Islamic financing: murabaha and tawarruq

Murabaha is a popular Islamic financing structure used as an alternative to interest-based loans in Muslim countries. It is a type of cost-plus financing that allows a buyer and seller to agree on the cost and markup of an asset, with the markup taking the place of interest. In this article, we will discuss what murabaha is, its key features, and an example of how it works.

What is Murabaha?

Murabaha, also known as cost-plus financing, is a financing structure used in Islamic finance that involves the sale of an asset with a pre-agreed markup on the cost of the asset. This markup replaces the interest that would be charged on a conventional loan. As a result, it is not considered an interest-bearing loan but rather a credit sale that complies with Islamic law.

How does it work?

In a murabaha contract of sale, a client approaches a bank to purchase an item on their behalf. The bank agrees to purchase the item and set a contract for the cost and profit to be paid in installments. The contract sets out the agreed cost of the item and the profit markup that the bank will charge. The client then purchases the item from the bank at the agreed markup, making repayments in installments.

One of the main differences between murabaha and conventional loans is that in murabaha, the bank buys the asset and then sells it back to the client with a profit charge. This type of transaction is considered halal or valid, according to Islamic Sharia/Sharīʿah.

Murabaha and default

Murabaha default occurs when a client fails to make repayments as agreed in the murabaha contract. Additional charges cannot be imposed after the due date, which makes murabaha default a concern for Islamic banks. Many banks believe that defaulters should be blacklisted and not allowed future loans from any Islamic bank to decrease murabaha default. However, if a debtor is facing genuine hardship and cannot repay the loan on time, respite may be given as described in the Quran. In cases of willful default, the government may take action. Murabaha defaults have become a problem for companies operating under Islamic law, and there has been no clear consensus on how to deal with them.

Example uses of murabaha

The murabaha financing structure is commonly used in diverse sectors in place of conventional loans. Consumers use murabaha when purchasing household appliances, cars, or real estate, while businesses use it when purchasing machinery, equipment, or raw materials. Additionally, it is used for short-term trade, such as issuing letters of credit for importers.

For example, Bilal wants to buy a boat that sells for $100,000 from Billy’s Boat Shop. Bilal approaches a murabaha bank that agrees to buy the boat from Billy’s Boat Shop for $100,000 and sell it to Bilal for $109,000, to be paid in installments over a three-year period. Bilal’s repayments consist of the agreed cost and profit markup, with no additional interest charge involved. In the event of a default, there are no additional charges that he would incur. The additional amount that Bilal pays over the cost price from the boat shop is in effect a 3% loan, but because it is offered as a fixed payment without any additional costs, it is allowed by Islamic law.

Murabaha is an acceptable form of credit sale in Islamic finance that allows for a buyer and seller to agree on the cost and markup of an asset, with the markup taking the place of interest. It is a popular financing structure used in place of interest-based loans in diverse sectors.

How is it different from Tawarruq financing?

Tawarruq financing is another type of financing used in Islamic banking that is often compared to Murabaha. While Murabaha is a cost-plus financing structure, Tawarruq involves a series of three or more transactions that enable the customer to obtain cash. The first transaction involves the customer buying an asset on credit, which is then sold to a third party for cash. The customer then purchases the asset back from the third party for a lower price, effectively obtaining cash.

One key difference between Tawarruq and Murabaha is that Tawarruq involves multiple transactions, while Murabaha involves a single transaction. Additionally, Tawarruq is often criticized for being too complex and for deviating from the principles of Islamic finance, while Murabaha is generally seen as a more straightforward and acceptable form of financing.

Another difference between the two is the nature of the underlying assets. In Murabaha, the bank purchases an asset and then sells it to the customer at a markup. In Tawarruq, the customer typically purchases a commodity on credit and then sells it for cash, which can be seen as a way of turning the commodity into a form of currency.

Overall, while both Murabaha and Tawarruq are used in Islamic banking, they have different structures and are used in different situations. Murabaha is typically used for financing the purchase of assets, while Tawarruq is often used for obtaining cash.