16E - Restructuring & Rescheduling

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 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.

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 (amortisation 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 maintan 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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ALLAH KNOWS BEST

NOTE

Due to many requests via personal emails received by the Writer, hereonward 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.

16D - Security Position & Collection

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.

16C- Equity Acquisition Period (EAP)

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 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.aminuddin@gmail.com

 

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ALLAH KNOWS BEST.

16B - DMF Structure

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 one contracted in its stead; basically, it is a legal document that formalizes an arrangement to substitute one party for another in a contract.]

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. Since the property is rented under the 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 benchmarked 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 renew 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 - to 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)

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 due Customer's request to lower his monthly rental, restructuring process etc, the amortization 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 : 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.

#3. It should be noted that although Option 3 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 necessararily 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.

I remembered when giving a talk on Islamic Banking to a group of trainees in Tenaga Nasional Training Centre about 10 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".

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.

IslamicBankingWay.ComALLAH KNOWS BEST

16A - Diminishing Musharakah

Diminishing Musharakah Financing (DMF) can be readily use as the alternative product for Al-Bai Bithaman Ajil (BBA). Nevertheless, DMF is considered a new product in Malaysia but internationally, DMF had already been offered by Al-Buraq, UK (Arab Banking Corp Group) and Lariba American Finance House ( established in 1987 in Pasadena, California USA). I think locally,  three (3) Islamic banks, including Maybank Islamic are offering this product too..

However, if we are to carefully study current DMF structure (especially by Malaysian Islamic banks), most are structuring akin to conventional mortgage. Why I still say "akin to conventional mortgage"? It's mainly because current DMF offered by Islamic banks here are using conventional "base lending rate" (BLR) as benchmark to determine its pricing. Although BNM National Shariah Council has no objection on this pricing benchmark, can the Islamic banks do away with this benchmark? Again, I would like to say, let's move forward, not backward or what most Islamic banks here are doing, maintain the status quo...

The writer is of the opinion that if DMF is properly structured, it can be a niche product for the Islamic banks. To have a clear product differentiation, DMF should be structured using real musharakah concept where pricing should also be based on "profit sharing ratio".

Before, we touch further on DMF, let's define what is Musharakah?

Investopedia defined Musharakah as a joint enterprise or partnership structure with profit/loss sharing implications that is used in Islamic finance instead of interest-bearing loans. Musharakah allows each party involved in a business to share in the profits and risks. Instead of charging interest as a creditor, the financier will achieve a return in the form of a portion of the actual profits earned, according to a predetermined ratio. However, unlike a traditional creditor, the financier will also share in any losses.

It further explained, Musharakah plays a vital role in financing business operations based on Islamic principles, which prohibit making a profit (..right term for it, is interest) from loans. For example, suppose that an individual (A) wants to begin a business but has limited funds. Individual (B) has excess funds and wishes to be the financier in musharakah with A. The two people would come to an agreement to the terms and begin a business in which both share a portion of the profits and losses. This negates the need for A to receive a loan from B.

On the other hand, Diminishing Musharakah is further defined as "a partnership between one party and another, to jointly purchase an asset". For non-banking transaction, the partners are most likely buying the asset to make money from rental or eventually capital gain from the sale of the asset. However, in banking perspective, when the Bank entered into a partnership with the Customer to purchase an asset, it’s real intention is not to jointly own the asset for long but the Customer is expected to purchase the entire shareholding/equity or control (hereafter to be referred to as "equity") over the asset over certain agreed period.

To ensure, the Customer is able to buy back its equity, the asset will be rented to the Customer. The rental amount is "to be agreed upon by both parties" (...will explain this later)  and the Customer’s portion of the rental based on its current equity holding, shall be used to increase its equity on the asset. The rental amount after deducting the Customer’s "equity purchase portion" is to be treated as profit to the Bank.

Technically in Malaysia, DMF should ONLY be offered by Islamic banks i.e. Islamic banks are allowed under Islamic Banking Act 1983 to own assets for trading purposes (which include buy, sell and lease) while under BAFIA, assets can only be owned by conventional banks for their own banking premises and business related activities such as training centre and the like.

Anyhow, let’s continue with our discussion on DMF. Why should Islamic banks start offering DMF compare to existing debt financing contract?

#1- Most Risk Managers are of the opinion that the fixed profit rate (commonly used for BBA financing) MUST be hedged to protect the bank’s profit margin. Under BBA; once the sale price is fixed, it cannot be changed until the facility is fully paid. This place the bank in situation where its income will be reduced or in a loss position vis-à-vis higher deposit cost compare to the profit (at the agreed fixed rate) that it received from the BBA contract. This argument make sense for example, if BBA fixed price is 6.0% per annum while prevailing deposit rate is 7.0% per annum, the Islamic bank will suffer negative variance of 1.0% per annum. That is why Risk Managers are not in favour of fixed rate financing. However, in order to comply with BNM aspiration in making Kuala Lumpur as an Islamic financial centre, the strategy of most banks (based on Writer's experience while working with Islamic subsidiary of a local conventional bank) is to achieve the target imposed by BNM on Islamic Banks. Most will go along with the requirement but imposed strict approving criteria just to meet the target with no real push to increase their Islamic banking business.

#2- Assume Islamic banks decide to hedge. This can be done as follows:-

a) Sale of debt (BBA receivables) can be done with Cagamas or the Islamic bank creates Negotiable Islamic Debt Certificate (NIDC-i). However, both products are not internationally acceptable Islamic hedging instruments since both are structured using the contract of Bai Al-Dayn (sale of debt). In Malaysia, Bai Al-Dayn contract is Shariahlly acceptable.

b) Hedging using Profit Rate Swap (PRS). Likewise to Bai Al-Dayn, PRS is structured using Commodity Murabahah. Again, this product also received mixed views from both local and international Shariah experts.

If we are to examine the above carefully, both the above products are structured to emulate conventional hedging products. If we are to question this, the arguments will never stop. So, let's not argue about it!

#3- Under BBA fixed rate financing, the contracted selling price (total installment payable) represents maximum amount that the Bank can claim (apart from other charges/debits) from a Customer in a foreclosure proceedings. In addition, Shariah only allows maximum amount that can be claimed from Customer in a foreclosure situation, NOT EXCEEDING outstanding sale price and maximum compensation charges accumulated; ALSO CANNOT EXCEED the outstanding principal balance. In addition, whatever compensation charges collected are to be given to Charitable organizations (bank cannot treat compensation charges as income). So due to these restrictions in making claims (...leading to opportunity loss of income to the Bank), Risk Managers are also against the Banks having too much exposure on fixed rate financing.

The writer remembered a friend from one of the active commercial banks offering Islamic hire purchase facility (i.e. AITAB- Al Ijarah Thumma Al-Bai) commented that despite his boss being a Muslim, the instruction was to reduce AITAB’s exposure since the compensation charges allowed for AITAB was only 1.0% per annum while under conventional hire purchase, the Bank can charge up to  8% per annum as allowed under the Hire Purchase Act. My only hope here is, Allah will show him (i.e. the boss) guidance!.

#4- In the conventional bank’s “letter of offer”, the loan amount and interest rate are clearly shown but in letter of offer normally issued by Islamic bank, only the purchase and sale price are shown. However, in practice, most Islamic banks will indicate the profit rate charge and set the profit margin above certain benchmark or base financing rate (derived from base lending rate). This is where the confusion starts. This situation became more complicated when CJ Dato’ Wahab Patail made controversial High Court decisions in the Affin Bank vs Zulkifli case where he commented that Islamic banking is more burdensome than conventional when a property is subject to foreclosure proceedings. Although that decision has been overturned, it nevertheless, creates an eye opener to BNM and the Islamic banks to review its BBA product exposure. In fact on June 7, 2010 Bank Negara made a bold decision due to maslalah (public interest) where Islamic Banks are to stipulate the rebate (ibrar’) clause in the agreement to ensure such arguments are no longer raised in the court. The writer is of the opinion that we should maintain the "status quo" where rebate is at discretion of the Banks but instead, BNM issue an operational guideline or perhaps, this can be done by AIBIM (Association of Islamic Banking Institution Malaysia) regulating Islamic banks to use standard rebate formula on finalization of the account. As explained in Article 15, one of the reasons why Islamic Bank should claim the outstanding sale price is that they are not sure when the case can be settled thus, when rebate amount kept changing from time to time (..statement of claim need to be changed from time to time in the foreclosure proceedings until the case is resolved) ...what is BBA akin too? Since the Shariah has deliberated over this issue and made a decision, no point arguing over it. What is important, is to expedite collective introduction of DMF.

With DMF, customers shall be able to differentiate clearly the value propositions between Islamic vis-à-vis the conventional mortgage/term financing. The writer is of the opinion that DMF can be a killer product compare to conventional loan if the same is structured properly and collectively offered by Islamic banks

In next article the writer will talk about the various method of structuring the DMF.


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15 - Interesting Argument on Debt Financing

A friend of mine sent me this article by email last week. A very interesting article about Al-Bai Bithaman Ajil (or deferred payment financing). Before I write about Diminishing Musharakah, I feel it is best for me to clarify some of the issues raised in the article first. Let's read what the article said:

QUOTE:

I recently attended a talk on “Contemporary Islamic Finance”. The speaker was a young man with a PhD in Islamic Banking and Finance (UK). He was from an outfit linked to INCEIF ( International Center for Education in Islamic Finance).

Islamic banking or Islamic finance exists because the religious folks have succesfully inculcated the idea that bank interest is riba and therefore haram. The Quran states clearly that riba is haram but nowhere can we derive the injunction that bank interest is riba. The two are not the same.

Anyway the religious folks have created ‘islamic finance’ and ‘islamic banking’. To cut a long story short there really is no such thing. Islamic finance and Islamic banking are just arabised versions of conventional banking. There is nothing islamic about it. Neither is there anything un-islamic about conventional banking either.
If you take a housing loan from a conventional “haram” bank you pay a monthly instalment. If you dont pay, the bank will auction your property. If you go to an ‘islamic bank’ you still have to pay monthly instalments which can be more expensive than the conventional bank. If you dont pay your instalment, the islamic bank will still auction your property too. What is so islamic or unislamic about that?

The conventional ‘haram’ bank will charge you interest say 10% a year. The ‘islamic bank’ charges you what they call a ‘profit rate’ which will also be 10% or more a year. Kira-kira semua sama, tapi ini halal, itu haram (translation - the calculation is the same but this is halal, the other is haram). This is called pulling the wool over peoples’ eyes.

Talking about the pricing of his Islamic banking products, the young man with the PhD in Islamic banking made no bones about it. He said it quite loudly and clearly ‘we want to be the same as the market’.

I discovered this islamic banking trick years ago when we were handling the earliest stages of Islamic banking in Malaysia . At that time we called it an ‘Islamic window’ – Maybank did not yet have a full fledged Islamic banking license. But three months Islamic Bankers Acceptances (IABs) were priced exactly the same as three months conventional BAs. And so on. Tak ada beza pun (translation - no different)

A colleague who wore a kopiah (transalation - cap normally use by a Malay) to work had volunteered to go and work in the Islamic banking part of the bank. After a while he became even more confused. He said the calculations were all the same. In Islamic banking you add an ‘Al’ prefix to everything. Al Wadiah, Al Murabahah, Al Mudharabah, Al this and Al that. Other than the ‘Al’ its all the same.

Then the speaker dropped a bombshell. There is a famous case where an Islamic bank was suing a borrower for non payment of a housing “loan”. According to Islamic banking the bank does not give you a “loan”. The bank first buys the house from you at the market price. Then it sells the house back to you at a higher price over the period of the “loan” say 10 years, 15 years etc. Its just a deferred payment scheme with a ‘profit rate’ factored in.

The Islamic bank determines the selling price by compounding the “profit rate” (say 10% - copycatting the conventional banking system - ‘we want to be the same as the market’) for 10 years or 15 years. For those of you who have financial calculators (and if I still remember my financial computations), this is just the Future Value (FV) of an annuity at 10% starting with Present Value (PV) being the price of the house today and going forward 10 years, 15 years, 20 years etc. The Casio calculator will give you the ‘islamic’ answer in seconds. Does that make Casio ‘islamic’ too?

In a conventional ‘haram’ bank, if you default on your 20 year housing loan say after just three years, the conventional bank will ask you to pay back the principal amount of the loan plus 10% interest compounded for three years. The islamic bank cannot do that. The islamic bank will ask you to pay the full selling price of the house (based on 10% for 20 years) – even though you defaulted only after three years.

This is what the Islamic bank was claiming. However the very wise judge of the High Court Abdul Wahab Patail, the brother of our present AG, made a landmark decision. He ruled that the Islamic bank cannot charge the borrower the full amount for the full tenure of the “loan” when the borrower had defaulted just a few years into the “loan”.

This decision by Justice Abdul Wahab Patail still stands until today and it has not been overturned. It also destroys a huge chunk of Islamic banking because the Judge has essentially ruled that the islamic banking system in Malaysia is actually unjust. It is worse than riba.

So how does INCEIF and the Islamic bankers handle this situation? This is where the speaker dropped the bombshell – and with a great big smile too. He said “the Muslims dont know” about Justice Abdul Wahab Patail’s decision. Well dear Muslims, I hope that now you know. Please do spread the word quickly.

The speaker said that ‘Islamic banking can still go on in our country because the Muslims dont know the decision by Abdul Wahab Patail’. In other words the islamic bankers are not going to tell the Muslim borrowers either. They will keep it quiet. Shhhhh ! ! And this is Islamic?

Then I learned something else too. While the speaker was talking about murabahah (one method of islamic financing), the Chairman at the talk was getting quite agitated. The Chairman was a foreigner from the Middle East and is an internationally acclaimed Islamic scholar himself. Suddenly he interrupted the speaker and made a clarification. He said that according to the Hanafi madhab (I think he is a Hanafi) murabahah was riba. Meaning murabahah was haram.
He then said that the Islamic banking practised in Malaysia was according to the Shafie madhab. Madhab means sect. Only then did it dawn upon me that in Malaysia we dont have generic islamic banking. It is “Shafie banking”, according to the Shafie madhab.

A Muslim friend with a PhD from Cambridge later explained that this is partly the reason why there cannot be an “international Islamic capital market”. One madhab’s murabahah is another madhab’s riba. One madhab’s al bai al bithaman ajil is another madhab’s riba also.

When a borrower defaults (or prepays) a 20 year housing “loan” say after just three years, the islamic bank can do what is called ‘ibrar’. (In the old days they called it muqassa – I dont know why the change). ‘Ibrar’ means to refund the balance owing but not yet due. In other words ‘buah belum masak lu jangan kira lah’(translation - you should not count an unripe fruit). But there is no fixed or detailed idea about ‘ibrar’ among the islamic bankers.

So defaulting borrowers have no choice but to fight it out in the Courts with the Islamic banks. The speaker said that todate there are 3,500 unresolved cases of islamic banking BBA housing loans (Al Bai Al Bithaman Ajil) being disputed at the Courts in KL. And one judge, a Dato Rohana, has been assigned to handle all these cases. Well good luck Justice Dato Rohana. She will become an expert in Al Bai Al Bithaman Ajil calculations – maybe faster than Casio.

If it is a conventional housing loan, all these 3500 cases can be resolved by a Casio calculator. (Ya Allah, why do the Muslims like to create all these strange things and end up tying themselves in knots?)

During the talk, the speaker put up a slide that had the arabic word ‘zulm’. Zulm in Malay is zalim, meaning oppressive. The meaning was that Islamic banking should not be zalim or oppressive like the ‘conventional’ banking system with its interest based practises.

But how is the islamic bank less oppressive than the conventional bank? You charge the same rates – quite unashamedly saying ‘want to be the same as the market’. The terms and conditions are the same except when the ‘loan’ turns bad. Then the islamic bank can become worse than Shylock the Jewish moneylender. They want their pound of flesh. And the conventional bank is still ‘haram’?

There is another danger lurking. Talk is some ignorant do gooders are thinking of legislation where Muslims will be barred from using the conventional banking system. They can only go to the Islamic banking system. That is how we end up in the Club of Doom.

UNQUOTE

The above article showed that there are still arguments among the Muslim scholars on some of the Islamic banking products. I'm not going to indicate who is right here(let the Shariah Scholars resolve this issue...) but what I plan to do (at this juncture) is to list down the various arguments based on practical issues raised by the article writer above. To do this, I will classify the arguments based on two sides i.e. those who support BBA (Murabahah) and those who are against it.

Supporter of Al-Bai Bithaman Ajil (BBA)

# Surah Al-Baqarah verse 275 in summary, Allah permitted trade and forbidden usury (riba)

# Thus, to validate the above, BBA is structured as a "trade transaction" where the Bank buys the asset and then sells the asset at an agreed price on deferred payment. Technically, it is not a loan (Al Qhad or benevelent loan) transaction so, we cannot classify the customer as a borrower. It is suppose to be a trading transaction.

#Another issue is about the buy and sell transactions. To ensure it is Shariah compliant, the transactions should be done on tripartie basis ("B" buys from "A" and the sell to "C") instead of bi-lateral ("B" by from "A" and then sell back to "A" at original price + mark up). A bi-lateral transaction is considered Bai Al-Enah. Most scholars argued that Bai Al-Enah is not shariah compliant. Again, I would like to stress.... let's the Shariah Scholars argue on this...

# Another issue raised in the article is "the price" Using Casio calculator, profit is pre-calculated based on agreed "profit rate" times (X) the agreed payment period. The monthly instalment and total payable (sale price) is lower if the payment period is one year but the sale price is higher if the payment period is two years. So, the sale price defer based on the deferred payment period agreed by both parties.

# Under BBA transaction, THE PROFIT RATE IS FIXED and is definitely calculated based on NON-COMPOUNDING basis compared to conventional compounding interest calculation. Bank Negara Shariah Council had forbidden "compounding profit calculation" during inception of Islamic banks in Malaysia (so the article writer was wrong on this issue). If we re-examine the profit issue, there is nothing in the Al-Quran or Hadiths that specifically indicate "profit formula" in sale transaction. So, why are we arguing on the profit formula? Of course, there are scholars that said, a Muslim cannot charge more than 30% profit over the original price of the goods. In my over 16 years experience in Islamic banking, I'm yet to find this hadith. Maybe someone out there can help me on this i.e. if there is such hadith, I stand to be guided. I assume the main argument is why higher profit is charged if the deferred payment period is longer (money over time). So, for those who support BBA transaction, their argument is that as long as there is proper purchase and sale agreement (trade transaction), BBA is acceptable by Shariah as a "halal' transaction.

#In the Middle East, most of the deposit are accepted under Al-Qardh (benevolent loan to the Bank) so there is no issue on profit payment (...they don't pay any profit or hibah to the account holders). But in Malaysia, due to the entrenched conventional savings system, deposits are collected under the principle of Al-Wadiah and Mudharabah. There is no issue on Mudharabah deposits (profit is distributed based on agreed profit sharing ratio) but for Al-Wadiah, some banks are still giving "hibah" although Bank Negara's Shariah Council decision forbids payment of "hibah" on Al-Wadiah deposits. Somehow, there is no strict enforcement on this decision due to maslahah issue..(I think so..) Without "hibah',the Islamic banks are scared that they may not be able to collect cheap source of savings deposits.

#Talking about Justice Abdul Wahab Patail decision, it has been overturned. When you examined the case carefully, the Judge decided the case based on "conventional decision" so whatever court awards was definitely 100% "riba". If the decision was based on Shariah decision, the original agreement stands thus, the customer only need to pay based on the original agreement signed between the Bank and the Customer (based on staff profit rate) because the second agreement was signed not according to Shariah Law which resulted the transaction having one (1) Purchase Agreement and two (2) Sale Agreements. The Judge actually awarded extra RM200k more to the Bank (considered as "riba"). Under Shariah decision, the Bank should only be awarded whatever outstanding sale price (...I think it was about RM400k)of the original agreement. In addition, one cannot say the process is unIslamic if the bank has to auction the property to recover their money. Islamic bank is also a business entity...

#In addition, the reason why Islamic Bank has to claim the whole outstanding sale price in a legal process is because the Bank is not able to determine when the legal case can be resolved. But once the case is resolved (..assume the customer settle the outstanding balance), the Bank may give some discount (..usually using similar formula adopted by conventional Bank). Although Shariah wise discount or rebate should not be mentioned in the Agreement (latest practise in Malaysia....this can done by Wa'ad or unileral promise)...morally, the Bank should give a rebate if the Customer settle prior the financing maturity date. In situation where the case drags on...and exceeded the maturity period of the account, the original sale price shall remained unchanged (..fixed) unlike conventional banks where outstanding loan balance shall continued to be compounded until fully settled. I will write full detail (including it's calculation) on this issue once we touch the subject of BBA in later session.

Those who said BBA is haram

Some of the arguments:

# Extra profit over time is not acceptable. Under a true Murabahah transaction, we should not calculate the profit based on time. So, if the profits is say, 20% + original price, the sale price shall shall remained fixed irrespective the deferred payment period i.e. 1 year, 2 years or longer.

# Most BBA transaction in Malaysia is based on bi-lateral transaction instead of tripartie.

As I mentioned in my earlier articles, all these issues can be resolved if the Islamic banks start exploring other better contracts such as Diminishing Musharakah. I'm not particularly worry about BBA as based 25 year interest rate trend (Islamic profit rate tends to be benchmarked by prevailing conventional interest rate), fixed rate financing is very much cheaper than conventional variable rate loan, if the payment period is long. In default situation, conventional bank will claim every single sen on compounding basis. Under Shariah decision in Malaysia, in case of default, the Bank can only claim maximum outstanding sale price. Any compensation charges (...akin to penalty interest in conventional bank) obtained as a deterent measure, has to be given to charity.

I hope the above explanations have answered some of the issues raised in the article but as I mentioned above, full detail on this issue will be examined once we touch on BBA in later session.


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14 - Will be writing again

Salam

I must apoligize for not able to update this blog since late last year. For past months I've been busy sorting-up my retirement plan and also have been travelling overseas (month than a month) since early March and only back to KL recently. Insha'Allah, I will be writing again hereon.

Instead of writing according to my earlier proposed contents (Article 4 i.e. starting with deposit products and then financing) ......I would like to touch on latest financing product in the market instead i.e. Diminishing Musharakah (DM). It's a very interesting product but some banks are offering this product akin to debt financing. Infact, if we examine carefully, DM can be more expensive than the normal fixed rate debt financing products. Although I totally support the introduction of DM (its high time..... as we have been offering debt financing since 1983), I think it can be structured more akin to real musharakah. We shall examine this in my next article.



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