Murabaha (Trade credit)

Murabah (Trade credit or loan)

       I want to write a small article on Islamic finance so I decided to focus on one area of Islamic finance i.e Murabah which is very similar to normal banking system and quite simple to understand as well. Before getting the overview of Murabah we'll first need to know that the key distinction between Islamic finance and conventional finance and what are the basic principles of Islamic finance?

Introduction to Islamic finance:-

       Actually, Islamic finance has the same purpose as other forms of business finance except that it operates according to principles of Islam. It is based on the rulings of Sharia on commercial and financial transactions. The main principles of Islamic finance are as under:-

- Wealth must be generated from legitimate trade and asset-based investment. The use of money for the purpose of making the money is forbidden.

- Investment should also have a social and an ethical benefit to wider society beyond pure return. 

- Speculations are prohibited in Islam.

- Interest is not allowed in Islamic finance instead it is replaced with cash flows from productive sources, such as returns from wealth generating investment activities.

- Trading in harmful activities like alcohol, gambling, drugs and sale of certain foods are forbidden in Islamic finance.

       The main sources of finance within Islamic banking model includes:-

1. Murabah. (Trade credit or Loan)

2. Ijara. (Lease finance)

3. Sukuk (Bonds)

4. Mudaraba. (Partnership or like equity finance)

5. Musharaka. ( Venture capital and business angels)

Definition of Murabah:-

•        It is a particular kind of sale where the seller expressly mentions the cost of the commodity purchased and sell it to another person by adding some profit thereon. So it is not a loan given on interest; it is a sale of a commodity for cash/differed price.

Difference between normal loan and Murabah?

       Murabah is like trade credit or loan. The key distinction between a murabah and a normal loan is that with a murabah, the bank(for example) will take actual constructive or physical ownership of the commodity/asset which is then sold onto the the person (who wants to borrow/purchase the asset) for a profit . Note here that bank transfers the ownership of the asset to the borrower which means the borrower is actually becomes the owner of the asset but the main point is that he is allowed to pay the sum over a set number of installments like trade credit. The payment period could be extended but without any penalty or extra charge. The bank cannot claim any additional mark-up. Another point to notice in murabah is that if buyer wants to par early then early payments discounts are not welcomed and will not form the part of the contract although financier may choose (not contract) to give discounts. As interest is forbidden in Islam so it can't be charged on agreed sum as well. So in murabah, the borrower fixes the amount which he has to pay in exchange for the asset/commodity purchased.

Applications in daily life:-

       The Murabah form of financing is being widely used by the Islamic banks to satisfy various kinds of financing requirements. It is used to provide finance in various and diverse sectors e. g. in consumer finance for purchase of consumer durable such as cars and household appliances, in real estate to provide housing finance, in the production sector to finance the purchase of machinery, equipment and raw material etc. However, probably the most common and the most popular application of Murabah is in financing the short-term trade for which it is eminently suitable. Murabah contracts are also used to issue letters of credit and to provide financing to import trade.

Basic Rules for Murabah:- 

Following are the rules governing a Murabah transaction:

• 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 as this makes the contract void.

• The subject matter should 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.

• The subject of sale must be in physical or constructive possession of the seller when it is sold to another person. Constructive possession means a situation where the owner has not taken physical delivery of the commodity yet it has come into his control and all rights and liabilities of the commodity are passed on to him including the risk of its destruction.

• The sale must be instant and absolute. Thus a sale attributed to a future date or a sale contingent on a future event is void.

• The subject matter should be a property having value in the eyes of Shari’a.

• The subject of sale should not be a thing used for an un-Islamic purpose.

• The subject of sale must be specifically known and identified to the buyer. For Example, ‘A’ 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.

• The delivery of the sold commodity to the buyer must be certain and should not depend on a contingency or chance.

• The certainty of price is a necessary condition for the validity of the sale. If the price is uncertain, the sale is void.

• 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.

This article contains some material from the following sources:-

-Kaplan textbook f- 9 Acca.
-Meezan bank site (http://www.meezanbank.com/murabaha.aspx)