24th Jun, 2016
As Islamic banking gradually continues to make strides into the mainstream financial services sector in Kenya, players are increasingly redefining their relationship with customers.
Just how does Islamic banking operate? How do the financiers cushion themselves from customer defaults and associated risks? Islamic banking operates on the basis of contracts that are deemed legal and lawful as per the Shariah standards on condition that these contracts are free from any prohibition .Some of the prohibitions include the provisions of interest popularly known as riba , financing of non-permissible activities, speculative and excessively risky activities .
The contracts can be designed to facilitate sale, exchange and trade transactions as well as financing that is characterised by the absence of debt –structures .For instance the financing contracts can be used to structure transactions like trade finance, asset-backed securities or equity financing. The contracts can also be used to handle financial intermediation processes like fee-based activities, trustee financial services, equity partnerships, agency models or insurance services.
One of the most commonly used contract is the Murabaha contract that is a trade-based model of deferred payment sale used for personal, home, motor vehicle and trade financing. Murabaha was in the past applied as a sales transaction where a business person purchased a product required by an end-user and sold it to the end-user at a price that is inclusive of the cost price as well as a mutually agreed mark-up .Murabaha is used on the basis of sale transactions to purchase goods and services and not for any other purpose.
The parties to Murabaha contract are the bank that provides the funds, the customer who needs the product that is being purchased and the vendor who sells the product that is the subject of the sale contract .The contract between the bank and the vendor is quite independent of the sale contract between the bank and the customer.
Misconceptions
The financier is allowed to ask for security to secure itself against default in future. Either a different asset of value can be taken as security or the same asset financed under the Murabaha structure can be taken if no other asset is available. The financier’s claims on the asset financed or offered as collateral can be registered in the insurance policy.
Globally, there has been misconceptions about Murabaha structured contracts and their compliance to the Shariah. One such misconception revolves around the difference between a mark-up and interest since Murabaha creates financial claim like a zero-coupon bond with a fixed rate of interest.
When a customer walks into a bank and asks to be financed under Murabaha model, the profit rate quoted is often not different from the prevailing interest rate in most of the markets. The practice of using interest-rate index to determine the mark-up rate for Murabaha contract is a major source of criticisms and confusion that affects perceptions about the compliance of Murabaha contract. The Islamic banks could argue that the mark-up rate is a function of an interest-rate index because there is no Shariah compliant benchmark that could provide an indication of the prevailing rate of return in a given economy in a good number of jurisdictions globally. The mark-up rate is influenced by the type of the product, the type of security or collateral, the creditworthiness of the customer and the tenure of the facility.
In the event of default, the Islamic banks are only entitled to the value of the assets and in case of late payments, there are no penalties that can be charged to the customers that benefits the bank. As a deterrent against frequency of defaults and late payments, the Shariah scholars have allowed the banks to charge penalties. However, these penalties are used for charitable causes under the guidance of the Shariah Advisory Boards and not the financing banks.
The conditions for the validity of the Murabaha contract
For Murabaha financing structure to be valid, the Shariah conditions dictates the asset being financed must be in existence at the of the sale contract, it should be owned by the financier and the sale must be instant as well as absolute. The subject of the Murabaha sale must be known to the buyer and it should be intended to be used for permissible business activities as per Shariah standards .
The requirement of the Shariah that the financier must own the subject of the sale before transferring the same to the buyer need not to be physical possession in most cases. There is the acceptance of constructive possession of the asset that essentially means the financier has not taken physical delivery of the asset , yet it has come to the financier’s control and all the rights and liabilities of the defined asset are passed on to him including the risk of its destruction.
The process of executing the Murabaha contracts actually determines its Shariah compliance posing the risk of loss of income and reputational risk to the bank. The Shariah Advisory Boards of the Islamic banks have the prerogative to audit and review all transactions and in the event they notice erroneously executed transactions, they could compel the banks to forfeit the earnings and return it to the affected customers or channel it to charity causes.
Some of the common practices that could invalidate the Murabaha contracts may stem from the practice of giving cash to the customer instead of financing an asset by some of the banks. This in the literal sense amounts to exchange of money for money at the price of interest which is offends the Shariah guidelines.
In case no disclosures of both the original cost price and the mark-up on the asset being transacted are not made, the sale contract is deemed to be non-shariah compliant. It is also important to note that no restructuring of an existing Murabaha facility can be undertaken without a new contract and one cannot have a multiple Murabaha contracts being executed on the same asset.
There should no practice of a customer having purchased an asset from a developer and getting a Murabaha agreement with the bank to purchase the same asset from the bank without the prior termination of the first sale contract.
The risk
The Islamic banks are exposed to credit risk just like in the conventional banks in such sale contracts in the event the customer defaults. Considering that there is a real asset in Murabaha sales offers good comfort against high exposure to risk that is common in the conventional banking system.
The additional risks to the Islamic banks in this structure could also come from the price risk that occurs in the event the customer declines to take the already purchased asset where there was no binding promise to buy from the bank the goods ordered .The price risk and other market risk could have cost implications on the bank that finds itself with rejected goods.
To limit the possibilities of such risks occurring, the banks usually execute Murabaha contracts with agency agreements that appoints the customer as the agent to take possession of the purchased asset and that leaves the customer in a better position to verify the quality of the asset that is the subject of the sale.
Another common form of risk comes from the operational nature of the Islamic banking transactions that involves buying and selling which could raise legal complications and requirements. It is important that the drafting of the contracts are well matched with the commercial intent of the transactions and have well established clarity for the parties involved.
Both the banks and the customers have to clearly understand their roles, responsibilities and the limits imposed upon them by Shariah that aims to promote harmony, fairness, justice and ethical conduct.
One could always refer to the guidelines developed and issued by the Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI), the global standard setting body in Shariah transactions for more guidance and clarity on the structuring of Shariah commercial contracts.
The Writer is the Head of Islamic Banking at KCB Bank Kenya & Chair of the Kenya Bankers Association sub-committee on Islamic Finance
