Two Types of Rebate (Ibra’) for Sale-Based Financing

UNDER ISLAMIC FINANCE, YOU HAVE TO PAY FULL SELLING PRICE NO MATTER WHAT.

Today

One of the misconceptions that plague the Islamic Banking financing in Malaysia is that once the Customer agrees on a price in an Aqad (Offer and Acceptance of Sale & its Terms), there is no backing out of the Selling Price and other considerations. If a house at current Value of RM400,000 (Principal) is purchased from a Bank at a Selling Price of RM1,000,000 to be paid in instalments over 35 years. This means the profit earned by the Bank over 35 years is RM600,000. The misconception is that when the Customer intend to Sell-Off or Pay-Off the financing in let’s say Year 8 of 35, the whole amount of RM1,000,000 must be paid to the Bank due to the concluded Aqad, where RM1,000,000 is contracted. So, if at year 8 the Customer has paid a total instalment of RM110,000,  the remaining RM890,000 is still payable by the Customer. Whereby the Principal Outstanding for the Financing is RM320,000 in this scenario.

For a Conventional Loan, the amount payable is the Principal Outstanding of RM320,000 + any interest outstanding (earned but not yet paid) + any early settlement penalties.

(The above figures are for illustration only. For a more accurate calculation, scroll down to the examples below)

SETTLEMENT OF THE SELLING PRICE.

Because of this misconception, a lot of Customers think that a Shariah-compliant financing is More Expensive than the Conventional Loan. This is just a half-truth. While the Selling Price Outstanding is RM890,000 as contracted in the Aqad, Islamic Banks are required to provide “Rebates” (Ibra’) on the Selling Price Outstanding to be fairer to the customer. Although entitled to earn the full amount of Selling Price from the Aqad, a Rebate on the Selling Price should always be given.

HISTORY OF GIVING REBATES

Traditionally and by nature, Rebates are discretionary on the financier, to be given to the Customer as the Aqad allow for the collection of the full contracted Selling Price. To achieve parity with the Conventional Loans, Islamic Banks have opted to give rebates on the Selling Price, based on their discretionary calculations. This may include early settlement penalties or other charges, which improves the Bank’s profit ratio. This has resulted in inconsistencies to the amount of rebate given; one Bank may charge differently to another.

MAKING REBATES MANDATORY

BNM issued a Guideline for Rebate (Ibra’) for Sale-based Financing in 2011 to address this inconsistent practice by making it MANDATORY (not discretionary) for Islamic Financial Institutions to provide rebates under specific scenarios. Under the guidelines, a specific formula is given for 2 scenarios where rebate may arise:

  1. Rebate arising from differences between the contracted Ceiling Profit Rate (CPR) and the Effective Profit Rate (EPR).
  2. Rebate arising from the waiver of Unearned Profit due to Early Settlement of Financing.

REBATES ON THE CEILING RATE

This is applicable where the structure allows for pricing based on floating-rate, usually prevalent for long term structures such as a 30-year home financing. The structure allows for the customer to be charged based on a floating rate ie prevailing market rate which moves in tandem with the various base rate benchmarks. The benchmark can also be a conventional pricing rate that moves with the market. For example, the prevailing rate consists of a Base Rate of 4.05% + Margin of 1.45%, giving us an effective rate of 5.50% pa.

Therefore:

  • Financing Amount : RM1,000,000
  • Base Rate : 4.05% (moving rate)
  • Profit Margin : +1.45% (fixed or movable based on event)
  • Effective Profit Rate (EPR) : 5.50%.
  • Tenure : 3 years
  • Instalment Amount (EPR) : RM30,195.90 per month

However, for the purpose of Aqad, all the terms must be agreed upon execution and perfection of Aqad. If the Rates are moving, how can all the rates be agreed upon up-front? Thus there is a need to agree on one Rate where Islamic Banks can conclude the Aqad with an agreed-upfront Selling Price. To conclude the Aqad by formalising the Selling Price, the following is required.

  • Financing Amount : RM1,000,000
  • Base Rate : 4.05% (moving rate)
  • Profit Margin : +1.45% (fixed or movable based on event)
  • Effective Profit Rate (EPR) : 5.50%.
  • Tenure : 3 years
  • Instalment Amount (EPR) : RM30,195.90 per month
  • Maximum Ceiling Profit Rate (CPR) : 10.0% (fixed)
  • Installment Amount (CPR) : RM32,267.19 per month (unchangeable if higher than 10.0%)
  • Maximum Selling Price (CPR) : RM1,161,618.74 (unchangeable if higher than 10.0%)

Therefore, for the purpose of Aqad, where every detail needs to be agreed upfront, the following is used:

  • Financing Amount : RM1,000,000 (fixed)
  • Tenure : 3 years (fixed)
  • Maximum Ceiling Profit Rate (CPR) : 10.0% (fixed)
  • Installment Amount (CPR) : RM32,267.19 per month (unchangeable if higher than 10.0%)
  • Maximum Selling Price (CPR) : RM1,161,618.74 (unchangeable if higher than 10.0%)

And for the purpose of day-to-day charge of Instalment and Profits, the following applies:

  • Financing Amount : RM1,000,000
  • Base Rate : 4.05% (moving rate)
  • Profit Margin : +1.45% (fixed or movable based on event)
  • Effective Profit Rate (EPR) : 5.50%. (moving rate)
  • Tenure : 3 years (fixed)
  • Instalment Amount (EPR) : RM30,195.90 per month (changeable based on EPR or events)

This means, the Aqad we have contracted is based on CPR of 10%, but on day-to-day basis, the EPR is 5.50%. Therefore, Rebate on the Ceiling Profit Rate is:

10.00% less 5.50% = 4.50%

In value, the monthly rebate is RM2,071.29 and TOTAL rebate based on Price is RM74,566.27

REBATE ON EARLY SETTLEMENT

The second element of misconception was what mentioned earlier. That to early settle you have to pay ALL the remaining balance of the contracted Selling Price. This proved to be a major contention by customers, although it is NOT TRUE in Malaysia.

Mandatory Rebate must be given in the following early settlement scenario, and a penalty for early settlement cannot be imposed as it will be deemed as trying to earn additional profit on top of whatever profit is rightfully yours. Upon early settlement, the Unearned Income or Profit must be waived from being charged to the customer. A Bank can therefore claim profit that is rightfully theirs ie “earned”.

The scenarios where mandatory Rebate must be given are:

  1. Financing when early settlement has occurred including from prepayments
  2. Financing where there is a restructuring into a new financing contract
  3. Financing settlement in cases of default
  4. Financing settlement where the customer cancels or terminates the financing before maturity date.

Looking at the above example, the illustration is as follows:

  • Principal Amount : RM1,000,000
  • Selling Price : RM1,161,618.74
  • Total Profit : RM600,000
  • Tenure : 3 Years
  • Early Settlement Date : Month 22 of 36 months
  • Total Instalment Paid as at Month 22 : RM664,309.84
  • Outstanding Selling Price on Month 22 : RM497,308.90
  • Outstanding Principal on Month 22 : RM408,559.26
  • Earned Profit Not Paid on Early Settlement Date : RM2,001.79
  • Unearned Profit Outstanding on Early Settlement Date : RM14,183.36 (AS REBATE)

Therefore for Early Settlement, the numbers are:

Early Settlement Amount is RM485,127.69 on Month 22 i.e Outstanding Selling Price (+RM497,308.90) less Unearned Profit Outstanding on Settlement Date (-RM14,183) plus Earned Profit Not Yet Paid on Early Settlement Date (+RM2,001.79). This amount is at par to what a Conventional Loan figure for Early Settlement would be. In fact, in some circumstances, a Conventional Loan figure may include additional Early Settlement Penalties that generally are not allowed under an Islamic Banking financing.

EARLY SETTLEMENT PENALTIES

In essence, Islamic Financing is govern by the understanding that debt must be settled (debt cannot be forgiven) and efforts to repay debts early should not be taken as opportunity to earn additional returns. If actual cost is incurred from the early settlement of the debt, that cost can be recovered but not additional income. Under the Ibra guidelines, it allows the Banks to charge reasonable estimates of “Actual Costs” incurred if early settlement is made within a “lock-in period” based on the following conditions:

  1. Costs that has not been recovered arising from a discount element in a specific period in the financing. For example, the Bank offers a Home Financing rate of 1.88% p.a. for the first 2 years and BR+1% thereafter. The reasonable costs in this case is the differential between BR+1% less 1.88% ie the shortfall from the promotional period against normal board rates.
  2. Cost borne by the Bank during initial stages of the financing for example Legal Fees absorbed by the Bank. If the package offers a Zero-moving cost solution, it means the Bank pays the legal and stamping fees for the customer to move from the other Bank. The cost will be recovered by the Bank.

Consequently, any reasonable costs incurred by the Bank as a direct result of the Early Settlement can be considered to be recovered by the Bank. The Shariah Committee of the Bank can take into consideration to approve the request to charge such fees, based on acceptable justification. This includes any “break funding costs” incurred by the Bank.

CONCLUSION

The common perception is that for Islamic Banking products in Malaysia, the Selling Price (which includes future profits ie Unearned Income) must be paid to early-settle an Islamic Financing is inaccurate. Currently, there are provisions to waive the unearned profits from the final settlement amount as guided by BNM. In essence, the settlement amount should consist of only the Outstanding Principal Amount + any due amount or earned amount still outstanding on the settlement date. This means, the settlement amount for Islamic Financing is NOT more expensive than a conventional loan, and in some cases, is even cheaper than the conventional settlement amount.

Is Risk Based Pricing Compatible with Islamic Banking?

As the deadline of 1st January 2015 to comply with the new Reference Rate Framework looms closer, Banks are scrambling to ensure the system is adequately able to cater for the new pricing regime.

To refresh what this initiative is all about, BNM has earlier in March 2014 issued the final paper for the Reference Rate Framework, the purpose being to move Banks to be more transparent in their pricing regime and start thinking about risk-based pricing more seriously. It is also expected to push Banks to be more efficient in their operations; the more efficient the funding infrastructure, collections and recovery teams in the Bank, the lower the expected risks associated to the pricing which means bigger “savings” on the margin for the Bank.

Which was fine when I read it a few months ago. For a quick recap, do read my earlier post:

Please Click Here

But the more we go into this Reference Rate project, the more confused I get. Reading again and again and comparing it with the earlier Guideline issued by BNM on Risk Informed Pricing (issued 13 December 2013), I realised while earlier we understood the concept of “building the element of risk into how we calculate pricing”, this Reference Rate Framework talks about something else. Something I am inclined not to agree to.

Before that, what is Risk-Informed Pricing or Risk-Based Pricing?

I am not sure if there is a difference between the two, but the general understanding of what is Risk-based pricing and the explanations in the BNM paper on Risk Informed Pricing sound similar; both  talk about Expected Loss being the justification of charging a higher financing rate to consumers deemed to be “credit unworthy”. There is an element of discrimination but certain rules have been put in place such as factors that should NOT be used to determine price, such as race, colour, religion, national origin, gender, marital status or age, but that leaves a lot of interpretation by Banks on what can be defined as “risk” factors of a consumer. Wiki even went to comment that the pricing convention hurts the financially disadvantage from access to affordable capital or financing. This leads to predatory lending where Banks may offer exorbitant rates to desperate customers as they have no choice but to enter into an unsustainable financing schemes that they will eventually default.

Does Risk-Based Pricing make sense for Islamic Banking?

In that sense, how do we, Islamic Bankers, deal with Risk-based pricing in the context of the new Reference Rate regime? Is there such as thing as risk-based pricing for Islamic Banking?

Personally, I view Risk-Informed Pricing to be in contradiction to Islamic Banking and what we are supposed to do for consumers. Many efforts have been made to ensure consumers are not unnecessarily burdened but instead to provide assistance. We understand the Bank’s needs to discourage consumer “who couldn’t afford it” to not borrow further and bring themselves into unsustainable debts. But the way of the world, with the Basel II accord being an important international standard,  risk is deemed to have a direct impact on Bank’s capital and therefore must be addressed accordingly via effective risk management where one of the methods for this is to have risk-informed pricing. Therefore, upon assessment of an application from a consumer, a “risk-informed” price will be offered for their consideration; a price where all the elements of risks (including Expected Loss) are built into additional costs and premiums.

Islamic Banking, like it or not, will still fall under such standards, and therefore will already “penalise” a certain unfortunate consumer upfront with a “risk-informed” pricing. Not something consistent with what I feel Islamic Banking should do.

What is it that I am confused about with the Reference Rate Framework?

While we have woken up and accepted that the world now is moving towards “risk-informed pricing”, we try to find ways to soften the burden to  consumers by regulating “late payment charges” and”early settlement charges”. The Late Punitive pricing was also off the radar for both conventional banking and Islamic banking.

But with this new framework, there is not only “Risk-Informed pricing” or “Risk-Based Pricing” but also “Risk-Adjusted Pricing”. Adjusted means Banks can adjust pricing AFTER a future event happening.

This concern basically boils down to this particular clause in the framework paper.

Risk based pricing

Usually, risk-based pricing means initially a price that is adjusted to cater to the risk are given upfront. But with 8.10, what this means is that if the credit risk profile or creditworthiness of the customer changes during the tenure of the financing, the pricing i.e. the Bank’s spread may be revised to compensate for the higher risks. Definition of changes of the “credit risk profile” or “creditworthiness”, based on our clarification with BNM, refers to default situation. Therefore, if a customer’s creditworthiness is compromised and becomes worse-off, then the Bank, in its facing additional risk for continuing to finance the customer, may revise the Bank’s spread to mitigate the higher risks. If you are a good paymaster for 1 year but on the 13th month is out of a job and unable to pay your home instalments, you are now “not-creditworthy” and the Bank has the “right” to mitigate that risk and charge a higher spread i.e. higher returns.

Unless I’m reading this standard wrong, this is a gross expansion to risk based pricing, where the facility rates are adjusted based on the customer’s prevailing risk profile.

RAP

Yes, if the customer’s risk profile shows good credit standing (therefore deemed a “low credit risk”), theoretically the customer may enjoy a low financing rate for their facility due to the low possibility of default to the Bank. This is definitely a benefit to the customer. But on the flipside, if the customer initial credit rating is already “marginal or bad”, they possibly will be offered an “elevated” Bank’s spread to mitigate the potential risks of financing an “unworthy” customer. Therefore the initial pricing will be higher than usual. This is the basis of risk-based pricing, which can be a beneficial tool for the Bank.

To make things worse, should the customer have no choice but to take the financing at a higher rate, they are open to further “elevation” if during the course of the financing, things go sour in their payment. The event of default will trigger the option to “revise” the rate further. This means a “marginal or bad” customer will be holding on two levels of risk-adjusted pricing; the first during the initial approval, and the second on default events during the financing period.

It seems there is now a backdoor to the Late Payment Charges (LPC) that the Islamic Banks have been restricted to. While it is difficult to charge Penalty (Gharamah) due to various restrictions, allowing Banks to directly revise upwards the banking spread actually resolves the issue of cost compensation that Banks were not able to charge before. In fact, if you really think about it, there is really no need for the LPC guidelines anymore; on default, Banks can raise the pricing spreads and it goes directly (and fully) into its income books.

How will this be acceptable to an Islamic Banking structure? Allow me to express my utmost shock to this.

Shocked

Simply put, risk-adjusted pricing and Islamic Banking do not make good companions. I understand the intention is to ensure customers don’t over-finance beyond their means, but to impose this for “default” customers  does not seem right as this looks very similar to a punitive action to consumers. I hope I am wrong about this, but as I know it, my conventional banking counterpart is already building this capability in their system. As this is a BNM standard now, I wonder how soon until we are asked to follow suit to comply with such requirements.

I am recording my official concern to this to my organisation’s Sharia committee. Hopefully it is a misunderstanding on my part. I would welcome this correction in understanding on my behalf.