By Jaafar Abdulkadir
As Islamic banking continues to make strides into the mainstream financial services sector in Kenya, players are increasingly redefining their relationship with customers. But, just how does Islamic banking operate? How do the financiers cushion themselves from customer defaults and associated risks?
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Islamic banking operates on the basis of contracts that are deemed legal and lawful as per 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, 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 contracts is the Murabaha Contract – a trade-based model of deferred payment sale used for personal, home, motor vehicle and trade financing.
Murabaha is used only on the basis of sale transactions to purchase goods and services.
The parties to Murabaha contract are the bank (funder), 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.
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.
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 criticism and confusion, which affects perceptions about the compliance of Murabaha contract.
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 and security/collateral, creditworthiness of the customer and the tenure of the facility.
In the event of default, Islamic banks are only entitled to the value of the assets; in case of late payments, there are no penalties that can be charged to the customers that benefit the bank. As a deterrent against frequency of defaults and late payments, 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, not the financing banks.
For Murabaha financing structure to be valid, the Shariah conditions dictates the asset being financed must be in existence at the date 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.
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. This, in the literal sense, amounts to exchange of money for money at the price of interest, which is offends the Shariah guidelines. 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 multiple Murabaha contracts on the same asset.
Expectedly, 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 the high exposure to risk. To limit the possibility of such risks, banks usually execute Murabaha contracts with agency agreements that appoint the customer as the agent to take possession of the purchased asset, which leaves the customer in a position to verify the quality of the asset.
Writer is Head of Islamic Banking at KCB Bank Kenya & Chair, Kenya Bankers Association sub-committee on Islamic Finance