By Salma Bouzoubaa,
Edited by Sanaa Kadi
The concept of Murabaha originates from the Islamic legal principle of “Bay’ al-Murabaha”, which is a type of sales contract allowed in Islamic law. This concept is rooted in the Quran and the Hadith (sayings and actions of Prophet Muhammad). In Islamic finance, Murabaha has been adapted as a financing tool to meet the needs of customers who require credit to purchase goods and assets (Muhammad Yusuf Saleem 2012). The use of Murabaha in Islamic finance is also in line with the principles of shariah law, which prohibits the charging of interest (Riba) on loans. Instead of charging interest, the bank earns a profit by purchasing the asset on behalf of the customer and then selling it at a marked-up price (Usmani 2002). This allows the bank to earn a profit while also providing a useful service to customers who require financing for their purchases.
Figure: Murabaha transaction
Source: Sanaa Kadi
Murabaha is widely used in Islamic banking as a means of providing financing for the purchase of goods and assets. According to the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), “Murabaha is a contract in which a bank or a financial institution buys a commodity from a supplier and sells it to the client at an agreed-upon price, which includes the cost of the commodity plus a profit margin.” The customer pays the bank for the commodity in installments, usually over a period of months or years. The marked-up price is the profit that the bank earns on the transaction, which is agreed upon at the time of the sale. Indeed, regardless of the circumstances, the price that was set before the sale can no longer be changed.
The Islamic finance concept of Murabaha is based on the principles of profit and risk sharing. The bank assumes the risk of the transaction, and the customer pays for the commodity over time, with the profit earned by the bank being shared between the bank and the customer. Murabaha is a widely accepted form of Islamic finance and is used in a variety of industries, including:
- Real Estate: The bank purchases a property on behalf of the customer and then sells it to the customer at a markup. The customer then pays the bank back over a period of time. (The same system is used in all the other categories)
- Consumer Finance
- Trade Finance
With Murabaha, customers can make purchases over time while providing a profit for the bank and sharing risk between the parties involved (Ruzian Markom and Nur Hidayah Abdul Salam 2019)
However, there may be differences between the theory and the real application of the principle of Murabaha (Osman M. Alyahya 2014). Here are some examples:
- Transparency: In theory, Murabaha transactions should be transparent, and the bank should disclose the actual cost of the commodity and the profit margin to the customer. However, in practice, some banks may not fully disclose this information, leading to confusion or misunderstandings about the transaction. This lack of transparency can lead to trust issues between the bank and the customer.
- Risk: In theory, Murabaha transactions involve the sharing of risk between the bank and the customer. However, in practice, the bank may place most or all of the risk on the customer. For example, if the customer is unable to make the payments on time, the bank may charge additional fees or penalties, which may make it difficult for the customer to repay the debt.
- Purpose: In theory, Murabaha should be used for financing the purchase of goods and assets. However, in practice, some banks may use Murabaha for other purposes, such as refinancing or working capital. This can lead to confusion about the purpose of the transaction and whether it is compliant with shariah law.
- Commodity: In theory, Murabaha should involve the purchase of a physical commodity, such as gold or grain, that is owned by the bank. However, in practice, some banks may use virtual commodities or financial instruments, which may not be compliant with shariah law.
A typical Islamic finance case is the Beximco case wherein a company entered into an Islamic Murabaha loan agreement with an Islamic bank. When the bank asked for repayment, the borrower declined to settle the balance and claimed that the contract was in fact an interest-bearing loan that was only dressed up as an Islamic transaction. In view hereof, the borrower argued, the contract was void and that there was no obligation to repay (Shamil Bank of Bahrain v. Beximco  EWCA Civ 99).
Moreover, from the Sharia perspective, the bank is required to acquire ownership of the asset and the risks attached to ownership in transit. But as we said earlier, in Islamic finance practice, the risks attached to ownership in transit of the bank are minimal if existent at all. First, the contracts normally provide for an allocation of risk that is like the one under a conventional loan agreement. And second, instead of acquiring a specific asset, the bank often sells certain commodities to the customer, who immediately turns them into cash on the commodities exchange.
This structure—called Tawarruq—provides the customer with liquid funds and is thus even closer to a conventional loan structure. Permissibility of these structures from a Sharia perspective is not uncontroversial, to say the least—with the effect that there is always a chance that a fatwa will be issued according to which the transaction is not permissible.
The chance that an Islamic financing transaction is challenged on grounds that it does not comply with Islamic law is called “Sharia risk.” Since the emergence of the first Islamic finance cases, the issue has attracted a lot of attention. Sharia risk illustrates the changed role of Islamic law in Islamic finance. In the world of finance, law (and lawyers) normally serve to make the transaction enforceable in court. Law provides transaction security. In Islamic finance, in contrast, the role of the Sharia is reversed. Sharia is a risk, which allows the transaction to be attacked on the basis that it did not conform to Islamic legal principles (Kilian Bälz 2008).
This phenomenon shows us that even though the Murabaha contract should be a contract that avoids risks, in fact, the very use of Sharia can cause problems leading to the cancellation of the contract.
However, to mitigate Sharia risk, Islamic financing transactions normally contain a so-called “waiver of Sharia defense” clause. In this clause, although worded slightly differently from one transaction to the other, the borrower normally waives the right to bring any defense based on the non-compliance of the transaction with Sharia principles (Kilian Bälz, 2008). In addition, the clause may also provide for an explicit statement on Sharia compliance, pursuant to which the parties agree to follow the interpretation of the bank’s own Sharia board as far as the transaction is concerned.
To conclude, while the principle of Murabaha in Islamic finance is based on clear principles, its application in practice can be more complex and may vary between institutions. It is important for banks to ensure that their Murabaha transactions are transparent, fair, and compliant with shariah law, and for customers to be aware of their rights and obligations in these transactions. For this reason, the AAOIFI provides guidance on the proper use of Murabaha in Islamic finance, including the need for transparency and fair pricing.
- Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). Shariah Standards for Islamic Financial Institutions. 2018.
- Kilian Bälz; Sharia Risk? How Islamic Finance Has Transformed Islamic Contract Law; (Occasional Publications 9 September 2008)
- Muhammad Yusuf Saleem; “The Concept of Bay’ al-Murabaha: An Overview” (ISRA International Journal of Islamic Finance, 2012)
- Osman M. Alyahya; “Misuse of Murabaha Contracts in Islamic Finance: An Examination” (International Journal of Economics, Commerce and Management, 2014)
- Ruzian Markom and Nur Hidayah Abdul Salam; “Murabaha Financing: A Shari’ah-compliant Tool for Islamic Financial Institutions” (International Journal of Business and Society, 2019)
- Usmani, M. T; An Introduction to Islamic Finance. Idara Isha’at-e-Diniyat (P) Ltd (2002)