34(B) DMF Shariah Concept

DMF Shariah Concept

In describing the Shariah Concept, the Writer will be using certain terminologies that may or may not be used by Islamic banks offering DMF.

Principally, DMF is structured on two types of contracts, as follows:

#1 Musharakah – For the joint ownership of asset;

#2 Ijarah Muntahiya Bitamlik (leasing ending with ownership) – For rental of property belonging to the joint-owners (it should be noted under tax neutrality Act in Malaysia, the rental income is tax exempted). In this case, the customer is normally the partner who shall rent the property from the Bank.

Thus DMF can be re-described simply, as a purchase of an asset by two or more partners. In this case, both the customer and the Bank will each contribute cash towards the purchase of an agreed property but prior that; they have to agree the quantum of contribution by each party and also who shall use the property. In practice, the property will be used by the Customer.

DMF Process Flow – completed property

DMF process flows outlined under this section (if it is different from existing practices) are suggestions of the Writer. The Writer invites both Shariah scholars and practicing lawyers to comment and share their experiences and research findings, with one objective in mind, to come-up with a standardize DMF model for Islamic banks.

In Malaysia, for purchase of a completed property, the Customer would have paid the down payment prior signing the Sales & Purchase Agreement (SPA). Technically, the Customer had already established beneficiary interest in the property although the full purchase price has not been settled. Common practice, the Customer will go to the Islamic Bank to seek financing with a copy of the signed SPA.

In a BBA contract (irrespective bi-lateral or tripartite agreement); the Bank normally signs a Novation Agreement (some banks discard this requirement) with the Customer. Somehow, there are Shariah scholars that are of the opinion that although Novation may meets the contractual requirements it however does not meet Shariah requirement. Most importantly is the intention or “niat" for example, issue on commodity murabahah. What is the main purpose? The customer "wants cash". So, why make a circle by buying and selling commodity although the intention is to give cash to the customer? Like the Writer said earlier, let's the Shariah experts argue on this. So, to avoid this type of argument, the Writer feels that we can do away with Novation Agreement but we should impose one condition, the Customer must not pay in full the intended down payment but just pay the booking fee first, normally RM1,000 prior seeking DMF from Islamic Bank. The balance of the down payment has to be paid directly to the Bank and the Bank will use that amount, to pay the balance of the down payment directly to the Vendor on behalf of the joint-venture partner.

[Novation is defined by Lectlaw as a substitution of a new for an old debt. The old debt is extinguished by the new contracted in its stead; basically, it is a legal document that formalizes an arrangement to substitute one party for another in a contract.]

Wikipedia defines:

Novation, in contract law and business law, is the act of –

1. replacing an obligation to perform with another obligation; or
2. adding an obligation to perform; or
3. replacing a party to an agreement with a new party.

for example,

Let’s assume the Customer applies for 90 percent (%) margin of financing and had paid booking fee of RM1,000. In addition, the Bank had also approved the Customer’s request for DMF.

To formalize the DMF transaction, the Bank need to undertake as follows (take note that whether these processes are acceptable under Civil or Contract law is immaterial as the Writer is of the opinion that, if current civil or contract laws cannot cater for the processes proposed, the laws should be revised to meet Shariah requirements rather than structuring the Islamic banking products to meet existing civil or contract laws, which are non-Shariah compliant. Thus, the process:-

#1. Write to the Customer an invitation letter for his/her agreement:

a.   To purchase the said property on joint-venture basis, and

b.   To obtain the Customer’s agreement to rent the property from the Bank (co-partner).

c.   To get the Customer’s agreement to pay balance of the Customer’s down payment directly to the bank and the Bank will undertake to pay the same to the Vendor.

d.   The Bank agrees to appoint the Customer to sign the SPA on behalf of the partnership

e.   The bank to acknowledge that the booking fee advanced or paid by the Customer to the Vendor shall be treated as booking fees or amount paid by the Customer on behalf of the partnership.

f.   The bank will then advise the Vendor that it shall pay the down payment (on behalf of the customer or rightly, the partnership and then release the full sum upon satisfaction of all legal requirements (similar to an undertaking to pay).

#2. Among other standard terms, to issue the Letter of Offer (LOF) to include the following terms and conditions:

     

a.   The monthly lease rental (refer to next section for types of rental payment)

b.   Determine the “Equity buy-back period” (EBBP) or simply, the financing period. For this example, let’s assume the financing period is 20 years. The LOF should stipulate the formula to determine how

i) the monthly rental is calculated

ii) profits that the Bank can earn and most importantly

iii) the “Equity purchase-portion" (EPP) to be embedded in the monthly rental. During the EBBP, the customer will use the EPP of the monthly rental to purchase additional equity overtime (with option to purchase more equity without prior notice) from the Bank’s original 90% equity when the joint venture was originally formalized. Thus, for each rental payment made by the Customer, the Bank’s equity stake in the property diminishes while the customer’s equity correspondingly increases.

c.   Once the Customer has fully bought the Bank’s equity, the Bank will release its rights over the property.

Customer’s Relationship With The Bank

Under DMF, the relationship between the customer and the Bank is different compare to debt financing.

#1. In a conventional mortgage facility, the customer is a borrower (debt financing).

However, in a DMF structure, the customer is a co-owner and also the Bank’s tenant. This different relationship between the Bank and its customer presents the Bank with different risks and requires different remedies to problems/issues that might occur (we shall discuss further on this in later session)

#2. As joint owner of the property, the Bank faces risk associated with the property ownership.

This situation does not exist under an “interest based mortgage” nor a BBA contract, where the bank never owns the property as it normally takes a charge over the property;

#3. Insurance on Property

Since the property is rented under the syariah principal of Ijarah Muntahiya Bitamlik, it shall be the responsibility of the partnership to take-up Fire Takaful (Islamic fire insurance policy) and the premium is to be shared in accordance with the equity position (in practise, bank's require this to be paid by the Customer) at time of purchase. In addition, the Quit rent cost shall also be shared according to the partner's equity stake. However, the Customer shall be solely responsible to pay for the assessment fee to the Local Council for service rendered and also other services such as Utility bills (where applicable) since the Customer solely enjoy the benefits of using the property.

Despite the above identifiable differences, unfortunately in Malaysia, Islamic Banks still take a charge over the property akin to a debt financing like BBA. By right, if the property is jointly owned, the bank should not take a charge? It should be noted that if the Bank takes a charge over the property, when it comes to foreclosure proceedings, the Bank has to undergo the normal National Land Code legal process commonly use for debt financing which totally against the principal of DMF. Anyhow, based on market findings, there is one international bank that secures their DMF via Trust Agreement but currently there is no test case yet in a foreclosure situation. The Writer supports the use of Trust Agreement (to be discussed further in later session)

Diagrammatically, the DMF can be described as follows:-

Figure 1

Figure 2

Note: We shall discuss on the DMF structure of incompleted property later in this session.

How to determine the monthly rental? 

After entering the DMF Agreement, the Bank will give the customer first option to rent the house under a Tenancy agreement. Before entering this tenancy agreement, both the customer and the Bank need to agree with the “monthly rental” using various rental calculation options to cater the risk profile of a particular customer. In determining the calculation of monthly rental, the Writer can only think of three (3) possible options at the moment, as follows:-

A. Rental Value Method (RVM)

#1. Under RVM, the Bank will seek rental quotations from various parties (if need be, to obtain in writing or verbally from a registered valuer), as benchmark to determine the monthly rental. Of course the best method is to use rental index. However, rental index may not be reliable in certain countries e.g. for Malaysia, the writer opine that rental index may not be reliable. One reason, a project developed by a good developer may command higher rental value and another project, although adjacent to the earlier project,  may not able to command similar rental value. This is the reason why the Writer is of the opinion that rental index in Malaysia is not reliable.

#2. In addition, the Customer is encouraged to provide his/her own rental quotation as comparison to justify any dispute in deciding the monthly rental under the tenancy agreement;

#3. The rental will be reviewed periodically e.g. annually or say, once every 2 years etc as agreed between the Bank and the Customer.

It should be noted that one disadvantage under RVM is that the tenant may ends-up paying high monthly rental due to exceptional appreciation of rental value in the surrounding locations. Nevertheless, this can be addressed, if the rental is also benchmark against, say at certain margin above Islamic base financing rate (which is normally bench marked against conventional BLR).

The Writer is of the opinion that the method used by Lariba Bank i.e. The Commodity Indexation Rule and Marking-To-Market Rule are good alternatives for Islamic banks. These rules were applied successfully since 1989 in the United States by the author Dr. Yahia Abdul-Rahman; considered to be the father of riba free banking in America, with proven results. However, rental index in Malaysia is yet to be developed. You should also visit http://www.bankofwhittier.com/ and http://www.islam-in-usa.com/  for more information the two rules and on Dr Yahia Abdul Rahman.

B. Effective Rate Method (ERM)

#1. Monthly rental is calculated based on ERM where the rental will be determined based on prevailing cost of funds or certain rate of return (margin above Islamic cost of funds or base financing rate) expected by the bank. In practise, the formula for calculating Islamic cost of funds is the same with the conventional calculation of base lending rate. That is the reason why, whenever conventional banks change their base lending rate, the Islamic banks will follow suit.

Note:

Islamic Shariah scholars have permitted Islamic banks to use conventional interest rate as benchmark since that rate is well known to everyone (transparent) and also currently there is no acceptable formula to calculate Islamic cost of funds. The Writer knows Dr Hassan (an actuary) who designed a formula for Islamic cost of funds. However, when we use this formula, the cost of funds turns out to be very expensive especially if the Islamic bank is a new set-up. The Writer will publish this formula, upon obtaining permission from Dr Hassan.

Under ERM method, the monthly rental is determined based on certain margin plus prevailing base financing rate however since we structure the DMF together with Ijarah Muntahiya Bitamlik, revision of the rental cannot be totally benchmarked against base financing rate. Instead, the Bank has to agree with the Customer on the rental renewal period, which can be monthly, quaterly, bi-yearly, yearly or any other period as agreed by both parties. Since we have to send prior notice (the DMF agreement need to be worded in such as way that the Customer agrees for auto renewal of the rental period and the notice is an advice to the Customer without the need for his consent) prior renewal of the rental period (this allow the Bank to change the monthly rental). Based on the Writer's experience, it would be very costly if we are to structure the pricing based on monthly or quarterly rental period since the mailing stamps need to be borne by the Bank. Bi-yearly is more acceptable but administratively it is still cumbersome (although this can be done by the system). Yearly basis will be more reasonable. This means, although the base financing rate change within the rental period, the price can only be changed after expiry of the prevailing rental period.

How to determine the monthly rental under ERM?

For example, the ERM requires by the Bank is 7.00% per annum. Using the formula below, the monthly rental for a DMF for RM 90,000.00 is RM517.81 (or rounded up to RM518.00 - see illustration in Figure 3 below)

Figure 3

Using above formula, frequency for rental period renewal is as per Table 1

Table 1

From the table you can see that if the renewal period is on bi-yearly basis, the new rental period shall be Aug 2010 although in between the period the base financing rate changes every month.

Some viewed using the ERM as little different from conventional mortgage because under both methods, the monthly installments are calculated using similar formula to determine the amortized portion of the principal and profit. However, unlike a conventional mortgage, where money is lent to help customer to purchase a property e.g. a house (pay interest for money lent), Islamic bank offering DMF make profits through the house’s physical use by Customer’s occupation as a tenant. This is one of the fundamentals of Islamic banking whereby customer can be charged for the use (usufruct or benefits) of something physical, like renting a house but customer cannot be charged for the use of the money, which is considered “interest or usury” under Islam.

C. Mutually Agreed Method (MAM) 

This is an alternative installment formula that the Writer would like to propose !

The Writer would like to promote the MAM as the payment mode for DMF mainly because the amortisation of the principal amount (or Equity Purchase Portion) and profits is determined based on the prevailing or month-to-month profit sharing ratio of the co-owners.

Although initially, the Bank can determine the effective return it wanted (and agreeable by the Customer), any changes on the monthly rental thereafer, maybe due to (i) Customer's request to lower or increase his monthly rental (ii) restructuring process etc, the amortization between the principal amount and profits, has to be determined based on profit sharing ratio until next rental renewal period.

How to determine the monthly rental using MAM method?

#1. The monthly rental can be decided based on any reasonable amount requested by the customer and agreed upon by the Bank. 

Before considering the Customer's request, the Bank may use the internal rate of return (IRR) formula, to determine whether the monthly return to the Bank is acceptable. Otherwise, the amortisation of principal and profits shall be based on prevailing profit sharing ratio. For this example, we shall use IRR to determine the monthly rental.

Example :

(a)  The Bank requires a IRR of 7.0% and based on the MAM formula, the monthly rental that the Customer is required to pay is RM575.00 per month. This formula is normally applicable on beginning of the transaction but of course, subject to agreement of the Customer. Thus, if both parties do not agree, the Bank may refuse to provide the DMF.

A view on the formula revealed that although the IRR appears 7.77%, due to the profit allocation based on profit sharing ratio, actual return to Bank is only 7.0% per annum.

Figure 4

#2. Customer must be advised that the monthly rental is subject to review but to be agreed upon by both parties.

It should be noted that although Option C is the best option for Customer however based on simulation, any changes in the monthly rental (especially if the rental amount is lowered),  it will take longer period to acquire the equity from the Bank since the amortisation of principal and profits is based on profit sharing ratio. For example, monthly rental is reduced from RM575.00 per month to only RM350.00 on the 7th month.

Figure 5

Once the monthly rental is changed, the effective return to the Bank is reduced to 4.26%. As earlier mentioned, reduction in the monthly rental should be considered in situation to avoid Customer from defaulting and indirectly giving time to the Customer to recover from whatever situation (ensure it is genuine) rather than allowing the account from becoming non-performing.

True Spirit of Shariah Law

If the management of the Islamic Bank and their Customers believe in the true spirit of Shariah Law, lower return to the Bank and equally lower return to the Bank's depositors does not necessarily mean lower income to the Bank or its depositors. The problem in today's Muslim world, many want to see and touch something tangible. Some willing to place their excess cash in non-halal investment basically to earn higher return.

Allah promise on "blessing" is something intangible (cannot be seen nor can it be touched). Let's look at these two (2) surahs:

Al Baqarah (Surah 276)

Allah will deprive Usury of all blessing, But will give increase For deeds of charity; For He loveth not Creatures ungrateful And wicked.

The writer remembered when giving a talk on Islamic Banking to a group of trainees in Tenaga Nasional Training Centre about 15 years ago, a non-Muslim trainee asked the Writer on the concept of "bless". At that time, the Writer gave the following examples:

Assume, you received a very low 3% return from a "halal and non-usury related investment" of RM1,000. If the return is halal (if you believe in Surah 276), you can probably save or double your return in some other investment without any unforseen hinderance.

Now, let's assume you received 6% return from a non-halal investment (higher by 3% from halal investment) but on the next day, your car broke down, one of your children fall sick and you have to pay high medical fees, and towards end of the month, you even have to use your credit card due to shortage of cash. This is the intangible part where Allah promised of depriving usury from blessing.

There is one investment here in Malaysia where there are arguments among the Muslim Scholars (sorry.....the Writer is unable to disclose the name of the investment.? Maybe you can guess?...). Shariah scholars from Islamic Banks commented that the investment is "haram" but a fatwa was made that the investment is "harus" because most of the investors are Muslims and we need this to go on, to raise the economic standard of the Muslims. Since Islamic banking and Islamic investments have been introduced in Malaysia for more than 30 years. there should not be any excuses about certain investment can be considered "harus" due to the investment being participated by majority Muslim. What the Writer can comment here is if you think you are a "Malay" than the investment is "harus" but if you think you are a "Muslim", then the investment is "haram".

Was informed reasonably, to circumvent issue of halal or haram fund, the investor (non-halal fund) transfer its fund (intended to be be invested in the same investment") to a fund manager, who in turn transfer the fund to the original intended investment. The writer still remembers, when asked why the fund comprises non-halal sources, the answer was, they are operating not to promote Islamic funds but agenda Bumiputra.


Al-Baqarah (Surah 280)

If the debtor is In a difficulty, Grant him time Till it is easy For him to repay. But if ye remit it By way of charity, That is best for you If ye only knew.

Being a business entity, the Writer does not believe that the Bank will stop their recovery process in case of default and write-off as charity but there is one method which the Writer is proposing that will meet the true spirit of Shariah on a "win-win basis" for both the Islamic Bank and the Customer. This will be discussed in later session.

IslamicBankingWay.ComALLAH KNOWS BEST

34(C) EQUITY ACQUISITION PERIOD

In all types of financing, it is important for Customers to know the total amount that they are required or expected to pay before they can fully own the property normally charged to the Bank. Under BBA financing, a Customer is able to know immediately the total amount payable since the sale price is fixed (with exception to hybrid fixed and variable pricing BBA facility) throughout the financing period. But for a conventional loan, the Customer will only know the total amount payable on maturity of the facility since the interest charge is on floating basis (pegged against base lending rate or BLR which moves up and down), although he can also know the potential amount payable on inception of the loan, by multiplying the monthly installment due with the total repayment period in no. of months.

For academic purposes, the Writer will provide comparative analysis table to determine whether DMF is cheaper than BBA financing. Comparison with conventional loan will only be done in later session on debt financing.

Simulation 1 – DMF (MAM)

• Monthly rental based on effective return of 7.0% to the Bank throughout the financing period;

• Distribution of principal payment and profits to the Bank is totally dependent on profit sharing ratio (PSR) except, during inception of the facility where the monthly rental is calculated based on effective return wanted by the Bank (if the Bank needs to maintain certain internal rate of return for its profit);

• Any changes in monthly rental thereafter, the distribution of principal payment and profit shall be  based on prevailing PSR.

Simulation 2 – DMF (MAM)

• Monthly rental amount and effective return to Bank is similar to Simulation 1 except Customer pays optional amount (without prior notice) to equate the actual monthly rental payable based on 7.0% profit rate used for calculating BBA monthly installment for similar financing period.

Simulation 3 – BBA

• Monthly installment based on actual calculation at profit rate of 7.0% which is RM697.77 instead of RM575.00 for Simulation 1. The reason for higher amount payable for BBA although the profit rate is the same; is because Islamic Banks are using same formula for calculating conventional loan monthly installment. We will learn more about this formula in our session later on BBA.

Simulation 4 – BBA

• Monthly installment is determined based on similar calculation under Simulation 1 and same amount is payable throughout the financing period;

• Non compounding on profit due but not yet paid.

Results of the above four (4) simulations are as follows:-

Explanation

Based on Simulation 1, the facility will be matured within 33.08 years and profit payable to the Bank is 156.58% above the original financing amount. However, for Simulation 2, with additional payment of RM122.77 monthly, to equate actual monthly installment of RM697.77 for debt financing, the facility will be matured by 19.83 years. In addition, total profit payable to the Bank is only 83.01% above the original financing amount compared to Simulation 3 which is 86.01% (maturing at almost similar time to Simulation 2). But when we use RM 575 instead of RM697.77 as the monthly installment under Simulation 4, the facility will be settled by 35.08 years and profits payable is 168.10% above the original financing amount. 

If we are to compare the Equity Acquisition Period (EAP), the differences between Simulation 1 and Simulation 4 is only about 1 year but under DMF-MAM model, the Customer can pay optional payments without notice and this will help Customer to buy the equity earlier.

Take note that this simulation does not mean anything if Islamic Banks do not adopt or offer MAM for their DMF but use ERM instead.

Those interested to have the excel version of the simulations, can email to the Writer at ismail.aminuddin2@gmail.com

IslamicBankingWay.Com
ALLAH KNOWS BEST.

34(D) SECURITY RECOVERY PROCESS

Currently, the National Land Code does not cater for Equity JV property financing thus, most Islamic banks offering DMF in Malaysia (with exception to 1 international bank) will take a charge over the property to be financed. As earlier argued, the ambiguity appears when the property is to be auctioned as though it is a debt financing.  Although, there are arguments that overdue rentals can be considered as debt when due but not yet paid, the the spirit of Musharakah should be observed under DMF. Thus, to maintain the spirit of Musharakah, disposal of the property should also follow the Musharakah way.

The Writer is of the view that the DMF facility should be documented using a Trust Agreement. Although for administration purposes, the property may be registered in the name of the Customer (due to current land laws in Malaysia), the Customer merely acts as the proxy of the joint venture partners or on behalf of the beneficiary owners who are actually the joint-venture partner. As the Writer is still not sure on the detailed legal implications using Trust Agreement, the Writer seeks Legal and Shariah practitioners to explain implications of the same, if used to document DMF. If there are loopholes or hindrances in our current land laws, how this can be revised to support the implementation of DMF in Malaysia. Anyhow, from Writer's little knowledge on Trust Agreement, it can be used but when we want to dispose-off the property, we need to go back to the Customer for consent. If this is so, perhaps, we can incorporate some kind of "pre-consent clause" allowing the Bank to take unilateral action when it comes to default situation.

The joint venture contract is considered terminated once the Customer has fully subscribed (through rental payment) the remaining equity previously owned by Bank including payment of whatever dues such as shared quit rent, Takaful and other administrative charges, where applicable.

Thus, the way DMF contract can be terminated are through the following options:-

1. Put Option Cash

Under Put Option Cash, the customer would like to terminate the Tenancy Agreement (and the DMF Financing) by acquiring balance of the equity still holds by the Bank at par value of RM1 by cash. Under this situation, the Bank is obliged to accept full payment from the Customer. By cash include receipt of redemption amount from other Bank on assumption that the Customer is refinancing the facility only.

2. Put Option Sale

Customer intends to sell the property for capital gain. Under this arrangement, the Bank can exercise the followings:

(a)  Customer to give consent to the Bank (should be incorporated in the Diminishing agreement) to arrange sale of the property through a registered real estate agent or any party introduce by the Customer at price most beneficial to both the Bank and the Customer. A “without prejudice” clause must also be incorporated in the Agreement to protect the bank and Customer from any dispute on sale price once sale is concluded through whichever mode agreeable by both parties.

(b) Customer will be allowed to suspense (if he wishes) to pay the monthly rental.

(c) Capital Gain from the sale of this property will be shared by the JV partners in accordance with the relevant share equity prevailing at time of receipt of sale proceeds.

(d) Real Property Gain Tax (if any) will be borne by the relevant parties in accordance to the country's tax structure;

(e) The “First Right of Refusal” clause will also be incorporated in the Agreement conferring the Bank the right to buy the property from the customer directly at price agreed by both parties. This is necessary if there is urgency to dispose of the property or somehow, there is no buyer for the property. On the other hand, this will give flexibility to the Bank to temporarily own the property on assumption that there is potential upside on the property value, if it dispose it later.

(f) If the property is bought over by the bank (on anticipation that the price can hike further), it would be treated as an investment and whatever Bank Negara rules regarding investment or property own by Islamic banks shall apply. Unless the Islamic Bank Act has been revised recently, current Acts allows Islamic banks to own, rent, lease and trade the properties. Unlike under BAFIA (for conventional Bank), the Bank can only own property for its business use only e.g. for its own business premises.

Note

Some propose the signing of Wa'ad requiring Customer to purchase the equity in situation of default since when monthly rental remained overdue, a debt is created. Yes, the Islamic Bank can claim the overdue rental which can be considered as debt when not paid but the Writer opine that when the Customer is already unable to pay the monthly rental, asking the Customer to acquire the balance of the DMF equity, is also against the spirit of Musharakah.

3. Call Option Default

When Customer is unable to service the monthly rental for more than 3 months it will trigger a situation of default. To have a "win-win" situation for both parties, the property will not be auctioned but instead sold through a panel of real estate agents (similar to Put Option Sale except, under this situation, the Bank has more say in handling the disposal of the property).

Allah Knows Best.

34(E) RESTRUCTURING & RESCHEDULING

This was also another article which was not published. I am not sure whether this is still relevant but those who studies Islamic Banking or existing Islamic bankers,  may use this as reference and improve the structure so this type of financing facility can be introduced or implemented by Islamic banks.

Start here...

While servicing the monthly rental under DMF, the Customer may request (if agreeable by the Bank) to lower his/her monthly rental due to unexpected situation such as sudden out of job, economic crisis, business failure etc. As long as the Islamic Bank is agreeable with such requests, the Bank can change the monthly rental at any time to suit its Customers' payment capabilities. If this is adopted, issue on non-performing financing will be resolved or at least reduced. The upside for both parties, the Customer will take longer time to finalise the facility and the Bank's effective return will be reduced.

The above proposal may not follow the GP3-i guideline (please look at the new guideline) issued by Bank Negara Malaysia but the Writer believe this is one way to avoid non-performing. In adverse situation, the Bank can still opt for Put Option Default but since the Bank is a joint venture partner, it is also subject to risk if the market value of the property is lower than the outstanding balance of the DMF facility. Any losses incurred on disposal of the property, shall be borne by the Bank accordingly. However, if the property is sold through a panel real estate agent and not at forced sale price but at best market value, the risk will be mitigated (there is a controversial issue on this from the remarks by Presiden Mahkamah Timbangtara.

To consider lower rental amount, the Bank should consider the following actions:

1. Rental Value Method – the profits and buy-back portion will be distributed based on the equity position of the JV partners.

2. Effective Rate Method – when the rental is re-computed at lower amount while the profit rate remained unchanged, the profit portion (amortization based on original rental) will result lower principal payment and possibly, the lower monthly rental cannot fully cover prevailing profits due. In such situation, whatever amount collected should go to profit first to maintain the Bank's IRR. This can also result, lower or temporary suspension of the principal payment which will also result extension of the payment period. 

3. Mutual Agreed Method – the treatment is similar to Rental Value Method.

Upon re-assuming the normal or reschedule monthly rental, there is no necessity for customer to update all the back dated rental (due to rescheduling to lower the monthly rental) unless original payment method is based on ERM, where customer need to observe the original payment tenor (or EAP). Under ERM, all back dated payments should be updated before the expiry of the original maturity period.

Non-performing situation will only be triggered if customer totally cannot pay AT ALL and the bank had to exercise the Call Option Default. The option is triggered as follows:

• Customer defaulted in paying the monthly rental for 3 consecutive months;

• Customer did not take effort in rescheduling or lowering his monthly commitment downwards to resolve his default position;

• Bank has to write to customer advising the Bank will exercise PUT OPTION DEFAULT. Upon expiry of the said notice, the Bank will appoint immediately a panel real estate agent to dispose-off the property.

• Any capital gain or losses from sale of this property shall be shared by the Bank and the customers after deducting all sale expenses and charges/debits due to the Bank.



IslamicBankingWay.Com
ALLAH KNOWS BEST

NOTE

Due to many requests via personal emails received by the Writer, here onward we shall go back to Writer's original proposed contents before we continue our discussion on financing products.

Actually there are two (2) more sessions to be discussed under DMF but we shall temporarily hold both sessions, namely (a) purchase of property under construction and (2) legal documentations, until we reach the session on financing contract of Ijarah Muntahiya Bitamlik or leasing ending with ownership.

34 (A) MUSYARAKAH MUNTANAQISAH

This is a reproduction of an earlier article on Diminishing Musyarakah (or Musyarakah Muntanaqisah) with some updates to look at the product based on current practices. The Writer has not been writing for many years due to some personal reasons but when he glanced through this blog somehow, a few articles were left as a draft. So, he was not sure to what extend the Islamic Banking Act has change and this article is published, just to complete the article. The write has no intention to update this product, to meets its current guideline, if any (year 2020).

Diminishing Musharakah Financing (DMF) can be readily use as the alternative product for Al-Bai Bithaman Ajil (BBA). 

A number of Islamic Banks in Malaysia are currently offering DMF but what Writer plan to write in this Section is to propose an ALTERNATIVE Musyarakah structure (probably not yet implemented by any Banks in Malaysia). Personally, the Writer feels that this alternative structure can be considered as "Real Musyarakah" rather than a DMF contract by name but pricing wise, it is comparable to the conventional floating interest rate facility.

Current DMF contract is advantage of those who are interested to seek short term financing facility but for long term financing (e.g. for home financing), it would be more advantage to go for fixed profit financing like the BBA or Murabahah (if this facility is still available, as Islamic banks are more keen to promote DMF due to the floating rate nature of the facility). Fixed profit rate financing facility is better for the consumer as they do not need to worry about the conventional  "interest rate" trend that may influence the DMF's profit rate due to its floating pricing structure.

Why the Writer says this? Malaysian (particularly the Malays), prefer long payment tenor i.e. 30 years or longer (some banks offer up to 40 years). When they signed-up for long payment tenor, they are actually exposing themselves to profit rate risk (akin to interest rate risk). Fixed profit rate (even though most Islamic banks are offering hybrid profit rate where  maximum profit margin (usually about 4.0% p.a.)  + base financing rate equal to sale price), the Customers are technically entering into a "natural hedge contract" where the sale price is fixed (at a glance its look very high) but what is important to the customer, the Islamic Banks cannot charge profit rate higher than the maximum contracted ceiling sale price.

If we are to look at current DMF structure, there is no ceiling profit rate or maybe if they do, it would be structure similar to the floating financing rates akin to BBA. If the profit rate is not fixed in DMF, when the conventional interest rate moves up to say, 15% or more per annum (this has happened before), the DMF pricing, may also moves up since Islamic base financing rate (BFR) is very much influence by the conventional BLR. Even though now, we have full fledged Islamic Banks, most of the Islamic banks are owned by conventional banks thus, they would not want to expose the group to what BNM termed as "Displaced Commercial Risk" i.e. moving of funds from Islamic deposit to conventional banking and vice versa.

Although BNM National Shariah Council has no objection on floating profit rate pricing, why can't the Islamic banks offer another alternative pricing or do away with the floating price benchmark? Although the Writer admit that under current trend (effective 14 March 2014), Mudharabah investment account (floating investment profit rate deposit) are preferred by Islamic banks BUT due to the new BNM classification of Mudharabah Investment Account (no PIDM insurance cover  and it is also treated as part of bank's investment vis-à-vis capital charge),  Commodity Murabahah is now preferred (with PIDM insurance cover) by Islamic Banks.

For social reasons, Writer's proposed DMF structure should be considered for offering because there is one special feature that is not available in any other type of financing i.e. Islamic banks can avoid potential non-performing financing.  Under current situation, where the Banks had to offer six months payment moratorium period, the DMF structure that the Writer would like to propose, would be benefits to both parties ie. to the Banks and the customers.The Writer feels that this type of structure is suitable for low cost housing financing and for those who prefer short term payment period, of say 3 - 5 years (it can be a special structure for high net worth customers).

Perhaps, the Islamic Banks can still offer fixed profit rate (using Writer's proposed  DMF structure) and backed by specific Mudharabah investment deposit (perhaps, there are depositors out there that still prefer Mudharabah deposit structure) to fund it. .

Before, we touch further on DMF, let's define again (this already defined in earlier article) what is Musharakah?

Investopedia defined Musharakah as a joint enterprise or partnership structure with profit/loss sharing implications that is used in Islamic finance instead of interest-bearing loans. Musharakah allows each party involved in a business to share in the profits and risks. Instead of charging interest as a creditor, the financier will achieve a return in the form of a portion of the actual profits earned, according to a predetermined ratio. However, unlike a traditional creditor, the financier will also share in any losses.

Actually, Musharakah plays a vital role in businesses. Formation of a limited company (Sendirian Berhad) between two (2) individual is actually a Musyarakah contract. For example "A" wants to begin a business but has limited funds; and "B" has excess funds, and is willing to finance the venture. When the two (2) enters in a JV agreement and begin the business, both are subject to profit and loss sharing. This negates the need for "A" to receive a loan from "B"{. Of course, if "B" is willing, he can still help "A" by giving a loan but it has to be non-profit/interest bearing (al Qhardul Hassan)

On the other hand, Diminishing Musharakah is defined as "a partnership between one party and another, to jointly purchase an asset". For non-banking transaction, the partners are most likely buying the asset to make money from rental or eventually capital gain from the sale of the asset. However, in banking perspective, when the Bank enters into a partnership with the Customer to purchase an asset, the bank real intention is not to jointly own the asset for longer than the agreed financing period as the Customer is expected to eventually purchase the entire shareholding/equity or control (hereafter to be referred to as "equity") over the asset. How the Writer wishes the bank can be a partner in a real property purchase contract as this would be the best way to avoid non-performance in the Bank (more explanation later).

Once the asset is purchased, the asset will be rented to the Customer. The rental amount is "to be agreed upon by both parties" (...will explain this later)  and the Customer’s portion of the rental based on its current equity holding, shall be used to increase its equity on the said asset. The rental amount after deducting the Customer’s "equity purchase portion" is to be treated as profits to the Bank.

Technically in Malaysia, DMF should ONLY be offered by Islamic banks i.e. Islamic banks are allowed under Islamic Banking Act 1983 (this Act i.e. the Islamic Banking Act 1983 has been repelled by Bank Negara Malaysia and replaced by the Islamic Financial Services Act 2013 effective 30 June 2013). I have not check whether there are more changes made since then. Musyarakah financing is provided under Interpretation 2 of the FSA 2013 (Act 758), under the term "provision of finance" which means entering into, or making an arrangement for another person to enter into, the businesses or activities which are in accordance with Shariah including - (a) equity or partnership financing, including musyarakah, musyarakah muntanaqisah and mudarabah (page 23 of the new FSA 2013) if there is no revision since 2013.

In the old Islamic Banking Act 1983; there was a BNM subsequent issue (the Writer has forgotten on its sources) relating to Asset own for trading (which include buy, sell and lease) while under BAFIA, assets can only be owned by conventional banks for their own banking premises and business related activities such as training centre and the like. This validate the buy and sell of Asset for trading-liked facility such as BBA (I think most banks no longer offer this structure anymore) and Murabahah.

Anyhow, let’s continue with our discussion on DMF. Why should Islamic banks also offer DMF as alternative to the existing fixed profit rate debt financing contract?

#1- Most Risk Managers are of the opinion that the fixed profit rate (commonly used for BBA financing) MUST be hedged to protect the bank’s profit margin. Under BBA; once the sale price is fixed, it cannot be changed until the facility is fully paid. This place the bank in situation where its income will be reduced or in a loss position vis-à-vis higher deposit cost compare to the profit (at the agreed fixed rate) that it received from the BBA contract. This argument make sense for example, if BBA fixed price is 6.0% per annum while prevailing deposit rate is 7.0% per annum, the Islamic bank will suffer negative variance of 1.0% per annum. That is why Risk Managers are not in favour of fixed profit rate financing. However, in order to comply with BNM aspiration in making Kuala Lumpur as an Islamic financial centre (if they still do...), the strategy of most banks (based on Writer's experience while working with Islamic subsidiary of a local conventional bank) is to achieve the target imposed by BNM on Islamic Banks. Most will go along with the requirement but imposed strict approving criteria just to meet the target with no real push to increase their Islamic banking business.

#2- Assume Islamic banks decide to hedge. This can be done as follows:-

a) Sale of debt (BBA receivables) can be done with Cagamas or the Islamic bank creates Negotiable Islamic Debt Certificate (NIDC-i). However, both products are not internationally acceptable Islamic hedging instruments since both are structured using the contract of Bai Al-Dayn (sale of debt). In Malaysia, Bai Al-Dayn contract is Shariahlly acceptable, I think so as per this link..

b) Hedging using Profit Rate Swap (PRS). Likewise to Bai Al-Dayn, PRS is structured using Commodity Murabahah. Again, this product also received mixed views from both local and international Shariah experts.

If we are to examine the above carefully, both the above products are structured to emulate conventional hedging products. If we are to question this, the arguments will never stop. So, let's not argue about it!

#3- Under BBA fixed rate financing, the contracted selling price (total installment payable) represents maximum amount that the Bank can claim (apart from other charges/debits) from a Customer in a foreclosure proceedings. In addition, Shariah only allows maximum amount that can be claimed from Customer in a foreclosure situation, NOT EXCEEDING outstanding sale price and maximum compensation charges accumulated; ALSO CANNOT EXCEED the outstanding principal balance. In addition, accept for 1% p.a. (this is an old structure, to know the latest please click this link...) whatever compensation charges collected are to be given to Charitable organizations (bank cannot treat compensation charges as income) although BNM has allow under the latest late charges method. So due to these restrictions in making claims (...leading to opportunity loss of income to the Bank), Risk Managers are also against the Banks having too much exposure on fixed rate financing.

The writer remembered a friend from one of the active commercial banks offering Islamic hire purchase facility (i.e. AITAB- Al Ijarah Thumma Al-Bai) commented that despite his boss being a Muslim, the instruction was to reduce AITAB’s exposure since the compensation charges allowed for AITAB was only 1.0% per annum while under conventional hire purchase, the Bank can charge up to  8% per annum as allowed under the Hire Purchase Act. My only hope here is, Allah will show him (i.e. the boss) guidance...! (anyhow this happen in early year 2000 ago but the Writer still share this story to describe attitude of bosses where conventional heads are still giving instruction to a Islamic subsidiary due to Group strategy). Infact, I think (if this has not change) now, sales people parked under Islamic banks, are required to cross-sell conventional banking products.

#4- In the conventional bank’s “letter of offer”, the loan amount and interest rate are clearly shown but in letter of offer normally issued by Islamic bank, only the purchase and sale price are shown. However, in practice, most Islamic banks will indicate the profit rate charge and set the profit margin above certain benchmark or base financing rate (derived from base lending rate). This is where the confusion starts. This situation became more complicated when CJ Dato’ Wahab Patail made controversial High Court decisions in the Affin Bank vs Zulkifli case (among the earliest controversial Islamic Bank legal case) where he commented that Islamic banking is more burdensome than conventional when a property is subject to foreclosure proceedings. Although that decision has been overturned, it nevertheless, creates an eye opener to BNM and the Islamic banks to  review its BBA product exposure. In fact on June 7, 2010,  Bank Negara made a bold decision on basis of maslalah (public interest) where Islamic Banks are to stipulate the rebate (ibrar’) clause in the agreement to ensure such arguments are no longer raised in the court. The writer is of the opinion that we should maintain the "status quo" where rebate is at discretion of the Banks but instead, BNM issue an operational guideline or perhaps, this can be done by AIBIM (Association of Islamic Banking Institution Malaysia) regulating Islamic banks to use standard rebate formula on finalization of the account. As explained in Article 15, one of the reasons why Islamic Bank should claim the outstanding sale price is that they are not sure when the case can be settled thus, when the rebate amount kept changing from time to time (..statement of claim need to be changed from time to time in the foreclosure proceedings until the case is resolved) and this is common for BBA financing. Since the Shariah has deliberated over this issue and made a decision, no point arguing over it. What is important, is to expedite collective introduction of DMF.

With DMF, customers shall be able to differentiate clearly the value propositions between Islamic vis-à-vis the conventional mortgage/term financing. The writer is of the opinion that DMF can be a killer product compare to conventional loan if the same is structured properly and collectively offered by Islamic banks

In next article the writer will talk about the various method of structuring the DMF.



ONLY ALLAH IS MOST KNOWING.
IslamicBankingWay.Com

Original article 14 March 2014
1st revision May 25, 2020
2nd revision, 31 July 2020

34. WHAT IS MUSYARAKAH.?

Article 33C(ii) is the last section on debt financing. At first the Writer thought of writing on other financing related matters such as legal documentation, risk ...etc on debt financing (including other financing products such as Ijarah, Salam etc.,)  however due a number of requests, the Writer agreed to write about Musharakah first.

In earlier Article 16A-16D, the Writer had explained about Diminishing Musharakah Financing (DMF) and this product is repeated under this Section 34 but with more details or with an updated version to meet requirement under the new BNM Islamic Financial Service Act (FSA) 2013 that replaced the old Islamic Banking Act 1983.

Before we start, let us define what is Musharakah or Musharakah financing?

Musharakah is a partnership agreement entered by at least two (2) parties or best to be described as partners, for a particular business venture (must be "halal" venture). In banking perspective, the business partners shall comprise the Bank (acting as a Financier) and the Customer (supposed to be the expertise in the venture or in reality, the person who needs the funding). The Writer really hope that one day, Islamic banks will readily to offer Musyarakah financing to replace or perhaps, to complement the venture capital companies that have been active in this area (especially in the Western countries), to certain extend. Capital charge issue is the main reason why Musyarakah financing is not yet readily accepted by banks but there are other ways of structuring Musyarakah, which we will discuss later.

We shall touch on Shariah requirements for Musyarakah under Article 34(B) but our focus later shall be on the Writer's proposed structure (particularly on Musyarakah Muntanaqisah or Diminishing Musyarakah) which is contrary to the current practices offer by Islamic banks in Malaysia and it's possible features.

Brief common features for Musharakah Financing?


a) Both partners shall together raise the joint venture working capital and they need to decide on the working capital contribution ratio prior commencement of business;

b) Both shall manage the business but they have option to allow the other partner to run or lead the venture instead. If they decide to do this, roles and responsibilities of each partner shall be defined in the shareholders' agreement;

c) Profit sharing ratio (PRS) to determine the allocation of profits from the business, need to be decided by the partners, prior signing the joint-venture agreement;

d) Losses this business venture shall be based on actual capital contributed by each partner and NOT based on the agreed profit sharing ratio.

e) The venture can either be an incorporated joint venture (setting-up a new company - for Malaysia this requires BNM approval and there will be a lot of regulatory requirements) or the simplest way is to set-up a loose joint-venture where the venture can be entered via a joint-venture agreement (couple with other agreements, if it need be) between the partners. Since the Bank is the financier, it can have control over the flow of funds (they can do this via a designated current account to control the inflow and outflow of funds).

What is most important in this venture is that the Bank as financier should not treat Musyarakah akin to debt financing especially in situation when there is a cost overrun (or in case of a loss situation) but to act as responsible partner especially under loose JV structure, by injecting new funds (of course, not in situation where good money to cover a hopeless venture) and renegotiate on the terms of the profit sharing distribution i.e. to resolve, it would be best for the customer to agree for profits reduction in lieu of the new capital injected (if they are unable to contribute more capital) or by other ways, subject to Shariah's consent on the revised structure.

To protect both parties, the joint venture agreement should be prepared to cover all possible eventualities especially since Musyarakah is something that have not been tested in court between the Bank as Financier and the Customer.

If the joint venture is set-up using a new entity, the cost overrun issue would be easier to handle i.e. the Bank as Financier can issue new shares and if the other partner (Customer) cannot subscribe to the new shares, it's current shareholdings will be diluted.

So before entering a  Musyarakah Financing arrangement, the Bank and the Customer need to study deeply on the type of JV they need to set-up i.e. either an incorporated JV (this will take sometime) or just enter a loose JV.

How to differentiate Musharakah from debt financing?

Musyarakah is akin to a "Venture Capital " financing where risk is borne by both parties. This is contrary to the one sided debt financing structure where profits are charged by the Bank (irrespective the customer is making a profit or a loss) and the terms of the debt financing is generally structured to minimize risk to the fullest benefits of the Bank. Infact, to lower the risk further, the Bank will requests for collateral as added security.

In Musyarakah Financing or specifically for Mudharabah type (where only bank provides the capital), collateral can be only be requested to cover possible negligence of the Customer in running the business.

Under debt financing, the Customer is required to pay the principal and profit portion due to the Bank on due dates and if the Customer defaults, the Bank will recall the facility (stop the customer from utilizing the facility) and sue the Customer to recover total amount owing to the Bank, and if need be, the collateral is auctioned when the Bank cannot recover the full amount owing to the Bank. Under Musyarakah financing both the Bank and the customer will jointly bear the losses according to their capital contribution and NOT based on agreed profit sharing ratio.

Under this topic, the Writer shall illustrate a number of possible Musharakah structures that can be considered by the practitioners, particularly the Bankers.

However before we discuss further,  it is necessary to highlight why Banks are reluctant to provide Musharakah financing. Put aside the risk aspects, the main reason for Banks not interested to venture into this type of financing is mainly because of the Bank Regulatory capital charge. What is it? It's simply the amount of capital that the Banks are required to hold against their assets. Generally, though the concepts have been evolving with various Basel Accords, regulatory capital for various debt financing instruments is 8% on the Bank's risk-weighted assets.

Surprisingly enough, there are actually lots of different answers. Many believe that it should cover a bank's potential losses in a portfolio with some cushion. There are opinions that say that this is wrong. Why? In reality, no banks will ever gets the luxury of seeing  whether over the long run,  the capital is enough to cover actual losses. The real world doesn't work like that.

Bank runs (people will start withdrawing their deposits on ground that the bank will go bankrupt etc..) start when people become concerned that if a bank had to liquidate its portfolio, there wouldn't be enough money to pay the deposit place by the customer in the Bank. So no matter what style of accounting method a bank uses, at some basic level, investors react to the perceived value of the assets, not eventual value. This is a key distinction.

Depositors reacting that way are the biggest threat, because if they pull deposits, then banks have to sell assets even though they hope to hold until maturity. If the bank isn't relying on the short term funding, the run is less likely, as they have more ability to weather the storm.

So regulatory capital or capital adequacy or just plain capital, actually needs to address the worst of eventual loss i.e. potential "mark to market loss issue". Since mark to market loss risk is almost always worse than eventual loss risk, that has to be the key focus. The way a bank funds itself is also important, the less it has "demand" deposits, the more control they have over the asset side of the balance sheet (no forced selling), so the liability side has to play a role in capital determination.

Therefore, not to be concerned over capital charge issue, the best sources of funds for a Musyarakah financing is a SPECIFIC OR RESTRICTED FUNDS where a the Bank uses money from depositor or a group of depositors whom are willing to fund partially (Bank still has impact on capital charge as per IFSB's Risk Weight of 400% under the Simple Risk Weight Method or between 90-270% under the Slotting Risk Weight Method) OR provide 100% funding to back the joint venture project i.e. able to absorb 100% of the losses, where the Risk Weight is supposed to be Zero % i.e. nil. For the this later structure, the Bank should be agreeable to earn less as no specific or restricted depositor would like to take-up risk if his return does not commensurate with the risks that he is willing to take-up. As a rule of thumb, return of above 15.0% per annum, would be considered a reasonable good return to a restricted depositor. Of course, there are those who are talking about a return of more than 20% per annum. Most importantly, both partners (under joint effort of the Bank and the Customer) are able to come out with a viable proposition to a potential restricted depositor.


To write this article, the Writer too need to undertake research and continued support by readers, who have been contributing opinions and related articles on Musyarakah. The Writer's own practical experience in dealing with Musyarakah Financing was a few years ago when he structured one (1) Musharakah financing using restricted funds and had involved in providing free consultancy services to a Credit & Leasing company that offers Musyarakah Contract Financing mainly for government contracts. The Writer will share both experiences with the readers of this blog.


Last but not least, there is an interesting article about debt and equity financing that the Writer would like readers of this blog to read. The Writer proposed the first article that you should read is an article on Bank of International Settlements leading to the issue of Basel Accord and indirectly to the issuance of the Islamic Financial Service Board (IFSB) standard. Please visit this link http://zahidsay.blogspot.com




ONLY ALLAH IS MOST KNOWING
www.islamicbankingway.com

33C(ii) WHICH IS CHEAPER? ISLAMIC OR CONVENTIONAL BANKING PRODUCTS. CONSUMER POINT OF VIEW

This topic is very subjective. As a Muslim, one has no choice but to take-up Islamic financing irrespective the pricing imposed by Islamic banks BUT for non-Muslims, their decision to take-up Islamic or conventional banking facility would depend on the pricing and benefits that they would enjoy from Islamic financing.

Our issue here (or is it an issue..??), what are the benefits for those who choose to take-up Islamic financing (irrespective of fixed profit rate or the hybrid fixed/variable profit rate pricing)? My reason for asking this question is because from the information provided to the Writer (including from his own experience), in most Islamic banks in Malaysia, their financing customers are non-Muslims (some reported, more than 60%).

Anyhow, from Writer's own experience most non-Muslim who took-up Islamic financing were due to as follows:

1. Natural Hedge - irrespective they take-up a fixed or hybrid financing profit rate, they are actually hedging themselves against possible hike in future interest rate. The 1997 Asian Financial Crisis has made many, especially those in business, aware of the danger of variable interest rate prevailing in conventional banks. Without BNM intervention during the financial crisis, the impact would have been more severe.

2. Sales campaign - most Islamic banks (and most of the existing Islamic banks are a full-fledged subsidiary of conventional banks) are having shared marketing/sale staff (most sale staff are non-Muslims either permanent or on contract basis). The sales people are commission driven and whenever a campaign is launched, for example, to write at least 500 Islamic new financing accounts (or a target of say, RM100 million sale for new Islamic financing account is set), the sale staff force will push the sale as the target will be included in they KPIs.

The Writer remembered introducing a pocket handbook with Q&A on all possible questions by Customers, including how profit is calculated, comparative analysis (basically, benefits of Islamic financing over conventional banking) etc so whenever a sales staff is landed with questions he is not familiar with, he can immediately refer to the handbook for answers. This handbook is a very effective marketing tools and all Islamic banks should made this available for their sale staff. We have to admit that in general sales staff are good in selling but weak in the product knowledge, especially Islamic products.

3. BNM target - the Islamic bank (as a group with their conventional) need to achieve certain targets imposed by BNM. The Writer is not sure whether such targets are still being imposed by BNM but the Writer opine, it is a good move to achieve the MIFC's objectives. By removing this target, the sale staff will prefer to sell products that they are familiar with.

Surprisingly however, prior to my retirement, there were a number of instances, Malays (who are supposed to be Muslims) still prefer to take-up conventional banking, despite  knowing (we even showed to them Sura Al Baqarah - 2:276 that Allah will deprive usury of all blessing...

...part of Al Baqarah (2:276)

Infact, there was one incident when a Muslim customer insisted conventional loan over Islamic banking financing facility just because to him, Islamic banking facility is more expensive than conventional. He further reiterated that it's was a matter of principle NOT religion. Honestly, this was something that the Writer cannot comprehend until today, a Muslim willing to sacrifice Allah's blessing for the sake of principle...?? There are some who said, existing Islamic banks are actually adopting a disguised "riba" so it is okay for them to take-up conventional loan due to 'dharurah" rather than taking disguised "riba". Irrespective of one's opinion, a fatwa has been issued by the National Shariah Advisory Council (NSAC) of BNM. We have to assume they have addressed all issues relating to "riba" as people sitting in the NSAC are reknowned Muslim scholars who are expert in their fields.The Writer hopes that there are NO OTHER MUSLIMS out there having same thinking about Islamic banking.

4. Pricing - in reality pricing is an important element when it comes to making decision to take-up financing or to borrow.! (common terminology used by people on the street).  As a true Muslim, what is most important to him is Allah's blessing. If a Muslim believes this, even if Islamic banking pricing is say, 1.0% higher than conventional bank loan, he will still take-up Islamic financing. What more , under Surah Al-Baqarah (2:279), Allah and his Prophet, declare war on those who takes "riba". Was informed, in the USA, "halal" meat is difficult to get, so the price of halal meat is normally more expensive than the non-halal meat but as a Muslim, one will still buys it because from young, a Muslim has been trained not to eat non-halal food. But when it comes to "riba".....why there are people who said "a matter of principle or they are not afraid of Allah's warning..?? The Writer trained his children from young "pork and riba are haram" although only a certain age they understand what is riba meant ...but most important we instill this saying in their mind from young. Perhaps, it's because "blessing" as promised by Allah to Muslims is something "non-tangible" or something that cannot touch, feel and visualize. We have also heard some said " not to worry, we can repent when older". Please visit my other blog http://alqamar5417.blogspot.com that touch a bit on these subject matters.

Anyhow, let's evaluate whether Islamic banking products are more expensive then conventional. Let's look at customers' point of view first. The Writer, in later topics, shall also discuss as to whether Islamic banking is a loosing business to the banking group (conventional bank plus its full-fledged Islamic subsidiary).

As for this topic, let's look at this comparative analysis..! Some of the points have actually been deliberated under Topic 33C(i).....


a) Comparative Analysis

Now, let's look at Chart 1 below

Late charges in Islamic banking is allowed basically as  a deterrent mechanism against cases of default by customers in discharging their financial obligation arising from Islamic contracts. Islamic banks used to charge only 1.0% p.a. on overdue installment. The side effect, there are customers (having both Islamic and conventional accounts) that placed priority in payment of conventional loans rather than Islamic due to the low penalty charges they will incur compared to delaying conventional loan payments. Due to this (the Writer believe that the pressure comes from conventional bank having Islamic subsidiary) there were banks that seek BNM to review the penalty charges to be imposed on Islamic banking customers.

As a result,  sometime in August 2011 (implemented in first quarter of 2012), the NSCA approved new late charges calculation that comprises both concepts of gharamah (fine or penalty) and ta'widh (compensation). Gharamah is not allowed to be recognised as income, and it must be channeled to specified charitable bodies. However, Islamic banking institutions may recognise ta'widh as income (normally at 1.0% p.a.) on the basis that it is imposed on the customers as compensation for the actual loss incurred by the Islamic banking institutions.  The maximum rate of gharamah and ta'widh that may be imposed by Islamic banking institutions will be determined by Bank Negara Malaysia. 

Chart 2

We have discussed the impact on compounding  under Chart 13 of Topic 33C(i)  but to see further impact on "compounding" we shall at end of this topic use the "famous" legal case "Zulkifli Abdullah versus Affin Bank"   to further elaborate the impact of "compounding" on default case.

Chart 2

The impact of fixed monthly installment for conventional Bank is shown in Chart 13 of earlier topic 33C(i)

Chart 3

Likewise, we can see this impact in legal case "Zulkifli Abdullah" versus "Affin Bank" in later section of this topic.


Chart 4

For Chart 4, rather than customer (particularly non-Muslims) seek re-financing from conventional bank (assume in low interest rate regime situation) it would be cheaper in long-run, for them to seek the bank to provide them a rebate (or a discount) on the profit payment i.e. not on profits already earned by the bank but on future profits (termed as unearned income). The Islamic banks on the otherhand, should consider the rebate request if they are to maintain the customer.

b) Legal case to show Islamic banking is cheaper..!

This has been discussed in Topic 15 of this blog. However, in this topic we shall provide detailed explanation on the impact of the Judge's decision if the case is not overturned. Infact, this case is a good example to show the impact of conventional loan when landed in court.

Chart 5

SELECTED FACTS OF THE CASE

• In 1997, the defendant took up a BBA financing of RM346,000-00 from BSN Commercial Bank (which was later taken over by Affin Bank Berhad) for a financing period of 18 years (216 equal monthly installments) under the staff loan [ the word "loan" is used here by court ] scheme at 3.5% profit rate (special staff profit rate) with the Bank’s selling price of RM466,847.28

• At commercial profit margin, the Facility was to be repaid over an 18 year tenure by 216 monthly installments of RM3,582.80  BUT since the defendant is a staff, by the applying Islamic principle of Ibra (for as long as the defendant remained in the Bank’s employee) the staff is entitled for a rebate of  RM1,421.47 per month. Thus, his monthly installment after rebate was RM 2,161.33 per month.

• Formula for calculating the installment:  [ RM3,582.80 less RM1,421.47  = RM2,161.33 ]  (Refer Chart 6 below)

• The total payments as long as he remained an employee of the Bank was therefore, RM2,161.33 x 216 = RM466,847.28

• This RM466,847.28 was described in the Letter of Offer of 26th May 1997 as the Bank Selling Price.

            Chart 6

      Chart 7

e

             Chart 8

                Chart 9

Chart 10

Due to the Judge statement, quote " when the gratification of being able to satisfy the pious desire to avoid financing containing the elements of riba (interest) gives way to the sorrow of default......" Writer felt obligated to explain the "actual calculation method" and took-up challenge then ..to explain how the judgement should be made based on Shariah decision. The Writer presented the facts to 2 universities (UIA and UiTM), bar council members (3 sessions, including one in Sarawak) and also 2-3 other seminars, including that organised by IBFIM. The slides used for this topics were actual sides used by the Writer during the presentation.

Chart 11

Based on the above court decision, the award of RM98.54 per day profit until full settlement is actually "riba". The award was calculated based on at 8.0% p.a. the standard penalty charges imposed by court today. You will notice that the court uses the word loan to imply Islamic financing. 

COMPARISON BASED ON JUDGEMENT

Chart 12

Based on current shariah view by providing refinancing facility, including capitalising the unpaid installments, the transaction is against the shariah principle of bay al-kali bi al-Kali nevertheless, Islamic banking were new then and such principle has not been raised by Shariah scholars at that time.

Nevertheless, based on earlier practises, the customer and the Banks MUST entered into a new contract which means there must be a new agreement entered by both parties  i.e. a new purchase price (principal + unpaid instalments + penalty charges) and a new sale price (total payable based on new profit rate and financing tenor). 

However, for this legal case, there was ONLY the original purchase agreement (when defendant signed as a bank staff) AND there were two (2) sale agreements i.e. the original sale price of  RM466,847.28 (at staff profit rate) and another sale price of RM958,909.21 (at commercial profit rate)

Chart 13

Chart 13 above (unfortunately, we are unable to make the image bigger) provide a single view between the conventional banking calculation determined by the Court and the Islamic Banking calculation where the Banks normally work from the outstanding sale price downwards. To explain, let's look at the chart individually as per Chart 14 and 15 below.

Chart 14

a)  Under conventional banking, all calculation shall begin from the principal outstanding figure as of a particular day and subject to certain validity period. In Chart 15, the principal outstanding was RM394,172.06  [line 1 of formula]

b)  Using daily profit of RM98.40 x standard 30 days per month, the monthly penalty interest due was RM98.40 x 30 days = RM2,952.00 per month.

c)  No. of months overdue was 74 x RM2,952.00 = RM218,765.49  [line 2 of formula]

d) Add penalty charges, miscellaneous charges and also MINUS total installments paid to date then of RM33,454.19, the outstanding balance due as at December 2005 then, was RM582,626.80

Chart 15

Now, lets look at Chart 15 below. Using similar formula, the calculation is actually the same, except the penalty charges awarded is considered "riba".

For BBA, the calculation shall start from the original sale price as follows:

a)  Original sale price (based on so call, new contract) was  RM 992,363.40

b)  To find out the actual outstanding sale price, we need to deduct all installment paid so the sum of RM33,454.19 is to be deducted from the sale price, giving an outstanding sale price of RM958,909.21

c)  The original sale price comprise UNEARNED INCOME NOT YET DUE (income that the bank was not entitled to earn as of December 2005). Using simple profit (interest) formula, the rebate amount due was RM379,425.84 and the principal outstanding equal to RM579,483.36

d) At late charges and miscellaneous charges (RM3,141.44 + RM2.0) the total amount due was RM582,626.80, which is the SAME AMOUNT DUE USING CONVENTIONAL CALCULATION.

Main reason for the misunderstanding by both all the parties concerned i.e. defendant's lawyer, the Bank and the Court was that they are not aware of the calculation method in default situation.

c) Shariah view of the above case.

Some pertinent questions raised as a result of the above case.

i)   Is the daily profit of RM98.54 award by court permissible under Syariah ?

ii)  Irrespective of Court decision then, if balance remained unpaid.. Can a Islamic Bank, continue to earn profits at RM98.54 per day until sale price of RM958,908.21 is fully exhausted…?


Now, let's look at the above case based on Shariah decision.!

a)  Outstanding sale price should be RM466,847.28 will apply i.e. sale price stipulated in the original agreement signed when the defendant was under employment of the Bank.

b)   No new agreement executed for the 2nd contract although letter of offer accepted by defendant. Since there is no new purchase price and new sale price executed, there is no "akad".

c)  Daily profit awarded is considered "riba". 

d) Any judgement amount in excess of original sale price i.e. RM466,847.28 is considered 'riba" and cannot be earnedd as income to the Bank to avoid other income as "tainted income" but whatever amount in excess awarded by Court, can be given to charitable organisation.

e) To resolve this issue, OK to stipulate in claim that a "rebate based on agreed formula...show the formula...will be granted if the account is full settled" prior expiry of the original financing tenor.

INTERESTING FACTS ABOUT INTEREST COMPOUNDING EFFECT!

As commented by Judge. Islamic financing is more burdensome..?
Is that statement true..?.

Chart 16

Bigger view of the chart

Chart 17

Assume that Court decision was right. Customer thereafter diligently pay his monthly installment based on the 2nd contract. In 25 years, the whole sale price of RM992,361.60 will be fully settled.

On the otherhand, in a similar situation but assume it is a conventional loan, the total payable shall be as follows:

Chart 18

Due to the "compounding effect" on the loan, those who took-up conventional bank loan under similar situation will only finalize the loan at 31years + 8 months and will end-up paying a total sum of RM1.312 million. Additional about RM320k vis-a-vis Islamic financing.

The case when through an appeal process but the Writer will stop his discussion on the above case up to here. What is more important, customer will be able to distinguish the benefits of fixed rate financing versus conventional in situation of default.




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