Should Islamic Banks Use Murabahah or Mudarabah Their Asset Side - Term Paper Example

Should Islamic Banks Use Murabahah or Mudarabah their Asset Side Lecturer Name : Student Name : Date of Submission : Signature : Table of Contents Table of Contents 2 Introduction 3 Islamic Finance Investment Type 5 Murabaha 5 Mudarabah 6 Risk Profile of Islamic Finance Investment Types 7 Murabaha 7 Risks in Islamic Banks 9 Market risks 9 Mark up risks 9 Liquidity risks 10 Operational Risks 10 Legal Risks 10 Withdrawal risks 11 Fiduciary risks 11 Focus of Islamic Banking 13 Conclusion 15 References 16 Introduction Islamic banking can be described as a banking activity that is consistent with the principles of Shariah law. Islamic banking and financing has lately emerged as a burgeoning subsector within the international financial market arena. The roots of this particular concept of Islamic banking & finance can be traced back to about 1,400 years ago, however, Islamic banking and finance approach begun taking centre stage recently in 1970’s when Islamic banking products were launched in Saudi Arabia and United Arab Emirates, and later on in the 90’s to countries such as Bahrain and Malaysia that have now emerged as centres of excellence worth emulating. It is today being estimated that approximately USD $1.3 trillion in assets are being managed under rules touching on Islamic finance (Ken, 2011). Deutsche bank is also estimating that by 2016 this particular market is poised to hit USD $1.8 trillion in assets alone, and even iconic companies such as Emirates airline have announced that they are deliberating on the idea of using Islamic finance market to fund their own fleet expansion (Brian, 2011). Established western banks grappled by tough operating conditions from markets that they have traditionally relied on are now turning to “Sukuk” a form of Islamic finance. For instance, in May 2011, HSBC issued a USD $500 million “Sukuk”, and in October the same year, Goldman Sachs also announced a USD $2 billion “Sukuk” program (Reuters, 2011). Sharia compliant assets have also increased their net-worth dramatically, and to be precise by 150% since 2006. It has been cited that banks hold approximately 90% of Islamic assets, with the rest being held in “Sukuk” which is basically a type of bond product structured for the Islamic market. According to latest information released by Zawya, a business information company, global issuance of “Sukuk” in 2012 is projected to be playing in the region of USD $43.3 billion. This is mainly attributed towards withdrawal of European banks lending towards the gulf co-operation council. Fig 1.0 Global “Sukuk” issuance Islamic finance & Banking derives its principal trading activities under Islamic, or Sharia law, whose primary sources are the Quran and sayings of Prophet Muhammad. Islamic finance on a wider perspective with Sharia law emphasizes on Justice and Partnership. Some of the Key Principles of Islamic Finance entails: All illegal and harmful activities (haram) should be completely avoided Risks regardless of the level should be shared All investments should come with social and ethical benefits to the general society Wealth accumulated should come from legitimate businesses and asset-based investments However, there are certain activities detested by sharia banking and the entire Islamic finance, these include; Charging and receiving interest (riba) Trading in illegal businesses such as pornography, pork, drugs, gambling, alcohol, or anything forbidden by the teachings of the Sharia law Getting involved in speculative businesses, or those with extreme risks such as gambling or future trading and options market Dealing with controversial subjects and terms of contract, and this may extend brokering or dealing with items that one does not own Islamic banking protagonists are of the idea that there is a market potential of a billion Muslims across the globe, and most of the Muslims if not all are seeking financial institutions that is in synch with their religious beliefs. According to different financial analysts, it is being believed that clients from Middle East have transferred billion worth of assets from conventional western banks. This particular asset transfer is being attributed to the recent strict new financial regulations that were passed in the wake of September 2001 terrorist attacks, and as a result, Islamic financial institutions have admitted being the main beneficiaries of these assets transfer (Zamir & Mirakhor, 2011, p.73). Islamic Finance Investment Type There are various types of Islamic contracts that apply uniquely to provide alternative Islamic financing options. These particular contracts are the bedrock of Shariah compliant substitutes. These contracts are structured in order to eliminate the interest (riba) and uncertaininty (Gharar) from transactions that involve money. Murabaha This entails selling products at a price that involves profit margin as it has been agreed by both parties (Buyer & Seller). Such a contract is only valid to the extent that the price, incurred expenses, and the profit margin are stated at the onset of the transaction. Fig 2.0 Diagrammatical illustration of using Murabaha in financing structure In most cases Murabaha is referred to as the cost-plus financing and often appears as trade that is mainly centred on letters of credit. In the simplest form, Murabaha entails selling products on a deferred basis. The product being sold is normally delivered on an immediate basis whereby the selling price of the item includes mutually agreed profit margin that is payable to the seller. In Murabaha contracts, the true cost of the item is shared between the buyer and the seller implying that this concept is more of a “trust sale” because the buyer must trust the seller that he/she is truly disclosing the real costs, whereby after disclosure of the real costs, profits are agreed either on the basis of percentage commissions or fixed amount. It is also vital to understand that the profit advanced to the financier is not as a result of using the financier’s resources. This implies that the financier cannot demand cash if he/she does not perform any service other than the use of his/her funds because this would resemble charging of interest that is considered haram. Murabaha is mainly used in short term business transactions and it is also the most preferred form of trading under Islamic finance. Mudarabah Under this concept there is an agreement initiated between the capital provider and a third party who acts as the entrepreneur. Under this particular agreement, the entrepreneur carries out business projects and profits are shared according to pre-agreed profit sharing ratio. When losses occur, they are normally borne by the financier, and the only exception to this particular rule is when it has been proved that losses arose as a result of negligence from the entrepreneur’s side and in such cases the entrepreneur bears the losses. Financiers maximum loss is only limited to his share of financing. Fig 3.0 Diagrammatical illustration of using Mudharabah in financing structure Under the Mudarabah model, a mudarib, or rather an entrepreneur comes in and provides management experience and this contribution is usually regarded as a form of capital. In this concept the investor is referred to as the rabb al-mal. Anticipated profits between the investor and the mudarib(s) are agreed at the onset of the deal in ratios. The rabb al-mal bears all the losses accrued by the invested assets (this includes both cash and other invested assets). In the eventuality of a loss, these losses shall be shared according to investment share held by each investor. Here the entrepreneur does not also bear losses arising from the invested capital. Under Mudarabah entrepreneurs are strictly not allowed to receive any sorts of remuneration other than the profit-share. Technically in layman’s language, the entrepreneur cannot receive any form of compensation unless the entire project is profitable, or unless there has been a guaranteed wage that was set prior to the deal. Risk Profile of Islamic Finance Investment Types Murabaha It works under the guise of a contract whereby the Islamic bank comes in and makes a purchase for some specified goods upon the client’s request, whereby the client also makes some deferred payments covering costs and some agreed profit sharing. Every Murabaha transaction must entail two distinct contract types. There is the first contract where the Islamic financing institution buys products from a supplier, and the second, is where the financial institution sells off the products to the client. As a result, this very financing does not necessary arise from transferring of money but rather through transfer of assets. Therefore in such circumstances, the condition of the validity of the transaction is based on the idea that the financial institution must hold the ownership and possession of the product under question before it can be disposed off to the client, and possession can be either constructive, or physical. With constructive it implies that the financial institution hasn’t taken any physical delivery of the product but it is in total control of the item with all the rights, liabilities, and risks including risks associated with destroying this particular product should the deal now work out as envisaged. With modern commerce, physical possession is not an issue provided that there is adequate documentation indicating constructive possession. The particular order placed by the client, is not a sale contract but rather a kind of a promise to buy the item. In some circumstances whereby the promise is not legally binding to the buyer, the client even after initiating an order, may proceed and cancel out the entire agreement. In such circumstances, the Islamic bank or the individual providing funds will bear the whole risk. The above selling methodology directly contradicts with the interest system whereby any delayed payments automatically push up the interest charges. However, with Murabaha contracts, late payments from the client cannot be penalized, because under the Murabaha contract Islamic financial institutions are not allowed by their own Shariah laws to charge anything in excess of the initially agreed price (Abdullah, 1996). In order to override the above problem, Islamic banks or investors can resort to a strategy known as “mark down” that provide rebates or some kind of incentives for early payments. It is also legal for the Islamic bank or individual to obtain some form of collateral from the client in order to ensure payments. However, critics to Murabaha contracts are arguing that when the mark-up is added to the original cost of the product, it becomes equal or even in some cases exceed the amount of interest that a client would have paid in non-Islamic banking system. Beside this particular criticism, it is beyond reasonable knowledge that the time taken between the purchase and sale is more likely to transpire as the time it takes to sign the two contracts, and as a result, the financial institutions is exposed to some relative amount of risks in exchange for a comparatively profitable return on an asset-backed basis (Ben & Emelki, 2008, p.83). Because Islamic banking is relatively new in the financial arena, some of the risks inherent in this form of business concept are not properly comprehended. Islamic financial institutions are therefore exposed on two basic types of risks; these are risks similar to those faced by conventional banking institutions, and risks due to compliance with the Shariah laws. In addition, institutions practising Islamic banking are constrained under the premise that using some of the risk mitigation instruments devised by their counterparts from conventional banking systems is not allowed due to Islamic commercial law (Muhammad, Mamoona, & Hassan, 2011). Risks in Islamic Banks Islamic banking asset and liability side come with unique characteristics because Islamic banking model is being believed to have evolved into a single tier Mudarabah model consisting of various investment tools. On the liability of side of Islamic financial institutions, savings and investments deposits have assumed the shape of profit sharing investments. Some of the risks exposed by Islamic based financial institutions include; Market risks This mainly arise from unsystematic or macro sources. For instance, currency and equity risks are under the umbrella of systematic category while, movement in commodity prices is under specific market risks. Mark up risks Islamic banking mainly uses benchmark rate in order to ascertain the cost of various financial instruments. For instance, in a Murabaha contract, mark-up is usually determined by accumulating the risk premium and the benchmark rate (LIBOR), and the nature of such Murabaha contract is that the mark-up must be fixed for the entire duration of the contract. In case the benchmark is adjusted, mark up rates on these fixed costs cannot be changed and as a result there is a risk arising from fluctuations in interest rates. Liquidity risks This may arise due to difficulties acquiring cash at some reasonable charges from borrowers that may either be funding the liquidity risks or sale of assets. This particular liquidity risks that come from all parties is crucial for Islamic banks. Due to various reasons, Islamic financial institutions are more prone towards liquidity risks mainly because, there is high restriction on the securitization of existing assets of Islamic banks, and Secondly, due to slow pace of financial instruments development, Islamic banks cannot quickly raise funds from the market, and the problem becomes even more grave due to the fact there is no inter-Islamic bank money market. Finally because the last resort lender (LLR) who normally provides emergency funds to conventional banking system, cannot support Islamic banks because the existing LLR facilities are based on interest charges. Operational Risks This mainly entails direct or indirect loss arising from failed internal processes such as external events, technology, people, or operational processes. Operational risks is also compounded by the fact that Islamic financial institutions may not have skilled personnel (in terms of capacity and capability) to conduct Islamic financial operations. Also going by the different nature of this Islamic finance business compared to conventional banking, computer software’s available in the market that are developed for the conventional banking system may not be suitable for Islamic banks and this provides system risk of embracing information technology in Islamic banks. Legal Risks Due to the uniqueness of Islamic finance, certain jurisdictions have not enacted specific laws/statues that support unique features of Islamic banking. For instance, Islamic banking is mainly centred on trading Murabaha and investing in equities such as mudaraba and musharakah. This is contrary to current banking law and regulations existing in most countries that forbid conventional banking system from dealing with such practices. Secondly, non standardization of contracts under Islamic banking makes the entire process of negotiating for various aspects of financial transactions extremely difficult and costly for that matter. Finally, lack of Islamic courts in most jurisdictions also increases legal risks of using such Islamic based contracts. Withdrawal risks Because the rates of return on savings and investments deposits are variable, this introduces some uncertaininty within Islamic financial instruments. The ability to preserve assets by minimizing risks arising from low rates of return is a crucial factor with depositors withdrawal decision. On the financial institutions perspective, this presents a withdrawal risk linked to lower rate of return relative to other competing financial institutions. Fiduciary risks This may arise when there is a breach of contract from the side of the Islamic financial institution. For instance, certain financial institutions may not be in a position of fully complying with Shariah requirements pertaining to specific contracts. This inability of compliance whether it is knowingly or unknowingly may lead to lack of confidence with depositors and may lead to mass withdrawal of deposits. Risks inherent with various Islamic modes of financing These risks constantly evolve hence increase on their complexity. According to a certain survey that was conducted on some 18 Islamic bankers, it was revealed that credit risk appears to be the least in Murabaha at and most in Mudarabah (Hennie & Zamir, 2008, p.16). Type of Contract Stage of Contract Credit Risk Market Risk Murabaha and non-binding Murabaha purchase order Asset available for sale (Asset on balance sheet) _ X Asset is sold to and payment is due from customer X _ Maturity f contract or upon full settlement _ _ Binding Murabaha Purchase order Asset available for sale (asset on balance sheet) X _ Asset is sold to and payment is due from customer X - Maturity of contract or upon full settlement _ _ Table1.0 Summary of risk transformation under Murabaha Focus of Islamic Banking Islamic banking refers to sets of banking activities consistent with the principles of Shariah law. These principles emphasize on moral and ethical values in all business transactions. Shariah law prohibits acceptance of any form of interest charges (riba), as well as conducting any form f trading activities contrary to Islam principles. Most Islamic financial institutions use Murabaha due to its compliancy with Shariah laws. In Murabaha, the seller willingly declares the cost that they have incurred on commodities for sale, and they normally add some profit that is known by the buyer. Murabaha due to its openness has transpired as a very popular mode used by commercial banks in Islamic countries to promote riba-free transactions. However, different financial institutions, use Murabaha in varying rations, mainly banks use Murabaha in commodity import-export, microfinance, property, and other forms of asset financing (Mervyn & latifa, 2001, p.14). It is impractical for banks to use Mudarabah or musharakah because these particular profit sharing modes involve substantial level of risks hence unlikely to guarantee the banks any income. However, on the other hand, Murabaha due to its fixed margin provides financial institutions with a more predictable income stream because it involves several profit sharing instruments that shares the risk more equitably between the seller and the buyer. With Murabaha transactions there are also practical guidelines in place that ensure that all the transactions conducted between the bank and the customer is based on trade and not just merely on financial transactions. For example, a financial institution is mandated by the rules of the Murabaha to take constructive or actual possession of goods before selling it to the customer. Even though the bank is justified to charge an additional margin to the client to reflect on the time value of money in terms of actual payment not received from the client at time zero, the bank may only impose penalties for late payments which also should be purified by being donated to a charity of choice (Rifaat & Simon, 2011, p.84). It is on the above rationale that it can be argued that Islamic banks use some altered forms of Murabaha to facilitate financing of short or long term trade transactions according to the end users requirements. Murabaha contract formats are neither independently applied contracts because all the Islamic trade rules either form pre-requisites or essential components that are widely adopted in the contract documentation. Because Islamic principles prohibits the any form of interest taking, financiers have realized that forwarding of non-interest bearing loans is likely to lead into loss on future purchases values of loans extended to clients mainly due to factors such as inflation. “Do not charge your brother interest, whether on money or food or anything else that may earn interest.” (Deuteronomy 23:19) “If you lend money to My people, to the poor among you, you are not to act as a creditor to him; you shall not charge him interest.” The Holy Bible (American Standard Bible) [Jesus said], “If you have money, do not lend it at interest, but give [it] to one from whom you will not get it back.” Gospel St Thomas, V95 As an alternative strategy to cushion on the above, rather than providing loans with no interest, financial institutions may either directly or indirectly purchase assets sought by the customer seeking financing. However, financial institutions embark on such transactions if they are certain they will dispose of the asset at a profit. In such a manner, banks do not exactly derive interest (Riba) and at the same time they have also fulfilled the economic interest of the borrower. With the above, in regards to Murabaha financing, banks are not the primary owners of the assets required by the financial institutions, but rather the banks acts as traders by purchasing assets on behalf of the client and sells it to him/her at some profit. Financing operations in Islamic banks have inclined towards Murabahah mainly because its perceived less risks, and also because of the fact that risks can be mitigated based on capital outlay and expected profits. Risks in Murabaha are mitigated by demanding collaterals and also accepting sureties as well as via tapping into the insurance systems that may or not be Islamic related (Yahia, 2009, p.37). Some of the key areas where Murabaha finance is applied include 1. Consumables (wholesalers and suppliers) 2. Tangible assets 3. Machinery 4. Office equipment 5. Motor vehicles 6. Housing and other fixed business or industrial property Conclusion Islamic banking is interest free and trade oriented and mainly based on profit sharing and loss sharing mechanisms. The performance of this banking concept can be described as remarkable because country specific performances and efficiency in Islamic Banking sector is significantly increasing. Islamic banking is also facing stiff competition from other products from conventional banking system, and this particular competition, is likely to create a very big challenge for Islamic banking. Should Islamic banking thrive in a competitive environment, then it means that it has better potential for improvements. Cultural differences have also been cited to act as setbacks that affect Islamic banking. Central banks regulations from non Islamic states also tend to affect Islamic banking operations, however, with increasing competition and the need to open up business opportunities, central banks are now beginning to lose grip on such rules and regulations. As a result, conventional banks are expanding their branch networks targeting the mass with Islamic banking needs. This clearly indicates that Islamic banking is a new and clear market opportunity not only for the banks but for the entire financial industry in general. References Abdullah Saeed, 1996, Islamic Banking and Interest: A Study of the Prohibition of Riba and Its Contemporary Interpretation. 2nd Edition, BRILL Publishers. Ben Arab Mounira, Elmelki Anas (2008). Managing Risks and Liquidity in an Interest Free Banking Framework: The case of Islamic Banks. International Journal of Business and Management. Vol. 3, No. 9. Brian B. Kettell, 2011, Introduction to Islamic Banking and Finance. Illustrated edition, John Wiley and Sons. Fig 1.0 Global “Sukuk” Issuance, Islamic Finance. Retrieved Friday, October 19th 2012 from http://www.economist.com/blogs/graphicdetail/2012/04/focus-2 Hennie van Greuning, Zamir Iqbal, 2008, Risk Analysis for Islamic Banks, stand alone series. Illustrated edition, World Bank Publications. Ken Garrett (2011). Introduction to Islamic Finance. Retrieved Friday, October 19th 2012 from http://www2.accaglobal.com/pubs/students/publications/student_accountant/archive/sa_mar11_F9_islamicfinance.pdf Mervyn Lewis, Latifa M. Algaoud, 2001, Islamic Banking, illustrated edition, Edward Elgar Publishers. Muhammad Akram, Mamoona Rafique, Hassan Mobeen Alam, 2011, Prospects of Islamic Banking: Reflections from Pakistan. Australian Journal of Business and Management Research. Vol. 1 No. 2, May 2011. Reuters (2011). Western Debt Crisis Spurs Growth of Islamic Finance. Retrieved Friday, October 19th 2012 from http://www.reuters.com/article/2011/11/30/us-finance-islamic-idUSTRE7AT1DS20111130 Rifaat Ahmed Addel Karim, Simon Archer, 2011, Islamic Finance: The Regulatory Challenge. John Wiley & Sons. Table 1.0 Summary of risk transformation under Murabaha, retrieved http://www.bankislam.com.my/en/Documents/shariah/RiskMgmtinIslamicBkg.pdf Yahia Abdul-Rahman, 2009, the Art of Islamic Banking and Finance: Tools and Techniques for Community-Based Banking. John Wiley and Sons. Zamir Iqbal, Abbas Mirakhor (2011). An Introduction to Islamic Finance: Theory and Practice. 2nd Edition, John Wiley and Sons. Read More