This report sheds some light on Murabaha, the most popular product of the growing Islamic Finance Industry. The report gives a step by step information on how it works, the conditions of a valid Murabaha, few issues around Murabaha & recommended solutions to those problems. In order to get a better understanding of the subject, a comparison has also been made with its conventional counterpart to strike out the various differences between a conventional loan & Islamic finance. This report will also attempt to answer few of the questions raised by the critics of Islamic Finance & also clear potential doubts regarding the shariah compliancy of Murabaha.
1. Introduction
"Those who devour usury will not stand except as stands one whom the Satan by his touch has driven to madness. That is because they say, "trade is like usury", but Allah has permitted trade and has forbidden usury"- Surah Al-baqarah verse no.275
Islamic Banking basically refers to a method of banking which complies with the Shari'ah standards. In order to be Shari'ah compatible Islamic banks cannot deal with interest or get involved in any activity which is prohibited by Shari'ah. Apart from Riba which means interest, Islamic banks also abstain from Gharar which is excessive uncertainty & Maisir which is gambling. Now, one might wonder, if Islamic banks cannot deal with interest then how do they make money, as that's how any bank would make money. Islamic banks believe in the method of profit & loss sharing, wherein the bank shares the risk along with its customer & then share profit or loss accordingly.
The Malaysian Islamic Banking Act 1983, defines an Islamic bank as
"… a company which carries on Islamic business. Islamic business means banking business whose aims and operations do not involve any element which is not approved by the religion of Islam…"
Islamic Banks use various Shari'ah compliant financing products some of them & are as follows:
Equity based financing products:
-Musharaka (Equity partnership, Joint Venture)
-Mudaraba (Trustee/Investment Partnership)
Debt based financing products:
-Murabaha (Cost plus sale)
-Ijarah (leasing)
-Salam (deferred delivery sale)
-Istisna (deferred manufacturing sale)
Now, let's look at Murabaha mode of financing, which is the most widely used products & accounts for some 80% of all financing provided by Islamic Institutions.
So what is it that makes it so popular?
How does it work? & what are the few issues around it?
2.0 What is Murabaha & How it works ?
The word Murabaha has been derived from the root word Ø±Ø¨Ø which basically means profit. So, it's a sale where the seller has to explicitly disclose the price of the commodity sold plus a profit margin mutually agreed by both the parties. It is very important that the buyer knows the breakup of the total price he is paying for, as failing to do so will result in a non compliant contract. The price in this sale can be both on spot or deferred. Murabaha contract can only be executed for tangible assets & commodities; hence one cannot borrow just cash & say that he'll pay it on a deferred basis with a mark up. A Murabaha contract is always tied with an asset.
So, if it's a transaction between a buyer & seller, then what is the banks role in that??
As discussed previously, that Shari'ah prohibits borrowing & lending on interest, it becomes really difficult for people to find Shari'ah compliant options & also fulfil their commercial needs. The Islamic banks basically help them achieve their commercial goals in a Shari'ah friendly way.
"Those who devour usury will not stand except as stands one whom the Satan by his touch has driven to madness. That is because they say, "trade is like usury", but Allah has permitted trade and has forbidden usury"- Surah Al-baqarah verse no.275
Islamic Banking basically refers to a method of banking which complies with the Shari'ah standards. In order to be Shari'ah compatible Islamic banks cannot deal with interest or get involved in any activity which is prohibited by Shari'ah. Apart from Riba which means interest, Islamic banks also abstain from Gharar which is excessive uncertainty & Maisir which is gambling. Now, one might wonder, if Islamic banks cannot deal with interest then how do they make money, as that's how any bank would make money. Islamic banks believe in the method of profit & loss sharing, wherein the bank shares the risk along with its customer & then share profit or loss accordingly.
The Malaysian Islamic Banking Act 1983, defines an Islamic bank as
"… a company which carries on Islamic business. Islamic business means banking business whose aims and operations do not involve any element which is not approved by the religion of Islam…"
Islamic Banks use various Shari'ah compliant financing products some of them & are as follows:
Equity based financing products:
-Musharaka (Equity partnership, Joint Venture)
-Mudaraba (Trustee/Investment Partnership)
Debt based financing products:
-Murabaha (Cost plus sale)
-Ijarah (leasing)
-Salam (deferred delivery sale)
-Istisna (deferred manufacturing sale)
Now, let's look at Murabaha mode of financing, which is the most widely used products & accounts for some 80% of all financing provided by Islamic Institutions.
So what is it that makes it so popular?
How does it work? & what are the few issues around it?
The word Murabaha has been derived from the root word Ø±Ø¨Ø which basically means profit. So, it's a sale where the seller has to explicitly disclose the price of the commodity sold plus a profit margin mutually agreed by both the parties. It is very important that the buyer knows the breakup of the total price he is paying for, as failing to do so will result in a non compliant contract. The price in this sale can be both on spot or deferred. Murabaha contract can only be executed for tangible assets & commodities; hence one cannot borrow just cash & say that he'll pay it on a deferred basis with a mark up. A Murabaha contract is always tied with an asset.
So, if it's a transaction between a buyer & seller, then what is the banks role in that??
As discussed previously, that Shari'ah prohibits borrowing & lending on interest, it becomes really difficult for people to find Shari'ah compliant options & also fulfil their commercial needs. The Islamic banks basically help them achieve their commercial goals in a Shari'ah friendly way.
Step by Step Murabaha Financing:
Purchase requisition: The client approaches the Islamic bank & requests the bank for purchase of a particular asset. The bank approves the purchase credit facility for Murabaha before entering into an actual agreement
.
Master Murabaha facility Agreement: It is an agreement signed between the bank and client. This includes an approval of credit facility to be extended to the client. The client needs to know that his facility has been approved which will enable him to buy what he needs. Apart from this the terms and conditions, detailed specifications of the asset of Murabaha & names of both the parties have to be mentioned.
Client's unilateral promise: In this stage the client will promise the bank to purchase the goods and bank can accept a collateral for its own security. The bank may even ask for earnest money termed as Hamish Jiddiyah.
Agency agreement: This agreement can be between the bank, the client or a third party. The client can also act as an agent, but the Shari'ah scholars are of the opinion that it's preferable, if the agent is a third party. At this point the specification of the asset can be changed but with a mutual consent. As long as agency is in force any damage will be banks responsibility, unless it can be proven it was due to client's negligence then he will have to compensate. Acting as an agent restricts the client to execute the khiyar al aib option i.e ability to return the good because of defect. Furthermore, Agency agreement can be divide into
Specific Agency : The agent is restricted to deal in a specific asset from specific supplier only.
Global Agency : The asset can be purchased from any source and can also enable to procure multiple assets.
Possession of Murabaha Goods: The agent takes the possession of the goods onbehalf of the bank, post which a purchase order form is now filled up by the agent. Now, in accordance with the agency agreement the money is disbursed and item is purchased. The agent then creates a document of possession and after the visual inspection by the bank & the possession document, bank formally takes the possession of the asset and agency agreement is concluded. It is permissible to obtain a discount by making an advance payment. The supplier can also be nominated by the client and Hamish Jiddiah may be taken. If there is a price increase during the procurement of an asset then if bank approves it then new price will be in the contract otherwise the original price will be considered instead.
Exchange of Offer and Acceptance: The exchange of offer & acceptance takes place between the client and bank to implement the Murabaha sale. This offer can be from either party, the client can offer to buy or bank can offer to sell. At this step Murabaha transaction is executed and client becomes the owner & the risk is transferred to him. The obligation of the seller concludes and obligation remains until the price is paid in full.
Transfer of Possession: The possessions of goods are transferred from the bank to the client & the Murabaha sale is concluded.
One has to be very careful, as all the steps have to be completed & the sequence in which they are executed is all also utmost important for a Murabaha transaction to be Shari'ah compliant.
4.0 Murabaha vs Conventional Loans:
Now that we're familiar with the step by step procedure of how a Murabaha financing works, let's compare it with the interest based loans offered by conventional banks to see what makes it different.
The conventional bank basically charges interest on the money they advance to their customers as loans. Murabaha is a sale contract between the bank & the customer, where in they share a relationship of a buyer & seller, unlike in conventional it's of a borrower & creditor.
The amount paid by the borrower to the conventional bank is based on an interest rate which might be fluctuating, whereas in Murabaha financing, the price & profit is fixed at the inception of the contract itself.(mutually agreed)
Murabaha transactions are always asset based & the purpose of the asset also has to be Shari'ah compliant. On the other hand loans extended by conventional banks are based on credit worthiness of the customer with the asset being the collateral & the purpose of the loan is not a constraint to them, as long as they get their returns.
Ownership risk is borne by the Islamic Banks which makes their returns more justified, which is not the case in conventional banking.
The late payment fees charged by the conventional banks form part of their income, whereas in Islamic banking any such fees are only deterrent to discipline the client & the fees thus charged do not form the income of the bank but is donated to a charitable institution.
5.0 Constraints in Murabaha Financing:
Now that we've compared Murabaha financing with its counterpart conventional lending & also acquainted with the steps involved, let's look at few constraints involved in Murabaha financing.
Subject Matter: Murabaha is solely used for sale & purchase of assets & cannot be used for any other purpose other than buying & selling of tangible assets. It cannot be offered for buying a company's shares or goods like Gold, silver or other currencies where payments are deferred.
Rebates on early payments: There can be a possibility that buyer is in a position to pay out the balance before its actually due & would expect a rebate for early payment which is normal in conventional banking. However, majority of the Shari'ah scholars are not in favor of any such rebates as it would mirror the conventional lending sales techniques. They do not have any objections if the banks are willing to offer some kind of rebate from their own will, provided it was not stipulated in the contract already.
Rollover in Murabaha: Firstly it's very important to understand that Murabaha is a sale of an asset with payment deferred to a future date & not a loan. After the sale of the asset the ownership & rights are transferred to the buyer like in any sale transaction, the only thing the bank can claim would be the amount owed by the buyer. Therefore the Murabaha transaction cannot be rolled over for a further period once the old contract is completed.
Ascertaining Cost : The cost of the asset plays a very crucial role, as a Murabaha can only be executed if the seller can ascertain the exact cost incurred in acquiring the commodity, as it's a condition of Murabaha that the cost is known to the buyer. Otherwise the sale would be more like a Musawamah where specifying the cost of the asset is not necessary.
Commodity Murabaha: There has been a spike in the usage of commodity murabaha in recent years as a tool for liquidity management within Islamic Banks. The majority of the Shari'ah scholars are of the opinion that this tool should be avoided & should be only kept as a last resort. It's a Tawarruq or a buy back arrangement between the banks which is prohibited by the Shari'ah, as there is no genuine sale. It is practiced generally on London Metal Exchange, wherein one party (in need) purchases a commodity on deferred basis, then sells it to on the spot for cash. The chances are that the commodities do not even exchange hands & it's merely a way of taking advantage of the party in need.
A lot of critics of Islamic finance target murabaha for various reasons, let us have a look at them & analyze as to how correct they are in their claims.
6.0 Criticism & Arguments :
By now we are aware that the main elements of the Murabaha financing is the 'Cost + Profit' & has to be disclosed before the Murabaha is executed & obviously both the parties have to agree with the arrangement. Also Murabaha is like a Purchase/Sale agreement & not a loan & every sale does have a profit component.
The issue is with ascertainment of the profit. Most of the Islamic Banks are using the LIBOR as a benchmark to set their profit rates which just makes it 'sound' or 'look' like a transaction based on interest. However, they fail to understand that by merely benchmarking it with LIBOR would not invalidate the transaction, as long as all the steps are followed & all the conditions are fulfilled, the transaction would be Shari'ah compliant. The banks are currently using this practice as there is no other alternative at the moment as Islamic Finance is still in its infancy stage & growing. Scholars are of the opinion that Islamic banks should take strong steps towards developing our own benchmark by creating our own inter-bank market based on Islamic Principles. A lot of efforts have been made in this field & Insha Allah; we'll have our own benchmark so that we're not dependent on these means.
7.0 Conclusion:
An attempt has been made to throw some light at this very famous Shari'ah compliant product called Murabaha. I believe that forming an opinion about something based on the end result & being ignorant about the whole process is not a wise thing. So, it's necessary for one to factor everything & hence this report has tried to touch base on all the aspects of Murabaha be it the definition, conditions, steps involved in executing Murabaha, its comparison with conventional lending, issues/constraints & criticism. Murabaha financing constitute around 80% of the total transactions in the Islamic Finance Industry. One reason for its popularity could be that the banks can anticipate their profit, if engaged in Murabaha transactions.. Most of the Islamic Scholars are of the opinion that, given the certainty of profit other modes of equity based finance like Musharaka & Mudaraba should not be neglected.
