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. .
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)
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
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
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