Today we will start our discussion on risk mitigation in Murabaha the most popular Islamic financing structure.

Readers would recall the detailed discussion we have had on Murabaha in these columns. For a quick recap, Murabaha is a sale contract where an Islamic financial institution (IFI) sells goods, commodities or assets to a client on deferred payment basis.

For ease of understanding, the Murabaha could be compared to the facility of Loan Against Trust Receipt (LATR) which the conventional banks extend to their clients as part of import financing.

Prerequisite

A Sharia prerequisite for Murabaha is that its subject matter must have been purchased by the IFI from an independent supplier/ third party. It would not be Murabaha if the goods were purchased by an IFI from a customer or a group company at a certain price and sold to the same customer or another company of the same group at a higher price. This is because such transaction, according to the rules, would tantamount to extending an interest-bearing loan to the customer, which is strictly forbidden in Sharia.

Another wisdom in such prohibition is that the system of Sharia encourages actual commercial transactions for genuine growth of the economy and commerce in a society and as such, the purchase and sell back of certain goods or assets to the same customer or group would, undoubtedly, defeat such purpose.

Sharia requires an IFI to first obtain the title and possession to the goods/assets before entering into Murabaha with its client. This is simply because one cannot sell something which it does not own.

The IFI's full legal ownership and possession over the goods or assets is thus a pre-requisite for entering into a Murabaha transaction with a client.

The possession to the Murabaha goods or assets could be physical or constructive as well. By constructive I mean through a trustee. For example, in import of goods by ship, the commercial invoice is considered the title document to the goods whereas the bill of lading (issued by the shipping company) is the document for constructive possession.

This is because the shipping company which

owns the vessel is carrying the goods for the importer in the capacity of its trustee, thereby establishing constructive possession to the goods by the importer.

As such, a Murabaha transaction for the imported goods cannot take place unless the IFI establishes the letter of credit in its own name as buyer. This differentiates an IFI from

a conventional bank which establishes the letters of credit in customer's name.

Once the title and possession to the goods or assets is with the IFI, it can sell the same to the client by way of Murabaha at

an agreed price and payment terms.

The Murabaha sale price will include IFI's profit agreed to by the client.

The IFI parts with the title and possession to the goods or assets in favour of the client at the time of entering into a Murabaha transaction whereas the payment of the purchase price by it to the IFI may be made in future.

While assessing the risks an IFI encounters in a Murabaha transaction, the first thing which comes into mind is what recourse does it have on the Murabaha goods or assets in case of default by the client in making timely payment to the IFI.

In conventional terms and as defined by Basel II, you may term it as the credit risk but since there is no room for credit in Sharia, we would allow ourselves to term it as default risk.

Interest

Before discussing the mitigation to the default risk in Murabaha, it is important to note that unlike conventional banks where any default in timely payment of LATR or any other debt on the client is greeted with three layers of interest normal, compound and penal, an IFI is barred by the Sharia to enhance its Murabaha amount even by a penny in case of default by the client.

The reason for such restriction is that Murabaha is not a transaction of loan with interest but a fixed price sale contract which cannot be altered even if the buyer fails to accomplish its financial obligation towards the seller.

The writer is vice-president and head, Sharia structuring, documentation and product development, Dubai Islamic Bank.