Istisna in Islamic Banking & Parallal Istisna

Conditions of Istisna

There are four basic conditions for sale:

• The subject is always a thing which needs manufacturing or construction;
• The manufacturer uses his own material;
• Quality and quantity should be agreed upon in absolute terms; and;
• The purchase price should be fixed with mutual consent.

It is important to note that:

• It is not compulsory for an undertaking party to accomplish the work itself and;
• Work or part of it can be done by others under the control of the undertaking party.

What is Parallel Istisna?

After executing an Istisna agreement with one party, a buyer or seller may execute another Istisna agreement with a third party, which is called a “Parallel Istisna Agreement.”

However, it is important to note that:

• These are two different contracts that cannot be tied up;
• Performance of one should not be contingent on the other; and;
• Parallel Istisna is allowed with the third party only.

Conditions for Istisna as an Islamic Banking Product

1. Price of Istisna

• It may be in the form of money, commodities, or usufructs.
• It may be spot and differ; therefore, it is applicable where Salam Contract is not applicable.
• It can be paid in instalments.
• The instalments may be tied up with different stages of projects.

2. Option

• When the required goods have been manufactured by the manufacturer, the purchaser can exercise his option of defect, but he can’t use his option of seeing.

3. Revoking of Istisna

• It can be cancelled unilaterally before the manufacturer starts working.
• After starting the work, it cannot be cancelled unilaterally.

4. Security

• A security in form of a guarantee, Islamic mortgage or hypothecation may be required for Istisna in order to ensure that the manufacturer shall deliver the commodity on the agreed date.
• In case of delivery default, the guarantor may be asked to deliver the same commodity. If there is a mortgage, the buyer can sell the mortgaged property, and the sale proceeds can be used either to realize the required commodity by purchasing it from the market or to recover the price advanced by him.

5. Time of Delivery

• It is not necessary that the time of delivery is fixed. However, the purchaser my fix a maximum time for delivery after the appointed time, he will not be bound to accept the goods and pay the price.
• In order to ensure that the goods will be delivered within the specified period, some modern agreement of this nature contain a penalty clause to the effect that in case the manufacturer delays the delivery after the appointed time, the price shall be reduced by a specified amount per day.

How Does Istisna Work in Islamic Banking?

Let us understand its Islamic banking mechanism in three simple steps:

Step-1: Request from Purchaser

The purchaser expresses his desire to purchase an asset, and the contract is signed between the Bank and the purchaser. The bank promises to deliver the commodity on a specific future date.

Step-2: Parallel Istisna Agreement with Manufacturer

The bank enters into a Parallel Istisna contract with a manufacturer, which is to be delivered by the due date in conjunction with the first Istisna contract.

Step-3: Delivery of Asset

The seller delivers the asset to the bank or to the purchaser if the bank requests it. If delivered directly to the purchaser, an agency agreement is signed between the Bank and the Purchaser.

Example of Istisna in Islamic Banking

1. Construction of Building

• If the customer or client owns a land, and seeks financing for the construction of a house or plant, financier may undertake to construct it.
• If the client does not own the land, the financier can provide him with a constructed building on a specified piece of land.
• If financier does not construct the building himself, he may either enter into parallel Istisna with a third party, or hire services of a contractor.

2. Mechanism to Finance a Building

• Financial institutions may use this contract to build a “house” or “plant” by considering it a “new product.”
• In such cases, the financial institution is involved in the relationship between the client and the contractor.
• The client and financial institution agree that the institution is responsible for preparing a house within a given period. The client may choose one of the designs offered by the institution, and the price is payable in instalments.
• The financial institution then enters into another agreement with a contractor to construct the house according to the specifications in the first agreement.
• When the contractor builds the house, it is delivered to the financial institution, and then the financial institution delivers it to the client.
• The financial institution pays the price to the contractor during the building period. However, the client pays it to the institution in installments. The price increases if the payment period increases.

Applications of Istisna

Istisna in Construction

This contract may be used to provide financing for house financing.

• If the client owns land and seeks financing for the construction of a house, the financier may undertake to construct the house based on this contract.
• If the client does not own the land and wants to purchase that, the financier can provide him with a constructed house on a specified piece of land.
• Unlike the diminishing musharakah contract, the financier does not have to construct the house himself. He can either enter into a parallel Istisna’ with a third party or hire the services of a contractor.
• He calculates his rest and fix the price of Istisna’ with his client that allows him to make a reasonable profit over his cost.
• The client’s payment of installments may start the day the parties sign the contract.
• In order to secure the payment of installments, the title deeds of the house or land, or any other property of the client may be kept by the financier as a security until the last installment is paid by the client.
• The financier will be responsible to strictly conform to the specifications in the agreement for the construction of the house. The cost of correcting any discrepancy would have to be borne by him.

Istisna for BOT

It may also be used for similar projects like installation of an air-conditioner plant in the client’s factory, building a bridge or a highway.

• The modern BOT (buy, operate and transfer) agreements may be formalized through an agreement as well. So, if the government wants to build a highway, it may enter into an Istisna’ contract with the builder.
• The price ’ may be the right of the builder to operate the highway and collect tolls for a specific period.

Using this contract, the client can get finance for raw materials, working capital, and overhead expenses. Other applications are:

• House Financing;
• Construction of buildings, factories, and plants;
• Project Financing; and;
• Export Pre-Shipment

AAOIFI Shariah Standards for Istisna and Parallel Istisna

The AAOIFI standard applies to transactions, whether the institution is acting as:

• An ultimate purchaser; or;
• A manufacturer; or;
• A builder for construction.

Istisna Contract Review

• The commodity is transacted before it comes into existence;
• After the manufacturer has started working, the contract cannot be cancelled unilaterally;
• Istisna and Parallel Istisna are two different contracts that cannot be tied up;
• Contract is valid for objects that can be manufactured and not valid for natural products;
• The manufacturer must satisfy the obligation, and the article must conform to all the specifications;
• Bank as a manufacturer is liable for Ownership risk, Maintenance, and Insurance expenses.

This lecture is a part of AIMS CIFE Islamic finance certification, Diploma in Islamic Banking and Finance, and the MBA Islamic Finance degree programs. These programs are accredited, and they are offered through an online and interactive learning system.