Murabaha Share Finance: Part 3
In part 1 (which can be read HERE), we started to look at how a Murabaha share financing structure would work. In part 2 (HERE) we completed the structure and also started to look at what it means to involve real assets - in this case, shares.
As a recap, this is the structure that we ended up with:
In reality, the structure used by any specific bank for Murabaha share financing may differ from this, however from my experience this is not often the case. If there is any departure from this, it will not be meaningful.
Once we concluded that we needed the 3 parties working together in this manner, we began to raise some issues around the risk surrounding these transactions.
When a bank gives a loan to a customer, the only risk it really wants to face is the risk of the customer not being able (or willing) to repay the bank. This credit risk is what a bank specialises in. That is why you (the customer) are asked to provide information about your earnings and financial status to the bank when applying for a loan. Where possible, the bank would try to reduce the credit risk it faces on you by various mechanisms such as the use of a guarantor, ensuring your salary is paid directly to the bank, or using an asset as collateral in some manner.
This credit risk certainly exists in our structure. It arises as a result of step 1, where the customer contracts to pay £1,050 to the bank in one year’s time. This is reflected, technically, as the deferred sale price paid to purchase the shares from the bank. In a conventional loan with interest, this amount is simply seen as the repayment of the loan (with interest of £50 having been added to the principal of £1,000).
We can see that in both cases, the amount owed to the bank is the same, and it is paid at the same time in the future. In that sense, the Islamic bank still ends up taking credit risk on the customer. This is exactly the outcome desired by the bank. It specialises in credit risk.
What the bank does not specialise in is the risk associated with the asset in question. In this case the asset is shares. Any risk that arises from the above structure, that relates to the shares, is a risk that the bank (and indeed the other two parties) desire protection from. These risks must be identified and mitigated.
At the end of part 2, I identified some of these risks. Now, we can take each risk in turn, and discuss how, in practice, Islamic banks deal with these risks. In addition, we will look at some of the commercial aspects of these three transactions.
1) Why would the customer pay £1,000 to purchase shares when all he wants is financing?
First of all, how do we know he wants financing, and he does not just want to invest in shares and keep them? Well, we know that these transactions only take place after the bank and customer have agreed a financing facility. They will agree the amount of the loan, the duration, and the (profit) rate to be paid. Once this is agreed, then the specific basket of shares is identified. So, the customer is not purchasing the shares for investment, he is purchasing the shares because:
- He has decided he wants financing
- He has decided to approach this specific bank for financing
- He has made an application for financing from this bank
- He has provided all required documents to support this loan application
- He has agreed the loan amount, and profit repayments, and the length of financing with the bank
- He has then been informed that he will purchase shares from the bank, and that the bank will act as his agent for this purchase
- He is then informed that he may keep the shares, or sell them, and that the sale price would be equal to the loan he has requested
Given all this, do we think that the customer will now decide he no longer wants the financing, and that he will instead choose to keep the shares for investment purposes? It is possible, but I would suggest it is not at all likely.
NOTE: the customer sells the shares for an amount less than what he is paying for the shares. He is making a loss on this sale transaction. And he agrees to do this upfront.
Going back to our question here, why would he agree to purchase these shares and pay £1,050 in the future? The only rational reason is that he knows, with certainty, that he can immediately sell the shares for a price of £1,000, and that he will receive the money immediately. It is this delivery of £1,000 that is, in effect, the disbursement of the loan from the bank. This is what he applied for.
2) Can the third party choose which shares comprise this basket, given that it is buying these shares in step 2?
The answer is – perhaps.
However, we will see that this is redundant. The third party will have arrangements to enter into step 3 immediately after step 2. Thus, it knows it will sell the shares - and for the same price that it has just paid for the shares. It makes no profit, but conversely it makes no loss on the trading of these shares. As such, the actual composition of the basket of shares is not relevant at all.
3) After the customer purchases the shares in step 1, what happens if the shares fall in value suddenly and they are now only worth £900. Will the third party still agree to pay £1,000 for them in step 2, which is now £100 more than their current market value?
The answer is – yes. Why will the third party agree to pay £1,000 for shares that may only be worth £900? The answer is as per above – it knows, with certainty, that it will immediately sell the shares to the bank for £1,000. As such, the actual market value of the shares is not relevant at all.
4) What if, after the third party purchases the shares in step 2, the bank refuses (or is unable) to execute step 3? Is the third party stuck with shares it might not really want to own on a long term basis?
Potentially – this is a risk that the third party will want protection from. This can be in the form of a written guarantee from the bank. In addition, if the third party is somehow affiliated to the bank, there might in fact be no need for this risk to be mitigated – the parties can simply agree that this risk will not crystallise.
5) What about the presence of any sales tax, or transaction costs, or brokerage fees for transaction on the relevant stock exchange? What if these costs are more than the profit made by the bank here? What if they are large enough to make the transaction no longer attractive for the bank?
This is a real risk – the only way to avoid is it to ensure these 3 sales transactions are not liable to any form of taxation. This is a specialised area, and is highly dependent on the asset involved, and the jurisdiction that these transactions take place in. To avoid exchange brokerage costs, the simple solution is to ensure these trades do not occur on the exchange. They are in effect private sale transactions.
6) - What does the third party get out of all this – it is buying and selling shares for the same price (and thus making zero trading profit), and in fact accepting some significant risks. What is the incentive for the third party here?
The third party will be paid a fee for its services in facilitating step 2 and step 3. Alternatively, if the third party is affiliated to the bank, then a fee may not well be payable. The general profit from this structure is retained by the bank, and can be shared (or otherwise recognised) by the third party via an agreed profit sharing agreement.
What does all this mean?
It means the following:
- The bank and the customer agree a financing deal
- The only desired outcome of the structure is that the bank wants to finance the client (ie lend some money and receive more money back in the future - this includes the required profit amounts)
- Assets are introduced to facilitate the relevant cash flows
- The assets bring a whole new raft of risk aspects into a structure
- Each risk is identified and mitigated
- Whoever buys the asset sells it again immediately for a price that has already been agreed between the parties
- A direct sell and buy-back (between the bank and the customer) is not permitted as this will be a Bay al Inah transaction – this is why we involve an extra party here.
One final question from me is – how is the profit amount (that is included in the final £1,050 payable by the customer to the bank in one year’s time) calculated? Is it calculated randomly? Does it depend on the liquidity and market price of the asset being sold (in this case, shares)?
Of course, the answer is obvious. The price is independent of any commercial transaction that is taking place. It is the price given to the risk that the bank takes in giving a loan to a customer. The markets (and individuals) have been doing this for a long, long time. The price for this activity is well understood. This price can not be avoided as long as one party is lending money to another for no other reason than to make profit from the lender.
This price is, of course, known as interest. Well, it is known as interest to anyone outside of Islamic banking. To Islamic banking, it is called profit on trading.
Is what we have learnt interesting? To me, it is fascinating. This process of identifying and injecting assets, creating new risks and mitigating those risks is one that interests me greatly. Of course, this method is exactly the same that is used for many kinds of financing in Islamic banking. It is not just used when a bank wishes to lend £1,000 – it is also used when a corporate wishes to raise £2 billion. We will look at this aspect in more detail later.
How do I know things work this way? Well, this is my job. I have been paid to deliver these solutions to clients, who have been mainly Islamic banks. And I have been employed by some of the most high-profile and demanding banks in the world – second-rate and incomplete and flimsy solutions are not good enough.
Are there not other methods that can be used apart from this specific structure for Murabaha share financing? Yes, there are several, and I would be happy to talk you through them, in detail, in due course.