Chapter 13

MURABAHA

Murabaha is one of the most commonly used modes of financing

by Islamic Banks and financial institutions.

Definition
Murabaha is a particular kind of sale where the seller expressly
mentions the cost of the sold commodity, and sells it to the buyer
by adding some profit thereon. Thus, Murabaha is not a loan
given on interest; it is a sale of a commodity for hand to
hand/deferred price.

The Bai' Murabaha in banks involves the purchase of a commodity

by a bank on behalf of a client and its resale to the latter on cost-
plus-profit basis. Under this arrangement, the bank discloses its
cost and profit margin to the client. In other words, rather than
advancing money to a borrower, which is how the system would
work in a conventional banking agreement, the Islamic bank will
buy the goods from a third party and sell those goods to the
customer at a pre-agreed price.

Murabaha is a mode of financing as old as Musharakah. Today

in Islamic banks world-over, approximately 66% of all investment
transactions are through Murabaha .

Difference between Murabaha and Sale

A simple sale in Arabic is called “Musawamah” - a bargaining sale
without disclosing or referring to what the cost price is. However,
when the cost price is disclosed to the client, it is called
“Murabaha”. A simple Murabaha is one where there is cash
payment i.e. payment is made at the time of sale. “Murabaha
 146 Meezan Bank’s Guide to Islamic Banking

Mua'jjal” is one on deferred payment basis i.e. payment is made

after few days of sale.

Differences between Murabaha and Conventional Financing

Conventional Financing Murabaha
1. Qard based contract A sale transaction
2. Compensation in the form of Compensation in the form of
interest, since any benefit over price of goods
loan is interest
3. Bank does not assume the The ownership and risk of the
ownership and risk of the assets asset are borne by the bank
4. Charges penalty in case of late No penalty can be charged in
payment case of late payment

Basic Rules for Murabaha

Following are the rules governing a Murabaha transaction:

1. The subject of sale must exist at the time of the sale. Thus,
anything that does not exist at the time of sale cannot be
sold and its non-existence makes the contract void.

2. The subject matter must be in the ownership of the seller

at the time of sale. If the seller sells something that he
himself has not acquired, then the sale becomes void.

3. The subject of sale must be in physical or constructive

possession of the seller when he sells it to another person.
Constructive possession means a situation where the
possessor has not taken physical delivery of the commodity,
yet it has come into his ownership and all rights and liabilities
of the commodity are passed on to him, including the risk
of its destruction.
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4. The sale must be instant and absolute. Thus, a sale attributed

to a future date or a sale contingent to a future event is
void. For example, 'A' tells 'B' on 1st of January that he will
sell his car on 1st of February to 'B', the sale is void because
it is attributed to a future date.

5. The subject matter should be a property of value. Thus, a

good having no value cannot be sold or purchased.

6. The subject of sale should not be a thing used for an un-

Islamic purpose.

7. The subject of sale must be specifically known and identified

to the buyer. For Example, 'A' the owner of an apartment
building says to 'B' that he will sell an apartment to 'B'. Now
the sale is void because the apartment to be sold is not
specifically mentioned or pointed to the buyer.

8. The delivery of the sold commodity to the buyer must be

certain and should not depend on a contingency or chance.

9. The certainty of price is a necessary condition for the validity

of the sale. If the price is uncertain, the sale is void.

10. The sale must be unconditional. A conditional sale is invalid

unless the condition is recognized as a part of the transaction
according to the usage of the trade.

Step by step Murabaha Financing

Five steps needs to be followed in Murabaha Financing:

1. The client and the institution sign an overall agreement

whereby the institution promises to sell the commodity and
 148 Meezan Bank’s Guide to Islamic Banking

the client promises to buy it from time to time at an agreed

rate of profit added to the cost. This agreement may specify
the limit up-to which the facility may be availed.

2. An agency agreement is signed by both the parties in which

the institution appoints the client as his agent for purchasing
the commodity on its behalf.

3. The client purchases the commodity on behalf of the institution

and takes possession as the agent of the institution.

4. The client informs the institution that it has purchased the

commodity and simultaneously makes an offer to purchase
it from the institution.

5. The institution accepts the offer and the sale is concluded

whereby ownership as well as risk is transferred to the client.

All the above conditions are necessary to affect a valid Murabaha.

If the institution purchases the commodity directly from the
supplier, it does not need any agency agreement.

The most essential element of the transaction is that the

commodity must remain in the risk of the institution during the
period between the third and the fifth stage. The above step or
transaction is the only way by which this transaction is
distinguished from an ordinary interest-based transaction.

Practical Example
“ABC & Co” is a manufacturer and exporter of rice. The company
purchases paddy rice from local suppliers and after processing
the rice, the company exports it to different countries. The
company has a working capital requirement of Rs. 100 Million
 Chapter # 13: Murabaha 149

for purchase of paddy rice from the suppliers. The company

approaches an Islamic Bank for granting finance facility of Rs 100
million.

Islamic Bank offers the facility of Murabaha to the customer

through which the Bank and the Customer signs a Master
Murabaha Agreement to sell and purchase Paddy rice on
Murabaha basis from time to time, as per the conditions of the
Agreement. Upon requirement for the purchase of paddy rice,
the customer gives an order to the bank to supply paddy rice
worth of Rs. 10 million to the company on Murabaha basis.Upon
receipt of the request from the Customer, the Bank authorizes
the Customer to purchase the paddy rice as an agent of the Bank
from the market. The Customer negotiates the deal with the
Unique Rice Trader (a supplier) and intimate the Bank to make
Pay Order in the name of Unique Rice Trader. Bank then issues
a Pay Order in the name of Unique Rice Trader, which can either
be paid directly by the bank to the supplier or the Bank may hand
over the Pay Order to the Customer to provide it to Unique Rice
Trader on behalf of the Bank.

Upon receipt of payment, Unique Rice Trader supply the rice to

the Customer (the agent of the bank). Immediately upon the
receipt of paddy rice, the agent (Customer) intimates the bank
about the receipt of rice worth Rs. 10 million from the supplier
and simultaneously offers to purchase the same rice from the
Bank for Rs. 11 million with deferred payment of 6 months. The
Bank, after verifying the genuiness of the transaction and ensuring
that all the basic rules of sale are being fulfilled, accepts the offer
of customer. With the acceptance of the Bank, the ownership
and risk of the rice transfers to the customer and the same rice
can now be used by the customer.
 150 Meezan Bank’s Guide to Islamic Banking

However, if the same customer would have approached some

conventional Interest based bank for financing the same
transaction, then the Conventional bank would have granted a
loan of Rs. 10 million for a period of 6 months with an interest
amount of Rs. 1 million.

Apparently, the end result of both the transactions look similar,

where customer ends up paying same amount of money but the
underlying transaction for the first transaction is a Sale based
Contract, which is allowed in Islam, whereas the contract of
Conventional Bank is a loan Contract for which any sort of
compensation is impermissible in Islam.

Issues in Murabaha
Following are some of the issues in Murabaha financing:

1) Securities against Murabaha

Payments accruing from the sale are receivables and for this,
the client may be asked by the bank to furnish a security. The
security may be in the form of a mortgage or hypothecation
or some kind of lien or charge.

2) Guaranteeing the Murabaha

The seller can ask the client to furnish a third party guarantee.
In case of default on payment, the seller will have recourse
to the guarantor who will be liable to pay the amount
guaranteed to him. There are two issues relating to this:

a) The guarantor cannot charge a fee from the original client.

b) However, the guarantor can charge for any documentation

expenses.
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3) Penalty for default

Another issue with Murabaha is that if the client defaults in
payment of the price on the due date, the additional price
cannot be changed nor can penalty fees be charged. In order
to avoid the adverse consequences, an alternative is that the
client may be asked to undertake that if he fails to pay
installment on its due date, he will pay certain amount to
charity. For this purpose, the bank may maintain a charity
fund and disbus charity from it under the directions of Shariah
board of the bank.

4) Rollover in Murabaha
Murabaha transaction cannot be rolled over for a further
period once the old contract ends. It should be understood
that Murabaha is not a loan rather the sale of a commodity,
which is deferred to a specific date. Once this commodity is
sold, its ownership transfers from the bank to the client and
it is therefore no more a property of the seller. Now what
the seller can claim is only the agreed price and therefore
there is no question of affecting another sale on the same
commodity between the same parties.

5) Rebate on Early Payments

Sometimes the debtors want to pay earlier than maturity to
get discounts. Majority of Muslim scholars including the major
schools of thought consider this to be un-Islamic. However,
if the Islamic bank or financial institution gives somebody a
rebate on its own, without stipulating it in the contract of
Murabaha, it is not objectionable especially if the client is
needy. This should not be made a regular practice and in no
way forms a part of the contract.
 152 Meezan Bank’s Guide to Islamic Banking

6) Calculation of cost in Murabaha

The Murabaha can only be affected when the seller can
ascertain the exact cost he has incurred in acquiring the
commodity he wants to sell. If the exact cost cannot be
ascertained then Murabaha cannot take place. In this case,
the sale will take place as Musawamah i.e. sale without
reference to the cost.

7) Subject matter of the Murabaha

All commodities cannot be the subject matter of Murabaha
because certain requirements needs to be fulfilled. For
instance, the shares of a lawful company can be sold or
purchased on Murabaha basis because according to the
principles of Islam, the shares represent ownership into assets
of the company provided all other basic conditions of the
transaction are fulfilled. A buy back arrangement or selling
without taking their possession is not allowed at all.

Murabaha is not permissible for items that cannot become the

subject of sale.

Basic mistakes in Murabaha Financing

Some basic mistakes that can be made in practical implementation
of the concept are as follows:

1. The most common mistake is to assume that Murabaha can

be used for all types of transactions and financing. This mode
can only be used when a commodity is to be purchased by
the customer. If funds are required for some other purpose,
Murabaha cannot be used.

2. The document in Murabaha signed for obtaining funds is for

a specific commodity and therefore it is important to certify
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(ensure) the subject matter of the Murabaha.

3. In some cases, the sale of the commodity to the client is

affected before the commodity is acquired from the supplier.
This occurs when the various stages of the Murabaha are
skipped and the documents are signed altogether. It is
important to remember that Murabaha is a package of
different contracts and they come into play one after another
at their respective stages.

4. It has been observed in some financial institutions that

Murabaha is applied on already purchased commodities. This
is not permitted in Shariah and can only be affected on
commodities that have not yet been purchased.

5. Both the customer and the Bank staff must be properly

educated. Lack of awareness about Islamic financing modes
may cause Shariah non-compliance issues.

Risk Management of Murabaha Financing

Some of the major risk and their mitigants are as follows:

1) Product Specific Risk

In Murabaha Financing, an Islamic Bank should assume the
risk of destruction or loss of the assets prior to its sale to the
Customer.

Mitigant
i) Takaful coverage for the Murabaha assets.
ii) Another tool for managing this risk is to minimize the time
of ownership by selling the asset to the customer immediately
after acquiring the assets.
 154 Meezan Bank’s Guide to Islamic Banking

2) Credit Risk
It is the risk pertaining to the default or delay of customer
in paying its obligations.

Mitigant
i) Any Shariah Compliant security can be taken to cover the risk
of non-payment or delay in payment.
ii) Robust evaluation of customer’s business performance and
Industry outlook.
iii) Matching the Murabaha financing with the cash cycle of the
customer. For example, if a customer sells its goods in the
market for a credit of 90 days, then tenure for Murabaha
financing must be kept around 90 days.

3) Shariah Non-Compliance Risk

This is the risk of Non-compliance of basic Shariah
requirements for a Murabaha transaction, which results in
the reduction of the income of the bank as non-compliant
income may lead to loss of bank’s income as banks cannot
accept or recognize income from a non shariah compliant
transactions.

Mitigant
i) Proper Training of Bank employees and the customer.
ii) Implementing strong control measures in the bank through
policy making.
iii) Implementing a system of Shariah Audit and Compliance.
iv) Development of easy to understand process flow for each
Murabaha financing.

Variants of Murabaha Financing

On the basis of requirements of customer, numerous variants
of Murabaha can be developed. Some of them are as follows:
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1) Advance Payment Murabaha

In this type of Murabaha structure, bank makes an advance
payment to the supplier of assets and sells these assets to
customer upon receiving its delivery.

2) Credit Payment Murabaha

In this type of Murabaha structure, bank sells the assets to
its customer which the bank has purchased on credit from
the supplier i.e. outflow of funds is made by the bank after
certain time of execution of Murabaha sale with the customer
and financing is booked prior to the disbursement of funds
by bank.

3) Murabaha Pledge
In this type of Murabaha structure, bank keeps the same
goods as pledge which the bank has sold to the customer
through a Murabaha transaction.

4) Murabaha Spot
In this type of Murabaha structure, the bank does not
immediately sell the asset to the customer but keeps the
asset in its inventory. The assets held in the inventory of the
bank are sold to the customer, as per his requirement against
spot payment.

Uses of Murabaha
Murabaha is being used in following scenarios globally for
Short / Medium / Long Term Finance:

• Raw material
• Inventory
• Equipment
• Asset financing