Murabaha is currently the most widely used Islamic sharia compliant mode of finance, used by Islamic sharia-compliant financial institutions: it is as simple as buy an asset for the customer; sell the asset at a premium (profit), allow payment of the sale price in instalments to the customer. That is a Murabaha. A Murabaha is a sale in which the seller’s purchase price of acquiring the asset and the profit earned from it is revealed to the customer or buyer. Murabaha based sales were mentioned in the first known book of Islamic jurisprudence, the Al-Muatta’a of Imam Malik ibn Anas (d. 795 CE) (Sultan and Ebrahim, 2011).
In practice, Murabaha works as follows, a master facility agreement for Murabaha is drawn up between the financing institution and the customer requiring the financing. The following steps then take place:
I. The approval of the customer’s credit facility
ii. The terms and conditions of the underpinning Murabaha contract terms are agreed upon
iii. The Murabaha underlying asset or item identification is made
iv. The customer undertakes to purchase the Murabaha asset or item once the institution acquires it.
3. The customer gives a unilateral commitment to purchase the Murabaha items, and the institution accepts the collateral, required as per the agreement. At this point, the Islamic financial institution in order to safeguard its position in the event that the customer backs out from entering into a Murabaha requests the customer to furnish earnest money called “haamish jiddiah”. In the event that the customer backs out from entering into the Murabaha arrangement, the Islamic financial institution charges for the actual loss incurred and returns the balance to the customer.
4. An agency contract is signed between the Islamic Financial Institution and the customer, as the Islamic Financial Institution does not usually possess the expertise to purchase the required asset; hence they appoint the customer as its agent to procure the asset from the supplier on their behalf.
Murabaha Conditions (Usmani, 2002).
Asset or item underlying a Murabaha
1. The underlying Murabaha asset has to be in existence at the time of the execution of the contract.
For instance, a Murabaha can be executed for a car that exists not for one that is to be assembled.
2. The bank should own the asset and have either physical or constructive possession.
3. The underlying Murabaha asset must be an item of value and shariah-compliant.
4. The underlying Murabaha asset must be a tangible good, clearly identified and quantified.
For instance, if the buyer wants to purchase rice, its exact quality and quantity in terms of weight.
Must be specified in the Murabaha contract to avoid gharar or uncertainty that leads to
A dispute between contracting parties.
Price
1. The Murabaha asset cost should be declared to the client.
2. The cost refers to all expenses involved in the asset’s acquisition.
3. The asset’s price includes all direct expenses.
4. Parties to the contract establish a profit rate by mutual consent or connected with a specified benchmark.
5. The Murabaha price may be charged at spot or be deferred and paid as a lump sum at the end of the contract or in instalments on fixed dates during the term of financing.
6. The Murabaha profit must be disclosed as a specific amount to the customer.
It is important to remember that the Murabaha’s execution must adhere to a particular sequence of process steps in order to ensure sharia compliance.
Steps in the execution of a Murabaha contract
1. The client’s submission of a purchase requisition for Murabaha goods:
Based on the requisition, the bank approves the credit facility before entering into an actual agreement.
2. The master facility agreement for the Murabaha between the financial institution and the customer, is drafted and signed. This master facility agreement includes:
I. An approval of the customer’s credit facility
ii. The terms and conditions of the Murabaha contract
iii. Murabaha asset specification
iv. Client’s undertaking to purchase the Murabaha asset once the bank acquires it (if not included in the master Murabaha facility agreement,
3. The client’s unilateral promise to purchase the Murabaha assets and the financial institutions
Acceptance of the collateral given. At this stage, the bank in order to safeguard its position in the event the customer backs out from entering into a Murabaha, requests the customer to furnish security or earnest money called Hamish Jedidiah. In case the customer backs out from entering into the Murabaha, the financial institution makes up for the actual loss from it and returns the remainder to the client.
4. The agency agreement between the financial institution and the client or a third party
Since financial institutions do not possess the expertise or human resources to purchasing the assets, they appoint the client as the agent to procure the asset from the supplier on their behalf.
Agency agreements are of two types:
1) The agent is restricted to purchase a specific asset from a specific supplier or
2) The agent may purchase the specified asset from any source of his choice. Such an agreement also lists several assets which the agent may procure on the financial institution’s behalf without executing a new agency agreement each time.
Key points to remember about the agency
During the agency stage, the financial institution’s exposure to asset risk is highest, and it is in the financial institution’s best interest to shorten this period as much as possible. The financial institution may minimize risk by ensuring the supplier receives payment for the Murabaha asset, not the customer.
The financial institution must also ensure that the Murabaha asset to be purchased is not already in the customer’s possession. To maintain the correct sequence of steps, the financial institution must disburse the money to the agent before the agent purchases the goods.
Note: The agency agreement is not a prerequisite but motivated by logistical ease, as the financial institution can procure Murabaha goods directly or establish a third party agency.
5. The agent takes possession on behalf of the Islamic financial institution
6. The exchange of a contract denoting an offer and acceptance between the client and the financial institution to implement the Murabaha sale. Either party can make the offer; the client may offer to buy the Murabaha goods, or the Islamic financial institution may offer to sell them the asset. The Murabaha sale is completed at the time of offer and acceptance.
7. The transfer of possession of Murabaha goods from the financial institution to the customer. Then the
The customer becomes the owner of goods and all the associated risk and rewards of ownership transfer to him. However, his obligation to make payment as agreed does not conclude until he makes complete payment of the Murabaha price.
Risks in Murabaha financing
Elgari, 2003 elaborates on the existence of the risk of extending credit in Islamic banking and financial institutions. He claims that direct financing offered by the bank is not reliance on the existence of credit risk. Besides that, the problem arises in terms of acceptance paper and guarantees because of the inability of financial instrument’s originator which is owed by the bank to meet his obligations, and it is faced by the most of Islamic banking modes of financing that they offered especially in Murabaha financing.
Khayed and Mohammed, 2009 studied the existence of risks of Islamic modes of finance in
Banking institution’s offered, and they found the existence of various types of risks in Islamic banking operations, including the risk of default by customers not meeting liabilities when they fall due.
Mitigating Murabaha Risks
• The sharia point of view regarding the validity of a Murabaha arrangement is intensely sensitive to following the designated steps in the correct sequence.
• A deferred Murabaha may not be executed for mediums of exchange (i.e. commodities such as
Gold, silver and currencies). Only a spot Murabaha may be executed for them.
• The financial institutions should obtain sharia-compliant takaful insurance for Murabaha goods or assets to cover transit period risk (i.e. the risk posed to the financial institutions once it purchases the goods from the supplier and has their possession and before it sells them to the customer).
Default in a Murabaha
There is no concept of a late payment penalty in a Murabaha contract. However, a charity clause is Inserted at contract execution to serve as a deterrent to default.
In case of a default in payment or delay in time, which triggers the charity clause, the client is obliged to pay a contribution of a predetermined amount to a designated charity.
Murabaha prohibitions
A roll-over provision which is an extension of the duration in return for an increase in the original amount payable is not allowed in a Murabaha arrangement, as it constitutes repricing and rescheduling:
Repricing is prohibited because the sharia principles do not permit an increase in debt once it is fixed.
Rescheduling is only allowed when the financial institution provides an extension of duration to ease the burden of the customer. However, this should be without an increase in the amount payable. Hence, a roll-over where the bank increases the debt in return for an extension is also not allowed, as the resulting amount of increment of debt is analogous to riba or interest which is forbidden in Islam.
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