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Mohsin Ali

Since the establishment of Islamic banking, many questions have


been raised on the different policies adopted by Islamic banks.
One of the questions is related to the excessive use of Murabaha
financing facility by Islamic banks. Islamic scholars treat equity
based instruments i.e. Mudarbah and Musharakah as a central
pillar of the Islamic banking model and consider them closer to
Islamic Finance Ideology. On the other side the scholars have
raised issues over permissibility and practice of debt based
instruments like Ijarah & Murabaha. This is why, many of the
advocates of Islamic banking, favor Musharakah and Mudarbah
over debt based modes. But even after all these issues and
oppositions, Murabaha is the most dominant mode of Islamic
financing being used by Islamic Banks. The sole purpose of this
paper is to explain the reasons of the popularity of Murabaha as
preferred mode of Islamic financing among Islamic Banks. The
paper suggests that, Murabaha is important to Islamic Banking in
its own capacity and practicing Murabaha as financing mode is
inevitable at least until a substitute is not available.

ABSTRAC
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Why Murabaha is Popular?
1. Introduction:
Islamic banking may not be a totally new concept; but the widespread expansion of this form of
banking is certainly a fairly recent phenomenon. There are more than 200 Islamic banking
institutions and these institutions not only operate in Muslim countries, but have also gained
footing in non-Muslim countries. In 2012, it was estimated that, on a global scale, total assets of
this banking system were about US$ 1 trillion
1
.
The term Islamic banking refers to a conduct of banking operation in consonance with Islamic
teachings. Theory of Islamic banking categorizes, financing modes under three power sets which
are: (a) Equity based financing; (b) Debt based financing and (c) Benevolent loan and services.
Islamic equity-based financing is an Islamic investment engaging at least two parties to do
business together under shariah principles. Examples of this are Mudarbah, Musharakah etc.
Islamic banking advocates consider this sort of financing more favorable in comparison to other
two. Meanwhile, debt based financing is a trade based financing engaging related parties with
buying and selling of good under shariah principles. This financing consists of Murabaha, Ijarah,
Salam and Istisna. In practice, this sort of financing is more popular among the Islamic banks but
in literatures Islamic scholars have raised issues on their usage particularly on the practice of
Murabaha financing.
Khan and Bhatti (2008) provided empirical evidence that on average murabaha represented
54.42 percent of the total financing and investment portfolios of ten Islamic banks during the
period 2004-2006. The weighted average use of Murabaha by the top ten Islamic banks,
representing 50.90
2
percent of the Islamic banking industry, was 65.66 per cent of their total
financings during the period 1994-1996
(Iqbal, 1998). This implies that Islamic
banks have been determined to rely heavily
on murabaha in carrying out their financing
and investment operations. If we look at the
contract wise percentage change in
financing, from the year 2007 to 2008, it is
evident that the highest percentage was in Murabaha contract which was about 50.90 percent

1
Governor BNM speech, Dec. 09, 2012
2
Nidal, Alsayyed. The Uses and Misuses of Commodity Murabaha: Islamic Economic Perspective, ISRA.
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Why Murabaha is Popular?
change in comparison to last years Murabaha financing. Percentage change in Murabaha
financing is much higher than the other modes of financing like Musharakah and Mudarbah,
which shows clear inclination of Islamic banks towards Murabaha financing. In this paper, I will
try to elaborate the reasons of the popularity of Murabaha despite it not being the financing
method favored by many of the advocates of Islamic banking. Let us first look what is Murabaha
and how is it being practiced by Islamic banks?
2. What is Murabaha?
Literary Murabaha means sale on profit.
Technically Murabaha is a particular kind of
sale where the seller expressly mentions the
cost of the sold commodity he has incurred,
and sells it to another person by adding some
profit thereon. Thus, Murabaha is not a loan
given on interest; it is a sale of a commodity for cash/deferred price.
3. Murabaha in Practice:
An Islamic bank buys a product normally at the request of a client, who promises to buy it from
the bank. The bank takes the risk while it owns the product. The bank then sells the product to
the client normally on deferred payment basis.
Murabaha is presently used to finance working capital requirement, import & Export financing.
Besides that Murabaha is also being used for purchase of fixed assets such as, land, building,
machinery and equipments, automobiles, computers, furniture; and also suitable for financing
purchase of personal assets and consumer durables, such as, PCs, cars, houses etc.
4. Issues with Murabaha:
One of the issues with the Murabaha is that in classical fiqh, Murabaha refers to sale (bay), with
all its implications and prescribed Sharia conditions pertaining to sale, and has nothing to do
with financing in the conventional sense. According to Ashraf Usmani It is only a device to
escape from interest and not an ideal instrument for carrying out the real economic objectives
of Islam. Therefore, this instrument should be used as a transitory step taken in the process of
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Why Murabaha is Popular?
Islamization of the economy, and its use should be restricted only to those cases where
Mudarbah or Musharakah are not practicable
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. Let us see few issues in Murabaha;
4.1 Not aligned with the ideology of Islamic Financial system at large:
Islamic finance experts like Abbas Mirakhor, Zamir Iqbal, Taqi Usmani etc. are of the view that
the debt based contracts are not aligned with the ideology of Islamic Financial system. As
according to them, the core of Islamic Finance lies in risk sharing rather than risk transferring as
being done in the case of Murabaha.
4.2 Merely a mean of circumventing the prohibition of riba:
Many people consider Murabaha as a universal instrument like conventional loan. Shariah
scholars argue that when it is used as merely a means of circumventing the prohibition of riba, it
does not remain an instrument to implement the real economic objectives of Islam. Its use should
be limited to circumstances where equity-based arrangements such as Mudarbah or Musharakah
are not practicable.
4.3 Profit Rates and Benchmarks:
In Murabaha, price includes a known profit or mark-up. The mark-up in Murabaha is part of the
sale price, it is set only once and then it does not change overtime. The bank use to calculate the
mark-up price (cost-plus) on the bases of market interest rate, such as, the LIBOR or BLR.
Advocates of Islamic banking argue that, using riba-based rates as a point of reference is not
desirable and should be avoided. Such dependency might influence the manner of operation of
Murabaha transactions, mimicking conventional interest based loans, and could lead to a
convergence between Islamic and conventional banking.
4.4 Rescheduling of Payments:
At times, rescheduling of installments is seen as a way out in the face of default. In conventional
banking, loan rescheduling is accompanied by additional interest charge for the timing
differences. Murabaha does not allow such rescheduling as no additional amount can be charged
for the same. The amount of the murabaha price remains unchanged. Some banks attempt to
circumvent this by changing the unit of currency. This attempt is strictly criticized by shariah
scholars.


3
Usmani, Dr. Muhammad Imran Ashraf, Islamic Banking, Darul Ishaat,first edition, 2002.
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Why Murabaha is Popular?
4.5 Securitization of Murabaha Debt:
The obligation of the debtor to pay is a monetary indebtedness and hence is money. Money can
only be exchanged with money at par. Thus the Murabaha debt cannot be made into a negotiable
instrument. But Islamic banks in Malaysia are indulged in sale of debt which is also criticesed by
the scholars from other parts of world.

5. Why Murabaha is Popular?
The use of Murabaha should be limited to circumstances where equity-based arrangements such
as Mudarbah or Musharakah are not practicable. Let us look at few reasons of popularity of
Murabaha and why it is practiced:
5.1 Most suited for banking arrangement
Murabaha is the most suited contract for banking arrangements like import financing, working
capital financing, personal financing (where an asset is required). It is most suited in the sense as
well that, its cost plus profit structure is very identical to the conventional interest based contract
with the exception of requirement of an underlying asset.
5.2 Predetermined, fixed and continuous rate of return
In Mudarbah and Musharakah, uncertainty of the rate of return on capital is very high due to
asymmetric information which creates moral hazard and adverse selection problem. On the other
hand, rate of return is fixed and pre-determined in other modes of contracts.
5.3 Requires less effort to monitor
Comparatively financing through Murabaha requires less effort to monitor, control or evaluate as
banks monitoring role finishes once the ownership risk is transferred to the client. On the other
hand in Musharakah and Murabaha lots of efforts are required to monitor, evaluate and control a
partnership (investment financing)
5.4 Recognition and understanding from practitioners of conventional finance
The major advantage of this mode of financing is the instant recognition and understanding it
gets from the practitioners of conventional finance. As cost plus profit structure of Murabaha,
with the exception of requirement of an underlying asset, is identical to conventional interest
contract in terms of fixed returns and the declaration of profit and principal.

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Why Murabaha is Popular?
5.5 Market driven mode of financing
Islamic Banking is a market driven industry. It offers a range of products (contracts) to its clients
and lets the market decide the perfect instrument for themselves. Murabaha is a contract which
market demanded more as compared to Musharakah and Mudarbah financing which is also
evident from the percentage share of Murabaha financing out of total financing. Particularly
entrepreneurs preferred Murabaha due to its (i) Fixed rate of return along payment period (ii) No
charge for late payment/default (iii) Treating an asset being purchased as collateral
5.6 Ideal for meeting working capital needs
Murabaha is a tailor made contract for manufacturers who need working capital on a relatively
short-term basis to finance acquisition of raw materials and consumables or for traders who need
working capital for financing acquisition of merchandise. No other contract meets the working
capital needs of manufacturers or traders so perfectly.
5.7 Flexible contract Easier to structure different facilities
Murabaha is a very simple and flexible contract, many different types of products have been
offered by Islamic banks by using Murabaha as underlying contract. Murabaha is presently used
to finance working capital requirement, import & Export financing. Besides that Murabaha is
also being used for purchase of fixed assets such as, land, building, machinery and equipments,
automobiles, computers, furniture; and also suitable for financing purchase of personal assets and
consumer durables, such as, PCs, cars, houses etc.
5.8 Relatively low risk
5.8.1 Equity investment risks: There is no equity investment risk in Murabaha
whereas Musharakah and Mudarbah are prone to Equity investment risks
specially when the project is not making profits
5.8.2 Credit risks: In comparison to Murabaha, credit risks are higher specially
when there are chances of delays in profit payments or not paid at all. Credit
risks are also high in Musharakah and Mudarbah because of the long term
nature of the project.
5.8.3 Fiduciary risk: Any misconduct or negligence of the partners in Musharakah
or Mudarbah can be the sources of Fiduciary risk. This can happen in the
absence of adequate monitoring of the financial performance of the venture.
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Why Murabaha is Popular?
5.8.4 Markup risks: Murabaha profit rates are fixed at the time of contract between
Islamic bank and its client and fluctuations in the market rate of return do not
have any impact. On the other hand fluctuations of rates cause changes in
profits of Islamic Banks in Musharakah and Mudarbah.
5.8.5 Liquidity risks: There is low liquidity risk in investing in Murabaha as
compared to Musharakah or Mudarbah as in contrast to the Equity based
contracts, Murabahas generally have smaller funding size and shorter maturity
periods.
5.8.6 Shariah compliance risk: In Musharakah or Mudarabah Shariah compliance
risk may arise due to the final allocation of profit taking place based on
expected profit not on the actual profit. There is no profit sharing in Murabaha
financing security breaches.
5.9 Low Capital Adequacy requirements
According to IFSB Capital Adequacy Standard, a Risk Weight (RW) of only 50% is applicable
on Murabaha financing whereas a 400% RW is to be applied to all equity exposures in private
and commercial enterprise and 300% RW is applicable on all Mudarbah Financing. This means
an Islamic Bank has to keep more capital for Musharakah and Mudarbah financing as compared
to Murabaha financing. This is one of the reasons that Islamic banks referred dabt based
instruments of financing over equity based instruments.
5.10 Meets the risk profile of most of the depositors
The risk profile of most of the depositors of Islamic banks is from low to medium term. Their
primary reason to open accounts in Islamic banks is usually safe keeping and to earn low to
medium rate of returns. Depositors at large do not want to invest in high risky projects, that is
why Islamic banks prefer less risky investments like Murabaha financing (debt based financing
rather than high risky equity investments) on their Asset side to match the risk profile of their
depositors on the liability side.
5.11 No legal issues
An Islamic bank which enters into Musharakah or Mudarbah contract needs to acquire some
shares from a separate legal entity that undertake Shariah compliant activities. A mixture of
shares in one entity may lead to legal risk if the regulation does not allow doing such action. On
the other hand Murabaha is at large acceptable as a financing mode in all jurisdictions.
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Why Murabaha is Popular?
5.12 No agency problem or governance issues
Musharakah and Mudarbah are basically partnership contracts and when a bank enters in to any
of these agreements it might have to face issues like adverse selection and moral hazard. Adverse
selection, prior to the contract and moral hazard, during the performance of Musharakah or
Mudarbah, arise where the Rab-ul-Mal cannot cost-lessly observe or monitor the Mudaribs
characteristics and/or actions, whereas, the agency problem does not exist in Murabaha.
5.13 Easier to train Islamic Banking staff
Murabaha is a very simple and straight forward contract and it is relatively easier to train Islamic
banking staff to deal with Murabaha financing. On the other hand Musharakah and Mudarbah are
complex contracts and very difficult to handle specially for those who do not have experience.
5.14 Solution to Asset-Liability mismatch problem
Islamic Finance industry is still facing a shortage in short-term investment products. In most of
the jurisdictions, Murabaha financing is the most widely used short term mode of financing.
Some Islamic banks have tried to structure alternative products, but they were faced by their
inability to generate assets caused by credit ratings and liquidity issues relating to their balance
sheet.

6. Conclusion:
Originally, Murabaha is a particular type of sale and not a mode of financing. The ideal mode of
financing according to Shariah is Mudarbah or Musharakah. However, in the perspective of the
current economic set up, there are certain practical difficulties in using Mudarbah and
Musharakah instruments in some areas of financing. Therefore, the contemporary Shariah
experts have allowed Murabaha on deferred payment basis as a mode of financing, subject to
certain conditions. The reasons mentioned above, shows that Murabaha contract is equally
important as Musharakah or Mudarbah contracts especially in the contemporary banking
scenario. The paper suggests that, Murabaha is important to Islamic Banking in its own capacity
and practicing Murabaha as financing mode is inevitable at least until a substitute is not
available.