Lexicus Islamicus Modern Murabaha - a fiduciary sale or a misnomer? Khalil Jarrar, J.D
Monday, July 27, 2009
Modern Murabaha - a fiduciary sale or a misnomer?
By Khalil Jarrar, J.D.
The use of the term infancy in reference to Islamic finance law - murabaha
included – is somewhat revolting when the infant is over fourteen hundred
years old. It gives rise to questioning the term used introducing old instruments
in a new garb, embroidered with Islamic calligraphy that might or might not be
Notwithstanding the known prohibitions in Islamic law, business transactions
are permissible by default. Absent necessities, when prohibitions are clearly
expressed, the perfect tender rule applies where substantial compliance does
not render an instrument permissible. Thus it seems the infancy label is used in
the context of modern finance and adapting some Islamic principles to
accommodate conventional financial instruments or banking practices.
However, Islamic market ethics have existed throughout history protecting
pecuniary, property and liberty interests of members of society. More
specifically, money in Islamic law is to be circulated creating equitable
economic opportunities with negative covenants safeguarding the exploitation
of the weaker party. The modern use the murabaha contract is at the center of
Loitering on the use and definition of murabaha is necessary as there are
significant implications: Today murabaha is far and wide the most popular and
most common mode of Islamic financing. It is also known as mark up or cost
plus financing (in fact the word murabaha is derived from the Arabic word Ribh
that means profit). It is by far the instrument of choice in most Islamic finance
houses minimizing risk for such institutions, with higher return in a short
investment cycle. This is further evidenced by some of the largest Islamic funds
trading vast amounts of murabaha contracts – often in the overnight or money
markets (indeed some murabaha mutual funds in Saudi Arabia hold well over
US$1 billion in assets under management).
Modern murabaha is as controversial an instrument as it is maligned by
practitioners, mainly due to the fact that the bank plays a marginal role in the
goods or commodities sold (where the bank is neither a merchant nor in the
business of selling the goods - rather a basket of kaleidoscope goods being
financed). Aside from being a financier, such practice will be held as a violation
of the ultra vires doctrine in most common law jurisdictions. Recently though,
there have been modest moves in Kuwait, Qatar and the UAE where banks
have become merchants acquiring car dealerships and real estate properties,
selling the products with a deferred mark-up margin, a move that is closely
aligned with shari’a principles (for instance in Kuwait some car dealerships
operate under the concept of musawama albeit the markup is not disclosed to
the buyer but asset ownership is far more exact). Although AAOIFI has
attempted to standardize murabaha contracts, the use of murabaha by IFIs is
consistently inconsistent - at least a dozen definitions or methods for
structuring such contracts exist.
In an article by Haider Ala Hamoudi on modern law murabaha titled “Chasing
Chickens and the Murabaha” the author describes a debate on the issue of
compliance of Murabaha contracts between him and Sheikh Yusuf Talal
DeLorenzo, this specific anecdote comes to mind:
“I referred to a moment in my childhood when I complained to my grandfather
respecting the Shi’a prohibitions on eating rabbit. Why was it, I wanted to
know, that all the Sunni school kids could eat rabbit, but I could not? My
grandfather, Allah bless him, was unfazed, and told me I wasn’t missing out on
anything, because scientists had shown that if you chase a chicken around for
30 minutes and then slaughter it, it ends up tasting precisely like rabbit. (If he’s
right, then I can confirm, rabbit tastes just like chicken.)”
Traditional murabaha is neither a chicken nor a rabbit, rather a fiduciary sale
where the seller expressly mentions the cost he has incurred on the
commodities to be sold with a mark-up known to the buyer conditioned by an
honest declaration of cost. Plain and simple. Murabaha is rarely used by
Islamic banks with the price paid immediately by the customer. In such cases,
there would be no financing included and the Islamic bank would simply be a
middle-man or broker-agent (simsar).
Modern day murabaha contracts arguably meet the requirements of the
traditional definition under Islamic Law. Or do they? If we take a look at a
generic modern murabaha definition (take for reference the recently issued
Islamic banking guidelines of the Monetary Authority of Singapore, as shown in
figure 1); it is a contract between the Bank (here Bank A) and a customer (here
Bank B) under which the customer initiates the purchase of certain
goods/commodities/assets as an Agent of the Bank, and after taking
possession of the goods/commodities/assets (normally constructive) Bank A
sells these to the same customer (Bank B) by adding a certain profit margin to
its cost over a deferred period of time (here P + X). Finally Bank B, after
purchasing the assets back, sells the assets to an external party (a commodity
house or other third party).
In most cases, the bank never takes actual or constructive possession of the
goods sold (the ‘flow’ of the commodity is very much transient), the buyer
does the shopping and price negotiation. Once a deal is reached between the
buyer and the seller, the buyer approaches several Islamic banks and gets
approval on financing the product. The buyer signs an agreement with the
bank for the scheduled payments and the bank in return communicates with
the seller and obtains the relevant information to finalize the purchase and
issues a check in the full amount for the goods purchased.
To begin with, we have two transactions: the first is a principal agent
relationship which is in most laws acceptable absent an agreement if the
principal ratifies this fiduciary relationship after the fact. However in most
instances the buyer does the shopping prior to contacting a bank. It is
acceptable to have an agency relationship without the knowledge of the
principal once the relationship or acts by the agent are ratified by the principal.
It is unusual to have an agent status without the knowledge by the agent
himself, as intent cannot be retroactive. The accidental agency here is a
stretch or a legal fiction of sorts but let’s assume that the buyer being an agent
is implied in fact.
The second transaction is Bai’ Bithaman Ajil (BBA) or modern murabaha, a
contract of deferred payment sale (i.e. the sale of goods on deferred payment
basis at an agreed selling price), which includes a profit margin agreed by both
parties. The profit margin in this context is justified since it is derived from the
buying and selling transaction as opposed to interests accruing from the
principal lent out.
As for the profit margin being a fixed rate , the opinion of the permissibility of
such contract is best articulated by Dr. Mahmoud Amin El-Gamal, a well-known
Islamic economist, in an article titled “Permissible Financing Methods” where
he cites Islamic jurists such as ‘Ibn Rushd (Malik?) and the likes:
“The contemporary confusion is hardly new. In ‘Ibn Al-’Arab?’s ‘Ahkam Al-
Qur’an, he reports a specific argument given by the Arabs during the time of
Prophet Muhammad (pbuh) to support their statement that “trade is like Riba”
[2:275]. They argued as follows: Consider a credit sale, with a price of 10
payable in a month. After a month, the buyer and seller agree to postpone for
one more month, and increase the price to 11. The latter is forbidden Riba.
They then argued: is this not the same as an initial sale with the price of 11
deferred for two months? The answer in [2:275] was a decisive “but Allah has
permitted trade and forbidden Riba”. The legal difference between the two is
very clear: one is a sale in which price is increased for deferment, and the other
is an increase in the amount of a debt for deferment. The first is permitted, and
meets almost all the financing needs, which can be met through forbidden
Riba-based lending. The second, however, is strictly forbidden. The
permissibility of the first and the prohibition of the second are both quite clear
and unequivocal. Therefore, we may use credit sales as a form of finance, and
we must categorically avoid interest-bearing loans.”
In the context above it is presumed that the transaction takes place directly
between the seller and the buyer. In most cases the bank is not a merchant nor
does it deal with the products sold. The role of the bank is less than marginal
and only as a financier.
In addition, the problem does not arise from the profit margin being fixed
rather the way it is calculated. Most Islamic banks today simply use LIBOR (a
Riba-based lending index for conventional banks) as a reference or a
measuring stick for the profit margin. Permissible? Yes. Ideal? No.
It is preposterous to assume that the need to finance a product is a Novus
concept in Islamic society, the need has existed throughout history. The two
major distinctions between traditional BBA and modern BBA is that currently
most Islamic banks take no risk in the transaction and the role is simply limited
financing. The commodity is often secured by filing a financing statement
securing the bank’s interest. And for an added measure some banks ask for
two co-signers who hold deposit accounts in the lending bank for the
transaction to be approved.
The disclaimer of all warrantees by the bank poses another problem, where
the risk of loss is on the buyer dealing with latent defects or the destruction of
the subject matter without fault leaving the customer to incur the hardship and
the expenses of litigation. The bank must take actual risk for the sale to be a
real bona fide shari’a compliant transaction.
Another contentious issue with the current modus operandi is having two sales
in one, a sale and a condition in one contract are not permissible in Islam,
although some Islamic jurists endorsed such practices if the sale is divided into
phases or separate transactions; However, the problem remains where the
ultimate buyer is normally unaware of such distinctions when the two
transactions take place contemporaneously.
Finally, the use of liquidated damages on non defaulting customers, where the
bank imposes a liquidated sum even in cases of an early repayment of the
financed amount is simply unconscionable. The liquidated damages provision
thus operates as a penalty and should not be enforced because it does not fix
damages in light of anticipated or actual harm that never happens. Damages
should thus be limited to any harm the bank suffers, if any not as punitive
A fiduciary sale that lacks trust, covenants of good faith and fair dealing or
equal bargaining positions is nothing but a misnomer. It is time for banks and
fatwa incorporated to reconsider such practices and stop the chase, let that
proverbial chicken rest, it will never become a rabbit.
ASIDE: Market signals & side-effects.
The debate over Murabaha is significant because it presents the industry with a
slippery slope. In their “Guidelines on the Application of Banking Regulations to
Islamic Banking”, the Monetary Authority of Singapore clearly states that it
“does not expect the risk profile of an Islamic bank to be fundamentally
different from its conventional banking counterparts.” The MAS is not at fault
of equating participatory banking with fractional banking (which could not be
more different), it is simply stating the facts of current market practice.
The MAS goes on to state quite succinctly that “the payoffs and risks in making
a murabaha deposit are similar to that of a deposit placed in the conventional
banking system”, it is no surprise that commodity murabaha is often branded
as ‘comedy murabaha’ by practitioners. In that sense, murabaha is just one
more example of the divergence we observe: what practitioners are clamoring
for and what the industry is delivering to them in practice.
When a regulatory body states that “throughout the transaction, the bank is
expected to minimise the holding period of the assets so as to avoid being
exposed to the price movements of the assets” one must wonder where are
the risk-sharing and asset-ownership principles that form the basis of Islamic
The MAS directive to the industry is clear: “The bank can also choose to take
security over the underlying asset in a murabaha to enforce the repayment of
the amount owed.” Never mind that foreclosure and forced-sale are not
exactly ideals of Islamic banking.
These are signals that are allowing the industry to move closer and closer to
conventional banking, when that model is suffering the worst crisis it has seen
in the last sixty years
اللهم صلي على محمد وعلى آله وصحبه وسلم
ALLAH BLESSES MOHAMMAD AND GIVES HIM PEACE