UAE Laws and Islamic Finance

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Archive for Murabahah

Murabahah in Islamic Finance

 

Murabahah is basically a sale-and-purchase agreement(s) for the financing of an asset or project for a cost plus a profit margin (mark-up), which is usually benchmarked against a conventional index such as LIBOR.  Therefore, Murabahah is also known as ‘cost-plus financing and frequently appears as a form of trade finance based upon letters of credit.

Under this structure, banks can purchase goods from a third party at the request of a client and sell the goods to the client at cost plus a mark-up with the goal of making a profit.  ‘Where a trader acts on behalf of another party in buying goods, the Murabahah mark-up may be seen as a payment for the trader’s service in locating, transporting and delivering the goods.’ (http://www.islamic-finance.com/item_murabaha_f.htm)

According to Islamicfinance.com, ‘The gain made by the seller is not seen as a reward for the use of his money capital, since it is not permissible to rent out money in Islam, but is instead seen as a profit on the sale of goods. However, this kind of sale of goods for money should be distinguished from a transaction in which a bank or financier buys an item and simultaneously sells it on at a profit to a customer. This operation is known as ‘Murabahah to the purchase-orderer’.’

According to Norton Rose, the original cost price of the asset is disclosed by the seller to the purchaser at the time of contracting and according to islamicfinance.com, the amount of the profit margin in money terms should be specified as well.  In addition according to Norton Rose, although often referred to as a singular Murabahah contract, the cost-plus financing may be achieved through using two separate contracts.  Norton Rose states that the way in which the two contracts are executed must be done carefully so as to be in compliance with the Sharia’h.

‘Islamic banks can engage in Murabahah because in contrast to conventional banks, trading is allowed.    Murabahah is considered legal in Islam and is for the benefit of the contractors and the community as a whole.  The concept is based on the fact that certain people are not skilled in buying and selling and enter into sale transactions with reliance on merchants to act in good faith and conduct a fair deal based on their duties as Muslims.’  (The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan)

Advantages of Murabahah

  1. Banks trading the goods ensure that there is a ready buyer.
  2. The buyer provides the bank information on the supplier of the goods.
  3. Banks have the chance to make a profit from cost-plus financing.

(The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan.  (2003), islamicfinance.com, and Norton Rose)

A Murabahah Transaction Usually Involves the Following Steps

  1. The purchaser/client submits an order to the bank to purchase the goods.
  2. The bank agrees to finance the purchase of the goods.
  3. The bank sends an offer to the purchaser/client.
  4. The purchaser accepts the offer, which binds the purchaser contractually to purchase the goods.  (Purchase Undertaking)
  5. The bank pays the supplier and purchases the goods using spot payment.
  6. The purchaser, acting for herself, enters into a contract to buy the goods from the bank.
  7. The purchaser purchases the goods from the bank for immediate delivery with deferred payment.
  8. On the due date, the purchaser pays the purchase price plus the mark-up.

(The Principles of Islamic Finance)

 

 

Terms of Murabahah

‘The subject matter of the Murabahah contract must be in existence, under the ownership, and in the physical or constructive possession of the seller at the time of contracting.

Where it is practiced in the modern financial market, Murabahah usually obeys the following terms:

  1. The end user settles the amount outstanding in one lump sum upon delivery or thereafter.
  2. The Settlement Date must be specified.
  3. The financier maintains ownership of the purchased items until delivery.
  4. The financier bears all the costs and risks of ownership until delivery.
  5. The end user and financier must pre-agree and specify the mark-up to be applied.
  6. The mark-up applies to all relevant costs incurred by the financier.
  7. The goods subject to the transaction must be specified.
  8. The cost of the required items and other relevant costs must be specified prior to contracting.
  9. In the event of default by the end user, the financier only has recourse to the items financed and no further mark-up or penalty may be applied to the sum outstanding although the seller may alternatively require the buyer to make a pre-specified donation to an agreed charity.
  10. The item purchased by the financier cannot be under the ownership of the financier, but must instead belong to a third party at the time of contracting.
  11. The seller may require the buyer to furnish security for the payment due, but only at the time when delivery of the purchased items to the buyer is made.’ (islamicfinance.com)

Risk Mitigation in Murabahah

1.  The purchase from the supplier and sale to the buyer may be done at the same time in order to minimize risk of liability for damage to the goods or the goods not matching specifications or meeting delivery dates, etc.( This may be seen as a ‘Murabahah to the purchase-orderer’ ) (The payment of the marked-up price is usually done at a later date, which in addition to risk, involves the provision of credit).

Side Note: ‘Scholars accept a transaction in which the aggregate value of the deferred installments equals the spot price (since even if such a transaction is viewed as a combination of a sale of goods with a loan advanced by the seller to the buyer, the loan in this case would be interest-free)’. (islamicfinance.com)

2.  The Bank can negotiate with the buyer to waive her rights to any claims against the bank for breach of warranty.  (indemnification)

 

The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan.  (2003),

 

 

Sharia’h Parameter Reference 1: Murabahah Contract Frequently Asked Questions (Bank Negara Malaysia)

http://www.bnm.gov.my/guidelines/05_shariah/01_murabahah_02_faq.pdf

Murabahah Contract by Malaysia International Islamic Finance Corporation/ Bank Negara Malaysia

http://www.mifc.com/index.php?ch=menu_know_principals_murabahah&pg=menu_know_principals_mur_final

Murabahah in Islamic Finance

 

 

 

Personal Financing: A bank may give the borrower cash for personal consumption or to buy an asset.  In this case, a bank credits the customer’s bank account with the cash. 

Asset Financing: A bank may facilitate a customer to purchase an asset by offering alternative payment plans such as installments or deferred lump sum payment.  The Islamic Bank actually delivers the asset to the customer. 

While asset financing enables the customer to own a particular asset, personal financing enables the customer to obtain cash for his consumption including the purchase of an asset.  (AMANIE)

Murabahah

‘Murabahah or murabaha (Arabic مرابحة, more accurately transliterated as murābahah) is a particular kind of sale, compliant with shariah, where the seller expressly mentions the cost he has incurred on the commodities for sale and sells it to another person by adding some profit or mark-up thereon which is known to the buyer. As the requirement includes an “honest declaration of cost,” murabahah is one of three types of bayu-al-amanah (fiduciary sale). The other two types of bayu-al-amanah are tawliyah (sale at cost) and wadiah (sale at specified loss).

It is one of the most popular modes used by banks in Islamic countries to promote riba-free transactions. Different banks use this instrument in varying ratios. Typically, banks use murabahah in asset financing, property, microfinance and commodity import-export.[1]

The seller may not use murabahah if mudarabah or musharakah are practicable. Since those profit-sharing modes of financing involve risks, they cannot guarantee banks any income. Murabahah, with its fixed margin, offers the seller (i.e. the bank) a more predictable income stream. A profit-sharing instrument, conversely, is preferable as it shares the risks more equitably between seller and buyer.

There are, however, practical guidelines in place which aim to ensure that the murabahah transaction between the bank and the customer is one based on trade and not merely a financing transaction. For instance, the bank must take constructive or actual possession of the good before selling it to the customer. Whilst it can be justified to charge an additional margin to the customer to reflect the time value of money in terms of actual payment not being received from the customer at time zero, the bank can only impose penalties for late payment by agreeing to purify them by donating them to charity.’ 

http://en.wikipedia.org/wiki/Murabaha

Commodity Murabahah

‘Under a Commodity Murabaha financing or Tawarooq, a Bank purchases and takes title to the relevant assets (usually precious metals such as Palladium) from a third party broker. The Bank then sells the assets to the Borrower at cost plus a specified profit. Payment of the sale price is usually deferred and may be structured in accordance with the wishes of the parties. The Borrower will enter into a contract to sell the assets to the Broker for the cost price. The net result is to create a deferred payment obligation from the Borrower to the Bank. Bank and Customer will usually enter into a succession of such transactions to create monthly, quarterly or semi-annual payment obligations.

The Commodity Murabaha has been criticised by Islamic Scholars who say it should only be used as a structure of last resort where no other structure is available. In most transactions the commodities never change hands and usually there are no commodities at all, merely cashflows between banks, brokers and borrowers. Often the commodity is completely irrelevant to the Borrower’s business and there is not even enough of the relevant commodities in existence in the world to account for all the transactions taking place.[2]

http://en.wikipedia.org/wiki/Murabaha

I.E., Under this structure, the surplus bank may initially purchase an asset from LME at USD 10 Million (or equivalent to the amount that the deficit bank is in need of).  Next, the surplus bank will sell the asset to the deficit bank at USD 10.5 million which is payable in one week (equivalent to the period of investment).  Upon the acquisition of the asset by the deficit bank, the deficit bank may sell the asset to the market/LME for USD 10 million cash.  This USD 10 million is essentially intended for money market purposes.  (AMANIE)

Murabahah v Lending on Interest  http://hazariba.com/Murabaha_Financing_VS_Lending_on_Interest.pdf

 

Murabahah Presentation

http://www.alhudacibe.com/images/Presentations%20on%20Islamic%20Banking%20and%20Finance/Bai%20(Murabahah,Salam%20&%20Istisna%20)/Murabaha%20-%20Process,%20Documentation%20&%20Practical%20Issues%20by%20Ahme.pdf

Murabahah as A Mode of Finance

http://www.albaraka.co.za/Islamic_Banking/Features_of_Marabaha_and_Leasing/Murabaha_as_a_Mode_of_Finance.aspx

 

Murabahah Explained

http://www.financialislam.com/murabahah.html

Sharia’h Parameters Murabahah http://www.bnm.gov.my/documents/conceptpaper/MurabahahCP.pdf

Fatwa on Murabahah

http://www.albaraka.com/media/pdf/Research-Studies/RSMR-200706201-EN.pdf

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