Ch 4 Islamic Finance

• Murabaha is a sale-based transaction used by Islamic banks as an alternative to term loans, where profit is made by selling at a cost-plus basis.
• Upon completion of this chapter, one should be able to define Murabaha, including its types like Tawarruq, its key conditions, describe the Murabaha process, discuss practical applications, and compare it with conventional loans.

Introduction to Murabaha

• Conventional banking treats money and commodities the same, but Islam views them differently.
• Money is only a medium of exchange without intrinsic value, unlike commodities, which have intrinsic value and satisfy needs.
• Money cannot be treated as a commodity, so pure lending of money with fixed return (interest) is prohibited.
• Islamic finance requires each financial transaction to link to a real asset.
• Excess can be charged when commodities are traded for credit, and sellers can charge different prices for cash or credit sales, with credit sales being higher.
• A sales contract can be executed only when the item exists, is owned by the seller at the time of sale, and is in the physical or constructive possession of the seller.
• Two exceptions to this rule are the contracts of Salam and Istisna.

Sales Classification in Islamic Commerce

• According to delivery and payment:
  • Immediate delivery with spot payment
  • Immediate delivery with deferred payment
  • Immediate payment with deferred delivery
• According to cost disclosure:
  • Musawama (bargain sale): Price agreed without reference to cost
  • Murabaha (trust sale): Seller discloses the cost and a known profit is added

Murabaha as a Trust Sale

• It requires the seller to disclose the cost to the buyer with a known profit added.
• The buyer trusts the seller for quality, specification, actual cost, and markup.
• Additional costs like storage and transportation are included.
• The markup can be a lump sum or a percentage of the price.
• Delivery of goods is immediate, but payment can be on spot or deferred, often used as a method of finance.
• Deferred payment can be in full amount at a deferred period or in installments.
• This arrangement allows customers to acquire and use assets, earn profit, and repay in deferred installments, aligning with Shariah principles.
• It is Shariah-compliant because the bank first acquires the asset for resale at a profit, assuming the associated risks.

Types of Murabaha

• Ordinary Murabaha: Client asks the bank to acquire an asset without promising to buy it.
• Murabaha sale with a promise: Client promises to buy the item once the bank acquires it, more common as Islamic banks seek assurance.
• In Murabaha with a promise, the client bears risk of goods not being delivered as per specification, while in ordinary Murabaha, the bank bears the non-delivery risk.
• Murabaha entails a sale and purchase agreement between the bank and the client.
• The client may be appointed as an agent to make the purchase, with ownership going to the bank, which may take security to protect against default.
• In case of default, the bank recovers dues but returns any excess from the security sale to the client.
• Islamic banks cannot charge late payment fees but may charge for costs incurred to recover payments, with any late payment fees donated to charity.

Conditions Related to Murabaha

• The conditions are characterized by various requirements.
• It must fulfill Shariah requirements of a valid sale.
• The item of sale must exist and be owned by the seller at the time of sale.
• Goods need to be legal, Halal, and have real commercial value, including tangibles like vehicles and intangibles like trademarks.
• Currencies cannot be traded via Murabaha on a deferred basis.
• All direct/indirect costs must be identified and mutually agreed upon.
• Markup or profit can be fixed or a percentage, stated clearly and agreed upon upfront.
• The seller needs be a third party beside client/Islamic bank.
• The client may need to sign a unilateral promise to buy, which is binding in some jurisdictions like the UK or USA.
• Contractually, it’s morally binding on both parties, but legally binding if the bank relies on the promise to acquire the property.
• Defects must be disclosed by the seller, or the buyer can demand compensation or cancel the sale.
• Risk of loss or concealed defects before delivery are borne by the bank.
• Murabaha is Shariah compliant because the bank acquires ownership and possession, assuming all asset-related risks before reselling.
• Advance payments/deposits are allowed and adjusted from the price.
• Delivery is immediate, and the client bears the risk after delivery.
• Repayment can be spot or deferred, with the schedule mutually agreed upon.
• Security may be required, and the purchased asset can serve as collateral.
• No interest on delayed repayments is allowed, but a penalty can be charged and donated to charity.
• Legal action can be taken against solvent debtors who delay, while leniency is recommended for insolvent debtors.

Calculation of Murabaha Profit

• The Arabic root word Ribh means gain or profit and is the foundation for the term Murabaha.
• Murabaha is an Islamic banking contract of sale, where the bank purchases an item at the request of the client and resells it to the client at a mutually agreed profit or markup.
• The markup amount can be a lump sum or a percentage of the cost of the item of sale.
• For example, the markup may be £8,000 or 8% of the item cost if a client purchases a car worth £100,000.
• A Murabaha contract is Shariah compliant because the Islamic bank is required to buy, own and bear all ownership risk of the item before selling it to the client.
• In conventional banks, it sells the funds to the client at the price of interest, but it sells the asset to the client at a marked-up price.
• Deferred instalments of repayment of Murabaha include cost and markup of the item of sale.
• Margin of profit is a ratio dividing net profits by sales, showing the degree of profit made in the contract.
• A penalty can be charged for delay or failure to repay as per Shariah rulings, but cannot benefit the Islamic bank but distributed to charity.
• In case of insolvency, the Islamic bank lacks authority to place a penalty on the client

The Murabaha Process

• A client requests the Islamic bank to buy a specific item or asset, promising to buy it from the bank for profit, but is not commitment yet
• If the bank accepts this invitation they need to source the item or asset as per client specifications, pays for the item, and buy/own it with all ownership-related risks
• The bank then makes a formal offer to the prospective buyer
• The prospective buyers can accept the offer to buy the item or asset or not, and if they do then it’s executed

Murabaha with a Promise

• The steps include the Islamic bank sources the appropriate vendor for the item and identifies the total relevant costs
• The bank negotiates with the client on the item its costs and the applicable markup
• Bank and client sign a joint agreement where the bank buys and sells to the client at a cost plus agreement and the client promises to buy the item
• The bank may assign the client as an agent to buy the asset on behalf of the bank
• The bank or client buys the asset where a sales contract is executed between the bank and vendor
• The bank delivers the asset to the client and the ownership title passes to the bank
• Murabaha is drawn where the clients pays the bank over the contract period as a lump sum/ instalments.
• Three parties are involved – the bank, the vendor, and the client.

Arbun

• The Murabaha contract includes an advance deposit called the Arbun.
• It is paid by the client to the bank in advance when signing the agreement but before the bank purchases the asset
• Arbun is paid to ensure the client's commitment and seriousness in acquiring the asset
• The Arbun will be considered as part payment.
• If the client doesn't fulfill the Murabaha contract, the Arbun would be treated differently
• For a binding contract in Murabaha with a promise, if the client refuses, the bank can use the Arbun to cover any loss
• For an ordinary Murabaha, the Arbun needs to be returned to the client

Practical Applications of Murabaha

• Because it is a simple cost-plus sale with deferred repayment, Murabaha is widely used by Islamic banks
• Retail Finance: Includes home/vehicles financing, and personal durables
• Working Capital Financing: Purchase raw materials
• Business (medium and long- term) Financing: Purchase land, buildings, equipment, machinery, and vehicles with medium and long-term repayment schedules
• Syndicated loans:Two or more Islamic banks come together for a joint Murabaha financing
• Trade Finance:Includes imports, exports, bills of exchange, and letter of credit

Trade finance Process

• Importer asks the islamic bank to open an L/C to imports goods and provides all the necessary information
• Bank checks and secures guarantees and then opens the L/C and sends it to the correspondent and exporter
• The exporter ships goods and hands over the shipping documents to the correspondent bank and sent to the Islamic bank
• Bank ownership if confirmed once it accepts documents
• The islamic bank finally sells the goods to the importer at a cost plus markup basis.
• The importer pays the bank on a deferred basis

Tawarruq

• Tawarruq/ reverse Murabaha happens when the client purchases a commodity from a seller, via an Islamic bank, on a deferred payment basis and then the client appoints the Islamic bank to sell the commodity to a third party on a spot payment basis
• Used to raise personal finance/ working capital and manage short-term cash shortage.
• Commodities are available, unique and not perishable and those previously used as money cannot be used.
• Some costs are involved for both buy/sell of the transaction with clear ownership transaction
• AAOIFI has also permitted it and is used more in south- east Asian countries
• Some Islamic scholars accept it if the client needs money with no other cash financing available.

Problems/ Challenges with Murabaha

• A murabaha contract is for a permissible Halal asset
• It appears like interest where fixed instrument appear like conventional banking
• LIBOR can be used as a benchmark if its one sided promise
• Ownership risk occurs when the bank acquires the Murabaha asset with risks before the sales contract is completed
• Murabaha is a sales transaction with deferred payments and the Islamic banks cannot increase sales price.
• Clients can take advantage of this, and Shariah allows charging a penalty, but to charity.
• Shariah scholars have allowed security and 3rd part to provide security
• Sharia prohibits buy back arrangement/ tax implications/secularization

Key Differences Between Murabaha and Conventional Loans

• Murabaha is a sales contract meanwhile a conventional loan is a loan contract
• Client requests the bank to acquire/sell an assets
• Murabaha has a fixed repayment schedule vs loans will have interest that is a fixed/ variable rate on the principal loan
• Major requirement of Murabaha is ownership while loans only lend funds