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Thursday, November 7, 2024

Trade Based Financing in Islamic Finance

In previous texts, we have mentioned that Islamic finance recognizes two types of financing models: those based on partnership and those based on debt. The most Sharia-compatible models are those based on partnership, for the reason that they position the client at the level of a partner to a financial institution where they jointly undertake a business venture, sharing the risk, profit, and loss. Debt-based models are Murabaha (cost plus trade) and Ijarah (rent). Although these models are completely acceptable in Sharia law, the reason they cannot be on the same level as partnership models is the fact that the end result is the client-debtor, which is identical to conventional models.

It is a well-known fact that debt is not a commendable phenomenon in the texts of the Revelation because there are many prayers in which the Messenger of Allah, Muhammad s.a.w.s., asks God to save him from debt. We can understand debt as a necessity that is present in interpersonal relationships, it is useful as a tool to overcome the problem of current liquidity, but it is also often a trigger for the destruction of interpersonal relationships. Debt and financial transactions have an important treatment in the Qur’an and are treated in the 282nd verse of Surah Al-Baqarah, which is the longest verse in the Holy Book which clearly speaks of the importance of this topic.

The Qur’an framed debtor-creditor affairs by prohibiting interest and clearly documenting transactions with the presence of witnesses so that there would be no confusion later. Therefore, in Islam, it is permissible to borrow money, but the amount that the debtor pays back must be equal to the amount that the creditor borrowed. The debtor is allowed to add a larger amount to the principal amount when repaying the debt, but it must not be pre-conditioned or agreed upon in any way. In order to avoid interest in debt-creditor business, Islamic banks resort to trade as one of the permitted and praised economic models. In this context, a model called Murabaha was created. The name itself is derived from the Arabic word ribh, which means earnings or profit.

Murabaha refers to a special type of sales contract where the seller clearly states the purchase price for which he bought the goods, and sells those goods with the addition of a margin or a certain profit on the base price. The profit within this model can be predetermined as a fixed amount or a percentage that is added to the purchase price. All the costs incurred by the seller when purchasing goods are included in the base price, and the margin is added to that price, with current business costs such as administrative costs, office space rent, etc. included in the profit added to the base price.

If it is not possible to determine the exact amount of the purchase price, then the Murabaha contract is invalid and cannot be established. In this case, the goods must be sold with a settlement without mentioning the purchase price or margin. In that case, the final price of the goods is fixed with mutual consent.

EXAMPLE: In order to better understand the above, we will give an example of a Murabaha contract based between a bank and a client. The client wants to buy a machine that he would use to start his own business. The price of the machine is EUR 10,000.00. The client does not have enough funds to buy that machine, so he turns to an Islamic bank for financing the purchase of the machine on a trade basis (Murabaha). The bank buys that machine for the amount of EUR 10,000.00 from the seller and thus the machine becomes its property. The bank sells the same machine to the client for deferred payment in 12 equal monthly installments with a charged margin of 10%. The client pays off the machine in equal monthly annuities and eventually becomes its owner. Simply put, the bank bought the machine for EUR 10,000.00 and sold it to the client for EUR 11,000.00, which is a completely legitimate and permissible form of business under Islamic law.

The basis for a halal transaction is that the subject of financing must be a real economic value and that the margin and profit can only be charged on the real economic value (real estate, vehicle, machine, goods, etc.), and never on money, because according to Islamic law, profit cannot be charged on borrowed money.

Murabaha as a model has many limitations in many countries where Islamic banks operate, especially in Europe as laws often prohibit banks from trading. It is important to note that Murabaha is the most profitable model in the Islamic finance industry and carries over 75% of profits. What can be cited as a criticism of this model is that, despite being permitted by Sharia, it causes the same effect as a loan from conventional banks, which is the debtor client. Islamic finance propagates partnership as the purest model of financing and business, but due to profitability, speed, security, and very often due to the policy of maximizing profits, Islamic banks resort to Murabaha as a financing model. In this sense, many experts in this field believe that Murabaha is actually only a temporary solution in order to evolve to higher levels of partnership-oriented models.

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