Murabaha in Islamic Banking: Meaning, Application & Types

How Does Murabahah Work?

It is widely used in Islamic banking as a way to provide financing for businesses and individuals while remaining true to the Shariah or Muslim laws. It is often seen as an alternative to conventional loans, where interest rates are charged. In Murabahah, the bank and the customer enter into a Murabaha contract, where the details of the sale are outlined. This includes the cost of goods, profit margin (markup), payment terms, and delivery date. The markup is usually based on current market rates for similar goods.

Murabaha in Islamic banking progresses through four distinct stages, each playing a critical role in the execution of this financial mechanism.

1. Promise Stage:

In the initial phase, the client approaches the Islamic bank with a request for goods. The client promises to buy the specified goods from the bank once it procures them from the third-party vendor.

2. Agency Stage:

Following the promise, the bank appoints the client as an agent. As an agent, the client is authorized to purchase the specified goods on behalf of the bank.

3. Possession Stage:

Once the customer purchases the goods the risk of the goods transfers to the Bank. The bank can now sell these goods to the customer. Please note that the customer plays two different roles in this transaction. One that of the Bank’s agent and the other of the purchaser, and these roles should be segregated to make the transaction Halal.

4. Execution Stage:

Finally, the bank sells the goods to the client, marking the execution of the Murabaha contract. The agreed-upon cost and profit margin are clearly stated in the contract, with payment terms being either immediate or deferred. Institutions must take constructive or actual possession of the product being sold. And, goods must exist at the time of execution. The Murabaha financing cannot be executed if these conditions are not fulfilled.

Comparison of Murabahah with other Islamic Banking Products:

A. MURABAHA VS IJARAH:

While both involve the bank purchasing the asset and then selling it to the customer, the key difference lies in the payment terms. In murabahah, the customer agrees to pay the bank a fixed price over a set period. In contrast, under ijarah, the bank leases the asset to the customer for a fixed period, during which the customer pays rent to the bank.

B. MURABAHA VS MUSHARAKAH:

Both involve profit and loss sharing. However, in مرابحة, the bank sells the asset to the customer at a markup price, while in musharakah, the bank and the customer jointly own the asset and share profits and losses.

C. MURABAHA VS MUDARABAH:

In Murabaha, the bank buys the asset and sells it at a markup, whereas in Mudarabah, the bank (or a bank’s customer) provides capital, and the other party uses that capital to carry out a business activity. Profits from that activity are shared between the parties.

D. MURABAHA VS SALAM:

Unlike مرابحة, salam and Istisna contracts involve the sale of goods that have not yet been produced or acquired. In salam, payment is made in advance, while delivery of goods is deferred. In Istisna, the payment terms are flexible, and the goods are produced according to specific requirements.

Examples and Application of Murabaha:

The following two examples illustrate the Murabaha in Islamic banking, providing customers with necessary financing while remaining compliant with Islamic law.

A. Example of Murabaha: CAR FINANCING

An individual, let’s call him Ahmed, needs to buy a car but does not have the entire amount to make an outright purchase.

1. Ahmed approaches an Islamic bank expressing his desire for a Shariah-compliant loan for a car along with the specifications.
2. The bank agrees to purchase the car on Ahmed’s behalf and then sells it to him on a Murabaha contract.
3. The selling price includes the original cost of the car plus a profit margin.
4. Ahmed agrees to pay this amount in monthly installments over a specified period.

B. Example of Murabaha: HOME FINANCING

Consider another scenario where a couple, Sarah and Khalid, wish to buy a house but lack sufficient funds.

1. They approach an Islamic bank for help.
2. The bank purchases the house and sells it to Sarah and Khalid using a مرابحة contract.
3. The selling price is the cost of the house plus a profit margin.
4. The couple is obligated to pay this total amount in scheduled installments over a predetermined tenure.

Types of Murabaha

There are several types of Murabaha contracts used in Islamic banking. These different types offer flexibility for both the bank and the customer, depending on their needs and preferences.

A. MURABAHA TO PURCHASE ORDERER (MPO):

The bank finances the purchase of goods on behalf of the customer and sells them to them at a markup price.

B. مرابحة TO CASH SELLER (MCS):

The bank purchases goods from a seller for cash and resells them to the buyer at a markup price on deferred payment terms.

C. MURABAHA WITH PARALLEL SALAM:

This involves a two-step process where the bank enters into a salam contract with the customer for future delivery of goods and then sells it to them at a markup price.

D. REVERSE MURABAHAH:

In Reverse Murabaha (also known as Tawarruq), the customer approaches the bank with a ready-to-buy asset and requests financing. The bank purchases the asset from the customer at market value and sells it back to them at a higher price, allowing the customer to pay in installments.

E. COMMODITY MURABAHA:

This is another form of مرابحة financing primarily used for short-term financing needs or cash management purposes.

1. In a Commodity Murabahah transaction, the bank buys a commodity at a specific price and then sells it to the customer at a markup price, which can be paid in installments over a period of time.
2. The customer then sells the commodity in the market to get the cash needed.
3. The bank and the customer engage in this transaction with the understanding that the objective is not the actual ownership and use of the commodity, but to facilitate the customer’s financing needs in a way that is compliant with Islamic finance principles.

This type is commonly used in Islamic banking for liquidity management and interbank borrowing.

Example of Commodity Murabahah:

1. Suppose a customer needs $10,000 urgently for business purposes and approaches an Islamic bank for help.
2. The bank then purchases a commodity, say metal, valued at $10,000 and sells it to the customer at a markup price of $11,000, payable in 12 monthly installments.
3. Now, the customer holds a commodity valued at $10,000. He then sells this metal in the market at $10,000 to meet his immediate cash need.

Shariah Laws for Murabahah Contract:

1. Conditions of Subject Matter:

• Item must exist and must be in the ownership of the seller.
• Subject Matter of commodity murabahah must be in the physical or constructive possession of the seller (transfer of risk and reward and permission of use/Tasarruf).
• The subject of sale must be a property, of a value.
• The subject of the Murabaha contract should not be a thing that is not used except for a Haram Purpose.
• The subject matter must be specifically known and identified to the buyer.
• The delivery of subject matter must be certain and should not depend on chance.
• The subject matter (such as Murabaha-based Islamic mortgage or commodity murabahah) must be tangible goods and commodities.
• The exact cost of the subject matter can be ascertained, and the subject matter is purchased by a third party.

2. Conditional Sale:

There are four types of conditions:

1. A condition which is the requirement of sale (Valid).
2. Reasonable condition for the safety of Subject matter (Valid).
3. Unreasonable condition but by normal market practice (Valid).
4. A condition that is Against the requirement of sale, not following the market practice Beneficial for the seller or purchaser (void).

3. Price of Murabahah:

• The price must be certain. (lump sum/by percentage).
• The price may be deferred or on the spot, and if the price is deferred, the installments and due date must be determined.
• When the price is fixed it cannot be decreased in case of earlier payment, whereas, when the price is fixed it cannot be increased in case of default.
• Fluctuation price is not permissible. However, the use of benchmarks at the time of the Master Financing Agreement is permissible.

4. Expenses of Al Murabahah:

The expenses incurred by the seller directly in acquiring the commodity like freight and customs duty can be included in the cost price.

Advantages and Disadvantages of Murabahah

Advantages of Murabaha Financing

It offers several benefits, including:

A. COMPLIANCE WITH ISLAMIC PRINCIPLES:

Since it is based on the Islamic principle of profit and loss sharing, making it a more ethical and religiously acceptable form of financing for Muslims.

B. NO INTEREST AND SHARED RISK:

Since مرابحة does not involve any interest, it eliminates the element of riba that is strictly prohibited in Islam. Also, both the bank and the customer share the risk of profit and loss, promoting a sense of partnership between them.

C. FLEXIBILITY IN TERMS:

It can be customized to suit the needs of both parties, allowing for flexibility in pricing, payment terms, and other conditions.

D. ENCOURAGES TRADE, COMMERCE, AND RESPONSIBLE SPENDING:

By providing financing for the purchase of goods, Murabahah promotes trade and commerce within the Islamic banking system. The contracts typically involve a higher markup price, which encourages customers to be responsible with their spending and avoid unnecessary purchases.

Disadvantages of Murabaha Financing

Despite its benefits, Murabaha financing also has several drawbacks such as:

A. LACK OF INCENTIVE FOR EARLY REPAYMENT:

Since profit is predetermined in this contract, there is no financial incentive for the customer to repay the loan earlier than the agreed-upon term.

B. DEFERRED PAYMENT RISK:

If the customer fails to make the payment on time, it can lead to a payment default. Unlike interest-based loans, there is no additional penalty for late payment in مرابحة.

C. LIMITED TO TANGIBLE ASSETS:

Murabaha financing only applies to tangible assets or goods. This limitation can be problematic for businesses or individuals who need financing for intangible assets, such as services or intellectual property.

D. POTENTIAL FOR MISUSE:

Some critics argue that Murabahah financing can be misused to mimic interest-bearing loans, thereby contradicting the principles of Islamic finance. This is especially true when the bank and customer pre-agree on the sale and purchase price, making it similar to an interest-based transaction.

The Future Outlook of Murabahah in Islamic Banking

As the world increasingly embraces ethical and socially responsible finance, the future of Murabahah in Islamic banking seems promising. The concept’s transparency and fairness positions it as one of the most attractive modes of Islamic finance. To contribute effectively to this growing sector, individuals are now turning towards educational platforms, seeking the best Islamic finance course or other qualifications like a postgraduate diploma in Islamic finance.

Furthermore, the rise of digital education has made it possible for many to pursue an online MSc in Islamic Banking and Finance, thereby gaining specialized knowledge in Murabahah and its application in the modern financial landscape. This educational trend is expected to foster a new generation of finance professionals, well-versed in مرابحة and other Islamic financial products, driving the future growth of this sector.

Conclusion

As one of the most widely used forms of financing, Murabaha in Islamic banking plays a significant role in promoting ethical and responsible financial practices among Muslims. Its unique features and flexibility make it a preferred choice for both banks and customers, contributing to the growth of Islamic finance worldwide. Individuals and businesses need to understand the concept of Murabahah to fully utilize its benefits and contribute to the development of an ethical financial system.  Overall, the application of Murabaha in Islamic banking is a testament to the compatibility of Shariah-compliant principles with modern financial practices.