Advanced Islamic Banking and Finance

Islamic Financial Contracts

Murabahah
Sources and Uses of Funds by
Islamic Banks

• Dual banking system

A banking system of a
country or territory that
incorporates both the
conventional and Islamic
financial systems
Sources and Uses of Funds by
Islamic Banks

Sources of Funds

Two major sources

1. Transaction deposits: risk-free funds which do not yield
return e.g. current accounts based on the wadi’ah concept

2. Investment deposits (UIA) and (RIA): profit-making

but have risk of capital loss, depending on amount invested
by bank
 Sources and Uses of Funds by
Islamic Banks

Three main types of accounts:

1. Current Accounts: account opened by individuals,
companies and firms by depositing cash, cheques and/or
bills (based on concept of wadi’ah)

2. Saving Account: funds deposited in saving account yield

some returns depending on bank financial results. Based on
wadi’ah, mudarabah and musharakah concepts

3. Investment Account: the most important source of funds

for Islamic banks; the customer and the bank enter into a
joint-venture agreement, based on mudarabah concept
Sources and Uses of Funds by
Islamic Banks

Application of Funds

• Islamic banks apply funds to raise profits in different ways

• The main channels for the outflow of the funds include the:
- musharakah (partnership)
- mudarabah (trust financing)
murabahah (cost-plus financing)
- ijarah (lease) -
istisna’ (manufacturing contract)
- bay salam (forward sale)
- bay mu’ajjal (deferred sale contract) models
Concept of Exchange-Based Contract

Exchange-based contracts in Islamic law have been

transformed into viable (debt financing) instruments:
- Murabahah (Mark-up) -- Sale contract.
- Istisna’ (Manufacture Sale)
- Salam (Forward Sale)
- Bay Dayn (Sale of Debt)
- Tawriq (Securitisation)
- Sarf (Sale of
Currency) - Tawarruq
(Cash Financing) - Bay
Inah (Sale with immediate purchase)

Debt-based financing instruments: Financial instruments

that create debt-like relationships between parties
Concept of Exchange-Based Contract

Murabahah (Mark-up/ cost plus)

• Murabahah: The sale of a lawful and commercially valued

commodity at the cost price that it was purchased plus an
additional profit, which has already been mutually agreed
upon by the parties
• Murabahah is derived from the root word ribh which means
profit, gain or a legal addition
Concept of Exchange-Based Contract

Figure 3.1: A Typical Murabahah Contract

Concept of Exchange-Based Contract

Figure 3.1: A Typical Murabahah Contract

1. The contractor contacts the bank to acquire 50,000 USD

worth of building materials
2. The bank enters into another contract with the producers
and buys the materials immediately
3. The producer sells the materials to the bank
4. The bank supplies the materials to the contractor at the
mark-up price
5. The contractor pays the mark-up price on a deferred basis
Concept of Exchange-Based Contract

Figure 3.2: An Overview of the Murabahah Contract

Concept of Exchange-Based Contract

The specific conditions for a valid murabahah

transaction:

1. The goods subject to murabaha must be lawful, real, and

have commercial value. Currencies or credit instruments
cannot be traded in murabaha
2. The buyer must know the cost price of the commodity as
well as the additional procurement costs (packaging,
transportation, delivery). However, in a Musawamah, the
price of the commodity is unknown to the customer
3. The margin of profit must be mutually predetermined by
the parties at the beginning of the contract
The 5 stages of Murabahah
• Firstly: The client and the institution sign an over-all
agreement whereby the institution promises to sell and the
client promises to buy the commodities from time to time
on an agreed ratio of profit added to the cost.
• Secondly: The institution appoints the client as his agent
for purchasing the commodity on its behalf, and an
agreement of agency is signed by both the parties.
• Thirdly: The client purchases the commodity on behalf of
the institution and takes its possession as an agent of the
institution.
• Fourthly: The client informs the institution that he has
purchased the commodity on his behalf, and at the same
time, makes an offer to purchase it from the institution.
• Fifthly: The institution accepts the offer and the sale is
concluded whereby the ownership as well as the risk of the
commodity is transferred to the client.
 The 5 stages of Murabahah

• (a) At the first stage, the institution and the client promise
to sell and purchase a commodity in future. This is not an
actual sale. It is just a promise to effect a sale in future on
murabahah basis. Thus at this stage the relation between
the institution and the client is that of a promisor and a
promisee.
• (b)At the second stage, the relation between the parties is
that of a principal and an agent.
• (c) At the third stage, the relation between the institution
and the supplier is that of a buyer and seller.
• (d) At the fourth and fifth stage, the relation of buyer and
seller comes into operation between the institution and the
client, and since the sale is effected on deferred payment
basis, the relation of a debtor and creditor also emerges
between them simultaneously.
Concept of Exchange-Based Contract

Issues with Murabahah:

1. Can the price of a commodity in a credit sale be increased

from the price of a cash sale?
2. What if the buyer refuses to buy after the Islamic bank has
purchased the commodity?
3. Can the buyer ask for a discount if he repays earlier?
4. Can the bank impose a penalty on default payment?
5. What about using the LIBOR as a benchmark rate?
6. Can the bank ask for a security against murabahah price?
7. Can the bank ask the buyer to furnish a guarantee from a
third party?
1 – Home Financing through Murabaha

Example of a Murabaha Home Finance transaction.

The total cost of a house is USD 1 million.

The customer makes no down payment (Hamish Jiddiyya) and requires 100% financing.
The bank agrees to finance 100% cost of the house.
Bank purchases the house and sells it to the customer on Murabaha Basis repayable in 5
years. The total Murabaha Sale Price is made up of the amount financed by the bank plus
the bank’s total profit based on a profit rate of 5 %.

Find the :

Total Murabaha Sale Price

Monthly Installements
Cost Portion Installement
Profit Portion Installement

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1 – Home Financing through Murabaha

Solution

Profit = Amount Financed (F) * Profit Rate (R) * Terms of

Financing
Profit = 1 000 000 * 5 % * 60/12 = 250 000

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2 – Vehicle Financing through Murabaha

1. A Customer who is in need to acquire a vehicle approaches the Islamic Bank

and applies for finance through Murabaha (Mark-up Sale) transaction.

2. As per Customer’s financing requirement Bank assesses the Customer’s

creditworthiness and approves the request.

3. The Bank seeks an undertaking from the Customer to buy the vehicle from
the Bank once latter purchases the same and takes the possession thereof.
Along with other details the Bank’s profit is also stipulated in such
undertaking.

4. If the financing is not approved for the 100% value of the vehicle the Bank
asks the Customer to pay certain amount as down payment (Hamish
Jiddiyyah) which is converted into Down Payment at the time of signing the
Murabaha Sale Contract.

5. The vehicle supplier submits a quotation to the Bank with the detailed
specifications of the vehicle and its sale price.

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2 – Vehicle Financing through Murabaha

6. The Bank issues the Local Purchase Offer (LPO) to the vendor and purchases
the vehicle on its fair market price. The sale and purchase agreement
between the Bank and the vendor is envisaged by accepting the vendor to the
above LPO.

7. After getting the possession of the purchased vehicle the Bank sells it to the
Customer through a Murabaha Sale Contract after adding its profit (mark-up)
to the cost of purchase.

8. Contract clearly stipulates the Murabaha Sale Price which consists of the cost
of purchase and the Bank’s profit. The payment term of the sale price is also
agreed between the Customer and the Bank in this contract.

9. The Bank hands over a Delivery Order to its Customer enabling him to receive
the vehicle from the vendor after which the ownership risk in the vehicle gets
transferred from the Bank to the Customer.

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2 – Vehicle Financing through Murabaha

10. To secure its finance the Bank generally mortgages the vehicle in its favor. In
accordance with the Bank’s risk appetite it may require from the Customer
some other securities like salary transfer.

11. The insurance is arranged by the Customer on its own the proceeds of which
are assigned to the Bank. In case of any accident which results into a total
loss of the vehicle the relevant insurance company pays the claim amount to
the Bank.

12. If the customer requires the insurance to be financed as well, the bank
obtains the insurance policy only from the Islamic Insurance (Takaful)
company and then sells the insured vehicle to the customer. In no case any
Islamic Bank can finance the takaful policy separately.

13. After getting all the documents along with the original invoice from the
Vendor, Bank releases the payment for the cost of purchase.

14. Customer starts paying the Murabaha Sale Price.

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2 – Vehicle Financing through Murabaha

1. The customer makes zero down-payment and requires 100% financing.

2. The bank agrees to finance 100% cost of the car which is USD 150 000.

3. The bank purchases the car and sells it to the customer on Murabaha basis payable in 5 years.

4. The profit rate is 5 %

Find the :

Total Murabaha Sale Price

Monthly Installements
Cost Portion Installement
Profit Portion Installement

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