Shifting from Murabaha to Mudarabah Based Finance

NEWHORIZON July-December 2014 IIBI LECTURES

Introduction

Mr Raza, Managing Director of IFAAS, said that the challenge Islamic finance is facing is its significant growth, but, at the same time, Islamic banks are relying on murabaha/commodity murabaha/tawaruq solutions to avoid risks associated with mudarabah, musharakah and to some extent wakala. Murabaha is a very straightforward, Shari’ah-compliant sales contract, however, when it is used in a certain way, in tawaruq, reverse murabaha or commodity murabaha, its compliance with the spirit of Shari’ah becomes rather controversial and questionable. Due, however, to certain limitations the industry has faced over the last 20-30 years, banks have favoured murabaha, which is quite close to conventional banking products offering fixed rate returns.

Islamic finance products need to fulfil the spirit of Shari’ah, as well as meeting client needs, being competitive in the market and profitable. The industry, however, has to move on and so there is a move to develop products based on mudarabah, musharakah and wakala.


The Problems with Traditional Mudarabah

Mudarabah is a partnership agreement, where one party provides the capital (rab ul-Mal) and the other party provides the labour, work or expertise (mudarib). This type of contract is very much preferred from the Shari’ah point of view, because the majority of scholars believe this represents the true spirit of Islamic Shari’ah, however there are issues that make the banks reluctant to use it for three main reasons.

Moral Hazard

There is a high probability of fraud or falsified financial disclosures, because the financial institution is only providing the capital and the client is deploying the funds and has no financial input into the structure. The possibility of the client committing fraud by, for example, having one set of books for the tax authorities, one for the bank and one for themselves, is high. Mr Raza said that such practices have been seen in the Islamic finance industry. He cited an example from his own experience, where a London-based Islamic lender had been persuaded to try out mudarabah. The client, a high-street retailer, presented a balance sheet showing the costs of running the business going up and income falling resulting in a loss, which the bank as rab ul-mal has no choice but to accept.

Agency Problems

When the money is coming from a third party and the client has no financial stake, the client tends to become more aggressive in their risk taking; they do things they would not do if their own money was at stake. They also start to make uninformed decisions.

Adverse Selection

Mudarabah is a profit-sharing instrument, but clients sometimes see it as a loss-sharing instrument. When an organisation is anticipating a profit, they will go to a conventional financial institution and take out a fixed rate loan. When, however, they are anticipating a loss they may go an Islamic lender and try to get a mudarabah agreement, because they know they will then be able to share the losses with the lender. Islamic lenders need, therefore, to be very careful and vigilant about how they select their clients.

A New Mudarabah Solution

In response to these problems IFAAS has developed a new solution. IFAAS has looked critically at the three problems outlined above and ways to control them, while keeping strictly to the requirements of mudarabah.

The solution allows the client to use any amount of funds up to an agreed limit as either working capital or as an overdraft facility; risks are reduced by control functions that have been embedded in this solution and it is efficient reducing transactional costs inherent in certain instruments.

There are, of course, some limitations. The solution is targeted mainly at well-established, medium and large-sized businesses with a proven track record and a good accounting structure in place. This solution is not for individuals raising a personal loan, nor for start-up businesses or small businesses that lack a robust accounting structure.

How the Process Works

The client will approach the bank and following due diligence an agreement will be reached on the borrowing limit and the profit-sharing arrangements. They will also reach agreement on the expected profit rate, because mudarabah by its very nature cannot guarantee a specific return.

The facility is made available to the client and can use the bank’s funds up to the agreed limit, as and when required. The bank will send a monthly statement to the client showing the amount of the facility used during the month and the advance profit. Under the IFAAS solution the client will be asked to pay the agreed expected profit rate for that month in advance of the mudarbaha’s maturity, when the final calculation will be made. If at that time the profit does not reach the expected rate, the bank will have to return any over payments to the client.

The client will also be required to send the headline figures from the quarterly management accounts to the bank and a statement about the achievability of the expected profit based on current business performance. The IFAAS solution contractually obliges the client to send these documents to the bank, which is why it is important for the client to have a robust accounting structure, because without it they will not be able to fulfil this requirement. This proactive approach is designed to ensure that they can be stopped before they go into a loss-making situation.

The Profit Calculation

Profit will be calculated in three stages. In the first instance, say the facility limit granted was £40,000 and the mudarabah profit-sharing ratio is 99% for the bank and 1% for the client, if there is a profit. The bank, however, is expecting a profit rate of 5%. The client’s existing business already has assets deployed in the business and they are generating profits and this capital consisting of the current assets – cash and inventory, not the fixed assets will be taken into account.

What will happen then is, say the client has drawn down £30,000 out of the possible £40,000 and their own capital is £70,000, the total capital of the mudarabah becomes £100,000. Say the gross profit for the period is £10,000, the gross profit will be split according to the capital ratio, so the client will get a £7,000 share of the profit and the mudarabah profit will be £3,000. The mudarabah profit will be shared according to the capital ratio, so £30 for the client and £2,970 for the bank, which is way above the 5% expected profit rate.

If the bank takes that £2,970 from the client, the product is simply not viable. IFAAS have, therefore, created a profit stabilisation reserve. At a profit rate of 5% for a £30,000 loan, the profit going to the bank should be £1,500, so the client pays £1,500 to the bank and the balance of £1,470 will be put into a profit reserve, which is retained by the client to use or not as they see fit, but if the profit rate falls below the expected rate of 5% later during the period of the mudarabah the bank can call on that reserve in its entirety or in part. The client will have the obligation of paying the reserve to the bank if there are any losses and this debt will take priority over any other debts the client may have.

Controls

There are controls around this structure. Firstly, the client’s business must be an established business with a good track record and a robust accounting system including projected accounts. Second, there will be ongoing monitoring through quarterly accounts, which will have to be presented to the bank. Third, there will be a stream of monthly income to the bank. This is unlike most other mudarabah agreements, where a lump sum is payable at the end of the term.

There is also a control designed to reduce any potential loss. Under the contract the client will be unable to sell their goods or services below cost. This is critical, because that is where the majority of the fraud and moral hazard lies. We understand that in some businesses, such as those dealing in perishable goods, there is a need to sell products before they go off. In this case the client, under the contract, must inform the bank that they are going to sell at below cost. The profit calculation is strictly based on gross profit, so that the client cannot manipulate the accounts by artificially inflating expenses. This again is aimed at reducing moral hazard.

In Conclusion

We believe this a Shari’ah-compliant, commercially-viable and practical solution. From a risk management point of view we have made it a contractual obligation not to sell the goods or services below cost price thus minimising fraud and moral issues; the use of gross profit rather than net profit also minimises fraud and the creation of a profit reserve to offset losses or lower than expected profits is a further protection for the lender. These controls can be used not only in mudarabah, but in any sort of transaction, for example musharakah or wakala.

The benefits for the customer are that it is very convenient to have an agreed facility that can be used as and when required. It is very flexible in that it is not tied to financing, say a certain item of equipment; it can be used for anything in the customer’s business. It is very easy; there are no complex procedures to follow. The customer is simply required to submit four or five headline figures from their monthly or quarterly accounts.

The benefits for the bank are that it requires minimal management – perhaps 15 minutes a month to review the accounts submitted by the customer. It also allows Islamic banks to be very competitive with the conventional market, by getting rid of all the onerous transactional costs of murabahah. The risk profile is also much more moderate, because of the profit reserve and also a regular income.

This product has already been implemented in a number of banks. It has received Shari’ah approval from banks in the UAE, Sudan and Oman. It has been implemented not only for large and medium-sized corporate but also for micro finance projects in Palestine on a pilot basis.


finance sector, the IFP DataBank http://www.ifpprogram.com/