer must accept the commodity if it fulfill all the criteria.

Hence, in order to ensure that the seller shall deliver the commodity on the agreed date, they also can ask him to furnish a security, which may be in the form of a guarantee or in the form of mortgage or hypothecation. In case of default in delivery, the seller may be asked to deliver the same commodity by purchasing it from the market, or to recover the price advanced by him. All of these terms must be clearly stipulated and explained in the contract of Salam and made known to the parties in order to eliminate elements of fraud and uncertainty which may led to frustration of the Salam contract.

6. SALAM AND THE FORWARD CONTRACT

Salam is the closest, among the contracts named in Islamic Law to the conventional forward contract. Some scholars have considered it as the conventional forward contract. Some scholars have considered it as the Islamic alternative to the forward contract. Thus Zamir Iqbal and Sudin Harun have considered salam to be closest substitute for the forward contract.

7. SALAM AS A MODE OF FINANCING

It is evident from the foregoing discussion that Shariah allowed Salam to fulfill the needs of farmers and traders; therefore, it is basically a mode of financing for small farmers and traders. The mode of financing can be used by modern banks and financial institution, especially to finance the agricultural sector. The bank will advance cash to the farmers on the conclusion of the contract for delivery of crop during the harvest period (future date). It is a structured financing that can help farmer to move away from informal financing means such as money lender, whereby they are charged with a heavy interest on a compounding basis. As pointed out earlier, the price in Salam may be fixed at a lower rate than the price of those commodities delivered at the spot. In this way, the difference between the two prices may be a valid profit for the banks or financial institutions.

The modus operandi of Salam can be summarized as below:

Step 1: Submission of application form with necessary documents i.e. identification credential, land ownership, other sources of income and past production volume to the bank for credit screening.

Step 2: The bank will offer a purchase price to the farmer based on the credit worthiness evaluation, crop quality, delivery date, etc.

Step 3: The farmer accepts the offer and sign a bai Salam contract stating the predefined crops, delivery date, crop quality between the farmer and the bank

Step 4: The bank pays the settlement price on the spot as defined in the contract

Step 5: The farmer deliver the crop to the bank on the agreed specification and pre-defined delivery date and venue

Step 6: The bank sells the crop/subject matter in the market at the selling price

Note:- the selling price will be higher than the purchase price in which the difference will be the bank’s profit

In the original mode of Salam financing, the bank will receive commodity from the farmers/client and not money. Being conversant with dealing in money only, it seems to be cumbersome for them to receive different commodities from different client and to sell them in the market. They cannot sell those commodities before they are actually delivered to them, because it is prohibited in Shariah. Besides, the banks will also facing a problem of storage and maintaining the commodity.

Further, whenever we talk about the Islamic modes of financing, one basic point should never be ignored. The point is that the concept of the financial institutions dealing in money only is foreign to Islamic Shariah. If these institutions want to earn a halal profit, they shall have to deal in commodities in one way or the other, because no profit is allowed in Shariah on advancing loans only. Therefore, the establishment of an Islamic economy requires a basic change in the approach and in the outlook of the financial institutions. They shall have to establish a special cell for dealing in commodities. If such a special cell is established, it should not be difficult to purchase commodities through Salam and to sell in spot markets.

8. RISK MANAGEMENT IN SALAM-BASED FINANCING AND PARALLEL SALAM

There are several risks to be faced by the Islamic Bank which will reduce the Salam contract’s value as a financing vehicle as follows:-

a) Counter-party Risk – the risk of default by the seller, made more severe by the fact of prepayment as the client/ seller may default after taking the payment in advance According to most scholars of the four schools, shari’ah requires that if at the time of delivery the seller can neither produce the goods nor obtain them elsewhere, the buyer has only two choices either takes back his price, without increase, or awaits the goods becoming available later, with no compensation permitted for the delay. In either case the buyer loses all or much of the profit from the use of his money. Another partial solution is to take security from the seller, whether pledge or guarantee. This is allowed by most, but not all, scholars.

b) Commodity Price Risk – it will not benefit the buyer if at the time of delivery and receive of goods; the price may be lower than the price that originally expected. In this scenario, the bank will be at loss.

c) Quality Risk/Low investment return or loss – goods received might not meet the desired quality and unacceptable for the potential buyer. In these circumstances, the buyer must either reject the goods of inferior quality to that specified in the contract or, accept them at the original price. The latter, if involve Parallel Salam, the goods would have to be sold at a discount unless the buyer under a parallel Salam agreed to accept the goods at the original agreed price.

d) Asset-Holding Risk – possibility to incur extra expenses on storage and takaful as the bank might not be able to market the goods on time, resulting in depreciation in goods quality for the unsold goods and locking fund in the goods until they are sold.

e) Asset-Replacement Risk – in the case the bank has to purchase goods from the market in Parallel Salam in default of the seller to supply the goods on the contracted date. The bank then will expose to price risk as the open market price may exceed the amount paid under original Salam contract.

f) Fidicuary Risk in the case of Parallel Salam in the event that the original Salam seller might not deliver.

Islamic banks therefore need to take proper measure for mitigation of the above risks and we would suggest of the following:-

a) only purchase those goods which have good marketing potential;

b) take proper security and performance bond;

c) to insert penalty clause in the contract as deterrent against late delivery;

d) obtain a binding promise from the prospective buyers along with sufficient amount of earnest money as security deposit as an act of good faith; and

e) fulfill the responsibility of parallel Salam by purchasing similar goods from the market on spot to meet supply to the buyer and recover the loss, if any, from the seller in original Salam.

How does the Parallel Salam could manage and mitigate risk? In addressing this problem the idea has surfaced of a “parallel” or “back-to-back” salam. After buying goods of a certain description from a seller and paying the full purchase price (salam sale 1), but before the seller is due to deliver on that contract, the bank, in a separate and formally date to a third party, receiving full advance payment from the buyer. The net result is the bank has reversed unconnected salam contract (salam sale 2), sells goods of exactly the same description and with the same due its position, fixed the profits will earn from the it two trades, and assured a purchaser for its goods.

The period of Salam in the second (parallel) transaction relatively being shorter compared to the original Salam contract, thus, the price may be a little higher than the price of the first transaction and the difference between the two prices shall be the profit earned by the institution. The shorter the period of Salam; the higher the price, and the greater the profit is. In this way the institutions may manage their short term financing portfolios. In arrangement of Parallel Salam, there must be two different but independent contracts; one the bank is a buyer and a seller in the second contract. These two contracts cannot be tied together and the performance of one should not be contingent on the other.

The known fact that the bank need to liquidate the goods after delivery, an inconvenience made more serious by the Islamic legal rule on the legality of Salam that buyer cannot sell the expected goods before actually taking possession of them. On the legality of Parallel Salam, majority of jurists disallowed selling of object of Salam contract before taking possession due to ‘llah that final deliverability of the subject matter of Salam still in question which open for gharar and uncertainty for its actual delivery. But some jurists such as Ibn Taymiyya and Ibn Al-Qayyim allowed it because there is no text from the Quran or Sunnah, ijam’ or qiyas to prohibit this. Besides, with current technology used in the agriculture sector for instance, the ‘illah i.e. gharar and/or uncertainty on its deliverability is almost eliminated.

Secondly if a parallel contract of Salam is not feasible for one reason or another, they can enter into a promise to sell the commodity to a third party on the date of the delivery. Being merely a promise, and not the actual sale, their buyers will not have to pay the price in advance. Therefore, a higher price may be fixed and as soon as the commodity is received by the institution, it will be sold to the third party on a pre-agreed price, according to the terms of the promise.

A third option is sometimes proposed that at the date of the delivery, the commodity be sold back to the seller on a higher price. But this suggestion is not in line with the dictates of Shariah. It is never permitted by the Shariah that the purchased commodity be sold back to the seller before taking its delivery, and if it is done on a higher price it will tantamount to riba which is totally prohibited. Therefore, this proposal is not acceptable at all.

Therefore, the Islamic bank needs to ensure that the legal implication of the Salam contract properly match the commercial intent of the transactions. Also, since the title of the asset has to first pass to the bank and not directly to customer, the documentation including letter of credit must be drawn up so as to ensure this.

From the above discussion, it seems that the nature of risks in Salam’s financing is more prone to price or market risks which is systematic in nature. However, the market risks could not be eliminated in total. This is in line with Shariah legal maxims of “al-ghurmi bil ghom” which means “no rewards without risks” and “al-kharaj bil daman” which can be translated as “profit must be accompany with liability”

9. WHY SALAM IS WIDELY NOT PRACTISED?

According to Zamir Iqbal, salam is not practiced in the financial market for two reasons: first compared to the western forward contract, salam requires full payment at the time of agreement. Second, since interest is incorporated in the determination of the forward contract of price, it is synonymous with paying or receiving interest. The question here would be whether an increase with deferred delivery is justified or not and, If such increase is allowed, will it amount to riba?

Proposal Related to Mitigate Risks in Salam

(a) Parallel Salam Contract

Islamic business consumers or producers of a certain commodity-like good can buy or sell Salam contracts on the good and then reassess that position over time. If the price outlook shifts, they can reverse their positions by undertaking a new set of Salam contracts that are opposite in effect to the first set but are otherwise unrelated. In theory, even further rounds of Salam contracts can be executed prior to the maturity of the original set if there are subsequent shifts in the outlook for the commodity price.

(b) The Default Penalty Option

A buyer in Salam contract for a particular commodity negotiates a contract provision permitting him to cancel the contract at an interim point in the contract life on payment of a “default” fee to the seller. This penalty along with a higher initial Salam price, compensates the seller for exposure to this downside risk. The seller does not enjoy a default privilege; he could, however, always reverse his position by buying goods in the market.

(c) An Islamic Clearinghouse

To lower the cost and rate of defaults in salam contracts, salam sellers become members of the clearinghouse. While sellers have a choice whether to join or to remain independent, becoming a clearinghouse member sends a signal of integrity to the market place. As a result, this seller most likely can get a better price than those that offer contracts independently. Buyers averse to risk buy a salam through the clearinghouse; the less risk-averse buyers go to the dependant sellers.

10. SALAM FINANCING: AGRO BANK MODEL (FORMERLY KNOWN AS BANK PERTANIAN MALAYSIA)

The Role of Padi Beras Nasional Berhad (BERNAS) as the purchaser of rice from Agro Bank (‘’AB”)

Risk-aversion or even risk-avoidance is evident in Agro Bank attitude’s towards Salam financing. Although the Bank plans to further introduce new Islamic products, the bottom line remains profits and safety. As an example, it will execute the first Salam only when the second Salam is confirmed, which may not be possible as the third party is not willing to face the price risk.

The Salam contract may be new and unique but not attractive enough to garner confidence. Unlike loan, Salam is risky. Price volatility and climate change may disrupt production. The risk open to AB can be disastrous if financing is made on all types of agricultural produce such as rice, palm oil, rubber, fruits and food production.

To reduce risks attached to Salam financing, AB has agreed to experiment on one project with BERNAS. Here, Agro Bank has engaged BERNAS, a government-owned rice wholesaler as the third party buyer. BERNAS took over Lembaga Padi and Beras Negara’s role as the custodian of Malaysian rice when the latter was privatized on January 12 1996. Apart from its primary role to guide and regulate the development of the national paddy and rice industry, the privatized BERNAS continued to assume the various social and commercial obligations previously undertaken by its predecessor. This include the management and disbursement of subsidies to paddy farmers on behalf of the Malaysian government, management of Bumiputra (indigenous Malay) Rice Miller scheme, undertaking the purchase of paddy from farmers at a guaranteed minimum price (RM560 per metric ton)