Whilst the terms ‘loan’ or ‘lending’ are commonly used, even by Islamic banks, they are not strictly correct in an Islamic context because an Islamic bank is engaged in mutual trading both with and alongside its clients on both sides of the balance sheet. An Islamic bank has a direct interest in the outcome of all these trading transactions, sharing both profits and losses with its partners/clients. Unlike a conventional bank where depositors are creditors and borrowers are debtors and there is almost no mutuality at all, an Islamic bank has partners, investors, principals and agents at every level.
Islamic banks provide a range of services that are genuinely profit (and loss) sharing and in which the bank’s required profit return or share is calculated using benchmark interest rates, is agreed with the client at the outset but depends on profit generation for payment. Under Islamic model, all lending activities must be trade-based, must involve real goods and services, must involve actual trade, avoid any uncertainty, avoid prohibited practices and must be carried out with the utmost integrity and good faith.
Islamic banks invest their funds very carefully and for this reason only a handful of the Islamic products i.e. Murabaha and Musharaka are available that are used in practice. Most Islamic banks advertising the wide range of Islamic investment products, including mortgage funding but most – in fact nearly all – have the lion’s share of their investments in either Musharaka or Murabaha form. Murabaha and Musharaka are two of six ancient trading contracts, which predate Islam itself and are reckoned to be thousands of years old.
A Musharaka project is similar to equity finance and is almost as close to ethical and pure trade related banking as it is possible to get. The genuine sharing of profits means the bank has a real stake in the outcome of its ‘clients’ business and forces it to concern itself very closely with the management and completion of the scheme. The fact that the scheme must be Shariah compliant means it is genuinely wealth and trade enhancing and is concerned with beneficial activities only.
The main problem is that as with equity finance, the due diligence process for a Musharaka is considerable as is the ongoing management and monitoring obligation. The costs of this direct involvement by the bank cannot usually be rewarded adequately by the profit sharing arrangement neither can the very real risk of incurring losses be built in sufficiently. The net result is that whilst the Musharaka remains the shining example of Islamic ethics and principles, the hard truth is that it is not used that much in practice because it cannot be made to pay commercially in a modern banking environment. Other Islamic products require much less supervision, earn just as much for the bank and are therefore the preferred offerings.
IMPORTANCE OF MURABAHA
Because Muslims may not charge interest but can make a profit, the basic trade deal, the Murabaha, is a ‘cost plus’ transaction in which the seller supplies goods to the buyer at a price which includes his disclosed costs plus a disclosed profit. When accepting the goods, the buyer agrees to the selling price and is aware of how much profit is being made (the argument being he can choose not to buy if he dislikes the price). If the buyer requires time to pay, then this can be granted, usually in return for a higher price including a bigger profit. This is one of the ways that the time value of money can be covered under Islam without charging interest.
However, there are some terms and conditions for Murabaha. First the seller must own and possess the goods which must be under his control. The goods must have a tangible value and there must be no uncertainty about quantity, quality or delivery dates. The seller may not take advantage of the buyer, may not cheat, deliberately mislead, overcharge or be anything other than scrupulously honest with him or her. Delivery and transfer of ownership must take place when the transaction is concluded. Once the deal has been done, it cannot be amended without the express approval of both sides. These ancient Murabaha trading rules are clearly framed to avoid disputes or problems and no doubt evolved over time.
Provided the rules set out above are followed, a Murabaha can be for almost any amount and in theory any time period although the range is usually 6 months to 10 years depending on the bank, which will also set minimum and maximum loan amounts. For the transaction to be Islamic, the Islamic bank must be the owner and supplier of the car, which means it must purchase and take delivery from the supplier before selling to its client. This creates a delivery risk as the client could walk away before the transaction is complete. For this reason, some Islamic banks ask for non-refundable deposits.
Despite this risk, Murabahas are priced at the higher end of the consumer funding scale. The attraction for Islamic banks providing Murabaha facilities in the returns are high, it is a relatively simple product to market and sell and the risk profile is low. The main drawback is rates are fixed at the outset and the average term is 5 years. This creates an immediate mismatch with funding sources (nearly all short term) and leaves the bank vulnerable to increases in the cost of funds (interest rates). A large portfolio of well spread and maturing Murabaha protects partially against interest rate fluctuations as new, higher return products replace maturing lower return deals, but not completely. In addition, a Murabaha cannot be turned quickly into cash in a crisis.