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 an asset;

#2 Ijarah Muntahiya Bitamlik (leasing ending with ownership) – For the rental of property belonging to the joint-owners (it should be noted under the Tax Neutrality Act in Malaysia, the rental income is tax-exempt). 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 to that, they have to agree on 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 practising lawyers to comment and share their experiences and research findings, with one objective in mind: to come up with a standardised DMF model for Islamic banks.

In Malaysia, for the purchase of a completed property, the Customer would have paid the down payment before signing the Sales & Purchase Agreement (SPA). Technically, the Customer had already established a beneficiary interest in the property, although the full purchase price has not been settled. In 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 of bilateral or tripartite agreement); the Bank normally signs a Novation Agreement (some banks discard this requirement) with the Customer. Somehow, there are Shariah scholars who think that although Novation may meet the contractual requirements, it however, does not meet Shariah requirements. Most importantly, is the intention or “niat" for example, an issue on commodity murabahah. What is the main purpose? The customer "wants cash". So, why make a circle by buying and selling commodities, although the intention is to give cash to the customer? Like the Writer said earlier, let's let the Shariah experts argue on this. So, to avoid this type of argument, the Writer feels that we can do away with the 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, before seeking DMF from the 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 debt for an old debt. The old debt is extinguished by the new contract in its stead; basically, it is a legal document that formalises 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 per cent (%) margin of financing and has paid a 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 thinks 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 a 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 the 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 a booking fee or an 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 the 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 over time (with the option to purchase more equity without prior notice) from the Bank’s original 90% equity when the joint venture was originally formalised. 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 compared 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 a later session)

#2. As a 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 principle 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 practice, banks require this to be paid by the Customer) at the 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 for paying 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 enjoys the benefits of using the property.

Despite the above identifiable differences, unfortunately, in Malaysia, Islamic Banks still take charge of 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 used for debt financing, which is totally against the principle of DMF. Anyhow, based on market findings, there is one international bank that secures its DMF via a Trust Agreement, but currently, there is no test case yet in a foreclosure situation. The Writer supports the use of the Trust Agreement (to be discussed further in a later session)

Diagrammatically, the DMF can be described as follows:-

Figure 1

Figure 2

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

How to determine the monthly rental? 

After entering the DMF Agreement, the Bank will give the customer the first option to rent the house under a Tenancy agreement. Before entering this tenancy agreement, both the customer and the Bank need to agree on the “monthly rental” using various rental calculation options to cater for the risk profile of a particular customer. In determining the calculation of the 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 a benchmark to determine the monthly rental. Of course, the best method is to use the rental index. However, the rental index may not be reliable in certain countries, e.g. for Malaysia, the writer opines that the rental index may not be reliable. One reason, a project developed by a good developer may command a higher rental value and another project, although adjacent to the earlier project,  may not be able to command a similar rental value. This is the reason why the Writer thinks that the rental index in Malaysia is not reliable.

#2. In addition, the Customer is encouraged to provide his/her own rental quotation for 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 end up paying a high monthly rental due to exceptional appreciation of rental value in the surrounding locations. Nevertheless, this can be addressed if the rental is also benchmarked against, say, a certain margin above the Islamic base financing rate (which is normally benchmarked against conventional BLR).

The Writer thinks that the method used by Lariba Bank, i.e. the Commodity Indexation Rule and Marking-To-Market Rule are good alternative 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, the 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 on 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 the prevailing cost of funds or a certain rate of return (margin above the Islamic cost of funds or base financing rate) expected by the bank. In practice, the formula for calculating the Islamic cost of funds is the same as the conventional calculation of the 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 a conventional interest rate as a benchmark since that rate is well known to everyone (transparent), and also, currently, there is no acceptable formula to calculate the Islamic cost of funds. The Writer knows Dr Hassan (an actuary),  who designed a formula for the 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 the ERM method, the monthly rental is determined based on a certain margin plus the prevailing base financing rate; however, since we structure the DMF together with Ijarah Muntahiya Bitamlik, revision of the rental cannot be totally benchmarked against the base financing rate. Instead, the Bank has to agree with the Customer on the rental renewal period, which can be monthly, quarterly, bi-yearly, yearly or any other period as agreed by both parties. Since we have to send prior notice (the DMF agreement needs to be worded in such a way that the Customer agrees to 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 allows the Bank to change the monthly rental). Based on the Writer's experience, it would be very costly if we were to structure the pricing based on a 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 that, although the base financing rate changes within the rental period, the price can only be changed after the expiry of the prevailing rental period.

How to determine the monthly rental under ERM?

For example, the ERM required 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 the above formula, the frequency for the rental period renewal is as per Table 1

Table 1

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

Some viewed using the ERM as little different from conventional mortgages because under both methods, the monthly instalments are calculated using a similar formula to determine the amortised portion of the principal and profit. However, unlike a conventional mortgage, where money is lent to help customers to purchase a property, e.g. a house (paying interest for money lent), an Islamic bank offering DMF makes profits through the house’s physical use by the Customer’s occupation as a tenant. This is one of the fundamentals of Islamic banking, whereby customers can be charged for the use (usufruct or benefits) of something physical, like renting a house, but customers 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 instalment 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 thereafter, 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 the 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 the prevailing profit-sharing ratio. For this example, we shall use IRR to determine the monthly rental.

Example :

(a)  The Bank requires an 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 at the beginning of the transaction, but of course, subject to the 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 to be 7.77%, due to the profit allocation based on the profit-sharing ratio, the actual return to the Bank is only 7.0% per annum.

Figure 4

#2. The 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 the Customer however based on simulation, any changes in the monthly rental (especially if the rental amount is lowered),  it will take a longer period to acquire the equity from the Bank since the amortisation of principal and profits is based on profit sharing ratio. For example, the 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, a reduction in the monthly rental should be considered in situations to avoid the 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 its 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 are willing to place their excess cash in non-halal investments, basically to earn a higher return.

Allah's promise of "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 about 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 unforeseen hindrance.

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 to deprive usury of 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 Muslim, and we need this to go on, to raise the economic standard of the Muslims. Islamic banking and Islamic investments have been introduced in Malaysia for more than 30 years. There should not be any excuses that certain investments can be considered "harus" due to the investment being participated in by a majority of Muslims. What the Writer can comment here is that if you think you are a "Malay", then the investment is "harus", but if you think you are a "Muslim", then the investment is "haram".

Was informed reasonably that, to circumvent the issue of a halal or haram fund, the investor (non-halal fund) transfers its fund (intended to be invested in the same investment) to a fund manager, who in turn transfers 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 the agenda of Bumiputra.


Al-Baqarah (Surah 280)

And if someone is in hardship, then (let there be) postponement until (a time of ) ease. But if you give (from your right as ) charity, then it is better for you, if you 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 a later session.

IslamicBankingWay.Com

ALLAH 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

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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.



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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