Make Purchases with Cost Plus Profit (Murabaha) Contracts

In murabaha agreements, a commodity is sold for cost plus profit, and both the buyer and seller know the cost and the profit involved. Basically, this product is a kind of trade financing instrument used by Islamic banks.

Murabaha basics

Under a murabaha contract, a bank purchases a commodity in order to supply it to a customer who isn’t financially able to make such a purchase directly. The bank sells the commodity to the customer for the cost plus profit — the profit being a markup that both the bank and customer agree on upfront.

The customer can make a lump payment when the commodity is delivered but usually sets up a deferred payment installment schedule.

For example, say a manufacturer wants to buy $100,000 worth of wood but doesn’t have enough funds. The manufacturer approaches the bank and signs an agreement to purchase the wood from the bank at cost ($100,000) plus profit (maybe 20 percent of the contract amount, or $20,000).

The manufacturer is liable to pay the bank $120,000 after the bank delivers the goods. Both parties know the profit and the cost of the product at the onset; there’s no financial uncertainty in the transaction.

Sharia scholars don’t advocate using the deferred payment system in a murabaha contract. Instead, they encourage using murabaha as a financial instrument only when other equity financing, such as mudaraba and musharaka, can’t be applied. The bank is allowed to take assets as security against potential future default by the client. However, when no such assets are available, the bank can take the commodity, which is financed by the bank.

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The murabaha contract is a basic sale transaction, and certain rules need to be followed to make sure it’s sharia-compliant:

  • If the client defaults on the payment, the financier isn’t allowed to charge extra fees as late payment or penalty charges. Sharia scholars allow charging additional fees in cases of loss or damage due to a client’s default, and they allow certain penalties to ensure that a buyer is not negligent. But such fees and penalties cannot be treated as income for the bank; they must be given to charity.

  • The contract should be used only for purchases. It’s not intended to be used for financing a working capital requirement.

Here are two types of murabaha contracts an Islamic bank may offer:

  • Murabaha to the purchase orderer: In this contract, the bank specifically purchases the assets for the client’s order. The client requests that the bank purchase the good(s) on her behalf, and she agrees to buy the good(s) from the bank.

  • Commodity murabaha: Interbank transactions are a source of funds for Islamic banks. The commodity murabaha is used as an instrument in Islamic interbank transactions. Generally, this financial instrument is used to fund the Islamic bank’s short-term liquidity requirement. This product was developed as an alternative to conventional interbank funding.

    Commodities such as gold, silver, barley, salt, wheat, and dates, which are used as mediums of exchange, aren’t allowed to be traded under the commodity murabaha contract.

Misconceptions about murabaha

Certain misconceptions exist about the cost plus profit contract and conventional banking loans. Many bankers take a view that the murabaha contract is a synthesized loan (a loan divided into pieces based on the risk involved).

This misconception is inflamed because Islamic banks use conventional, interest-based benchmarks such as LIBOR (the London Interbank Offered Rate) to determine what profit rate to charge for such contracts. However, conventional bank loans and murabaha contracts are indeed different. In the murabaha contract

  • Financing is linked to the asset purchased on behalf of the client. No money is actually loaned to the client, as happens with conventional banks.

  • The markup of the asset doesn’t increase if the client defaults on the payment installments. In contrast, conventional banks compound the interest and charge a penalty in this circumstance.

  • Economic activity is produced when real assets are traded. Conventional banks lend money to clients without any tangible economic activity taking place.

What about the benchmark rates? Because the Islamic banking industry never before had its own benchmark for markup rates, it opted to follow conventional benchmarks such as LIBOR. That doesn’t mean that Islamic banks were charging an interest rate; they simply got guidance for what may constitute acceptable fees.

However, in late 2011, Thomson Reuters developed a benchmark called the Islamic Interbank Rate (IIBR) that is likely to alleviate this source of controversy.

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