34(B) DMF Shariah Concept

DMF Shariah Concept

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

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

#1 Musharakah – For the joint ownership of asset;

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

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

DMF Process Flow – completed property

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

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

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

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

Wikipedia defines:

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

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

for example,

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

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

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

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

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

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

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

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

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

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

     

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

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

i) the monthly rental is calculated

ii) profits that the Bank can earn and most importantly

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

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

Customer’s Relationship With The Bank

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

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

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

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

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

#3. Insurance on Property

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

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

Diagrammatically, the DMF can be described as follows:-

Figure 1

Figure 2

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

How to determine the monthly rental? 

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

A. Rental Value Method (RVM)

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

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

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

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

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

B. Effective Rate Method (ERM)

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

Note:

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

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

How to determine the monthly rental under ERM?

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

Figure 3

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

Table 1

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

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

C. Mutually Agreed Method (MAM) 

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

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

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

How to determine the monthly rental using MAM method?

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

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

Example :

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

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

Figure 4

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

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

Figure 5

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

True Spirit of Shariah Law

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

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

Al Baqarah (Surah 276)

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

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

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

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

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

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


Al-Baqarah (Surah 280)

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

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

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