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.

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