Islamic Finance: Penalties reduce default and aid charities

We saw last week how Islamic banks and conventional banks finance the purchase of assets in different ways. We used the example of a buyer looking to purchase a car to explore some of these differences.

When our hypothetical car was sold by the bank to the customer under Murabaha, both the title as well as the possession were transferred to the customer at the time when the transaction was concluded — that is, on delivery.

The bank protects itself by having the car mortgaged in its name until such time as the customer fully pays back the Murabaha amount. In addition, the Islamic bank would also obtain post-dated cheques made out to cover the total Murabaha payment installments owing.

What if the customer defaults in timely payment of the Murabaha installments? Unlike a conventional bank, which can levy penalty interest, an Islamic bank is barred by Sharia from charging such penalties.

In contrast, the conventional bank does not sell the car to the customer. Instead, it provides a loan with interest to the buyer, enabling him or her to purchase the car. The bank can charge penalty interest for the late repayment of the loan.

Readers must be asking the following question: if Islamic banks do not charge delay penalties, might that not encourage some customers to default?

Unfortunately, some customers may indeed take undue advantage of an Islamic bank's limited freedom of action under Sharia. While these customers are careful to meet all their commitments when it comes to dealing with conventional banks, so as to avoid penalty interest charges, sometimes they accomplish this at the cost of their obligations to Islamic banks.

Sharia scholars have noted how delay penalties act as an effective deterrent against this failure to pay. They have agreed to allow Islamic banks to charge such penalties on their customers' past-due obligations.

This has been approved with the condition that the amount collected through these penalties will not be added to Islamic banks's profit, but must be donated to charity in a transparent manner. This must be done in such a way so that the customer receives proof the penalty charged has actually been given to a charity.

Alternatively, the customer may also be asked to pay the penalty not to the bank but to a charitable organisation of his or her choice and submit the receipt to the Islamic bank. The receiving charity should be advised the donation represents a kind of interest payment, so it can refrain from utilising the donation for projects involving Zakat funds (Islamic charity).

Islamic banks have therefore started to insert delay penalty provisions in their Murabaha, Ijara and Musharaka agreements. In some recently concluded high-profile transactions, a list of charitable organisations slated to receive funds as a result of any penalty interest charges has been appended to ensure clarity in this matter.

Under such agreements, the lead bank, acting as the agent for the other participating banks, is pre-authorised to collect penalties from the customer and donate them to charity.

One more point in this regard — conventional banks can participate in Islamically-structured transactions. Islamic banks are barred from taking part into a conventional financing transaction. Conventional banks that participate in Islamically-structured transactions will not agree to the idea of donating penalty interest income to charity. They will instead request that they be paid any penalty amount owing in proportion to their participation in the overall transaction.

Sharia scholars have allowed this arrangement to proceed, so that each conventional bank participating in an Islamically-structured transaction can be paid in this fashion. All remaining penalty-derived money is donated to charity.

The above arrangement has started to see results. Permitting delay penalty charges has reduced some of the differences between the conventional and Islamic banks in terms of ensuring that customers meet their financial obligations.

We should not overlook the fact accumulated penalty interest charges do not increase the Islamic bank's overall profitability. The charges become profits for the conventional banks, however.

Sohail Zubairi is the vice-president, Sharia structuring, documentation and product development, Dubai Islamic Bank.