Islamic financing in various forms and shapes is playing an increasingly important role within the overall money markets. In essence, Islamic financing is provision of financial services in accordance with Shari'ah law. Shari'ah law does not permit receipt and payment of interest, making any short sales or lending that will be deemed against the society's interest. The latter of course demands an evaluation, a judgement call to be made by a presiding authority. This is where the Shari'ah Board comes into action which is the authority making the determination that the financing transaction is in compliance both from the contractual terms and conditions aspect and the aspect of interest to the society (which is why for example financing for personal consumer needs are likely to be overruled by the Board). The parties must share the risk and rewards of a business transaction which is being funded and such transaction shall have a real economic purpose without undue speculation and exploitation. Thus, it is clear that any business transaction having predominantly speculative nature would not be eligible for any Islamic finance structure.
According to World Islamic Banking Competitiveness Report 2016 prepared by Ernst & Young, "Participation banking assets with commercial banks in Qatar, Indonesia, Saudi Arabia, Malaysia, UAE and Turkey (QISMUT) are set to cross US$801 billion in 2015 and will represent 80% of the international Participation banking assets".
Taking murabaha loan as an example we hereby attempt to provide a very brief and basic introduction to certain different aspects of this form of lending when compared to a traditional bank loan:
- Start by understanding the fundamentals of a murabaha financing. A buyer requests a bank to purchase designated goods from a third party supplier and sell the same to the buyer which forms the basis of a murabaha arrangement and the agreement to this effect sets forth the terms and conditions for this trade including of course financing provided by the bank for the purchase of such goods from the supplier. The cost of the goods to the buyer must be explicitly declared to the bank which will in return put a reasonable profit margin on top of such cost as and when sold back to the buyer. Since the subject matter of the financing will be a specific pool of goods murabaha financing is ideal for asset financing or in foreign trade.
- Goods, being the subject matter of murabaha financing must be real/existing at the time of the transaction. Murabaha does not tolerate a future promise buy or constructive ownership concept where the seller does not own the goods in question at the time of the transaction. Also the buyer and the third party supplier are expected to be unrelated parties.
- A diversion however from the rather traditional goods murabaha system as explained above is a commodity murabaha structure where the subject matter of the purchase is a commonly traded/priced and liquid commodity. In commodity murabaha the buyer arranges purchase of the commodity by the bank and immediate repurchase of the same on a deferred payment scheme with a view of immediately selling the same commodity on spot thus deriving cash out of the transaction. Evidently the focus in this instance is not asset financing but to obtain cash financing. Suffice it to say that commodity financing receives formidable criticism by scholars in some jurisdictions suggesting that this structure eliminates the true and actual sale aspect of the transaction.
- Use of proceeds by the buyer carries a heightened role. Murabaha may not be a form of financing for purchase of certain goods or for buyers engaged in usury, alcoholic beverages, speculative trades or similar subject matters that are inconsistent with Islamic principles. Also, the buyer is requested to arrange purchase of the goods from the third party supplier directly and not engage a middle man or arranger who receives a commission or alike payment.
- Refrain from referring to any "interest" component or to a "loan". In Islamic finance, financing income is replaced by a markup amount which is usually product of a mark-up percentage and shipment price for goods. As the mark up is and shall remain a fixed amount and may not be changed this aspect poses an issue as compared to a traditional term loan providing for a variable interest component such as libor plus (x) percent interest. This inevitably results in shorter maturities being set in murabaha financing as compared to a traditional term lending.
- "Facility" is an approved amount allocated by the bank to the buyer, exclusively for the purpose of procuring the specified goods on behalf of the bank so that the bank may sell the same to the buyer on a murabaha basis. Therefore, the party seeking financing (buyer himself) is acting as an agent for the purchase of goods by the bank which goods will thereafter be sold back to him with a profit margin. Usually the buyer is paid a very small representative agent fee for this service. Of course, the parties may decide an independent third party to act as an agent as well rather than the buyer himself. In any case the bank makes payment for the purchase directly to the third party supplier and never indirectly through the buyer.
- So far what happens is that buyer designates a specific kind of goods it desires to purchase, negotiates the purchase price thereof with the supplier, inspects the same, makes sure that the delivery will be made directly to it, advises the bank to purchase those goods in the form a true sale and then undertakes to purchase those goods from the bank with a markup. Buyer is in the driving seat and the bank remains passive with respect to the steps of the trade except providing financing and acquiring legal title. It is generally accepted that murabaha rules do not allow the bank to entirely contractually relieve itself from loss or damage to goods before delivery. After all the transaction's essence must remain to be that of a purchase and resale of goods. Mitigation is usually achieved by insurance and contractual clauses that minimize holding period of the goods by the bank. Bank may authorize direct delivery of the goods to the buyer but only after paying for the goods and acquiring legal ownership thus the liability associated with it.
- The buyer does not pay for the purchase price in lump sum in single payment but during the course of a time in several installments, similar to an amortization scheme.
- Immediately after the buyer completes purchase of the goods on behalf of the bank, it shall offer to re-purchase the goods by sending an offer notice to the bank on an immediate basis or effective as of a predesignated future date. If such offer is accepted by the bank on immediate basis by sending an acceptance notice to the buyer at which point the murabaha contract shall be concluded and ownership of the goods shall transfer to the buyer.
- Naturally there will not be a traditional "default interest payment" for late payments by the buyer. If there is a payment default the buyer will pay to the bank an amount calculated at a certain % per annum on the amount due. The bank pays such amount to a charity fund which will be used for charitable purposes approved by Shari'ah and does not in any case form part of the income of the bank.
- A security against payments by the buyer may be freely chosen. In fact, a murabaha financing provides a stronger security position for the financing provider as, in addition to any other security that may be agreed to be given, the asset so financed may remain in banks' ownership until the end of the financing period thus repurchase. Customary representation and warranties and covenants can be freely incorporated into the agreement.
- Events of defaults may be drafted in the customary fashion. However, one should be aware of the inherent difference between the consequences of an event of default in a traditional loan and murabaha financing. Remember the bank is exposed in case the buyer fails to honor its repurchase undertaking thus the bank will favor a structure where the goods can be returned to the third-party supplier/seller in case of a buyer default before repurchase. Also, the bank will remain responsible from any latent or hidden defects in goods against the buyer. Therefore, supplier warranties and indemnities are important terms that the bank must also take into account so that an effective recourse can be made.
- Murabaha agreements may freely be set as to be governed by English law provided of course the law of conflict rules of the country in which the agreement is executed so allows. Usually arbitration (in Dubai) is chosen as dispute resolution mechanism. Increasing tendency is for selection of DIFC-London Court of International Arbitration jurisdiction which is a special economic zone in Dubai where LCIA rules will be applicable.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.