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Buy back system or "Murhabhah Financing"

A study of "Buy back system" or "Bai Muajjal" / "Murabahah" "Calculation of buy back price" or "Repurchase price"

By Saalim Salam Ansari, Advocate
June 25 - July 01, 2001

It is an admitted fact that interest (Riba) is strictly prohibited in Islamic Shariah. "Imam-i-Azam Imam Abu Hanifa introduced in his Fikha the new financing system in the name of "Murhabahah" in which the finance is to be granted on re-purchase price having buy back arrangements and it is called "Bai-e-Mujial" in which the profit for the Buy Back period is to be charged from the borrower and the concept of trade and profit which is allowed in Islam has been introduced and the same system has been approved in the religious decree issued by Imam Yousuf, Imam Abu Muhammad and Ala Hazrat Muffti Ahmed Raza Khan Bralvi. The reference books in this regard are (a) "Hidaya", (b) "Darul Mukhtar" and (c) "Kul-Fikha-ul-Fahim" although the same system was not approved in "Fatawa Kazi Khan" and in a division bench judgment of High Court of Sindh at Karachi reported in PLD 1997 Karachi 62 it is held that the buy back arrangement is an interest based borrowing arrangement but in the said judgment the religious decrees and the historical aspects of the "Murabahah Financing" or the "Buy Back System" or "Bai Muajjal" was not discussed. Appellate Shariat Bench of the Honourable Supreme Court of Pakistan has defined the Murahabaha financing or Buy Back or Bai Muajjal at page 748, 749, 750, 751 of its judgement reported as PLD 2000 SC 225 at pages 218, 219, 220, 221, 222, 223, 224, 225, 226 and 227 and declared the Buy Back transaction as interest free and in accordance with to the Islamic Shariah.

Under mark-up based financing, the lender and the borrower enter into a mark-up agreement under which the banking company advances a certain sum of money to the borrower as the sale price of certain goods sold by the borrower to the lender. There is a simultaneous buy-back of the goods by the borrower from the lender at a purchase price which is marked-up price, is payable by the borrower to the lender at a specified date or dates (if the repayment of finance is to be in installments) and constitutes the liability of the borrower towards the lender. An example may perhaps make the concept a bit clearer.

Suppose a customer wants to obtain a loan of PKR 100 from a bank, and the bank is agreeable to provide such a loan to him. A mark-up agreement would then be entered into between the bank and the customer whereby the customer would sell certain goods (specified in the mark-up agreement) to the bank for a sale price of PKR 100. The bank would advance this sum of PKR 100 to the customer who would simultaneously agree, under the terms of the mark-up agreement, to buy-back the goods from the bank at a marked-up purchase price of PKR 120. This Purchase price of PKR 120 thus becomes the liability of the customer and contains the mark-up amount of PKR 20.

The crucial difference between interest-based finance and mark-up based finance is that while under the former banks could continue to levy and charge at the agreed rate return on the amount lended , even after the expiry of the due date of repayment, in the latter mode of finance the banks cannot charge any such return after the expiry of the due date of repayment. In other words, the underlying simultaneous sale purchase transaction in mark-up based lending prevents any increase in the fixed marked-up price even if such price is not paid by the borrower to the lender on the agreed date. It is essentially this fixation of the return on the amount lended that distinguishes mark-up based finance from interest based finance. Instead of allowing the mark-up to increase or to continue to run (as in the case of interest) after the due date of repayment, the mark-up agreements used by banks invariably provided for liquidated damages to be payable by the customer in the event of his failure to pay the marked-up buy-back price on time.

Despite the above concept of finance based on mark-up, banking companies treated mark-up based financing as just another name for interest-based financing, and charged mark-up calculated at a daily basis in interest-based transactions. As such, despite the fundamental difference between mark-up based and interest based financing, mark-up agreements continued to be entered into between banks and their customers where under the bank provided finance ostensibly under the mark-up basis system, but instead continued to levy and charge interest on such finance under the garb of mark-up.

One could attempt to speculate the reason behind the banks treating mark-up based transactions as essentially interest based ones, albeit with a different name. The reason may perhaps be that even the introduction of Islamic banking in Pakistan made no difference whatever as far as the banks' obligations towards their depositors were concerned. The banks felt obliged to give their depositors a fixed and guaranteed rate of return even under the profit and loss sharing deposit scheme, for the simple reason that no bank could afford to declare a loss in its deposits, and thus cause a run on itself. The banks, therefore, understandably felt constrained to keep accumulating their return in non-interest based transaction, just as they accumulated interest in transactions based on interest. This, the banks felt compelled to do in order to recover enough revenue to keep paying profit to their depositors. They found themselves in a situation where, in order to survive commercially, they could not afford to transfer to, or share with, their depositors the risk of loss in banking transactions and, at the same time, felt constrained to bear such risk themselves.

It was perhaps because of such considerations that section 8(2)(c) of the 1979 Ordinance provided that in a recovery case involving a loan given on the basis of participation in profit and loss, the decree passed by the special Court shall provide a return on the judgment debt at a rate not less than the rate of the annual profit for the preceding six months paid by the banking company on term deposits of six months accepted by it on the basis of participation in profits and loss.

The banks however not only started piling-up mark-up in all non-interest based transactions, whether or not such transactions were based on mark-up, but even charged mark-up on mark-up from their defaulting customers by compounding it just like they compounded interest in interest-based transactions. This the banks did despite the fact that conceptually such action on their part negated the very principal of non-interest based finance.

Confusion was also created as to how mark-up based finance was to be implemented in practice. It was not entirely clear how certain banking transactions, such as running finance, for instance, could be harmonized with the mark-up based system. No clear-cut and effective directions or guidelines were also issued by the State Bank to clarify matters in this regard. The entire concept of mark-up based financing thus came to be viewed as just a new and Islamized name for the old interest based lending.

The State Bank formula for calculation of buy back or re- purchase price.

The State Bank Formula for the calculation of mark-up of buy back period is, interalia, herein as under:
Example: Suppose a Finance limit of PKR 100,000 for 365 days was allowed upon a buy back arrangement. Mark-up on PKR 100,000 (a) will be calculated thus if the finance is provided as per sanction advise at the rate of 50 paisas per thousands rupees per day.

i.e. Amount of Finance x rate of Paisas x

days of mark-up = Mark-up of
100 X 1000 365 days
1000.00 x 50 x 365 = PKR 18250/-
1 X 1000 X 100

(a) Principal Amount plus
(b) Mark-up of Buy Back period is PKR 100,000

Plus PKR 18250
i.e. (a) + (b), = Net payable amount
PKR 100,000/ + 18250 = PKR 118250/=
Principal amount +
Markup of 365 days + Total Net.



That under the "non-interest banking" or "Interest free Islamic financing" mark-up upon mark-up or "penal mark-up" or "mark-up with quarterly rest" or "any rest" is not allowed after the elimination of "Riba" in Pakistan from 1984 and State Bank Circular's 13 and 32 of 1984 are extraordinary circulars according to which interest free banking has been introduced in the cases where buy back agreement or Murhabahah Financing is not existing only "simple mark-up" can be charged but in the cases of "Murhabahah Financing" only the mark-up of "Buy Back Period" plus "mark-up of cushion period of 210 days" can be charged and is the "mark-up of period of default and demand, which has been replaced by Section 15 of Banking Act XV of 1997.

That under the extraordinary State Bank Circulars BCD's Circular No.13 and 32 of 1984, the "Riba" or interest has been eliminated and under "Murhabahah Financing" in which the "Buy Back Price" has mentioned in the agreement on the basis of Buy Back Arrangements and mark-up of cushion period of 210 days has been replaced through Section 15 of Banking (Recovery) Act XV of 1997 according to which the "mark up will be charged from the date of institution of suit till realization" and no future and further mark-up is permitted under the "Interest-free financing System" or "non-interest Islamic banking.

(The author, Mr. Saalim Salam Ansari, Advocate is a practicing banking Lawyer, Prominent Economist, and author of ample of books on Law, Banking & Economics.)