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Islamic Mode of Finance "Istisna"
Alfalah Institute of Banking and finance
Bahauddin Zakariya University Multan
MBA (Banking & Finance)
4th
Semester

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Article
On
"Istisna" Islamic Mode Of finance
Submitted to:
Mr. Umair Shahid
Submitted by:
Muhammad Aamir Ayaz
MBK-11-01
Muhammad Asif
MBK-11-03
Rashid Aqeel
MBK-11-21
Muhammad Faheem
MBK-11-32
Kashif Waseem
MBA (B & F) 4th
semester
Alfalah Institute of Banking and Finance

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Abstract:
This paper examines the meaning and concepts of the Islamic mode of finance istisna in Islamic
banking. Different thoughts of Islamic scholars about istisna are given. How the istisna compliance
with Islamic shariah. Two case studies are discussed that how the istisna in Islamic banking work. It is
shown that how istisna can be used for export finance.
Introduction:
This paper will analytically explain the theory of the contract of istisna' and its practical application in
Islamic banking and financial institutions operations. The topics to be discussed, among others, are
the concept and definition of istisna', differences between Salam sale and istisna', legitimacy of
istisna', the binding effect of istis.nii' contract, conditions for the legality of istisna, penalties in
istisna', termination of the contract of istisna. In this article also two case studies are discussed. with
the help of these case studies you will be able to understand the physical application of the istisna in
Islamic banking.
Istisna and its concepts and definition:
Definition: The word istisna is derived from the word Sana'a which literally means "making,
manufacturing or constructing something."
Istisna„a, is a special kind of Bai„where the sale of a commodity is transacted before the commodity
comes into existence.
We can define istisna in following way:
"Istisna„a is an agreement in a sale at an agreed price whereby the purchaser places an order to
manufacture, assemble or construct (or cause so to do) anything to be delivered at a future date."
OR
In other word it is a contract ('aqd) made with a manufacturer pursuant to which the manufacturer
agrees to produce a specific thing for a purchaser on certain agreed upon specifications at a
determined price and for a fixed date of delivery.
Parties:
There are two parties in istisna
1. Sani
2. Mustani
Sani: The person who makes it is called sani'.
Mustani: person who causes it to be made called mustani.

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Masnu: the thing made called Masnu.
Subject Matter of Istisna:
This contract is valid only for those objects that have to be manufactured or constructed. But it is not
necessary that the seller himself manufactures the item, unless stated in the contract. The subject of
Istisna„a (the thing to be manufactured or constructed) must be known and specified to the extent of
removing any ignorance or lack of knowledge of its kind, type, quality and quantity.
The sellers agree to provide the subject matter transformed from raw materials through manufacturing
or goods manufactured by human hands. It is invalid for natural things or products like animals, corn,
fruit, etc. Both unique and homogeneous types of assets are covered under Istisna„a provided their
specifications are agreed at the time of the contract.
For example, items of unique description that have no regular market, have no substitute in the market
and where the value of each unit of that type of goods may be different, are covered by istisna„a.
In Istisna„a, the manufacturer arranges both the raw material and the labour. If material is supplied by
the purchaser and the manufacturer is required to use his labour and skill only, this is the contract of
Ujrah (doing any job against an agreed wage/remuneration) and not of Istisna.
It is not permissible that the subject matter of an Istisna„a contract be an existing and identified asset.
For example, it is invalid for an Islamic bank to conclude a contract to sell a particular designated car
from a factory on the basis of Istisna„a. But an asset that has already been produced by the seller or by
another can become the subject matter of Istisna„a provided that it is not identified in the contract and
the contract identifies speciation only.
An Istisna„a contract may be drawn for real estate developments on designated land owned either by
the purchaser or the contractor, or on land in which either of them owns the usufruct. It is allowed
because the contract involves the construction of specified buildings that will be built and sold
according to specification and, in this case, the contract of Istisna„a does not specify a particular
identified place.
Price in Istisna:
The price in Istisna„a can be in the form of cash, any tangible goods or usufruct of identified assets.
The price should be known in advance to the extent of removing ignorance or lack of knowledge and
dispute. It is permissible that the price of Istisna„a transactions varies in accordance with variations in
delivery date. There is also no objection to a number of offers being subject to negotiation, provided
that eventually only one offer is chosen for concluding the Istisna„a contract. This is to avoid
uncertainty and lack of knowledge that may lead to dispute.
The price, once settled, cannot be unilaterally increased or decreased. However, as manufacturing of
huge assets may involve more time, sometimes necessitating many changes, the price can be

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readjusted by the mutual consent of the contracting parties because of making material modifications
to the item to be manufactured or due to unforeseen contingencies or changes in prices of the inputs.
It is not necessary in Istisna„a price is paid in advance (unlike Salam, in which spot payment of price
is necessary). The price can be paid in installments within the agreed time period and can also be
linked with the completion stages.
Penalty Clause: Delay in Fulfilling the Obligations:
An Istisna„a contract may also contain a penalty clause stipulating an agreed amount of money for
compensating the purchaser adequately if the manufacturer is late in delivering the asset. Such
compensation is permissible only if the delay is not caused by intervening contingencies (force
majeure). Further, it is not permitted to stipulate a penalty clause against the purchaser for default in
any payment because this would be Riba. A voluntary rebate for prepayment is permissible, provided
it is not agreed in the contract. It can be agreed, in other words, between the parties that in the case of
delay in delivery, the price shall be reduced by a specified amount.
The scholars have contended this on the basis of analogy. The classical jurists allowed such a
condition in Ijarah, e.g. if a person hires the services of a tailor, he may tell him that the wage will be
10 dirham's if he prepares the clothes within a week and 12 if within two days. By analogy, experts
allow a penalty clause in the Istisna„an agreement in the case of a delay in delivery, supply or
construction of the subject of Istisna„a.
In Fiqh, this principle is termed Shart-e-Jazai (penalty condition), or the condition of
decreasing the price on account of a delay in delivery of the subject matter of Istisna„a. This reduction
will enhance the income of the orderer (purchaser) and it will not go to charity, as in the case of all
other modes. This special permission is on account of the fact that, in Istisna„a, timely completion of
the work depends on labour and commitment of the manufacturer (seller). If he does not devote full
time to completion of the job of a particular contract and engages in other contracts in his quest for
more and more orders and maximum earnings, he can be fined. This benefit would go to the
purchaser, who might suffer in the case of non delivery at the stipulated time. Any such undertaking
by the manufacturer would be binding on him.
The Binding Nature of an Istisna Contract:
The Hanafi jurists generally divide the binding effect of this kind of contract into three stages. Their
views are mainly based on their position about the legal basis of this contract.
At the first stage, where the work of manufacturing has not yet started, the Hanafi jurists are
fully agreed that the contract is not binding ('aqd ghayr lazim) upon either of the parties and the

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manufacturer may refrain(stop) from making the commodity. On the other hand, both contracting
parties have the right of revocation.
At the second stage, the manufacturer may finish making the needed goods, but the purchaser has not
seen the manufactured object yet. The manufacturer still has the right even to sell the commodity to a
third party.
The third stage is when the required goods have been manufactured and presented to the purchaser. In
this case, Muslim jurists have different opinions whether the purchaser has the right to reject the
commodity or not. AI-Imam Abu Hanifah is of the opinion that the purchaser can exercise his option
of inspection (Khiyar-e-RoiyyaT) after seeing the goods, because istisna' is a sale and if somebody
purchases a thing which he has not seen, he has the option to cancel the sale after seeing it. The same
principle is also applicable to istisna'. Abu Yusuf, a follower of Abu Hanifah, opines that if the
commodity was in conformity to the inspections agreed upon between the parties at the time of the
'contract, the purchaser is bound to accept the goods and he cannot exercise the option of inspection
(khiyar al ru'yah).
Finally, influenced by Abu Yusuf new opinion and the change of circumstances in the new
and modem transactions, Majallah al-Ahkam al- 'Adliyyah considers the contract of istisna' as binding
from the beginning. "After istisna is concluded by an agreement, the parties cannot go back on the
bargain. But if the thing does not agree with the description, the person who gives the order has an
option". It is clear from the above mentioned of Majallah that the contract is binding from the
beginning unless the recommended goods do not fulfill the prescriptions in the contract.
Conditions for the Legality of Istisna:
These conditions are divided into general conditions and specific conditions. In the case of general
conditions, the istisna' sale must fulfill the requirement of a valid contract as discussed by the jurists,
i.e. the capacity of the contracting parties, offer and acceptance, and the subject-matter should be a
valuable thing. In addition to these general conditions, there are some specific conditions for the
contract of istisna' to be legal, as follows:
1. The object must be precisely determined both in its essence and quality. In other words, it is a
condition in istisna' contract to state in the clear type, quality, quantity and all the
specifications required because it is a condition that the sold commodity must be known by
the parties involved to avoid ignorance which may lead to dispute later on.
2. The recommended manufactured goods should be things that people customarily deal with in
the field of manufacture. Otherwise, the contract of istisna' will be invalid. In this regard, Ibn
'Abidin, a Hanafi Jurist, is of the opinion that it is not permissible to practice istisna' in what

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is not familiar among people under this contract such as the manufacture of cloth. However,
the example of cloth manufacture prohibited by the early Hanafis was undoubtedly different
from the modem practice, as nowadays it has become very familiar. Perhaps what was said by
the earlier jurist was just an example on reason the types of manufacture differ from age to
age and for this reason the Majallah al-Ahkam al- 'Adliyyah cites new permissible things
stating that: "or if there is a bargain with a ship-carpenter to make a ship or boat and its
length, breadth, quality and things required are explained, the istisna' becomes a complete
contract".
3. It is a condition that the time of delivery is specified whether it is short or long so as to avoid
ignorance, which might lead to conflict between the two parties. Nevertheless, this is not the
position in Abu Hanifah view where he says that the time of delivery must not be stipulated in
the contract of istisna', otherwise the contract will be a contract of Salam rather than istisna.
However, the two disciples of Abu Hanifah, namely, Abu Yusuf and al-Shaybaru hold that it
is not a condition to stipulate a time of delivery. If the time of delivery stipulated, the contract
would still be a contract of istisna' and would not be transformed to a contract of Salam. They
argue that this is customarily practiced and people normally stipulate a time of delivery in the
contract of istisna. As istisna itself is allowed, because of the need and practice of the people,
the stipulation of time for delivery would be part of the practice and it would not transformed
istisna' into a Salam contract. It is worth to mention here that the opinion of Abu Yusuf and
Muhammad b. al-Hasan al-Shaybani is preferable to the view of Abu J:Ianifah and in line
with the practice of the modem transaction which makes the stipulation of a time of delivery a
necessary requirement. Moreover, in our time, the era of heavy industry and technology,
when the manufacturing of some commodities may take years to complete, it is reasonable
and rational to make the stipulation of delivery compulsory for the stability of transactions.
4. The materials should be supplied by makers, if they are supplied by the buyer, the contract is
regarded as al-Ijarah and not istisna'.
5. It is a condition that the place of delivery is stated if the commodity needs loading or
transportation expenses.
Guarantees:
The bank, acting either in the capacity of the manufacturer or of the ultimate purchaser, can give or
demand security, collateral or a performance bond to ensure that the work is performed within the
agreed time and as per specifications. It can also get „Arbun, which will either be part of the price if
the contract is fulfilled, or forfeited if the contract is rescinded. However, it is preferable that the
amount forfeited be limited to an amount equivalent to the actual damage suffered.

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Parallel Contract – Subcontracting:
Istisna is not confined to what the manufacturer himself makes, and if the contract is silent or it
expressly allows such, the seller/supplier can get it manufactured as per the specifications given in the
contract from anyone else. Financial institutions, as sellers, would contract with someone else to
manufacture the same. This could be a case of a Parallel Istisna„a contract.
An Istisna„a contract shall be entered into, on the one hand, between the bank and a customer, while
on the other hand, the bank may enter into a Parallel Istisna„a with a third party (contractor) for
preparation of the subject matter of the first Istisna„a. The delivery date of the parallel contract must
not precede the date of the original Istisna„a contract.
In one contract, the bank will be the buyer and in the second, the seller. Ownership related risks of the
two contracts will remain separate and will have to be borne by the respective parties so long as the
asset is not transferred to the other. Each of the two contracts shall be independent of the other. They
cannot be tied up in a manner whereby the rights and obligations of one contract are dependent on the
rights and obligations of the other contract. Further, Parallel Istisna is allowed with a third party only.
It is permissible for the bank to buy items on the basis of a clear and unambiguous
Specification and to pay, with the aim of providing liquidity to the manufacturer, the price in cash
when the contract is concluded. Subsequently, the bank may enter into a contract with another party in
order to sell, in the capacity of manufacturer or supplier, items whose specifications conform to the
wishes of that other party, on the basis of Parallel Istisna„a, and fulfill its contractual obligation
accordingly.
Post Execution Scenario:
Work in Process:
Before the manufacturer starts work on the subject matter of Istisna, both of the parties have the right
to rescind the contract. Once the seller/manufacturer initiates the work, the contract becomes binding
and any change is possible only with mutual consent. The parties to the contract are inevitably bound
by all obligations and consequences flowing from their agreement. The purchaser will make the
payment as per the agreed schedule and the manufacturer/seller will supply the asset as per the
specifications agreed. If the subject matter does not conform to the specifications agreed upon, the
customer has the option to accept or to refuse the subject matter. The purchaser shall not be regarded
as the owner of the materials in the possession of the manufacturer for the purpose of producing the
asset.
If the actual cost incurred by the bank (as seller) on an asset sold on Istisna„a is less than the forecast
cost, or the bank gets a discount from the subcontractor on a Parallel Istisna„a basis, the bank is not
obliged to give a discount to the purchaser and any additional profit, or loss if any, pertains to the

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bank. The same rule adversely applies when the actual costs of production are greater than the
forecast costs.
If so desired by a customer, the Islamic bank (as purchaser) may replace an existing contractor to
complete a project which has already been commenced by the previous contractor. For this purpose,
the existing status of the project needs to be assessed, whereby the cost of such assessment and all
liabilities as of that date shall remain the responsibility of the customer. The bank, working as a
manufacturer (seller), must assume liability for ownership risk, maintenance and Takaful expenses
prior to delivering the subject matter to the purchaser as well as the risk of theft or any abnormal
damage. The manufacturer cannot stipulate in the contract of Istisna„that he is not liable for defects.
Therefore, if the bank is the manufacturer for the purpose of an Istisna„a contract, it cannot absolve
itself from loss on this account. The orderer (purchaser) has the right to obtain collateral from the
manufacturer for the amount he has paid and as regards delivery of the commodity with specifications
and time of delivery.
A voluntary rebate for prepayment is permissible, provided it is not agreed in the contract.
Delivery and Disposal of the Subject Matter:
1. Before delivery of the asset to the purchaser, it will remain at the risk of the seller; any loss to the
raw material or to the item in the process of manufacturing will be borne by him.
2. After delivery, risk will be transferred to the purchaser.
3. Possession of goods can be physical or constructive, depending upon the nature of the asset and
transfer of ownership/risk. Transferring risk and delegating authority of use and
utilization/consumption are the basic ingredients of constructive possession. For this, there should be
a demarcation line between handing over and taking over of possession.
4. If a manufactured asset is delivered before the agreed date, the purchaser should accept it if the
asset meets the stipulated specifications. He can refuse to accept the goods if these are not as per the
agreed specifications or there is some other genuine justification for not accepting before the agreed
date (Istisna„a Standard, clauses 6/1 to 6/3).
5. If the condition of the subject matter does not conform to the contractual specifications at the date
of delivery, the ultimate purchaser has the right to reject the subject matter or to accept it in its present
condition, in which case the acceptance constitutes satisfactory performance of the contract.
The Potential of Istisna:
Islamic banks can use Istisna for manufacturing of high technology goods like aircrafts, ships,
buildings, dams, highways, etc. It can also be used for housing and export financing, meeting working
capital requirements in industries where sale orders are received in advance.
Potential areas are given below:
• financing the construction industry – apartment buildings, hospitals, schools and Universities;

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• Development of residential/commercial areas and housing finance schemes;
• financing high technology industries such as the aircraft industry, locomotive and shipbuilding
Industries.
Risk Management in Istisna:
Banks could face the following risks in Istisna„a-based financing:
• Settlement risk;
• Price risk;
• Delivery risk;
• Possession risk;
• Market risk.
As a whole, risks in Istisna„a would be mitigated by taking proper collateral, performance bonds,
technical expertise in the relevant areas for timely and effective marketing and for ensuring cost
effectiveness, by resorting to suitable Takaful policies, by choosing good clients and by adopting
suitable capital budgeting and liquidity management policies. Mitigation for some of the risks is
shown in Box 10.9. As little is available so far on the practical application of Istisna„a, we shall also
give a number of hypothetical case studies.
Risk Mitigation in Istisna:
Ownership of material:
The Islamic bank is not the owner of the materials in the possession of the manufacturer for the
purpose of producing the asset. It can have no claim on it in the case of any nonperformance.
 Security is available with the bank.
Delivery risk
The bank may be unable to complete the manufacturing of goods as scheduled due to late delivery of
completed goods by the subcontractor in Parallel Istisna„a.
 On the basis of the rule of “Shart-e-Jazai”, the bank can put in the Istisna agreement a clause
to reduce the Istisna„a price in the case of delay.
Sale not permissible before delivery
Sale of Istisna„a goods is not allowed before taking physical possession. This may lead to asset, price
and marketing risk
 The bank can take a “promise to purchase” from a third party and can make arrangements for
sale through agency.
Quality risk
The Islamic bank gets delivery of inferior quality manufactured goods, which also may affect the
original contract.

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 The bank can obtain a guarantee of quality from the original supplier.
Termination of the Istisna' Contract:
As one of the nominated contracts in Islamic Commercial Law, istisna' is terminated by the normal
ways of termination of contracts, namely when manufacturer makes the commodity and presents it to
the purchaser and receives the payment.
Furthermore, the jurists are of the opinion that the contract of istisna' can be terminated by the death
of one of the contracting parties. This rule is based on the analogy of istisna' to Ijarah in the Hanafi
School due to the similarity between ijarah and istisna.' However, due to the extensive application of
the contract of istisna' now a days' transactions, the manufacturer is not a single person. It is rather a
large corporation. Therefore, it is not applicable the contract will be ended by the death of one or two
persons because this one or the other has signed the contract on behalf of the corporation. Thus, it
must be differentiated between a contract of istisna' between individuals and one which involves
corporations and companies.
In the former case, it will be terminated by the death of one of the contracting parties, but in the
second case, it will continue as long as the corporation or company is in existence and will not be
affected by the death of its members.

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Housing Finance through Istisna:
Rs. 5million+rent over a period
Of 10 years
Hypothetical Case Study:
The following could be the flow process:
1. Suppose a builder/contractor C has announced a scheme for the construction and sale of apartments
costing Rs. 7 million each. (He demands cash and has no financial relationship with the bank.)
2. Client A decides to have an apartment; he has Rs. 2 million and needs financing from bank B of
Rs. 5 million for ten years.
Bank Rs.5M DIMINISHING MUSHARAKAH CustomerRs.2 M
Spot
Deferred
Rs.7M
Istisna
Spot
Contractor
Istisna-Housing Finance during Construction Phase

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3. A and B create a Musharakah pool of Rs. 7 million under the principle of Shirkat_ul_ milk and
jointly enter into Istisna agreements with C for the construction and sale of an apartment of defined
specifications and pay Rs. 7 million in four installments.
4. C starts building the apartment as per the requirements of the Istisna contract.
5. The bank appoints A its agent to supervise the construction work.
6. C hands over the apartment to A; B leases out its part of ownership to A in rent.
7. A purchases one unit of the bank‟s part every month; the rental starts decreasing after each payment
and after ten years, the bank‟s investment is redeemed and ownership is transferred to the client.
Istisna for Pre shipment Export Finance:
Rs.110M
(Export proceeds)
Hypothetical case study:
1. Client A gets an export order for the export of ready-made garments of value
Rs.110 million.
2. A approaches bank B for financing and indicates that he has the expertise to prepare the
consignment.
Istisna-Pre shipment -Export
Bank Rs.100 M (Istisna)
Spot
Customer
Deferred
Agent
EXPORT Rs.110 M

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3. B enters into an Istisna agreement with A for the supply of garments of a specified nature for
Rs. 100 million within a period of three months. This contract will be a sale; A will make
delivery at the agreed time.
4. B also appoints A its agent for export of the garments when they come under its ownership.
5. A foreign importer opens an L/C of value Rs. 110 million in the name of B (the L/C can also
be in the name of A but that would be under an agency agreement). If an L/C has already
been opened, Istisna is not possible (avoiding Bai„ al „Inah).
6. A prepares the garments and informs B to take delivery; the bank takes actual/constructive
delivery of the garments and henceforth the garments come under its risk/liability.
7. A exports the consignment as agent of B, sending documents on behalf of B. B gets Rs. 110
million, as per the terms of the L/C.
Difference between Istisna’ and Salam:
Istisna Salam
1. The subject of Istisna is always a thing
which needs manufacturing.
The Salam subject can be either
natural products or manufactured
goods.
2. The price in Istisna does not
necessarily need to be paid in full in
advance.
The price has to be paid in full in
advance.
3. Penalty in the form of a reduction in
price on account of a delay in
delivery will reflect the income of
the purchaser (the principle of Shart-
e-Jazai approved by the jurists.)
Penalty for late delivery shall go to
charity and the P&L Account of the
purchaser (bank) will be unaffected.
4. As long as work has not started,
Istisna is nonbinding; any of the
parties can revoke the contract.
Salam is a binding contract; once
executed, it cannot be rescinded
without the consent of the other.

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Difference between Istisna’ and Ijarah:
Istisna Ijarah
1. The manufacturer uses his own
materials and the sale price is fixed.
The manufacturer on an Ujrah basis uses
the material provided by the buyer and he
is paid the agreed wages.
2. Istisna can be of anything that needs
manufacturing.
Ijarah can be only on those assets
the corpus of which is not consumed
with use.
3. In Istisna, asset risk is transferred to
the purchaser soon after delivery of the
item to him and he has to pay the price
irrespective of what happens to the
asset.
In Ijarah, asset risk remains with the
owner (lessor) and the lessee has to give
rental only if the assets capable of being
used as per normal market practice.
Conclusion:
The above discussion can be safely concluded that istisna contract in Islamic Commercial Laws
is one of the important methods of investment in Islamic banking and can play an important role in
economic development. It encourages the demand for manufacturing goods, financing economic
activities, contributing to the stabilization of prices of manufactured goods, promoting industrial and
technological advancement and making use of the available possibilities of the economy.
References:
1. Meezan Bank's Guide to Islamic Banking by Dr. Imran Ashraf Usmani.
2. Istisna in Islamic Banking: Concept and Application by Joni Tamkin Borhan.
3. Understanding Islamic Finance by Muhammad Ayub.
4. AAOIFI, 2004–5a, clauses.
5. Muhammad al-Bashir, op.cit, pp. 80-82.
6. Majallah al-Ahkam al- 'Adliyyah, Art. 388.
7. Draft Shariah Parameter Reference5:Istisna Contracts by Central Bank Of Malaysia
8. Istisna by Al Maali Islamic Finance Training & Consultancy
9. Islamic Banking and Finance By Mufti Muhammad Taqi Usmani.