Analysis of Salam Contracts: Risk Management in Islamic Finance

This report examines the mechanism of Salam contracts within Islamic finance as a means of managing financial risks while adhering to Sharia law. Salam contracts, which function as a type of forward contract, involve upfront payment by the buyer for future delivery of specified assets. The report highlights key aspects of these contracts, including the requirement of full payment at the outset, the importance of asset quality, and the role of the seller as a producer or manufacturer. It addresses the risks associated with Salam contracts, such as counterparty risk and commodity price fluctuations, and discusses the concept of parallel Salam contracts to mitigate supplier defaults. Furthermore, the report outlines various clauses implemented in Salam contracts to manage risks, including security deposits, promissory notes, and penalty clauses for late delivery. These measures are designed to protect the buyer and ensure the contract's effectiveness in Islamic finance. The analysis is supported by references to relevant academic literature.

ISLAMIC FINANCE

Mechanism to manage risk according to sharia compliance
Salam contracts can be used as a useful mechanism to reduce the financial risk by
complying with sharia law. It is a type of forwarding contract in which the buyer pays the money
in advance and the seller who will sell the specified asset will supply asset on a future date. The
seller has the liability to deliver the asset on a specified date to the buyer. According to sharia
law, the full payment which has been done at the time of entering into contract is the principle
ley for any Salam contract to exist. The Sharia law specifies that the goods or asset which will be
supplied should be of good quality so that no dispute can arise. According to Ajmal, Rafay & Sadiq
(2017), at the time of supply of goods, the goods which are to be delivered should be available.
Salam cannot be applied in case of identical items. The seller or supplier in contract should be
producer or manufacturer of the specified asset.
As opined by Elamer, Ntim & Abdou (2017), if the supplier made late delivery of contracted
asset then the seller will have to pay penalty in terms of money to the purchaser. The penalty
amount should not be considered as income for the purchaser; it should be utilized for charitable
assistance. In Salam contract there is a risk of counterparty risk. Another risk which has been
attached to this agreement is related to commodity price. This means that at the settlement the
purchase price may be lesser than the agreed price. According to Hisham & Jaffar (2016), there is a
concept in Salam contract which is known as parallel Salam. In this contract, the Islamic bank
will take guarantee to supply the quality goods if the supplier defaults in making supply. So the
Islamic bank has to suffer from the risk known as storage risk or asset holding risk. There are
also many risks related to contracts such as fiduciary risk, risk of locking fund, quality risk.
According to Saeed (2017), all these risks can be considered as risk which if not reduced will
affect the income of the other party that is the buyer or purchaser.
So to mitigate the aforementioned risks Islamic finance has inserted some clauses in
Salam contract. These clauses will help to mane the buyer risks in the contract. According to
these clauses, the buyer entering into the contract should deposit a high amount of security
deposit or earnest money and a promissory note by the buyer to acquire those assets or goods.
The sellers are also required to supply goods which carry market potential and are required to
give proper security to the Islamic banks. There is also one penalty clause in the Salam contract
related to late supply of assets. This penalty clause can be useful to protect the buyer from late

delivery. If the seller suffers from the original Salam contract then they can enter into parallel
Salam contract. This means that they can acquire similar goods or assets from the market and the
goods that will be purchased on spot price and then the goods will be handed to the buyer and the
losses to the supplier will be recovered.

References
Ajmal, M., Rafay, A., & Sadiq, R. (2017). Pricing of Bai Salam: An Analytical
Perspective. Ajmal, MM, Rafay, A. & Sadiq, 167-176.[Available at
http://www.ijbs.unimas.my/images/repository/pdf/Vol18-S1-paper10.pdf ] [Accessed
on 12th March 2020]
Elamer, A. A., Ntim, C. G., & Abdou, H. A. (2017). Islamic governance, national governance,
and bank risk management and disclosure in MENA countries. Business & Society,
0007650317746108. [Available at
https://journals.sagepub.com/doi/pdf/10.1177/0007650317746108] [Accessed on 14th
March 2020]
Hisham, A. F. B., & Jaffar, M. M. (2016). SALAM CONTRACT WITH CREDIT RISK
MODEL BY PARTIAL DIFFERENTIAL EQUATION APPROACH. Jurnal
Teknologi, 78(11). [Available at
https://www.researchgate.net/profile/Maheran_Mohd_Jaffar/publication/
309753425_Salam_contract_with_credit_risk_model_by_partial_differential_equation_
approach/links/59cb47dc45851556e982a251/Salam-contract-with-credit-risk-model-by-
partial-differential-equation-approach.pdf ] [Accessed on 13th March 2020]
Saeed, T. V. (2017). A Theoretical Study of Salam and Istisna’in the Light Of Islamic
Jurisprudence. [Available at http://www.ijetsr.com/images/short_pdf/1503310210_977-980-
saeed_ijetsr_july2017.pdf ] [Accessed on 13th May 2020]