•AAMIR MUMTAZ•ABDUL SALAM•ADNAN ABID•AHMAD ALI

• Islam prohibits charging fixed interest on money, but permits charging fixed profit on sale of goods. This clears a common misconception that charging fixed profit is haram.

• Islamic banks therefore use a sale-based transaction (Murabaha) instead of a term loan for financing purchase of assets by their clients, especially for working capital requirements

“MURABAHA is a particular kind of sale in which seller honestly discloses the cost incurred on the sale of commodities to be sold and sell to the buyer at disclosed cost plus mutually agreed profit margin ratio”.

A simple sale in Arabic is called Musawamah - a sale without disclosing or referring to the cost of goods sold

However when the cost price is disclosed to the client, it is called Murabaha.

The distinguishing feature of Murabaha from ordinary sale is

- The seller discloses the cost to the buyer

- And a known profit is added

A simple Murabaha is one where there is cash payment and Murabaha Muajjal is one on deferred payment basis.

In case of riba, lender of the money gets a specific interest on the amount lended, after a specific time period, whereas the principle retains in the ownership of the lender.

While in murabaha, there is no loan, instead one person sells a commodity to other and the possession as well as the risk transfers to the buyer, and the seller get his reward in the shape of profit.

Financing of purchasing commodities and goods from the local markets

Financing import and export transactions Financing fix assets (machines and equipments) Financing of working capital (purchasing

feedstock used for production) Financing construction and installations material

purchases Financing purchasing of real estate (land and

building)

Murabaha is not a loan given on interest. It is a sale of a commodity for a deferred price which includes an agreed profit added to the cost.

Being a sale and not a loan, Murabaha should fulfill all the conditions necessary for valid sale.

The financier must have a good title to the commodity before he sells it to his client.

The commodity must come into possession of the financier, whether physically constructively, in the sense that the commodity must be in the risk of the financier even though the risk may be for a short period.

The best way for Murabaha according to Shariah is that financier himself purchases the commodity and keeps it in his own possession or purchases the commodity through a third person appointed by him as his agent before he sells it to the customer. However, it is also allowed that the financier may make the client himself his agent to buy the commodity on his behalf.

Firstly, The client and the institution sign an over-all

agreement whereby the institution promises to sell and the client promises to buy the commodity on an agreed ratio of profit added to the cost.

Agreement to Murabaha

Bank Client

Secondly, The institution appoints the client as his agent for

purchasing the commodity on his behalf and an agreement of agency is signed by both the parties

Bank ClientAgreement to

MurabahaAgency

Agreement

Thirdly, The client purchases the commodity on behalf of

the institution and takes its possession as an agent of the institution.

Agency

Agreement

Agreement to Murabaha

Bank Client

Fourthly, The client informs the institution that he has

purchased the commodity on its behalf and at the same time makes an offer to purchase the commodity from the institution.

 

Bank vendor

Client purchases goods and takes possession

Transfer of Risk client

Offer to purchase

Bank

The client makes an offer to purchase the commodity from the institution

Client

Fifthly, The institution accepts the offer and the sale is

concluded whereupon the ownership as well as the risk of the commodity is transferred to the client.

Bank Client

Murabaha Agreement +

Transfer of Title

• Meezan Bank has been using Murabaha to finance purchase of raw material

by its clients.

• They have successfully entered into Murabaha transactions with a number of

clients. Some of them are:

Client Transaction volume (Rs in millions)

ICI 270

PSO 200

PARCO 100

NEWAGE CABLES 75

SITARA CHEMICALS 50

The most essential element of the transaction is that the commodity must remain in the risk of the institution during the period between the third and the fourth stage..

It is also a necessary condition for the validity of Murabaha that they purchased from a third party. The purchase of the commodity from the client himself on a buy agreement is not allowed in the Shariah.

The abovementioned procedure of the Murabaha financing is a complex transaction which the parties involved have different capacities different stages .

All these capacities must be kept in mind and must come into operation with consequential effects each at its relevant stage and these different capacities should never be mixed up confused with each other.

In the event of default by the buyer (client) in respect of the payment of the purchase price on the due date, the purchase cannot be increased. However, if he has undertaken in the agreement to pay an amount for a charitable purpose, as mentioned in clause 7 of the rules of Bai'Mu'ajjal, he shall be liable to pay the amount undertaken to be paid by him.

The most common mistake is to assume that Murabaha can be used for all types of transactions and financing. This mode can only be used when a commodity is to be purchased by the customer. If funds are required for some other purpose Murabaha cannot be used.

The document is signed for obtaining funds for a specific commodity and therefore it is important to study the subject matter of the Murabaha.

In some cases, the sale of commodity to the client is affected before the commodity is acquired from the supplier. This occurs when the various stages of the Murabaha are skipped and the documents are signed all together. It is to be remembered that Murabaha is a package of different contracts and they come into play one after another at their respective stages.

It is observed in some financial institutions that Murabaha is applied on already purchased commodities, which is not allowed in Shariah.

Default Case

In the case of default by the buyer in the payment of price at the due date, the price cannot be increased. However if he has undertaken, in the agreement to pay certain amount for a charitable purpose, he shall be liable to pay the amount undertaken by him.

Rebates in Early Payment

If the customer makes the payment before the due date and there is no commitment that he would gain any discount in the price of Murabaha. Then it is permissible for bank to give any rebate to the client.

Rises in Prices and Change in Assets

The institution reserves the right to reject the purchases if made other then agreed price. Change of Asset(s) in the agency agreement can be done with mutual consent. If Agency Agreement is for specific Asset(s) then new agreement is required for changed Asset(s).

Murabaha with Related Parties In case of Murabaha, the Vendor and the Customer

must be independent to each other. Banks are not allowed to enter into a Murabaha Transaction where Vendor and Customer are associated parties. Parties are considered to be related parties if one party has 33% or more shares/ownership in the business of other party.

Delays in the Supply from Supplier Delay in Supply from the supplier in case where

specific time was allowed leads to the revocation of agency agreement. In such cases the customer will refund the cost of goods.

Rollover in MurabahaRollover in Murabaha is not possible since each Murabaha transaction is for a particular asset. A new Murabaha can only be executed for the purchase of a new asset.

Purchase EvidenceThe customer is required to submit purchase evidence and declaration. The purchase evidence must confirm that customer as an agent has purchase the goods after agency agreement

RISK FACTORRISK FACTOR RISK RISK CATEGORYCATEGORY

SOLUTIONSOLUTION

1. AGENCY RISK CREDIT RISK Pre-inspection and direct payment to the vendor.

2. OWNERSHIPTRANSFER/ASSET RISK

CREDIT RISK Takaful of goods during transit and induce customer to submit declaration immediately after the purchase of goods.

3. PAYMENT/ DEFAULT RISK

CREDIT RISK Obtain Shariah compliant collateral and adapt staggered payments.

4. PRICE RISK MARKET RISK Time lag between purchase and offer acceptance should be minimum.

RISK FACTORRISK FACTOR RISK RISK CATEGORYCATEGORY

SOLUTIONSOLUTION

5. LIQUIDITY RISK LIQUIDITY RISK Make separate pools for different maturities considering their different maturity dates.

6. PROFITABILITY RISK

OPERATIONAL RISK A charity may be imposed to discourage a delay to make Murabaha repayments

7. LEGAL RISK OPERATIONAL RISK Proper documentation and timely checking is required.

8. SHARIAH NON COMPLIANCE RISK

OPERATIONAL RISK Ensure that relevant staff has appropriate training and has proper knowledge of Shariah principles. Checklist of the sequence may be followed.

There may be three different cases for payment of Murabaha pricing.

1. Bullet Payment

Murabaha Price = Principal+ Principal x Profit Rate x No. of days

= 1,000+ (1,000*.10*1) = 1,100

2. Payment in Equal Installments

The payment is calculated by using IRR (Internal Rate of Return) formula

Installment = [(principal x rate)/ (1-(1/ (1+rate) ^n)]

= [(1,000*.10)/ (1-(1/1.10) ^12)

Murabaha Price = Installment x n

3. Unequal installments In such a way, profit part of the selling price is paid over the total tenor of the transaction, whereas the principle amount is paid at maturity. Price is calculated as following:

Murabaha Price = Principal amount+ Principal x Profit rate x No. of days

Interim Installment = Principal x Profit rate x No. of days (days per period)

 

PRE ADOPTIONPRE ADOPTION POST ADOPTIONPOST ADOPTION

Murabaha Financings were recorded at the time of disbursement of funds.

Funds disbursed for purchase of goods are recorded as ‘Advance for Murabaha’. On culmination of Murabaha i.e. sale of goods to customers, Murabaha Financings are recorded at the deferred sale price net of profit payment

Goods purchased but remaining unsold at the balance sheet date were recorded as ‘Advance against future Murabaha’.

Goods Purchased but remaining unsold at the balances sheet date are recorded as Inventories

ExampleExample Amount in Rs. / %Amount in Rs. / %

Purchase price/Cost/Principal 1000

Profit Rate 10%

Tenure 1 year

Total profit on transaction 100

Sale price (Contract price) 1,100

Date of Disbursement to supplier/customer

Jan 1, 2010

Date of Culmination of Murabaha Transaction

Jan 15, 2010

Date of Maturity of Murabaha Dec 31, 2010

A-When there is bullet payment of profit and Cost (Principal) at the end of the period:

1) At the time of payment to the client for the purchase of goods on behalf of bank or directly to the supplier by the bank the transaction will be accounted for as follows:

2010, January 01

Dr Advance against Murabaha (B/S Asset side) 1,000

Cr Pay Order / Party Account (B/S Liability side) 1,000

At the Culmination of Murabaha i.e.

At the time of sale of goods to the customers with signing of Declaration by the bank and the client following entries would be passed:

2010, January 15

Dr Murabaha Financing 1,000Dr Unearned Murabaha Profit Receivable 100

Cr Advance against Murabaha 1,000Cr Deferred Murabaha Income 100

Booking of Accrual of profit@ 10% from the date of disbursement to the date of culmination, the following entry would be passed. [(1000 x 10%) x 15 / 365]:

2010, January 15

Dr Deferred Murabaha Income 4.10Dr Murabaha Profit Receivable 4.10

Cr Income on Murabaha Financing 4.10

Cr Unearned Murabaha Profit Receivable 4.10

Booking of Accrual of profit@ 10% for remaining days of the month, the following entry would be passed. [(1000 x 10%) x 16 / 365]:

2010, January 31Dr Deferred Murabaha Income 4.39Dr Murabaha Profit Receivable 4.39

Cr Income on Murabaha Financing 4.39

Cr Unearned Murabaha Profit Receivable 4.39

And so on this entry will be passed at the end of EACH month till maturity for the accrual of profit.

On Maturity of Murabaha transaction i.e.

On December 31, 2010 and at the time of receiving of final payment following entry would be passed:

2010, December 31

Dr Party Bank A/c 1,100Cr Murabaha Financing

1,000Cr Murabaha Profit Receivable 100

Treatment for Inventory If goods purchased for Murabaha remain unsold on the reporting date they are shown as “Murabaha Inventory” in Other Assets.

Following are possible scenario:

Bank is holding assets for future sale to its customers against a promise

The Goods are imported as Bank’s agent and are not sold to the importers

Any other reason due to which the goods remain unsold

BANKS

YEAR TOTAL Assets MURABAHA FINANCING

% OF MURABAHA FINANCING

REVENUES MURABAHA SALES % OF MURABAHA of Murabha Sales

 ALBARAKA  

2009 29304960 9667814 32.99% 2555597 1349821 52.82%

2008 24197826 8562432 35.38% 1764924 1090725 61.80%

2007 22077113 6994844 31.68% 1493035 764279 51.19%

 MEEZAN BANK 

2009 124181734 16645275 13.40% 10102060 5090510 50.39%

2008 85276070 14590314 17.11% 6803213 4689554 68.93%

 DUBAI ISLAMIC BANK  

2009 35368894 2430861 6.87% 3047195 1102381 36.18%

2008 32050078 2559791 7.99% 2723796 905896 33.26%

2007 21308247 2205258 10.35% 1119716 308965 27.59%

 EMIRATES GLOBAL BANK  

2009 19762450 3453856 17.48% 1914228 220904 11.54%

2008 16537387 3150693 19.05% 1060376 18135 1.71%

2007 8941475 1152289 12.89% 381172 139730 36.66%

Description Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08

Total Assets 13 44 72 118 276 276

%age of Banking Industry (Total Assets) 0.50% 1.40% 2.10% 2.90% 4.20% 4.90%

Deposits 8 30 50 83 202 202

%age of Banking Industry (Deposits) 0.40% 1.20% 1.90% 2.80% 4.10% 4.80%

Financing. & Invest. 10 30 48 72 186 187

%age of Banking Industry (Financing $ Investments)

0.50% 1.30% 1.80% 2.40% 3.60% 4.40%

Conventional Banks with Islamic            

Banking Branches 3 7 9 12 12 12

No. of Branches (Including Sub            

Branches) 17 48 70 150 289 514

Underlying Islamic Mode Murabaha

Type of Product Corporate / SME

Basis for Pricing KIBOR Based/Risk Rating/Bank's

Minimum Financing Limit No

Maximum Financing Limit as per SBP Prudential Regulations (PRs)

Minimum Tenors 7 days

Maximum Tenors 1 day

Target Customers corporate

Security/Collateral Required Cash / MOTD /Letter of Hypothecation/Pledge

Underlying Islamic Mode Murabaha

Type of Product Corporate / SME

Basis for Pricing KIBOR based fixed rates for each transaction.

Minimum Financing As per PRs and subject to bank's internal assessment for allocation of limit

Maximum Financing Limit As per PRs and subject to bank's internal assessment for allocation of limit

Minimum Tenors 90days

Maximum Tenors 1 year

Target Customers All customers falling under corporate, SME sector

Security/Collateral Required Cash, Collateral, Pledge, Mortgage or hypothecation of asset or as per PRs or bank's requirement

Underlying Islamic Mode Murabaha

Type of Product Corporate / SME

Basis for Pricing KIBOR

Minimum Financing As approved by bank's credit committee

Maximum Financing Limit Rs.900 million (linked with bank's equity)

Minimum Tenors 15 days

Maximum Tenors 180 days

Target Customers Corporate, SME

Security/Collateral Required Cash margin, Equitable/registered mortgaged pledge of stocks/shares, Hypothecation charge on current assets

Underlying Islamic Mode Murabaha

Type of Product Corporate / SME and Investment Banking

Basis for Pricing depend on the credit worthiness of the client

Minimum Financing No

Maximum Financing Limit As per PR’s

Minimum Tenors no

Maximum Tenors 3 years

Target Customers SME, Local Corporate

Security/Collateral Required pledge of commodity finance inclusive of margin, Hypothecation, Mortgage, Personal Guarantee, Cash Margin, Lien,

Underlying Islamic Mode Murabaha

Type of Product Corporate / SME , Commercial

Basis for Pricing Cost plus mutually agreed profit

Minimum Financing As per PR’s

Maximum Financing Limit As per PR’s

Minimum Tenors NA

Maximum Tenors 1 year

Target Customers Manufacturing industries, Construction Industries, Traders and Individuals

Security/Collateral Required Hypothecation of assets, Charge on current & fixed assets or any other security deem necessary by the bank

Thank You!