Diminishing Musharakah Financing (DMF) can be readily use as the alternative product for Al-Bai Bithaman Ajil (BBA). Nevertheless, DMF is considered a new product in Malaysia but internationally, DMF had already been offered by Al-Buraq, UK (Arab Banking Corp Group) and Lariba American Finance House ( established in 1987 in Pasadena, California USA). I think locally, three (3) Islamic banks, including Maybank Islamic are offering this product too..
However, if we are to carefully study current DMF structure (especially by Malaysian Islamic banks), most are structuring akin to conventional mortgage. Why I still say "akin to conventional mortgage"? It's mainly because current DMF offered by Islamic banks here are using conventional "base lending rate" (BLR) as benchmark to determine its pricing. Although BNM National Shariah Council has no objection on this pricing benchmark, can the Islamic banks do away with this benchmark? Again, I would like to say, let's move forward, not backward or what most Islamic banks here are doing, maintain the status quo...
The writer is of the opinion that if DMF is properly structured, it can be a niche product for the Islamic banks. To have a clear product differentiation, DMF should be structured using real musharakah concept where pricing should also be based on "profit sharing ratio".
Before, we touch further on DMF, let's define 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.
It further explained, Musharakah plays a vital role in financing business operations based on Islamic principles, which prohibit making a profit (..right term for it, is interest) from loans. For example, suppose that an individual (A) wants to begin a business but has limited funds. Individual (B) has excess funds and wishes to be the financier in musharakah with A. The two people would come to an agreement to the terms and begin a business in which both share a portion of the profits and losses. This negates the need for A to receive a loan from B.
It further explained, Musharakah plays a vital role in financing business operations based on Islamic principles, which prohibit making a profit (..right term for it, is interest) from loans. For example, suppose that an individual (A) wants to begin a business but has limited funds. Individual (B) has excess funds and wishes to be the financier in musharakah with A. The two people would come to an agreement to the terms and begin a business in which both share a portion of the profits and losses. This negates the need for A to receive a loan from B.
On the other hand, Diminishing Musharakah is further 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 entered into a partnership with the Customer to purchase an asset, it’s real intention is not to jointly own the asset for long but the Customer is expected to purchase the entire shareholding/equity or control (hereafter to be referred to as "equity") over the asset over certain agreed period.
To ensure, the Customer is able to buy back its equity, 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 asset. The rental amount after deducting the Customer’s "equity purchase portion" is to be treated as profit 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 to own assets for trading purposes (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.
Anyhow, let’s continue with our discussion on DMF. Why should Islamic banks start offering DMF compare to existing 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 rate financing. However, in order to comply with BNM aspiration in making Kuala Lumpur as an Islamic financial centre, 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.
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, whatever compensation charges collected are to be given to Charitable organizations (bank cannot treat compensation charges as income). 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!.
#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 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 due to 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 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) ...what is BBA akin too? 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.
IslamicBankingWay.Com
ALLAH KNOWS BEST
To ensure, the Customer is able to buy back its equity, 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 asset. The rental amount after deducting the Customer’s "equity purchase portion" is to be treated as profit 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 to own assets for trading purposes (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.
Anyhow, let’s continue with our discussion on DMF. Why should Islamic banks start offering DMF compare to existing 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 rate financing. However, in order to comply with BNM aspiration in making Kuala Lumpur as an Islamic financial centre, 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.
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, whatever compensation charges collected are to be given to Charitable organizations (bank cannot treat compensation charges as income). 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!.
#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 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 due to 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 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) ...what is BBA akin too? 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.
IslamicBankingWay.Com
ALLAH KNOWS BEST
