A Murabaha is a sale in which the seller’s cost of acquiring the asset and the profit earned from it are disclosed to the client or buyer. Islamic banks offer the Murabaha to fulfill asset purchase requirements and not as a liquidity financing facility. A banking Murabaha involves three parties: the bank, the client and the supplier.
Murabaha is one of the most common modes used by Islamic Banks. It refers to a sale where the seller discloses the cost of the commodity and amount of profit charged. Therefore, Murabaha is not a loan given on interest rather it is a sale of a commodity at profit. The mechanism of Murabaha is that the bank purchases the commodity as per requisition of the client and sells him on cost-plus-profit basis.
Under this arrangement, the bank is bound to disclose cost and profit margin to the client. Therefore, the bank, rather than advancing money to a borrower, buys the goods from a third party and sell those goods to the customer on profit. A question may be raised that selling goods on profit (under murabahah) and charging interest on the loan (as per the practice of conventional banks) appears to be one of the same things and also produces the same results. The answer to this query is that there is a clear difference between the mechanism/structure of the product.
The basic difference lies in the contract being used. Murabahah is a sale contract whereas the conventional finance overdraft facility is an interest based lending agreement and transaction. In case of Murabahah, the bank sells an asset and charges profit which is a trade activity declared halal (valid) in the Islamic Shariah. Whereas giving loan and charging interest thereupon is pure interest-based transaction declared haram (prohibited) by Islamic Shariah.
Originally, murabahah is a particular type of sale and not a mode of financing. The ideal mode of financing according to Shari‘ah is mudarabah or musharakah. However, in the perspective of the current economic set up, there are certain practical difficulties in using mudarabah and musharakah instruments in some areas of financing. Therefore, the contemporary Shari‘ah experts have allowed, subject to certain conditions, the use of the murabahah on deferred payment basis as a mode of financing. But there are two essential points which must be fully understood in this respect:
- It should never be overlooked that, originally, murabahah is not a mode of financing. It is only a device to escape from “interest” and not an ideal instrument for carrying out the real economic objectives of Islam. Therefore, this instrument should be used as a transitory step taken in the process of the Islamization of the economy, and its use should be restricted only to those cases where mudarabah or musharakah are not practicable
- The second important point is that the murabahah transaction does not come into existence by merely replacing the word of “interest” by the words of “profit” or “mark-up”. Actually, murabahah as a mode of finance, has been allowed by the Shari‘ah scholars with some conditions. Unless these conditions are fully observed, murabahah is not permissible. In fact, it is the observance of these conditions which can draw a clear line of distinction between an interest-bearing loan and a transaction of murabahah. If these conditions are neglected, the transaction becomes invalid according to Shari‘ah.
In the light of the aforementioned principles, a financial institution can use the murabahah as a mode of finance by adopting the following procedure:
Firstly: The client and the institution sign an over-all agreement whereby the institution promises to sell and the client promises to buy the commodities from time to time on an agreed ratio of profit added to the cost. This agreement may specify the limit up to which the facility may be availed.
Secondly: When a specific commodity is required by the customer, the institution appoints the client as his agent for purchasing the commodity on its behalf, and an agreement of agency is signed by both the parties.
Thirdly: The client purchases the commodity on behalf of the institution and takes its possession as an agent of the institution.
Fourthly: The client informs the institution that he has purchased the commodity on his behalf, and at the same time, makes an offer to purchase it from the institution.
Fifthly: The institution accepts the offer and the sale is concluded whereby the ownership as well as the risk of the commodity is transferred to the client.
All these five stages are necessary to effect a valid murabahah. If the institution purchases the commodity directly from the supplier (which is preferable) it does not need any agency agreement.
In this case, the second phase will be dropped and at the third stage the institution itself will purchase the commodity from the supplier, and the fourth phase will be restricted to making an offer by the client. The most essential element of the transaction is that the commodity must remain in the risk of the institution during the period between the third and the fifth stage. This is the only feature of murabahah which can distinguish it from an interest-based transaction. Therefore, it must be observed with due diligence at all costs, otherwise the murabahah transaction becomes invalid according to Shari‘ah.
It is also a necessary condition for the validity of murabahah that the commodity is purchased from a third party. The purchase of the commodity from the client himself on ‘buy back’ agreement is not allowed in the Shari‘ah. Thus murabahah based on ‘buy back’ agreement is nothing more than an interest based transaction.
The above mentioned procedure of the murabahah financing is a complex transaction where the parties involved have different capacities at different stages.
- At the first stage, the institution and the client promise to sell and purchase a commodity in future. This is not an actual sale. It is just a promise to effect a sale in future on murabahah basis. Thus at this stage the relation between the institution and the client is that of a promisorand a promise.
- At the second stage, the relation between the parties is that of a principal and an agent.
- At the third stage, the relation between the institution and the supplier is that of a buyer and seller.
- At the fourth and fifth stage, the relation of buyer and seller comes into operation between the institution and the client, and since the sale is effected on deferred payment basis, the relation of a debtor and creditor also emerges between them simultaneously. All these capacities must be kept in mind and must come into operation with all their consequential effects, each at its relevant stage, and these different capacities should never be mixed up or confused with each other.
The institution may ask the client to furnish a security to its satisfaction for the prompt payment of the deferred price. He may also ask him to sign a promissory note or a bill of exchange, but it must be after the actual sale takes place, i.e. at the fifth stage mentioned above. The reason is that the promissory note is signed by a debtor in favour of his creditor, but the relation of debtor and creditor between the institution and the client begins only at the fifth stage, whereupon the actual sale takes place between them.
In the case of default by the buyer in the payment of price at the due date, the price cannot be increased. However, if he has undertaken, in the agreement to pay an amount for a charitable purpose, he shall be liable to pay the amount undertaken by him. But the amount so recovered from the buyer shall not form part of the income of the seller / the financier. He is bound to spend it for a charitable purpose on behalf of the buyer.
The first and foremost question about murabahah is that, when used as a mode of financing, it is always effected on the basis of deferred payment. The financier purchases the commodity on cash payment and sells it to the client on credit. While selling the commodity on credit, he takes into account the period in which the price is to be paid by the client and increases the price accordingly.
The longer the maturity of the murabahah payment, the higher the price. Therefore the price in a murabahah transaction, as practiced by the Islamic banks, is always higher than the market price. If the client is able to purchase the same commodity from the market on cash payment, he will have to pay much less than he has to pay in a murabahah transaction on deferred payment basis. The question arises as to whether the price of a commodity in a credit sale may be increased from the price of a cash sale. Some people argue that the increase of price in a credit sale, being in consideration of the time given to the purchaser, should be treated analogous to the interest charged on a loan, because in both cases an additional amount is charged for the deferment of payment. On this basis they argue that the murabahah transactions, as practiced in the Islamic banks, are not different in essence from the interest-based loans advanced by the conventional banks.
This argument, which seems to be logical in appearance, is based on a misunderstanding about the principles of Shari‘ah regarding the prohibition of riba. For the correct comprehension of the concept the following points must be kept in view.
The modern capitalist theory does not differentiate between money and commodity in so far as commercial transactions are concerned. In the matter of exchange, money and commodity both are treated at par. Both can be traded in. Both can be sold at whatever price the parties agree upon. One can sell one dollar for two dollars on the spot as well as on credit, just as he can sell a commodity valuing one dollar for two dollars. The only condition is that it should be with mutual consent.
The Islamic principles, however, do not subscribe to this theory. According to Islamic principles, money and commodity have different characteristics and therefore, they are treated differently. The basic points of difference between money and commodity are the following:
(a) Money has no intrinsic utility. It cannot be utilized for fulfilling human needs directly. It can only be used for acquiring some goods or services. The commodities, on the other hand, have intrinsic utility. They can be utilized directly without exchanging them for some other thing.
(b) The commodities can be of different qualities, while money has no quality except that it is a measure of value or a medium of exchange. Therefore, all the units of money, of same denomination, are 100% equal to each other. An old and dirty note of Rs. 1000/- has the same value as a brand new note of Rs. 1000/-, unlike the commodities which may have different
qualities, and obviously an old and used car may be much less in value than a brand new car.
qualities, and obviously an old and used car may be much less in value than a brand new car.
(c) In commodities, the transaction of sale and purchase is effected on a particular individual commodity or, at least, on the commodities having particular specifications. If A has purchased a particular car by pin-pointing it and seller has agreed, he deserves to receive the same car. The seller cannot compel him to take the delivery of another car, though of the same type or quality. This can only be done if the purchaser agrees to it which implies that the earlier transaction is cancelled and a new transaction on the new car is effected by mutual consent.
Money, on the contrary, cannot be pin-pointed in a transaction of exchange. If A has purchased a commodity from B by showing him a particular note of Rs. 1000/- he can still pay him another note of the same denomination, while B cannot insist that he will take the same note as was shown to him. Keeping these differences in view, Islam has treated money and commodities differently. Since money has no intrinsic utility, but is only a medium of exchange which has no different qualities, the exchange of a unit of money for another unit of the same denomination cannot be effected except at par value. If a currency note of Rs. 1000/- is exchanged for another note of Pakistani Rupees, it must be of the value of Rs. 1000/- The price of the former note can neither be increased nor decreased from Rs. 1000/- even in a spot transaction, because the currency note has no intrinsic utility nor a different quality (recognized legally), therefore any excess on either side is without consideration, hence not allowed in Shari‘ah. As this is true in a spot exchange transaction, it is also true in a credit transaction where there is money on both sides, because if some excess is claimed in a credit transaction (where money is exchanged for money) it will be against nothing but time.
Murabaha Prerequisites
Subject Matter
1. Murabaha subject matter or the Murabaha asset must exist at the time of contract execution. For instance a Murabaha can be executed for a car that exists not for one that is to manufactured.
2. The bank must own the asset and have either physical or constructive possession.
3. The subject matter must be an item of value and Shariah-compliant.
4. The subject matter must be a tangible good, clearly identified and quantified. For instance, if the buyer wants to purchase rice, its exact quality and quantity in terms of weight must be clearly specified in the Murabaha contract to avoid gharar or uncertainty that leads to dispute between contracting parties.
Price
1. The Murabaha asset cost must be declared to the client.
2. The cost refers to all expenses involved in the asset’s acquisition.
3. The asset’s price includes all direct expenses where the bank pays for all indirect expenses.
4. Parties to the contract establish a profit rate by mutual consent or in relation to a specific and known benchmark.
5. The Murabaha price may be charged at spot or be deferred and paid as a lump sum at the end of the contract or in installments on fixed dates during the term.
6. The Murabaha profit must be disclosed as a specific amount. It is important to remember that the Murabaha’s execution must adhere to a certain sequence of
procedures in order to ensure Shariah-compliance.
procedures in order to ensure Shariah-compliance.
Steps of Murabaha Execution
1. The client’s submission of a purchase requisition for Murabaha goods:
Based on the requisition the bank approves the credit facility before entering into an actual
agreement.
Based on the requisition the bank approves the credit facility before entering into an actual
agreement.
2. The Master Murabaha Facility Agreement (MMFA) between the financial institution and the client. It includes:
i. An approval of the client’s credit facility
ii. The terms and conditions of the Murabaha contract
iii. Murabaha asset specification
iv. Client’s undertaking to purchase the Murabaha asset once the bank acquires it (if not
included in the MMFA, it constitutes step 3)
i. An approval of the client’s credit facility
ii. The terms and conditions of the Murabaha contract
iii. Murabaha asset specification
iv. Client’s undertaking to purchase the Murabaha asset once the bank acquires it (if not
included in the MMFA, it constitutes step 3)
3. The client’s unilateral promise to purchase the Murabaha goods and the financial institution’s acceptance of collateral. At this stage the bank in order to safeguard its rights in case the client
backs out from entering into a Murabaha, requests the client to furnish a security or earnest money called Haamish Jiddiah. In case the client backs out from entering into a Murabaha, the bank makes up for the actual loss from it and returns the remainder to the client.
backs out from entering into a Murabaha, requests the client to furnish a security or earnest money called Haamish Jiddiah. In case the client backs out from entering into a Murabaha, the bank makes up for the actual loss from it and returns the remainder to the client.
4. The agency agreement between the financial institution and the client or a third party since banks do not possess the expertise or manpower to purchase the asset, they appoint the client as the agent to procure the asset from the supplier on their behalf.
Agency agreements are of two types
Specific Agency Agreement: Agent is restricted to purchase a specific asset from a specific supplier
Global Agency Agreement: Agent may purchase the asset from any source of his choice. Such an agreement also lists a number of assets which the agent may procure on the bank’s behalf without executing a new agency agreement each time.
Key points to remember about the agency:
During the agency stage, the bank’s exposure to asset risk is highest and it is in the bank’s interest to shorten this period as much as possible. Bank may also minimize risk by ensuring the supplier receives payment for the Murabaha asset.Bank must also ensure that the Murabaha asset to be purchased is not already in the client’s possession. To maintain correct sequence, the bank must disburse the money to the agent before the agent purchases the goods. The agency agreement is not a prerequisite but motivated by logistical ease. Banks can procure Murabaha goods directly or establish a third party agency.
5. The possession of the Murabaha goods by the agent on behalf of the financial institution. After the agency agreement the client completes the purchase order form. The bank disburses the money to the client, who as agent pays it to the supplier and receives possession of the Murabaha goods.
6. The exchange of an offer and acceptance between the client and the financial institution to implement the Murabaha sale. Either party can make the offer; the client may offer to buy the Murabaha goods or the bank may offer to sell them. The Murabaha sale is completed at the time of offer and acceptance.
7. The transfer of possession of Murabaha goods from the financial institution to the client. The client is the owner of goods and all the associated risk and rewards however his obligation does not conclude until he makes complete payment of the Murabaha price.
Mitigating Murabaha Risks
The Shariah validity of a Murabaha is strongly sensitive to following the designated steps in the correct sequence.A deferred Murabaha may not be executed for mediums of exchange (i.e. commodities such as gold, silver and currencies). Only a spot Murabaha may be executed for them.The bank must seek Shariah-compliant Takaful insurance for Murabaha goods to cover transit period risk (i.e. the risk posed to the bank once it purchases the goods from the supplier and has their possession and before it sells them to the client).
Default in a Murabaha
There is no concept of a late payment penalty in a Murabaha contract, however, a charity clause is established at contract execution to serve as a deterrent to default. In case of a default in payment, based on the charity clause, the client is obliged to pay a predetermined amount to a designated charity.
Murabaha Prohibitions
A roll-over is the provision of an extension in return for an increase in the original payable amount and is impermissible in a Murabaha. It constitutes repricing and rescheduling:
Repricing is prohibited because the Shariah does not permit an increase in debt once it is fixed.
Rescheduling is only permissible when the creditor provides an extension to ease the burden of a debtor, so a roll-over where the bank increases the debt in return for an extension is impermissible as the resulting amount of debt is analogous to riba or interest which is prohibited in Islam.
Calculating Murabaha Profit
From an accounting perspective, there are two stages in a Murabaha:
1st stage: The investment stage - Begins after the bank and client sign the agency agreement. It is the time period where the bank has disbursed money for the purchase of the asset from the supplier but has not yet acquired possession in order to sell it.
2nd stage: The financing stage - This stage begins when the bank receives the asset and goes ahead with the exchange of offer and acceptance with the client. It ends once the bank receives the Murabaha payment from the client. It is during this time that the bank has the right to accrue profit.
Example
A bank extends an advance for Murabaha to the client on the 1st of March, knowing that he will not purchase the asset until the 1st of June.
The client purchases the asset on the 1st of June and the Murabaha sale takes place between him and the bank on the same day.
If the tenure of the Murabaha is 4 months, it will commence on the 1st of June and last until the 1st of October.
The bank will begin calculating profit on the 1st of June and not the 1st of March so that no income accrues to the bank between 1st of March and 1st of June.
Is charging more on credit sales (Murabaha) permissible?
The supporters of Murabaha present two conditions in it which they think distinguishes it, to them quite clearly, from riba. One condition they present is that unlike in the case of riba where cash or cash-like circulating asset is involved, in Murabaha a real commodity is involved. The other condition is that in Murabaha they don't allow mark-up on mark-up, where as, they believe, in riba interest on interest is also charged.
Sale Contracts is Shari’ah are many forms. They can be auction like where seller and buyer negotiate the price. But they can also be based on mutual trust where parties negotiate the rate of profit, which will be over and above the cost of purchase to the seller.
Murabahah is the old was a simple sale contract, where a mark-up is negotiated between the parties and calculated on the basis of cost of purchase of the seller. Nevertheless Murabahah in contemporary Islamic banking present an interesting case of financial engineering where this simple sale contract was developed into a substitute for bank lending. Because banks are not “merchant”, goods are assets that can be subject to murabahah are not owned by the bank when client desires to buy them. One solution would be for the bank to sell first and then precare saves goods from the market. This however, is not permissible from Shari’ah point of view. Islamic bank opted for obtaining a “commitment to purchase” from the client. One may say: if such commitment is binding, then it is a kin to contracting for sale, and if it is contract not a value promise. The client is not obligated to buy, rather he is obligated to honor his promise. If the bank, relying on such promise, bought these good and the client decides not to go ahead with the purchase, bank will then sell same to a third party. If a loss is made, then the bank will have a recourse to that client since the loss was caused by the promise.
Profits to the bank are basically the difference between the purchase price, which in cash, and the deferred sale price. This difference are very closely-related to the going interest rates which occasionally makes people suspect of Islamic banking. However, they are not the same. The mark-up in Murabahah is part of a sale price, it is set only once and then it is does not change overtime. The bank can calculate the price (cost-plus), in any way, even basing such calculation on the going LIBOR ( Inter-bank offered rate in London), it is set, it can't be changed even if the client defaulted on his debt or was delinquent. While principal is easily distinguishable from the mark up, such distinction should remain an accounting exercise. Murabaha is a sale contract, the price is just one amount and, contractually, it should be always treated so.
Risks
Murabaha mode of finance resembles, in its risk profile, conventional lending. Except for bank’s purchase of the goods and resell to the client, Murabaha creates a bank asset similar to that of conventional banks, with much-the same risks, the main difference are basically:
(a) Risks related to changes in price of the goods when such goods are owned by the bank prior to sale to the client. No specific length of time is required by Shari’ah hence such time can be reduced to the minimum to control commercial risks. What is necessary, however, is that ownership as defined by Shari’ah is sustained in such time. Hence, these risks can be significantly reduced through efficient procedures. Furthermore, since murabahah is effectively cost-plus, change in the prior of goods will not affect the sale price to the client since it is based on cost of purchase.
(b) Shari’ah does not permit any financial penalty to be imposed on delinquent debtors for purpose of compensating the creditor. This is clearly a major disadvantage over conventional banking. This makes the risk related to the client default or failure to pay on time is relatively high. Many Islamic banks opt for fining the client and then pay such fines to charity. This way the impose preserve on the client without falling into the definition of usury in Shari’ah.
(c) Murabaha is a fixed-return type of finance. It is naturally exposed to interest rate risks. Because of this, most Murabahas in Islamic banks are short-term.
Heeding the Murabaha risks
One major drawback of Murabaha mode of finance is the fact that it is fixed return type of transaction. it is because of this that Murabaha deals are always short term. While a three year Murabaha is not uncommon in Islamic banks, anything beyond that needs hedging of interest rate risks. All conventional hedging mechanisms involve Shari’ah non-permissible contracts. Because no hedging method has so far come out of Islamic banking “laboratory”, murabahah remains a commercial short term mode of finance. Securitization of debt is not permissible from Shari’ah point of views. This banks such hedging a formidable task.
However, Murabaha may not be suitable for housing or other long term investments in economies with a high rate of inflation. The reason for that is that the bank might face a greater risk in the possible return if the general rate in the market increases owing to inflationary pressures. Murabaha can still be used for mortgage financing for longer periods ranging in economies where inflation is not a major issue. Also, Murabaha is not the right mode to provide financing for the purchase of easily perishable items.
Nevertheless, Islamic banks must bear a certain amount of risk associated with Murabaha transactions in order to legitimize their returns. They use some techniques to manage and mitigate each type of the common risks. In order to ensure that the bank's gains are above all suspicions of Riba, the bank reduces Shari´ah non-compliance risk by making direct payment to the supplier, it requires the invoice from the seller for the goods purchased, the date of which not before the offer and acceptance is carried out and not later than the declaration and it also arranges for the random physical inspection of the goods. This technique seeks to avoid that the client has already purchased the goods and subsequently wants the financing to make payment to the supplier. The bank can also obtain Takaful Insurance to reduce in-transit risk of destruction or loss of goods occurring without the agent’s negligence. The bank may ask the client to provide security through any assets of the client and stipulates a penalty payment clause in the contract that in the event of payment defaults. Murabaha does not allow additional charges in case of instalments. The amount of the Murabaha price remains unchanged. Long-term Murabaha may be avoided to guard against rate of return risk.
Read more:
Ethica, Handbook of Islamic Finance 2017 edition.
