Murabahah

Murabahah is the most widely used mode of finance in almost all Islamic Banks. In some Islamic Banks, Murabaha constitutes more than 90% of total assets of the bank. It does have clear advantage which make it very comparable to lending in conventional banking. It is because of this Murabahah is now becoming a mode of finance practiced even by convention banks. Contrary to what many people think, Murabahah is not new. It is one form of sale contract, which is known in Islamic Shari’ah for hundreds of years, albeit, not exactly the same from banks practice now.

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 banks 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. Only actual loss is considered and no cost of funds are accounted for. A murabahah is a deferred payment sale.

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. Once, 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.

Source: An Introduction To Islamic Banking, Shaykh Dr Mohamed Ali Elgari. Republished with permission.