Islamic banking promotes fairness

The holy month of Ramadhan offers an opportunity to consider the essence of Islamic banking, which operates on the basis of contracts that are deemed legal and lawful, according to the sharia standards on the condition that these contracts are free from any prohibition.

Some of the prohibitions include the provision 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, the financing contracts can be used to structure transactions such as trade finance, asset-backed securities, or equity financing.

The contracts can also be used to handle financial intermediation processes such as fee-based activities, trustee financial services, equity partnerships, agency models, and insurance services.

One of the most commonly used contracts is the murabaha, a trade-based model of deferred payment sale used for personal, home, motor vehicle, and trade financing.

Murabaha was in the past applied as a sales transaction where a business person purchased a product and sold it to an end-user at a price that is inclusive of the cost price as well as a mutually agreed mark-up.

Murabaha is only used to purchase goods and services.

The parties to a murabaha contract are the bank that provides the funds, the customer who needs the product, and the vendor of the product.

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 against default.

Either a different asset 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 claim on the asset financed or offered as collateral can be registered in an insurance policy.

Globally, there have been misconceptions about murabaha-structured contracts and their compliance to the sharia. One such misconception revolves around the difference between a mark-up and interest since murabaha creates a financial claim.

When a customer walks into a bank and asks to be financed under the murabaha model, the profit rate quoted is often not different from the prevailing interest rate in most markets.

The practice of using the interest-rate index to determine the mark-up rate for murabaha contracts is a major source of criticism and confusion that colours perceptions about the compliance of these contracts.

Islamic banks could argue that the mark-up rate is a function of an interest-rate index because there is no sharia-compliant benchmark to provide an indication of the prevailing rate of return in a given economy in many jurisdictions globally.

The mark-up rate is influenced by the type of product, security or collateral, the 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 and in case of late payments, the customer cannot be charged penalties that benefit the bank.

As a deterrent against default and late payment, Sharia scholars have allowed the banks to charge penalties which are used for charitable causes under the guidance of sharia advisory boards and not the financing banks.

Islamic banks are exposed to credit risk, just like the conventional banks, in the event the customer defaults.

The real asset in murabaha sales offers comfort against high exposure to risk that is common in the conventional banking system.

To limit risks, the banks usually execute murabaha contracts with agency agreements that appoint the customer as the agent to take possession of the purchased asset.

Another common form of risk comes from the operational nature of the Islamic banking transactions that involve buying and selling and which could raise legal complications and requirements.

It is important that the drafting of the contracts be matched with the commercial intent of the transactions and be clear to the parties involved.

Both the banks and the customers must clearly understand their roles and responsibilities, and the limits imposed upon them by sharia, which aims to promote harmony, fairness, justice, and ethical conduct.

The writer is the head of Islamic Banking at KCB Kenya.