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 Chapter 4

Murabaha

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 Chapter 4 - Learning outcomes

1. Define Murabaha, types of Murabaha, including Tawarruq and key

conditions of the Murabaha contract.

2. Describe the Murabaha Process for a standard contract and that

commonly used by Islamic banks.

3. Discuss practical applications of Murabaha and the challenges faced.

4. Compare the Murabaha contract with conventional loans.

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 Introduction to Murabaha
Islamic finance requires each financial transaction to be linked to a real asset. When
commodities are traded for credit, an excess can be charged according to the majority of
Muslim scholars. The seller can charge a different price for a cash sale or a credit sale,
where the credit sale price would be higher.
According to Shariah rule, a sales contract can be executed only when the item already
exists, is owned by the seller at the time of sale and is in the physical or constructive
possession of the seller. Two exceptions to this rule are the contracts of Salam and
Istisna, respectively.

In Islamic commerce, sales can be classified according to delivery and payment, as:
1. Immediate delivery with spot payment,
2. Immediate delivery with deferred payment
3. Immediate payment with deferred delivery.

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 Introduction to Murabaha
Based on disclosure of cost to the customer, ISLAMIC SALES can also be
classified as:
• Musawama or Bargain Sale: In this sale, the seller and buyer agree upon a
price without any reference to the cost, because a seller is not obliged to
reveal it. When we buy something from a shop we are aware of the price but
do not know the cost. We either decide to buy at the given price or try to
bargain on the price.
• Murabaha or Trust Sale: Murabaha is the simplest Islamic banking instrument
and is a widely used product. Islam prohibits charging fixed interest on
money, but permits charging fixed profit on sale of goods. Murabaha is a sales
contract where profit is made by selling at a cost-plus basis. It is an agreement
where the bank purchases a specified item at the request of the customer,
adds a pre-agreed profit to it and sells it to them at the marked-up price.
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 Introduction to Murabaha
• Murabaha is also called trust sales, since the distinguishing feature of
Murabaha from regular sales is that the seller discloses the cost to the buyer
and a known profit is added; the buyer puts their trust in the seller to buy the
required item and to disclose to the client the quality or specification of the
item and the actual cost as well as the markup added.
• If there is any storage, transportation or other cost incurred by the seller in
delivering the item to the buyer, that will be added to the cost. The markup
can either be a lump sum or a percentage of the price of the goods. The
delivery of the product is immediate.
• The client can pay on spot or pay deferred. Sales mostly is on deferred
payment, so credit is extended, and this is used as a method of finance when
the customer requires funds to buy goods.
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 Introduction to Murabaha
• Deferred payment also has the option of the full amount at a
deferred period or in instalments, the latter being more common.
Thus, Murabaha provides the customer with the advantage of
acquiring and using the asset, earning profit from it and using this
profit to repay in deferred instalments.
• Murabaha is a Shariah-compliant instrument since the bank first
acquires the asset for resale at profit along with the risk associated
with purchase and resale, so an asset is sold for money and the
transaction is not an exchange of money for money.

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 Types of Murabaha
There are two types of Murabaha:
1. Ordinary Murabaha - Clients ask the bank to acquire an asset that they
would like to purchase without making any promise to buy it.
2. Murabaha Sale with a Promise also called Murabaha to the Purchase
Order - Client makes a promise to buy the item once the bank acquires it.
More commonly used.
• The bank sometimes may not prefer to buy the item itself because it does
not have sufficient knowledge, and appoints the client as an agent to make
the purchase. In such a situation, the client may take delivery of the item but
the ownership will go to the bank.

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 Types of Murabaha
• The bank may take security as a mortgage, guarantee, charge or lien to
protect itself against default of the deferred payments. In case of default the
bank may sell the security and recover its dues, but will make no profit and
any excess remaining from the sale of the security will be returned to the
client.
• Under Shariah rulings, Islamic banks cannot charge a late payment fee, or if
they do charge the bank cannot benefit from it and it is given away to charity.
On the other hand, Islamic banks can charge for any costs they incur to
recover the payments from the client.

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 Murabaha Contract

Figure 4.1 Murabaha Contract

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 Conditions Related to Murabaha
Murabaha contracts executed between an Islamic bank and a client are characterized by various
conditions.:
1. Conditions of Sales Contract: Murabaha from an Islamic bank is not a loan in exchange for
interest payment as in a conventional bank, but the sale of a good or service. As such,
Murabaha needs to fulfil the Shariah requirements of a valid sale – that is, the item of sale
must exist at the time of the sale and be owned by and in the physical or constructive
possession of the seller at the time of the sale.
2. Goods Subject to Murabaha Contract: These items need to be legal and Halal, having real
commercial value. The items can be tangibles like vehicles, machinery, equipment and
intangibles like brand name, trademark, copyright, patent, royalties, etc. Currencies and other
mediums of exchange, like gold or silver, cannot be traded by Murabaha as they cannot be
exchanged on a deferred basis.
3. Costs Related to the Murabaha Item: All direct and indirect costs, including the original cost
of the item plus all other costs (e.g. packaging, transportation, delivery, installation and any
agency costs), need to be identified and both the buyer and the seller should be aware of them
and mutually agree to them.
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 Conditions Related to Murabaha
4. Mark-up or Profit: This can be a fixed amount or a percentage of the cost of the Murabaha
item. This amount will constitute the Islamic bank's profit and for the Murabaha client or buyer
it is the extra cost incurred for the advantage of deferred payment. The markup or profit will be
clearly stated and mutually agreed by the bank and the client and cannot be changed later.
5. Third-party Seller: The seller of the good or service in a Murabaha needs to be a third
party, besides the client and the Islamic bank.
6. Client’s Promise: To reduce its risk, the bank may require the client to sign a unilateral
promise to buy the goods once they have been acquired by the bank and in Western
jurisdictions like the UK or the USA, this promise is binding. This is called Murabaha with a
promise.
7. Binding Promise: In Murabaha, when the two parties contract it is morally binding on
both. However, if the bank – while relying on the promise – takes the necessary steps to
acquire the property then the promise becomes legally binding.

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 Conditions Related to Murabaha
8. Defects in the Item: If there are any defects in the Murabaha item, the seller needs to
inform the buyer or else it would be a betrayal and the buyer can demand compensation or the
sale can be cancelled. Moreover, any risk of loss of the asset before delivery, or risk related to
any concealed defects in the asset, are borne by the bank.
9. Ownership of the Item: Murabaha is Shariah compliant because the bank needs to
acquire the ownership and physical or constructive possession of the asset, thus assuming that
all risks associated with it before reselling to the client; in contrast, the conventional bank
simply lends the money to the client to acquire the asset without taking any risk related to the
asset.
10. Advance Payment or Deposit: The client may be required, or want, to make an advance
payment or a deposit, which is part of the price and is adjusted from the price during
repayment. This is allowed by Shariah.

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 Conditions Related to Murabaha
11. Delivery of the Item: This is immediate, and after delivery the client bears
the risk of the item as the sale has concluded.
12. Repayment: This can be spot or deferred, made in a lump sum or in
instalments. The payment schedule and sequence of transactions should be
mutually agreed upon before Murabaha is concluded.
13. Security: The Islamic bank may ask the client to provide some security or
guarantee, or sign a promissory note to fall back on in case of non-repayment.
The asset purchased via the Murabaha transaction can serve as the collateral.

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 Conditions Related to Murabaha
14. Delayed Repayment: if repayments are delayed, then conventional banks
charge interest on interest but Islamic banks cannot increase the price or the
markup. This may sometimes motivate customers to delay payments. To
discourage this, Shariah scholars allow the Islamic bank to charge a penalty for
delayed payment, but they cannot benefit from this money and it is donated to
charity.
15. Failure to Repay: According to Shariah rulings, if a solvent debtor deliberately
delays or fails to repay, then legal action can be taken; if the debtor is insolvent,
leniency in repayment is recommended.

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 Tawarruq or Reverse Murabaha or Commodity
Murabaha
Tawarruq or reverse Murabaha - where the client purchases a commodity from a seller, via an Islamic
bank on a deferred payment, then the client appoints the bank to sell the commodity to a third party
on spot payment, technically raising immediate cash, to be repaid by future in instalments.
Tawarruq is used by retail customers to raise personal finance and by businesses for short term
liquidity and working capital. Islamic banks also use Tawarruq to manage short-term cash shortage or
surplus, serving as alternate to conventional interbank liquidity market.
In commodity Murabaha. Shariah restricts use of commodities previously used as money like gold,
silver, barley, wheat etc.
Tawarruq is a controversial product since client does not purchase the commodity for their use and
the transaction is not linked to any real economic activity, so some scholars believe it is just raising
cash and thus creates Riba. A disadvantage of Tawarruq is that some cost is involved for both the
buy and sell part of the transaction. AAOIFI has permitted Tawarruq under certain conditions, used
more in the South East Asian countries, rather than in the GCC.

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 Example
Ahmad wants to purchase a new car, priced at 720,000 L.E. He wants to
finance the car on the Murabaha basis from ABC Islamic Bank. The Bank’s
required profit mark-up for the car finance is 7% for a repayment period of 6
years. Compute the total cost of the car with the mark up. How much will be
the monthly payment on this Murabaha auto-financing?
Solution:
The total cost of the car to Ahmad including costs plus mark-up is
L.E. (720,000 + 720,000 x 7% x 6) = 720,000 + 302,400 = 1,022,400
Monthly payments will be 1,022400 /72 = L.E. 14,200

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