Islamic Modes of Financing

Murabaha
 Summary of the Previous Lecture
In previous lecture we discussed the;

•Governing features of Islamic banking system

1.The prohibition of interest based transactions

2.Avoidance of speculations (gharar)

3.Avoidance of oppression (zulm)

4.Introduction of Islamic tax (zakat)

5.Financing of Sharia Approved activities

•Comparison of Islamic and conventional banking system.

 Learning Outcomes

After this lecture you should be able to understand

•The concept of Murabaha

•The stages involved in Murabaha transaction

•Practical issues in Murabaha and their resolution

•Murabaha documentation

•Uses of Murabaha as Mode of finance (Local as well as import

Murabaha)
 Definition of Murabaha

Murabaha is a particular kind of sale where

seller expressly mentions the cost it has
incurred on purchase of the asset(s) to be sold
and sells it to another person by adding some
profit, which is known to buyer.
 What is Sale?

Sale is defined in the Islamic Fiqh as an

Exchange of a thing of value with another thing of

value, with mutual consent.
 Components of Valid Sale
SALE

CONTRACT SUBJECT PRICE POSSESSION

MATTER

•Existence •Quantified
•Offer/Acceptance •Physical
•Ownership •Certain
Buyer/Seller
•Possession •Constructive
•Valuable
•Specific
•Halal Purpose
•Delivery
 Features of Murabaha

1. Murabaha finance is not a loan given on interest, it is

a sale of asset(s) for cash/deferred price.

2. It is the obligation of the seller to disclose the cost

and profit to the buyer.
 Features of Murabaha
3. Murabaha finance can only be used for the purchase of fresh
asset(s) only.

4. Buy-back arrangement is prohibited. This means that

Murabaha transaction cannot be executed for the asset(s)
already purchased by the customer.

5. Murabaha Transaction can either be a cash sale (Spot Payment

Murabaha) or a credit sale (Deferred Payment Murabaha) or a
combination of both.
 Features of Murabaha
6. Payment of Murabaha Price can be made in lump
sum or in installments or combination of both.

7. It is a fixed price sale and normally is done for

short term.

8. The Murabaha Finance can be used to meet the

working capital requirements. However, it cannot be
used to meet the liquidity requirements.
VARIOUS MODELS OF
MURABAHA FINANCE
Model - I
Two party relationship
• Bank – customer

Model - II
Three party relationship
• (Bank-vendor) and customer

Model - III
Three party relationship
• Bank and (vendor-customer)
 Model - I
• The simplest possible model emerges when the transaction
involves two parties only, i.e. Bank and the customer.

• The bank is also vendor and sells the asset(s) to its customers on
deferred payment basis.

• From Shariah perspective it is an ideal model and its profits are

fully justified because bank assumes all risks as vendor/trader.
MODEL I – GRAPHICAL PRESENTATION

Customer 1 Bank/Vendor

3
 Murabaha

Financing asset purchase

Goods Goods
(immediate (immediate
Goods delivery) delivery)
Supplier Bank
$100,000 $130,000 Customer
(spot payment) (deferred
Bank must own payment,
the asset before including profit
selling it. mark up)

Debt Based Financing:

Why it is called debt based?
Why is it Shariah complaint?
 Model I - Phases
Phase 1:
The customer approaches Bank (Vendor) and identifies
Asset(s) and collects relevant information including cost
and profit.
Phase 2:
Bank sells Asset(s) to the Customer, transfer risk and
ownership to the Customer at certain Murabaha Price.
Phase 3:
Customer pays Murabaha Price in lump sum or in
installments on agreed dates.
 Model - II
• In most cases Murabaha transaction involves a
third party (i.e. Vendor) because bank is not
expected to engage in sale of variety of products
required for variety of customers.

• The bank directly deals with the vendor and

purchases the asset(s).
 Model II
• The bank sells the purchased asset(s) to the
customer on cost plus basis.

• There are two distinct sale contracts at different

point of times. First between bank and vendor and
second between bank and the customer.
Model II – Graphical Presentation

1 Vendor 3
4

5
Customer 2 Bank

6
 Model II - Phases
Phase 1:
Customer identifies and approaches the Vendor
or Supplier of the Asset(s) and collects all
relevant information.
Phase 2:
Customer approaches the Bank for Murabaha
Financing and promises to buy the Asset(s).
Phase 3:
The Bank makes payment to vendor directly.
 Model II – Phases
Phase 4:
Vendor delivers the Asset(s) & transfers the
ownership of Asset(s) to the Bank.
Phase 5:
Bank sells the Asset(s) to Customer on cost plus
basis and transfers ownership.
Phase 6:
Customer pays Murabaha Price in lump sum or
in installments on agreed dates.
 Model III – Banking Murabaha

• This Murabaha model is mostly practiced

model in banking now a days and therefore
we will look at it in more detail.
We will also look at the documentation
required at different stages of the
transaction.

• It is also a three-party structure but it is bit

complicated than previous ones.
 Model III – Banking Murabaha

• The product of Murabaha that is being used in Islamic

banking as a mode of finance is something different
from the Murabaha used in normal trade .

• It is called Murabaha to the purchase order.

 Model III – Banking Murabaha

• It is a bunch of contracts completed in steps and

ultimately serves the financial needs of the client.

• The sequence of their execution is extremely important

to make the transaction Shariah compliant.
 Model III – Graphical Presentation

3
Vendor
4
5

Customer 2 Bank

6
Offer Acceptance
1

7
 Phase I – Promise to Purchase and Sell
• The customer approaches the bank for Murabaha
Finance and promises to purchase the asset(s) from the
bank which, the customer will purchase as an agent of
the bank.

• Master Murabaha Finance Agreement (MMFA) shall be

signed by the bank and the customer at this stage. This is
basically a memorandum of understanding between two
parties.
 Phase II – Appointment of Agent

• In the absence of expertise required to purchase particular

kind of asset(s), the bank appoints customer as its agent to
buy asset(s) on its behalf
 Phase II – Appointment of Agent

• The appointment of an agent for purchase of asset(s) for

and on behalf of the bank and the ultimate sale of such
asset(s) to the customer shall be independent transactions
of each other and separately documented.

• However, according to Shariah, it is preferable to appoint

the agent other than the customer.
 Phase II – Appointment of Agent
• Agency agreement is not the condition of the Murabaha if
the institution can make direct purchases from the supplier.

• It is advisable to execute agency agreement because

financial institution does not have the expertise to identify
the asset(s) and negotiate an efficient price.
 Phase II – Documentation
Agency agreement

• This agreement must contain:

a. Types (global/specific)

b. Description of asset(s) to be purchased

c. Mode of disbursement of funds

d. Roles and responsibilities of agent

• This documents must be signed before purchase of asset(s) by

the agent
 Phase III & IV –
Purchase of Assets by Agent

• The customer identifies the vendor, selects the asset(s) on

behalf of the bank and advice its particulars, including the
vendor’s name and purchase price to the bank.

• If the supplier is nominated by the customer itself, guarantee

for good performance can be demanded from the customer.
 Phase III & IV –
Purchase of Asses by Agent

• The customer takes possession of the asset(s) as an agent of the

bank.

• It is the obligation of the customer(agent) to ensure, at this stage,

that asset(s) supplied is in accordance with the given
specifications.

• To ensure that fresh asset(s) are purchased by the agent, bank’s

staff should verify actual purchase of asset(s).
 Phase III & IV– Documentation
Declaration from customer (agent)

• The customer (agent) will inform the bank, through

this document, that it has taken the possession of
asset(s) on behalf of the bank.

• This transactional document shall be an integral part of

master Murabaha financing agreement (MMFA).

• This declaration must contain the statement that

customer has inspected the asset(s) to ensure that its
appropriateness and suitability to the customer.
 Phase v
Disbursement of Funds / Payment to Vendor

• The bank has two options regarding payment of purchase price

of asset(s) bought by agent on its behalf.

a) Direct payment to vendor by the bank (preferable).

b) Disbursement of funds to agent’s (customer’s) account for

onward payment to vendor through cross cheque / pay order /
demand draft etc.
 Phase V - Documentation

Letter of disbursement

• This documents is a request from customer to

disburse funds for payment to vendor.

• The disbursement of funds to the customer shall

be treated as “advance against Murabaha”.
 Phase VI - Murabaha Execution Stage
(Offer and Acceptance)
• The customer offers to buy the asset(s) from the bank
which it has purchased as an agent of the bank.

• The bank gives the acceptance to the customer’s offer.

• This is the point where the Murabaha comes in to

existence.
 Phase VI Murabaha Execution Stage (Offer
And Acceptance)
• It is obligatory that the point when the risk of the asset(s) is
passed on by the bank to the customer be clearly identified.

• It is mandatory to determine the Murabaha price at this

stage, otherwise Murabaha shall not be valid.

• It is also mandatory to determine the date of payment of

Murabaha price rendering the Murabaha to be valid.
 Phase VI
Murabaha Execution Stage Documentation

a) Offer for purchase

• The customer offers to buy the asset(s) purchased by it as
an agent.

• This documents should be signed after actual possession of

asset(s) by the customer but before consumption of such
asset(s).

• This transactional document shall be an integral part of

master Murabaha financing agreement (MMFA).
 Phase VI
Murabaha Execution Stage Documentation

b) Bank’s acceptance of offer

• Bank accepts the customer’s offer and sells the asset(s)

purchased by customer(agent) on its behalf on Murabaha
price to be paid on agreed future date.

• The asset(s) must be in bank’s possession by either way,

i.e. Physical or constructive.
 Phase VI
Murabaha Execution Stage Documentation

• This document must contain

i. Murabaha price (cost+profit)

ii. Repayment date
 Phase VI
Murabaha Execution Stage Documentation

c) Payment schedule summary

• The customer has three options to pay the Murabaha

price.

i. Lump-sum payment

ii. Installment payment

iii. Partly instant and partly in installment

• This documents is required if the customer wishes to pay

the Murabaha price in installments
 Phase VI
Murabaha Execution Stage Documentation

d. Demand promissory note

• After execution of Murabaha, the Murabaha price will

become the debt (dayn) on the customer.

• This document is customer’s acknowledgement to the

debt amount and its promise to pay the debt.
 Phase VII
Payment of Murabaha Price by Customer

• Customer will pay the Murabaha price to the bank on the

agreed date.

• The customer is not entitled to any reduction in Murabaha price

in case of early payment of Murabaha price.

• In same way bank can not increase the Murabaha price if the
customer defaults or make delayed payment.
 Securities in Murabaha
• The institution may ask the customer to furnish a security to its
satisfaction for prompt payment of the Deferred Murabaha
price.

• It is also permissible that the sold asset(s) itself is given to the

seller as a security.

• It is preferable not to take Interest bearing instruments as

securities.
 Securities in Murabaha
• Bank can obtain any of the following security
from its customer client depending upon the
nature of credit facility, amount of facility and
credibility of the customer.
a. Hypothecation of assets
b.Pledge of goods and/or marketable securities.
c. Lien on deposits.
d.Mortgage on immovable properties.
e. Bank guarantees.
f. Personal guarantees.
 Murabaha in Foreign Trade

Murabaha

Import Export
Murabaha Murabaha

Pre-shipment Post-shipment
 Use of Murabaha in Imports

• Agency agreement must be signed before opening of

L/C in case of imports.

• All costs/charges (e.g. SWIFT charges, L/C opening

commission) shall be included in the cost of
Murabaha asset.

• Offer and acceptance may be signed when the asset(s)

arrived at port.
 Use of Murabaha in Exports
• In case of pre-shipment, normal procedure as adopted in
local Murabaha shall be strictly followed.

• In case of post-shipment, Murabaha can not be executed

for goods already exported. However, Murabaha can be
executed for fresh purchases required for next shipment
against assignment of receivables for first shipment.
Practical Issues in Murabaha
 Discount on Acquisition of Assets

Discounts from supplier (If any) would be passed on

to the customer at the time of Murabaha Sale by
reducing the cost of sales.
 Rise in Prices of Asset(s)
• If there is a rise in prices and the amount escalates for
which financing is availed then the transaction can only be
executed if the Bank has been informed and the Bank
subsequently accepts the same.

• The institution reserves the right to reject the purchases if

made other then agreed price.
 Change of Asset(s)

• Change of Asset(s) in the agency agreement

can be done with mutual consent.

• If Agency Agreement is for specific

Asset(s) then new agreement is required for
changed Asset(s).
 Delay in Supply from the Supplier

Delay in Supply from the supplier in case where specific time

was allowed, leads to the revocation of agency agreement. In

such cases the customer will refund the cost of goods.

 Rollover in Murabaha

• Rollover (renegotiate) is also not allowed.

• Rollover in a Murabaha transaction would imply that

payment of earlier Murabaha price by executing new
Murabaha.
 Partial Murabaha
• At times Customer may require partial financing for
its shipment.

• In this case the share of Seller (Bank) should be

mentioned on the invoice and that share should be
separately kept to facilitate the verification by Bank’s
officer.
 Murabaha with Related Parties
• In case of Murabaha, the vendor and the customer must be
independent to each other.

• Banks are not allowed to enter into a Murabaha transaction

where vendor and customer are associated parties.

• Parties are considered to be related parties if one party has 33%

or more shares/ownership in the business of other party.
 Summary of the Lecture
In this lecture we covered
•The concept of Murabaha

•The stages involved in Murabaha transaction

•Practical issues in Murabaha and their resolution

•Murabaha documentation

•Uses of Murabaha as Mode of finance (Local as well as

import Murabaha)