Principles of Islamic banking and finance/PIBF202/Islamic banking products/Debt based IB products

While PLS financing methods are the preferred modes, due to a number of factors, the Islamic banking industry has shown disproportionate inclination toward those products that are less risky and replicate the debt-based products of conventional banks. In this session, we cover three most popular debt-based products.

Murabaha

Murabaha in Classical fiqh (Islamic jurisprudence) is essentially a sale transaction with mark-up over the cost disclosed to the customer. It is important to note that as interest is considered prohibited, Islamic financial products must be structured based on modes that are either already considered permissible in Islam (such as ijarah, salam, etc. discussed in Unit 1) or they must be structured as sale (bay’) – in all cases free of the interest mechanism.

In the classical sense, there is nothing inherently Islamic about murabaha, because if it is merely cost-plus or mark-up transaction, other things remaining the same, murabaha or cost-plus/mark-up transaction is simply an ordinary retail transaction practiced in business context everywhere in the world. Of course, there are certain aspects of transactions that must be fulfilled so that the transaction can be considered shariah-compliant. Since murabaha is essentially a sale or trade transaction, let us first refresh ourselves with the conditions of a valid sale – conditions that must be met in all sales transactions.

Conditions of a valid sale

1. The transaction must be based on free and mutual consent of the parties involved.
2. Parties to the sales transactions must be duly qualified and authorized as per the general fiqhi rules.
3. The contract must be free of gharar and therefore essential terms pertaining to price, date, place and mode of delivery, date and mode of payment, etc. must be clearly specified.
4. For a valid sale to occur, the ownership must be transferred to the buyer immediately, since this has implications because whoever is the owner carries risk for relevant liabilities.
5. The object of the sale must exist at the time of the sale. A valid sales contract cannot be based on a product non-existent at the time of the sale.
6. The object of the sale must be clearly specified/defined and seller must be the owner of the object.
7. As an owner the seller at the time of ownership must be in physical or constructive possession of the object. This is based on the general Islamic rule that a seller cannot sell anything that is not in his possession. In Classical fiqh, the emphasis is on physical ownership. Given the nature of complexities of modern transactions, the scholars also have extended the permissibility to constructive or legal possession. A person is said to have constructive possession when he has the power and intention to have and control property but without having direct or physical control of it. This has legal implication in the sense that even though the owner might not be in physical possession, as the ownership has been legally transferred to the buyer, the buyer would carry the risks associated with the object.
8. Sale must be instant and final in the sense that for a sale to occur now, it cannot indicate a future date for the sale to occur. This condition also covers any contingency aspects, such that a valid sale cannot be contingent upon a future event.
9. Islamic commercial law stipulates that the object of sale must be lawful (i.e., it cannot be otherwise prohibited – haram – to begin with) and it must also be something of a value. Anything that does not have any value cannot be an object of sale. For some scholars, this condition is somewhat inconsequential, because value is not always subjective. If two rational and sane parties enter into a transaction involving and object that otherwise might be considered worthless, the very transaction based on mutual consent establishes or indicates that at least to those two parties the object is of some value.
10. The object must be specifically known and identified/specified to the buyer. This is also to avoid gharar.
11. The delivery of the object of the sale should be determinate or certain and not contingent upon some future or unspecified event. Uncertainty here may involve gharar as well as maisir (chance).
12. While negotiations can involve multiple prices of a product, for a valid sale one certain price must be stipulated.
13. Sales must be unconditional. Certain exceptions are allowed by fiqh when such exceptions are customary (urf) and without violating any prohibition.

In a classical sense, in case of a murabaha transaction, for example, Party A (buyer) would go to Party B (seller) to buy an item X. B informs A about the terms and conditions, including the mark-up, and both parties agree to the transaction, the exchange takes place and the transaction is completed with the seller receiving the price and the buyer ending up as the owner of X. Contemporary murabaha as practiced by Islamic banks, however, constitutes an important and fundamental refinement that more often than not the transaction involves a financing component. Thus, in a classical context, A approaches B, where B is purely a seller of the product. In the Islamic banking context, when A approaches B, the latter is a bank, not necessarily a merchant. Thus, in this context the customer A approaches a bank, Party B, to purchase something, where it is understood that the customer is seeking finance. Otherwise, the customer, of course, could go directly to the merchant selling the product. As part of the transaction, Bank, if not already in possession of the product, purchases and become the legal owner and then sells to the customer, the result being the customer becoming the owner of the sold item and owing debt to the bank equal to the agreed price (mark-up included).

The similarity between murabaha transaction like above and interest-based financing of the same product often the overall cost of the transaction is comparable in the sense that the difference between the amount financed and the financing cost and the difference between the cash and deferred payment in murabaha are quite comparable. The difference between the two types is that in case of interest-based transaction, the bank is not a seller (rather a lender) and actual cost of the transaction can vary based on the repayment, late payments, missed payments, etc. In case of murabaha, it is a sale transaction between a buyer and a seller, the mark-up is generally disclosed and the agreed-upon price does not change during the term of the contract. This is of course assuming ideal scenario, where there is no delinquency (late payments, etc.).

Risk issues associated with murabaha

One of the risks the sellers (or bank) is exposed is whether the buyer will follow up on his intent to buy and complete the transaction. Otherwise, of course, the seller may acquire the product, be constructive owner and then get stuck with the product. In Classical murabaha, this was a risk the seller bears. In modern Islamic finance, this issue has been addressed by adding a sub-contract of waa’d or promise, whereby the buyer makes a promise to buy the product by following through the contract. In classical fiqh, promise is generally treated as a moral obligation, not a legal obligation. While the same classical view is held, the contemporary Shariah scholars are converging toward the position that such promise on the part of the buyers is legally binding and enforceable and thus eliminating that part of the risk of murabaha transactions for the sellers.

Secondly, according to the classical fiqh, which in this case is also generally upheld to date, late penalty, as is customary in conventional banking/finance is riba and thus prohibited. This introduces serious moral hazard to the process and buyer behavior can suffer a serious discipline problem. Shariah scholars have not found a perfect and defensible solution yet. The current preference is based on fund purification, where the customers are charged late penalty, but the penalty is not for the benefit of the bank or the creditor. Rather, it goes for charitable purpose. Thirdly, if the market is not efficient in facilitating a transaction, the seller runs another risk. If the gap between the seller becoming the owner the product and buyer buying it is long or gets prolonged, the seller can be exposed to price fluctuation risk. Islamic fiqh does not provide any specific ruling or guideline about the length of period; it only provides the guideline about ownership and its transfer. Thus, markets become more efficient, such risks are minimized.

Lastly, most murabaha transactions in substance is similar to conventional finance, and are vulnerable to interest-rate risk – risk that interest rate will fluctuate and adversely affect the value of the asset. Given that risk, conventional banks also try to limit their financing as shorter term as possible. Even in case of long-term financing, such as mortgage, it is well known that banks do not hold these mortgages for long; rather, they shift their risk by selling these mortgages at discount in the secondary market. For the very same rationale, as Islamic finance industry is fundamentally benchmarked to market interest rate, murabaha is inherently biased toward short-term financing, which is generally suitable only for trade or retail purpose, but not for development or other real sector activities routinely requiring long-term financing.

Bai bi-thaman-ajil (BBA) or Bai-Muajjal (credit sales)

Murabaha, as explained above, can be cash transaction, just like any mark-up/cost-plus transactions take place in the business world. However, neither people have any need to go to banks for straightforward cash transaction, nor banks would have any reason to get involved into such transaction. Islamic banks assume the role of a seller, because customers go to them for financing. Whenever a murabaha transaction involves financing or deferment of payment, it becomes bai bi-thaman-ajil or bai-muajjal (credit sales), usually taking the form of installment payments.

Except that the payment terms and penalties, if any, must be clearly specified in the contract, all the conditions of a valid sale in general and the conditions related to murabaha must be met in case of credit sales. It is also important while cash or credit price of a transaction can be considered during the negotiation, a valid sale and contract must specify one particular price: cash or credit, not keeping both as a choice. At the time of concluding the contract and completing the sale, the choice must narrow down to either cash or credit.

All the risks pertaining to murabaha also apply to bai al-muajjal.