why murabaha is popular @unikl

Mohsin Ali

Since the establishment of Islamic banking, many questions have been raised on the different policies adopted by Islamic banks. One of the questions is related to the excessive use of Murabaha financing facility by Islamic banks. Islamic scholars treat equity based instruments – i.e. Mudarbah and Musharakah – as a central pillar of the Islamic banking model and consider them closer to Islamic Finance Ideology. On the other side the scholars have raised issues over permissibility and practice of debt based instruments like Ijarah & Murabaha. This is why, many of the advocates of Islamic banking, favor Musharakah and Mudarbah over debt based modes. But even after all these issues and oppositions, Murabaha is the most dominant mode of Islamic financing being used by Islamic Banks. The sole purpose of this paper is to explain the reasons of the popularity of Murabaha as

ABSTRAC

1. Introduction:

Islamic banking may not be a totally new concept; but the widespread expansion of this form of

banking is certainly a fairly recent phenomenon. There are more than 200 Islamic banking

institutions and these institutions not only operate in Muslim countries, but have also gained

footing in non-Muslim countries. In 2012, it was estimated that, on a global scale, total assets of

this banking system were about US$ 1 trillion1.

The term “Islamic banking” refers to a conduct of banking operation in consonance with Islamic

teachings. Theory of Islamic banking categorizes, financing modes under three power sets which

are: (a) Equity based financing; (b) Debt based financing and (c) Benevolent loan and services.

Islamic equity-based financing is an Islamic investment engaging at least two parties to do

business together under shariah principles. Examples of this are Mudarbah, Musharakah etc.

Islamic banking advocates consider this sort of financing more favorable in comparison to other

two. Meanwhile, debt based financing is a trade based financing engaging related parties with

buying and selling of good under shariah principles. This financing consists of Murabaha, Ijarah,

Salam and Istisna. In practice, this sort of financing is more popular among the Islamic banks but

in literatures Islamic scholars have raised issues on their usage particularly on the practice of

Murabaha financing.

Khan and Bhatti (2008) provided empirical evidence that on average murabaha represented

54.42 percent of the total financing and investment portfolios of ten Islamic banks during the

period 2004-2006. The weighted average use of Murabaha by the top ten Islamic banks,

representing 50.902 percent of the Islamic banking industry, was 65.66 per cent of their total

financings during the period 1994-1996

(Iqbal, 1998). This implies that Islamic banks

have been determined to rely heavily on

murabaha in carrying out their financing and

investment operations. If we look at the

contract wise percentage change in financing,

from the year 2007 to 2008, it is evident that

the highest percentage was in Murabaha contract which was about 50.90 percent change in

1 Governor BNM speech, Dec. 09, 20122 Nidal, Alsayyed. The Uses and Misuses of Commodity Murabaha: Islamic Economic Perspective, ISRA.

2Why Murabaha is Popular?

comparison to last year’s Murabaha financing. Percentage change in Murabaha financing is

much higher than the other modes of financing like Musharakah and Mudarbah, which shows

clear inclination of Islamic banks towards Murabaha financing. In this paper, I will try to

elaborate the reasons of the popularity of Murabaha despite it not being the financing method

favored by many of the advocates of Islamic banking. Let us first look what is Murabaha and

how is it being practiced by Islamic banks?

2. What is Murabaha?

Literary Murabaha means “sale on profit”.

Technically Murabaha is a particular kind of

sale where the seller expressly mentions the

cost of the sold commodity he has incurred,

and sells it to another person by adding some

profit thereon. Thus, Murabaha is not a loan

given on interest; it is a sale of a commodity for cash/deferred price.

3. Murabaha in Practice:

An Islamic bank buys a product normally at the request of a client, who promises to buy it from

the bank. The bank takes the risk while it owns the product. The bank then sells the product to

the client normally on deferred payment basis.

Murabaha is presently used to finance working capital requirement, import & Export financing.

Besides that Murabaha is also being used for purchase of fixed assets such as, land, building,

machinery and equipments, automobiles, computers, furniture; and also suitable for financing

purchase of personal assets and consumer durables, such as, PCs, cars, houses etc.

4. Issues with Murabaha:

One of the issues with the Murabaha is that in classical fiqh, Murabaha refers to sale (bay’), with

all its implications and prescribed Shari’a conditions pertaining to sale, and has nothing to do

with financing in the conventional sense. According to Ashraf Usmani “It is only a device to

escape from “interest” and not an ideal instrument for carrying out the real economic objectives

of Islam. Therefore, this instrument should be used as a transitory step taken in the process of


Islamization of the economy, and its use should be restricted only to those cases where

Mudarbah or Musharakah are not practicable”3. Let us see few issues in Murabaha;

4.1 Not aligned with the ideology of Islamic Financial system at large:

Islamic finance experts like Abbas Mirakhor, Zamir Iqbal, Taqi Usmani etc. are of the view that

the debt based contracts are not aligned with the ideology of Islamic Financial system. As

according to them, the core of Islamic Finance lies in risk sharing rather than risk transferring as

being done in the case of Murabaha.

4.2 Merely a mean of circumventing the prohibition of riba:

Many people consider Murabaha as a universal instrument like conventional loan. Shariah

scholars argue that when it is used as merely a means of circumventing the prohibition of riba, it

does not remain an instrument to implement the real economic objectives of Islam. Its use should

be limited to circumstances where equity-based arrangements such as Mudarbah or Musharakah

are not practicable.

4.3 Profit Rates and Benchmarks:

In Murabaha, price includes a known profit or mark-up. The mark-up in Murabaha is part of the

sale price, it is set only once and then it does not change overtime. The bank use to calculate the

mark-up price (cost-plus) on the bases of market interest rate, such as, the LIBOR or BLR.

Advocates of Islamic banking argue that, using riba-based rates as a point of reference is not

desirable and should be avoided. Such dependency might influence the manner of operation of

Murabaha transactions, mimicking conventional interest based loans, and could lead to a

convergence between Islamic and conventional banking.

4.4 Rescheduling of Payments:

At times, rescheduling of installments is seen as a way out in the face of default. In conventional

banking, loan rescheduling is accompanied by additional interest charge for the timing

differences. Murabaha does not allow such rescheduling as no additional amount can be charged

for the same. The amount of the murabaha price remains unchanged. Some banks attempt to

circumvent this by changing the unit of currency. This attempt is strictly criticized by shariah

scholars.

3 Usmani, Dr. Muhammad Imran Ashraf, Islamic Banking, Darul Ishaat,first edition, 2002.


4.5 Securitization of Murabaha Debt:

The obligation of the debtor to pay is a monetary indebtedness and hence is money. Money can

only be exchanged with money at par. Thus the Murabaha debt cannot be made into a negotiable

instrument. But Islamic banks in Malaysia are indulged in sale of debt which is also criticesed by

the scholars from other parts of world.

5. Why Murabaha is Popular?

The use of Murabaha should be limited to circumstances where equity-based arrangements such

as Mudarbah or Musharakah are not practicable. Let us look at few reasons of popularity of

Murabaha and why it is practiced:

5.1 Most suited for banking arrangement

Murabaha is the most suited contract for banking arrangements like import financing, working

capital financing, personal financing (where an asset is required). It is most suited in the sense as

well that, its cost plus profit structure is very identical to the conventional interest based contract

with the exception of requirement of an underlying asset.

5.2 Predetermined, fixed and continuous rate of return

In Mudarbah and Musharakah, uncertainty of the rate of return on capital is very high due to

asymmetric information which creates moral hazard and adverse selection problem. On the other

hand, rate of return is fixed and pre-determined in other modes of contracts.

5.3 Requires less effort to monitor

Comparatively financing through Murabaha requires less effort to monitor, control or evaluate as

bank’s monitoring role finishes once the ownership risk is transferred to the client. On the other

hand in Musharakah and Murabaha lots of efforts are required to monitor, evaluate and control a

partnership (investment financing)

5.4 Recognition and understanding from practitioners of conventional finance

The major advantage of this mode of financing is the instant recognition and understanding it

gets from the practitioners of conventional finance. As cost plus profit structure of Murabaha,

with the exception of requirement of an underlying asset, is identical to conventional interest

contract in terms of fixed returns and the declaration of profit and principal.


5.5 Market driven mode of financing

Islamic Banking is a market driven industry. It offers a range of products (contracts) to its clients

and lets the market decide the perfect instrument for themselves. Murabaha is a contract which

market demanded more as compared to Musharakah and Mudarbah financing which is also

evident from the percentage share of Murabaha financing out of total financing. Particularly

entrepreneurs preferred Murabaha due to its (i) Fixed rate of return along payment period (ii) No

charge for late payment/default (iii) Treating an asset being purchased as collateral

5.6 Ideal for meeting working capital needs

Murabaha is a tailor made contract for manufacturers who need working capital on a relatively

short-term basis to finance acquisition of raw materials and consumables or for traders who need

working capital for financing acquisition of merchandise. No other contract meets the working

capital needs of manufacturers or traders so perfectly.

5.7 Flexible contract – Easier to structure different facilities

Murabaha is a very simple and flexible contract, many different types of products have been

offered by Islamic banks by using Murabaha as underlying contract. Murabaha is presently used

to finance working capital requirement, import & Export financing. Besides that Murabaha is

also being used for purchase of fixed assets such as, land, building, machinery and equipments,

automobiles, computers, furniture; and also suitable for financing purchase of personal assets and

consumer durables, such as, PCs, cars, houses etc.

5.8 Relatively low risk

5.8.1 Equity investment risks: There is no equity investment risk in Murabaha

whereas Musharakah and Mudarbah are prone to Equity investment risks

specially when the project is not making profits

5.8.2 Credit risks: In comparison to Murabaha, credit risks are higher specially

when there are chances of delays in profit payments or not paid at all. Credit

risks are also high in Musharakah and Mudarbah because of the long term

nature of the project.

5.8.3 Fiduciary risk: Any misconduct or negligence of the partners in Musharakah

or Mudarbah can be the sources of Fiduciary risk. This can happen in the

absence of adequate monitoring of the financial performance of the venture.


5.8.4 Mark‐up risks: Murabaha profit rates are fixed at the time of contract between

Islamic bank and its client and fluctuations in the market rate of return do not

have any impact. On the other hand fluctuations of rates cause changes in

profits of Islamic Banks in Musharakah and Mudarbah.

5.8.5 Liquidity risks: There is low liquidity risk in investing in Murabaha as

compared to Musharakah or Mudarbah as in contrast to the Equity based

contracts, Murabahas generally have smaller funding size and shorter maturity

periods.

5.8.6 Shariah compliance risk: In Musharakah or Mudarabah Shariah compliance

risk may arise due to the final allocation of profit taking place based on

expected profit not on the actual profit. There is no profit sharing in Murabaha

financing security breaches.

5.9 Low Capital Adequacy requirements

According to IFSB Capital Adequacy Standard, a Risk Weight (RW) of only 50% is applicable

on Murabaha financing whereas a 400% RW is to be applied to all equity exposures in private

and commercial enterprise and 300% RW is applicable on all Mudarbah Financing. This means

an Islamic Bank has to keep more capital for Musharakah and Mudarbah financing as compared

to Murabaha financing. This is one of the reasons that Islamic banks referred dabt based

instruments of financing over equity based instruments.

5.10 Meets the risk profile of most of the depositors

The risk profile of most of the depositors of Islamic banks is from low to medium term. Their

primary reason to open accounts in Islamic banks is usually safe keeping and to earn low to

medium rate of returns. Depositors at large do not want to invest in high risky projects, that is

why Islamic banks prefer less risky investments like Murabaha financing (debt based financing

rather than high risky equity investments) on their Asset side to match the risk profile of their

depositors on the liability side.

5.11 No legal issues

An Islamic bank which enters into Musharakah or Mudarbah contract needs to acquire some

shares from a separate legal entity that undertake Shariah compliant activities. A mixture of

shares in one entity may lead to legal risk if the regulation does not allow doing such action. On

the other hand Murabaha is at large acceptable as a financing mode in all jurisdictions.


5.12 No agency problem or governance issues

Musharakah and Mudarbah are basically partnership contracts and when a bank enters in to any

of these agreements it might have to face issues like adverse selection and moral hazard. Adverse

selection, prior to the contract and moral hazard, during the performance of Musharakah or

Mudarbah, arise where the “Rab-ul-Mal” cannot cost-lessly observe or monitor the Mudarib’s

characteristics and/or actions, whereas, the agency problem does not exist in Murabaha.

5.13 Easier to train Islamic Banking staff

Murabaha is a very simple and straight forward contract and it is relatively easier to train Islamic

banking staff to deal with Murabaha financing. On the other hand Musharakah and Mudarbah are

complex contracts and very difficult to handle specially for those who do not have experience.

5.14 Solution to Asset-Liability mismatch problem

Islamic Finance industry is still facing a shortage in short-term investment products. In most of

the jurisdictions, Murabaha financing is the most widely used short term mode of financing.

Some Islamic banks have tried to structure alternative products, but they were faced by their

inability to generate assets caused by credit ratings and liquidity issues relating to their balance

sheet.

6. Conclusion:

Originally, Murabaha is a particular type of sale and not a mode of financing. The ideal mode of

financing according to Shariah is Mudarbah or Musharakah. However, in the perspective of the

current economic set up, there are certain practical difficulties in using Mudarbah and

Musharakah instruments in some areas of financing. Therefore, the contemporary Shariah

experts have allowed Murabaha on deferred payment basis as a mode of financing, subject to

certain conditions. The reasons mentioned above, shows that Murabaha contract is equally

important as Musharakah or Mudarbah contracts especially in the contemporary banking

scenario. The paper suggests that, Murabaha is important to Islamic Banking in its own capacity

and practicing Murabaha as financing mode is inevitable at least until a substitute is not

available.


why murabaha is popular @unikl

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