Murabaha – Cost Plus Sale

Murabaha is an instrument where the bank acquires a product upon request from the customer and sells it at an agreed upon profit. This is an extensively used transaction by Islamic banks. There are variations of Murabaha in which the payment or delivery of the product can be on the spot or at a future date. The payment could be at one time or a series of payments. Though Musharakah and Mudarabah are considered ideal transactions for Islamic banking, the scholars have allowed Murabaha due to practical difficulties in other two transactions. Due to similarity to interest based transactions, the scholars have raised various concerns about legality of these contracts. Therefore, Murabaha requires careful scrutiny before execution to seek assurance that it is not just interest renamed. One basic requirement of Shari’ah based transactions is that money should not be treated as a commodity and no fixed rate should be imposed on it by the financier. The bank purchases a product based on customer’s request and takes physical possession assuming all the risks of ownership. Then the bank sells the product to the customer at an agreed upon markup. This consists of two separate transactions, one of purchase of the product by the bank, and then the sale to the customer. In case of delay or default on the payment, the bank does not make additional profit from penalties. In contrast, in a conventional interest based transaction, the customer borrows the money from the bank at a fixed interest rate and pays it back over time. The bank may hold a lien on the purchase until full payment is made to protect in case of default. The customer also pays late payment charges in case of delay which go to increase the profits for the bank. One concern regarding Murabaha transactions is the risk exposure of the banks. If the customer has agreed to buy a product at an agreed upon markup then the risk of the bank is very similar to that of an interest based transaction. But since prices have to be agreed upon on all trades, the scholars have allowed Murabaha as long as the all the other Shari’ah requirements of a legal trade transaction are followed. Questions have also been raised about the markup in Murabaha which is usually based on a prevailing interest rate. This has been an accepted practice to keep the Islamic banks competitive with traditional banks. There have been also concerns regarding the difference between cash and credit price. The markup usually takes into account the time required by the customer to pay the money to the bank. In this essence, it seems similar to interest and time value of money. But the difference that makes it Shari’ah compliant is that there is a commodity purchase involved and price once fixed cannot be changed even if there is a delay in payment. Hence the time value of money concept is not involved. A Murabaha is not suitable to all financing transactions just to avoid interest. It applies when the customer is interested in buying a certain product and seeks assistance of a financier. Simple Murabaha transaction can be illustrated with an example. A manufacturing firm needs raw material of cotton yarn to produce fabric. The cash cost of the yarn is $100,000. Instead of using their own cash which is normally tied up in the business, they ask an Islamic bank to acquire the yarn for them. The bank acquires the yarn and becomes its owner. They deliver the yarn to the farm. The firm will pay for the yarn after one year after making the fabric, selling it and then collecting their revenue. A five percent markup has been agreed as the deferred price of the yarn. At the completion of one year, the customer pays the agreed price of $105,000 and finishes the Murabaha contract. Since the structure of a Murabaha contract is different and more involved than a traditional interest bearing loan, there are risks that require mitigation. These risks can be bundled together in four broad categories.

1. Shari’ah Compliance is a core requirement for the operation of Islamic bank. Since Murabaha seems very similar to a interest based loan, the banks need assure that there is no element of riba or gharar in the contract. Also, where a normal bank is only concerned with the legality of a customer’s operation, the Islamic bank also requires that the business activity is not forbidden in Islam. Further, the customer must not have already acquired and/or utilized the goods in advance of Murabaha contract. That would make the transaction void. The banks can mitigate this risk by comparing invoice dates and by making physical inspections.
2. Commercial risks involve transit, default, rate of return, and non-performance by supplier or customer. The goods can be destroyed in transit which can be protected by takaful insurance. Also, the customer may default on the payments. This could be mitigated by including late payment penalties and taking customer owned assets as security deposit. If the customer is late in payments, this could increase of cost of capital to the bank as it is not allowed in Shari’ah to increase prices of goods once they are fixed. The bank should promote only short duration Murabaha to avoid this situation. Another risk is that the supplier of goods may not be able to deliver for a variety of valid business reasons. This would require a performance guarantee bond from the supplier or the customer acting on behalf of the supplier. Alternately, there is also the risk of customer not accepting the goods as agreed. This can be mitigated through an earnest money contract to recover the loss to the banks.
3. Fiduciary risk arises when customer has agreed to act as an agent of the bank in the transaction but does not act in good faith. The bank can protect itself in those cases by making the customer liable for losses.
4. Legal and liquidity risks may arise when any party does not fulfill the requirements of the contract. The transaction could be stalled mid-stream by any of the contracting parties. The bank could face liquidity problems if it ends up owning goods which are not acceptable to the customer. The bank may have to resort to litigation to recover its losses. The contract should be reviewed by legal experts to avoid litigation later, and also an earnest money deposit should be secured to cover the losses as well as legal costs.