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Introduction of Islamic Banking
The fundamental sources of Islam - the Quran and the Sunnah of the Prophet (PBUH) provide guidelines for economic behaviour and how the economic system of a society should be organized.
"Early Islamic theory and practice formed a complete economic system for a new order in society, in which all participants would be treated more fairly an economy of poverty prevailed in Islam until 13th and 14th century. Under this system flow of money and goods was purified by being channelled from those who had much of it to those who had little by encouraging zakat and discouraging Riba on loans". Michael Bonner.
Muslims based their economic analyses on the Quran (such as opposition to Riba, meaning usury or interest), and from sunnah, the sayings and doings of prophet Muhammad (PBUH)
As it says in Quran:
"Those who devour usury will not stand except as stands one whom the evil one by his touch hath driven to madness. That is because they say: 'Trade is like usury.' But Allah hath permitted trade and forbidden usury. Those who after receiving direction from their Lord, desist, shall be pardoned for the past; their case is for Allah (to judge). But those who repeat (the offence) are companions of the fire, they will abide therein (forever)" (2:275)
Section # 1
Murabahah is actually from the word rabbi which literally means profit. Murabahah is defined as selling a commodity for its purchase price plus a specified mark-up or profit agreed upon. The mark-up may be a lump sum or a certain percentage of the purchase price. Thus, murabahah is the resale of a thing at some profit added on the original cost. In simple it is known as Cost plus sale.
Murabahah is a trust based transaction. If the seller in a Murabahah transaction is guilty of any deception, the purchaser has the option to reject the thing or to take the full price stipulated or some compensation. If the subject perishes before the purchaser returns it, or anything happens to it which would prevent cancellation of the sale on discovery of the deception, the purchaser is liable for the full price mentioned, and is without any option.
This literally means sale of goods at a mutually agreed price. Technically, it is a contract of sale in which the seller declares his cost and profit. As a financing technique, it involves a request by the client to the bank to purchase certain goods for him/ her. The bank does that for a definite price which is usually over the cost and set in advance. The price usually includes a profit margin agreed by both parties. The purchase and selling price, other costs, and the profit margin must be clearly stated at the time of the sale agreement. Murabaha finance is not a loan given on interest, it is a sale of asset(s) for cash/deferred price. It is fixed Â¬price sale which is normally done for short Â¬term and can only be used for the purchase of fresh assets only. The bank cannot charge additional money on late payments. However, in most cases asset retains in the ownership of the bank until the loan is paid fully. This sort of financing is most controversial but also the most common around 60 to 70 percent of all Islamic financing is based on Murabaha and mostly in Malaysia due to the more liberal nature of the Ulema there, where as in subcontinent and in Arab countries it is seen with some serious questions.
For instance a person needs to buy a machine for his/ her factory. The client will go to the Islamic bank and the bank will buy the machine on its behalf and then sell it to the person at an increased price but on instalments deferred for a certain period of time.
Condition of Price and the Profit
The price and profit should be known. The profit can be a lump sum or based on percentage. For example, the thing can be sold at a relative profit, as eleven for ten or 10% profit. It signifies a profit of one in ten, two in twenty, and three in thirty. Expense incurred on transportation, storage, etc or any other expenses the addition of which is accepted may lawfully be added to the original cost.
When a person purchases a thing on credit, he cannot lawfully sell it by Murabahah without informing the buyer of the fact. It is because when a property is bought on credit its price is necessarily higher than the cash price
Conditions for Murabahah
The most important conditions of the murabahah sale are as follows:
- The buyer has to know the original price of the commodity including all the expenses. Bank can not hide the cost from the customer.
- The profit to seller must be declared to the buyer whether it is a certain fixed amount of money or a percentage of the original price.
- The first contract must be legitimate from the point of view of shariah; otherwise, the murabahah contract will be cancelled.
- If the commodity was inflicted by any defects, the seller has to inform the buyer about it, because murabahah sale is a trust sale and the seller should not betray his buyer. If, however, the buyer discovers that the seller has betrayed him he either for a compensation or a cancellation of the sale.
- Murabahah is not allowed with regard to the ribawi properties. Any exchange of ribawi properties should be like for like and on the spot. As such the sale of, for instance, 10 kg of rice for 15 kg is not allowed. Any increase or delay in exchange of ribawi commodities amount to usury.
Murabahah in Islamic Banking:
Murabahah sale can be ordinary Murabahah when the seller buys a commodity without depending of a prior promise of purchase and offers the commodities for a Murabahah sale for its price and a profit to be agreed upon. Murabahah sale can also be connected with a promise where three parties could be involved. These could be the seller, the buyer, and the bank. The bank does not purchase the property unless the buyer specifies the commodity and promises to buy it. The bank undertakes to purchase the commodity as requested by the customer and resell it to him for the cost price plus a margin of profit previously agreed upon during the promise stage. The payment would be settled by the customer within an agreed time frame either in lump sum or installments.
The bank would have to sign two separate contracts, one with the supplier and the other with the customer. It is necessary that the commodity should be in the possession of the bank before the sale contract with the other party is concluded. Any risk prior to the delivery should be borne by the bank until the ownership is transferred to the customer.
The practical steps of the Murabahah sale are:
- The purchaser identifies the commodity and requests the seller to send a quotation.
- The bank studies the request, and negotiates the selling price, mode of payment, duration of instalments, and other conditions and securities. The purchaser promises to buy the commodity from the bank on the basis of Murabahah.
- If the banks aggress it will notify the purchaser and buys the commodity. The seller approves the sale and sends the invoice.
- The bank and the purchaser sign the Murabahah sale contract in accordance with the promise already agreed upon.
Additional Conditions for Practicing Murabaha :
In addition to the conditions mentioned earlier the following conditions should be observed when Islamic banks practice Murabahah.
- The bank should acquire ownership and possession of the goods prior to its sale to the customer.
- The bank must carry the risk of loss before delivery, or the consequences of rejection of the goods by the buyer because of concealed defects.
- Promise from any of the two parties of the contract is morally binding on both the parties. However, if the bank while relying on the promise takes the necessary steps to acquire the property the promise becomes legally binding. The promise is needed as the customer may refuse to purchase the property. On the other hand, the bank cannot enter into a valid contract as it does not have the property.
- The mutual promise may be valid subject to the condition that each of the two parties must have the option.
"Murabaha Sukuk is certificates of equal value issued for the purpose of financing the purchase of goods through Murabaha so that the certificate holders become the owners of the Murabaha commodity. The issuer of the certificates is the seller of the Murabaha commodity, the subscribers are the buyers of that commodity and the realized funds are the purchasing cost of the commodity. The Sukuk holders own the Murabaha commodity and are entitled to its sale price".
Murabaha is a transaction, which cannot be securitized for creating a negotiable instrument to be sold and purchased in the secondary market because in the last stage of Murabaha transaction, the relationship between the bank and client is that of the creditor and debtor. Therefore, "Murabaha Sukuk certificate only represents a monetary debt receivable from the client in the form of Murabaha price which is non-negotiable as per the rules of Shari'a. If otherwise then the transfer of the Sukuk to a third party will mean transfer of debt which can only be exchanged at par value. This restricts the possibility of creating a secondary market for Murabaha Sukuk. However, trading of Murabaha certificates is permissible after purchasing the Murabaha commodity and before selling it to the buyer".
Murabaha in Foreign Trade:
Murabahah can also be used to finance foreign trade. The risk of the transaction is born by the bank until the possession is transferred to the customer. The transaction should not be one of remitting the account from the supplier on behalf of the purchaser as it will amount to interest. The bank should actually buy the goods and continue to be responsible until they are delivered to the customer. The bank should act as a trader and not a financier. Profit in this context is justified since it is derived from the buying and selling transaction as opposed to interests accruing from the principal lent out.
Section # 2
Is Murabaha Islamic?
One may argue that Murabaha is similar to a loan from a conventional bank. But the fact is that it differs from loan in many ways. Mufti Taqi Usmani responds to criticism on Murabaha in following ways:
Firstly, Murabaha transaction is always assetÂ¬ backed, which means that the Islamic bank first buys the asset that is going to be sold to the customer who has placed a request, before it actually makes its transaction, whereas in conventional banks, asset Â¬backing is not prerequisite for interest bearing loans.
Secondly, Murabaha is a fixed price contract; price can only be increased in case of default, whereas in conventional banks, interest is charged on daily basis from the customer.
Thirdly, Murabaha is purely a sale and purchase transaction in which the bank receives a request from client to buy certain goods on client's behalf. The bank thus has to take purchase the asset and gets the ownership of the asset and hence, assumes the risk of keeping the asset with itself until the client purchases it from bank. The profit charged by bank is to compensate for this profit. While a loan from a conventional bank is lending of money and charging of interest. Fourthly, in such transactions, relationship between Islamic bank and a customer is of seller and buyer, whereas in conventional banks, it is of creditor and debtor.
Fifthly, an Islamic bank cannot remain indifferent as what asset is purchased, whereas conventional banks are indifferent as to what is being purchased.
But still it brings negatives of Islamic finance that Murabaha is used as a trick to do what conventional finance is doing, i.e. lending on the basis of interest. It is only the practitioner who can ensure that Murabaha does not degenerate to that level. And they also need to elaborate the differences between murababa and a bank loan. They need to market those differences as well. Since financial intermediation does not involve selling goods and services directly, it would be more appropriate to get financial intermediaries involved in Murabaha business indirectly.
Now imagine a whole range of businesses doing Murabaha. These businesses would know the risks they are taking. They would also be able to diversify their activities as a means of reducing risk. Perhaps they are already specializing in handling different market segments in terms of the commodities involved. These businesses would need financing. This financing could come from Islamic financial institutions. This way there would be a buffer between the changing circumstances of real businesses and those handling only finance. It will thus relieve the Islamic financial institutions from the need to reduce risk by making their contracts look like payment of less money now in exchange of more money to be received in future. In my opinion the most appropriate form will be Mudaraba or profit sharing.
Section # 3
Comparison of Murabahah & Interest-based Loans:
- Murabahah is based on sale contract while a conventional bank advances loan and charges interest. The relationship between Islamic bank and the customer is one of seller and purchaser while in conventional banking it is one of creditor and borrower.
- In Murabahah the price of the sold asset is fixed while the amount paid by the borrower to the conventional bank may depend on the rate of interest which fluctuates.
- In conventional banking in case of default payment, the borrower will be charged interest on interest as the arrears would be capitalised. However, in Islamic banking the bank may sue the purchaser for default but cannot increase the price.
- In conventional banking if the borrower is unable to pay the instalments the property will be possessed by the bank. In Islamic banking if the customer is unable to pay the price, the bank will take a legal action, possess the property and sell it to another purchaser. The Islamic bank is entitled to receive the outstanding amount and should return the balance to the customer.
- In conventional banking if the borrower wants to pay before the due date of instalments, he may get a rebate. On the other hand, a purchaser who wants to pay all the outstanding balance in lump sum may get ibra from the Islamic bank.
- The purchaser from an Islamic bank should be entitled to the various options that enable him to cancel the contract. This issue does not arise in a conventional banking as the contract between the parties is a loan contract.
Reasons behind Murabahah's Popularity:
Murabaha (cost plus) financing and Mudaraba, Islamic financial institutions consider Murabaha to be superior to debt financing on a number of grounds. They also consider induction of murabaha in Islamic financial instruments makes that box really capable of handling all financial situations. Islamic bank claim that it serves to keep the financial market in relation with the market for real goods and services, thus making it less vulnerable to gambling like speculation.
- Murabahah is necessitated by the fact that people want to buy properties such as house or vehicle. Profit/loss sharing contracts are not suitable for sale and purchase agreements.
- It is a sale contract where the ownership with all its obligations, for instance, insurance, maintenance, and taxes, is transferred to the purchaser.
- It generates an unconditional debt in a fixed amount, unlike a partner's right to share in future profit.
- As a debt obligation, it can be secured.
- Compare to partnership, reduces the need to monitor the customer's business or trust his honesty.