Category Archives: Islamic financing

Bai Al Inah and Interconditionality Issues

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I have been asked recently on the validity on a Bai Al Inah contract that had sparked controversies many years ago by claims that it is not a valid Islamic contract that is rejected by most Shariah scholars.

What do I think? As limited my Shariah knowledge is, the position of Bai Al Inah, and its counterpart Bai Bithaman Ajil (BBA), have always been that it is a structure of 2 standalone contracts of Musawamah (simple sale) and Murabahah (deferred cost-plus sale). The intention of these 2 contracts is for the purpose of obtaining cash or working capital through creation of debt. Both contracts are executed consequentially and valid as all the tenets of the contracts are met perfectly.

SO WHAT IS THE ISSUE THEN?
Generally both contracts of BBA and Bai Al Inah suffers from the same issue ie the existence of “Interconditionality” practices in their legal clauses in transaction documents. Both contracts have 2 standalone contracts i.e. one sale contract and one buy-back contract. Both contracts must be able to stand alone and the aqad is executed sequentially, which makes it valid based on trading rules.

The Aqad for the Bai Al Inah transaction uses the Bank’s own Assets for the underlying transaction, as the customer do not have any Asset to sell to the Bank in the first place. So Banks have been using their own Assets such as pieces of land, office hardware, office furnitures, company shares, investments in securities, machines, and any other valuable Assets that is identifiable, transferable and valuable.

CONTRACT #1 – SALE OF BANK’S ASSET (MURABAHAH) TO CUSTOMER IN BAL AL INAH 

These Assets are to be sold by the Bank to the Customer at a Sale Price (includes profit) and to be settled at a later date or at specific intervals. For example, the Bank sold its ATM equipment to the Customer at a price of RM180,000. This amount is to be paid back within 5 years (Deferred). This is a valid and perfected standalone contract. The debt created here remains valid until full settlement at the end of the 5th year.

CONTRACT #2 – BUY-BACK OF BANK’S ASSET (MUSAWAMAH) FROM CUSTOMER IN BAL AL INAH 

The Bank then makes an offer to Buy-Back the Bank’s Asset from the Customer at a simple sale transaction where the amount will be settled immediately. As the Customer intention is to obtain Cash or Working Capital, the Customer will generally agree to the Bank’s offer to Buy-Back the Asset at the current market price. For example, the Bank offers to buy-back the ATM equipment from the Customer at a price of RM100,000. This amount is to be paid immediately for settlement. Bank takes ownership of the ATM and pays the Customer RM100,000 cash. This is also a valid and perfected standalone contract

BUT WHAT HAPPENS IF THE CUSTOMER, AFTER COMPLETING CONTRACT #1, REFUSE TO ENTER INTO CONTRACT #2 AND DECIDE TO KEEP/TAKE THE DELIVERY OF THE ATM EQUIPMENT INSTEAD? THIS REPRESENTS A RISK TO THE BANK AS THE ASSET (ATM EQUIPMENT) IS NOW RIGHTFULLY OWNED BY THE CUSTOMER UPON COMPLETION OF CONTRACT #1

Because banks want to minimise risks, the interconditionality clauses are added to ENSURE that once the first sale contract (#1) is concluded, the second buy-back contract (#2) MUST be executed (mandatory). It goes on to say that if the second buy-back contract is not executed, then the first sale contract is invalid and restitution (going back to the original state) must be effected to recover the Asset already sold; in this case the ATM Equipment.

From Shariah point of view, it is problematic, because the first Aqad for the sale contract (#1), is a valid contract and completed under Aqad which meets all its trading tenets. To impose that another external event (i.e. the non-completion of the buy-back contract) that will invalidate a valid sale contract (already concluded and perfected), implies that the whole arrangement is superficial and do not carry real value.

This must not be the case, because the Aqad is already validly executed and is now running. Thus having the interconditional clauses is not favoured by Shariah and needs to be removed.

In Summary:
1) The Sale of Asset contract is valid on completion of Aqad
2) The Buy-Back of Asset contract is valid on completion of Aqad
3) If the Buy-Back of Asset contract (#2) is not completed, the Sale of Asset (#1) remains valid as the Aqad is already completed.
4) The requirement to force the Buy-Back of Asset contract to be completed via an interconditionality clause is problematic in substance. The notion of “one contract is only valid upon completion of another contract” does not sit well with Shariah.

Of course, for Banks, removal of such clauses from the documents represents a risk as the assets used for the transaction belongs to the Bank in the first place. The idea that the Customer cannot be compelled / forced to re-sell the assets back to the bank (or banks not allowed to buy-back) is a risk banks are not willing to take. As such impasse, the only way most banks can comply with the requirements to remove interconditionality in their contracts is to remove these contracts from their shelves.

There are still some Banks using products based on BBA or Bai Al Inah, but such usage is now limited to its uses are required by design (such as restructuring an existing Bai Al Inah account) and/or mainly transactions between financial institutions (not between banks and retail consumers) where the interconditionality clauses are not required/ can be ignored.

For the public, Tawarruq or Musyarakah Mutanaqisah or Ujrah structures are now used as acceptable replacements of both Bai Al Inah and BBA products, signalling the demise of these hugely unpopular products.

Wallahualam.

 

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Making Islamic Banking Resilient

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Recently, I was invited to be part of a panel to present our views at the International Islamic University of Malaysia (IIUM) on how to make Islamic Financial Markets resilient. With great excitement I prepared my slides (panelists are given 20 minutes to present) and tried to figure out the best approach to present it in such a short time. However, when the session came, due to time overshoots and constraint, me as the last speaker was only left with 10 minutes. I had to make it count, so I talked fast.

Afterwards, however, I do not feel as if it was mission accomplished. Time was too short for me to put my argument properly and I had to drop many points in fear of cramming too much information into that 10 minutes. So I decided to post my slides up, and make a proper short commentary on what I meant to be communicated. Bear with me.

The Financial Industry Must be Resilient

  • STABILITY : The public must be confident on the resilience of the financial markets where the public is assured that there is not misconduct of public funds in the day to day operations of the banking industry. BNM has put in great lengths to ensure stability via sufficient capital, liquidity and funding. The operations of the bank must always meet the statutory requirement on financial stability with the introduction of the Liquidity Coverage Ratio (LCR), Net Stable Funding Ratio (NSFR), Rate of Return Framework (ROR), and Risk Informed Pricing.
  • SUSTAINABILITY : Any business, must intend to survive in the long run. Selecting your customers are important, and risk mitigation mechanisms must be available to defend the business. But at the same time, re-investment of profits must also be made for future growth, so it is a balance to be maintained.
  • INTEGRITY : As Bankers, integrity always plays an important, and fundamental, part.  But Islamic Bankers, another layer of integrity is also imposed which is Shariah. Banks are expected to be more and more of a moral champion in support of the various SDGs and ESGs where the idea of being good will eventually lead to better profits and prosperity. BNM’s Value Based Intermediation aims to expand the role of banks to be more than just profit driven, but more inclusive to embrace a wider range of customers and cater for their needs.

The Challenges are manifold.

Being resilient is always a challenge for the Banks, especially with so many moving parts in the financial world. New regulations, new competition, new structures, new products and new models continue to plague the banking industry. To change our mindset to make Banking and Financial Market more better requires a lot of soul searching and will power to make the change. I summarised the challenges into 3 broad categories:

  1. Consumer Market. Any major change in the banking model is not taken well by the consumer market. Customers come to the Bank mostly for advise on their banking services. The Banks struggle to introduce differentiating products, from the debt structures and into the thought of creating value through investments. I am not sure how successful introducing the VBI into the consumer market, but the has been a lack of awareness programmes to introduce to the public.
  2. Corporate Market. Corporates are driven by profits and benefits. It is their core function ie to increase shareholder value.
  3. Financial Markets. We lack sufficient financial instruments in the market. That is why the industry can only grow organically. It needs the strong-will to pump more capital into the market and creation of structures that do not mirror the conventional books.

The Reality is that Traditional Banks need to keep up.

  • Traditional Banks. Heavily regulated to ensure financial stability. But the speed of adaptation to new thinking and new technologies are too slow. It is high cost to make the change, but also it is high cost just staying where you are. Ask Nokia. If all Islamic Banks do is replicate, they are in danger of becoming obsolete in the near future.
  • Challenger Banks. Provides alternative banking structures or arrangement, with little or no hassle, with or without the use of technology. A lot of customers now by-pass banks to opt for the most convenient and fast banking products. With very minimal regulatory requirements.
  • Digital Banks. This new breed of banks are definitely very interesting. There are two differentiators i.e. 1) Banks that only digitalise their processes and paperwork and speed, but the fundamental bricks are the same, and 2) Banks that try to be different and offer a totally new proposition with a new set of bricks. Yet, Islamic Banks are expected to do all and adopt more stringent requirements when entering into the Digital space, while dealing with old issues such as constructive ownership and Aqad. More importantly, these issues can probably be resolved by NON-BANKS, offering the same terms and conditions, sometimes with slightly better proposition such as speed, accuracy and low cost. For example, big data companies such as Facebook and Grab intend to open their own “bank”. Facebook just launched its Libra bank trading in cryptocurrencies. Grab is rumoured to enter as well and these Big Data companies already have their database of ready customers for them to roll out their Digital Banks.

Stop Looking at Your Feet. Stretch out your hand and move to touch new Horizons.

A lot of discussions have been held between the academia and practitioners. It seems we are always looking ways to innovate and integrate into the future, but without any real solutions on how to actually do it. As mentioned, the will-power to affect change remains a huge challenge. Instead of “What Is….”  to be turned to “What If…” where solutions are always been discussed and developed for a solution, and “What Next…” clearly implying the shift in banking products from traditional to new developments.

It is no longer sustainable to just replicate. True innovation is on the rise. New solutions are needed to be offered to the customers.

The Next Generation bankers must familiarise themselves with all the blockchain and Internet of Things language and terms currently floating around. More importantly, there should be a look at the whole ecosystem to see where the Shariah elements can be included, and where others must be excluded. Collaborative discussions, between regulators, academicians, practitioners and Shariah scholars must work together for the growth in the industry. It is not just any growth, it involves a total paradigm shift to adopt the new ecosystem.

There is a need to differentiate and upscale the business practices. While we continue to focus on the Traditional Bank in making it more resilient, we might miss this opportunity to join the Industry Revolution 4.0 to revamp Islamic Banking and overlook the threats coming from other financial institutions (NON-BANK). This is the Banking disruption in real life.

No Pork No Lard : The Shariah-Neutral Transactions

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TO COMPLY OR NOT TO COMPLY, BUT THERE IS A THIRD OPTION

Following my earlier writing on the Digital Wallet / ePayments and how such transactions may have not breached Shariah requirements but lacks the validation to ensure all elements do not touch the prohibited elements, I am called to further expand on the topic. In my opinion, there are possibilities that more Shariah-Neutral products and transaction enter into the space of Islamic Banking, but without the validation of Shariah scholars or committees and yet, it will remain acceptable. It is possible, and it is already happening now.

“NO PORK NO LARD”

It is an interesting situation in Malaysia now, when it comes to food. In general, Malaysia as a Muslim country, the expectation is that the food consumed must be Halal and more importantly certified as such. The reason for it is that it gives comfort to the public that certain standards are adhered to according to religious requirements. To walk into a restaurant with the Halal signage gives us Muslims confidence to consume the food till our bellies are filled.

But there are challenges. The desire to ensure the standards are met has resulted in difficulties for restaurants getting certification quickly. The process is detailed and granular, and this is a good thing, but can be disheartening when the certification drags. And in some cases it is impossible to obtain, especially if the eatery has halal standard food but also offers alcoholic drinks to its non-Muslim customers. The Muslims know (or assume) the food is halal if they see there is no pork on the menu, and will ignore the alcoholic drink. This is now a common sight in Malaysia.

And thus the loop-hole or short-cut is discovered. Rather than going for certification of Halal for their restaurant, many owners now deemed it sufficient that the signage “No Pork / No Lard” will result in a Halal understanding. And this may be true; many small roadside businesses do not carry a Halal certification but is nonetheless patronised by Muslims as it does not carry pork on the menu. That cue is taken by the restaurant owners and over a period of time, the “No Pork / No Lard” now is understood to be serving halal food but without Halal certification.

DOES “NO PORK / NO LARD” MEANS IT’S SHARIAH NEUTRAL?

Taking that concept into the banking world, will consumers eventually be accepting Shariah Neutral products and services as the new norm? A product or services with no prohibitive elements that is deemed acceptable by both the producer and consumers but without any Shariah Committee validation. For many years some conventional banks have been offering Shariah compliant third party Takaful or Unit Trust products which was vetted by the Shariah Committee of the providers.There is total reliance on the providers validation for Shariah compliance.

Additionally, there are products and services that is by nature, very close to meeting the Shariah requirements in a contract. For example the leasing products which is perhaps 95% in line with Shariah requirements for Ijarah such as rental arrangements, ownership transfers and roles and responsibilities of lessor / lessee. The contention will always be the penalties and perhaps some operational practices, but in my view, these can be amended.

THEY WALK AMONG US

Believe it or not, there are already efforts on becoming Shariah-neutral where it is deemed acceptable practice for attracting Muslim consumers. Some non-Islamic banks have been aligning some of their products features to be consistent with Islamic banking practices under the guise of responsible financing or sustainable banking. For example, the compounding late payment interest which some non-Islamic banks no longer practice. Another example is that some are considering to remove “Commitment Fees” from unutilised financing balances in overdraft / revolving credit to align it to Islamic banking practices. We are starting to see non-Islamic banks realigning themselves to be on par with Islamic banking practices. Just to regain the competitive edge.

This will eventually lead to offerings that remove the prohibited elements and validated as acceptable by the public themselves, without further validation of Shariah scholars. Can a non-Islamic bank eventually offer products that it deemed as meeting the Shariah expectations? Surely, Shariah Committee will not have jurisdiction over a non-Islamic bank offering Shariah-Neutral offerings.

The more crucial question is perhaps : Will the public eventually become not so demanding for a stricter (or complicated)  Shariah Compliant product, and begin accepting Shariah-Neutral products that is offered by non-Islamic banks? Is that possible?

Such offerings may be offered via the digital world where the contractual lines are not so clear. Rebranding of a product can be done with minimal effort. The terms used can be made Shariah-friendly. How a transaction is handled behind the scenes may be less important  with the convenience of using Apps or Mobile Banking. And without Shariah scholars prohibition or decision on such matters, the public will hold to the opinion that it is deemed compliant and thus acceptable. Eventually, this opinion will become customary and generally accepted.

“No Pork No Lard” may one day become the new acceptable norm in the non-Islamic banking space. And my suspicion, a lot of sceptics of Islamic Banking already hold this view. Maybe it is time to make clear of the colours of the offering; is it white or is it black? Otherwise, the colour of grey will become the new white.

To read the earlier posting, click on the following: https://islamicbankers.me/2019/01/15/e-wallets-did-you-forget-us-again/

It is 2019. BBA and Bai Al Inah are Old News.

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WHY ARE YOU STILL ASKING ME ABOUT BBA AND BAI AL INAH?

It remains a mystery when people ask me why Malaysia continues to offer Bai Bithaman Ajil (BBA) and Bai Al Inah products, as according to them, these structures are based on elements of Hilah (trickery). It is a mystery because starting from 2012/2013 period, the instructions on Interconditionality issued by BNM to Islamic Financial Institutions requires that the provisions of “mandatory buy-back” must not appear in financing contracts such as Bai Inah and BBA. Because of this, Malaysian Islamic Banks have slowly weaned itself from such products and have since moved to other Islamic contracts.

Read the circular issued by Bank Negara Malaysia in 2012 on the practice of Bai Inah and their expectations by clicking this link (BNM Circular).

WE ARE STILL READING OLD BOOKS AND ARTICLES

In general, I still find that some learning institutions are incorrectly teaching students that the contracts are still alive and well in the Malaysian market. The text books used are still ones that predates 2011 and really, this is a disservice to students. When they come for interviews with our bank, it does not give the students any advantage or good impression as the syllabus remains outdated. Many do not know about the Policy Documents issued by Bank Negara Malaysia or the contracts covered by the policy documents. This really should be covered in a learning module as the latest requirements are captured in these documents. It is a good reference read, but it seems only practitioners and Shariah scholars are aware of these documents.

This is true as my last few interns also impressed the same. Tawarruq structures sounds alien to some of them, as their teachers prefer to teach BBA and Bai Inah  to unlock its controversies as points for discussion. Let us be clear that most banks NO LONGER offer Bai Inah or BBA, and those which does, offer it as a continuation for a legacy arrangement or due to certain unavailable scenarios, such as fresh new documentations are not obtained for Tawarruq arrangement (such as Wakalah to buy commodities). It is no longer offered as a product to the public and this is evidenced from the Banks website where the structures can no longer be found. And most of the time if used, this is a temporary fix allowed until the deal reaches expiry or the Tawarruq appointments are obtained.

And with Tawarruq arrangements now being ably supported by good infrastructure such as Bursa Suq As Sila trading platform and other commodity brokers worldwide, there is no issue of Darurah (emergency) to justify the continued usage of Bai Al Inah or BBA.

SO, WHERE HAVE WE GONE TO SINCE 2011?

In short, we have moved to the following contracts:

  1. Bai Bithaman Ajil (BBA) – Usually BBA is used for purchasing of properties (Home financing or Commercial properties financing), or sometimes for trade financing products. These usage is now done under the Tawarruq arrangement (using Commodity Murabahah) where the proceeds from the sale of Commodities is used to settle the purchases of houses or commercial properties. Alternatively, Musyarakah Mutanaqisah arrangement (Diminishing Partnership) is also used by many banks where houses or properties are purchased by the Bank and leased out to the customer, who then pays rental and gradually purchases the shares of the house and properties over time. So now, BBA has been replaced with Islamic arrangements of Tawarruq or Musyarakah Mutanaqisah. Other Islamic contracts has also been known to support some elements of BBA, such as Istisna’a (property construction), Murabahah (good sale at profit) or Ijarah / Ijarah Mausufah fi Dhimmah (forward lease).
  2. Bai Al Inah – Usually Bai Inah is deployed for Personal Financing or Working Capital Financing and even Islamic Credit Cards. Again, Tawarruq arrangements has generally replaced these usage with the end result of providing cash. On a smaller note, the contract of Ujrah (Services) is also deployed to support some requirements of personal financing (where purchase of goods and services are required) and Islamic Credit Cards. So now, Bai Al Inah has now been replaced by Tawarruq arrangements or Ujrah contract to meet the cash and working capital requirements.

The final controversial contract that Malaysia currently deploy is the Bay Ad Dayn (Discounted Sale of Debt), which serves a specific purpose in trade financing products. Eventually a common ground must be found to make this contract more globally accepted, or replaced with a better solution.

UPDATE YOUR STUDY NOTES, PLEASE

The main challenge nowadays is to innovate further by improving what we have. Criticisms are good, especially on the old structures. But we practitioners do hope the learning academia afford us a bit more confidence and trust, especially these criticisms and consequent issues are not “unknown” to us, since we lived and breathed in its controversies many years ago. The comments made in recent times are something we had encountered and resolved 10 years ago. We enhance and evolve, and it will be good to see new students coming into the market armed with the latest updates of what is happening and let’s move forward.

It is now 2019. Do not get stuck in the muddy past. These contracts have gone into the history books. We have so much to do in the future arena.

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

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

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 There a Secret Book I Don’t Know About?

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ISLAMIC BANKING PRODUCTS ARE EXPENSIVE?

It is one of the mysteries of the universe that there is this perception that Islamic Banking products are MORE EXPENSIVE than the Riba products counterpart. It never fails to surprise me that in Malaysia, whenever I open the session for Q&A after a talk on Islamic Banking, that the question put to me was “Why is Islamic Banking financing products more expensive than conventional banking products?”.

Honestly, I wondered if this question comes from the possibility of everyone reading from the same exact book published many many years ago, making that one point of contention again and again. Which book have people been reading? Can someone pass me this book? It seems everyone is reading or referencing the same book which says “Islamic Banking products are expensive”. Can someone tell me about it?

So I decided to ask around. I asked the persons asking the question on why does he/she say that? In what scenario? Which product? What feature of the product makes it expensive? In all attempts, they replied “It is the general view that Islamic Banking is more expensive”. But they have yet to give me any evidence when I asked for their source.

Amazing…

This is like a scary bedtime story that parents tell their children if they don’t behave. So now I am asking around for specific scenarios on why they made such comments. From what I gathered, these are some of what I think people are referring to. But I couldn’t be 100% sure, so please, do leave your comments and scenarios (and details) for me to evaluate and respond to.

Because, for the past 20 years (in Malaysia at least), this claim of “Islamic Banking products are more expensive than conventional banking” are simply not true.

YES, THERE ARE DIFFERENCES

Of course, before I delve deeper into this perception, there are differences in Islamic Banking that requires additional items or costs, but mainly these are operational costs or documentary costs or management costs which are linked to mainly Shariah requirement on Aqad. For conventional banking, it is just a loan agreement, For Islamic Banking, a trading transaction may occur, and if it does… there may be additional costs.

But these costs are usually absorbed by the Bank itself, and hardly passed on to the customers. So why would it be more expensive for the customer, if the Bank is absorbing these “costs” as part of their cost of doing Islamic Banking business?

And additionally, the costs borne by the Bank for doing Islamic Banking business are not significantly higher. The Bank have to remain competitive as well, either against conventional banks or other Islamic banks as well. So the costs, if significant, will not be passed to customers to remain competitive. It should be on par with other players in the market.

FINDING THE REASONS

As far as I can tell, some of the perception on Islamic Banking is more expensive than Conventional  products are based on these:

  1. Selling Price – In some Islamic Banking products, there are trading requirements (Murabaha / Tawarruq / Istisna’a / BBA) and one of the tenets of valid sale is that there must be a Selling Price. Selling Price is the sum calculation of all the Installments the customer has to pay over the period of financing. The formula is that Selling Price = Monthly Installment x No of Months of Financing. Once this is agreed, it cannot change; anything above and beyond the agreed Selling Price (maximum) is considered Riba. Conventional Banking products do not have this as they only declare the Installment amount per month based on prevailing rate. Truth is, no one really know how much they eventually pay under conventional banking product, because there is no capping of the amount they may pay. The tenure can be extended, the installment can be increased, the rates may be revised upwards under conventional banking. There is no control of how much (maximum) conventional banking can collect from the customer. If conventional banking products add up the installments over the period of time, they can also see the amount equivalent to a Selling Price ie total amount payable over the tenure. But they don’t, because it ties their hands from collecting more. So, is Islamic products more expensive? It is possibly the opposite i.e. cheaper than conventional due the maximum Selling Price compared to a conventional loan without any maximum amount (sky is the limit).
  2. Ceiling Rate – Islamic Banking products may work on either a fixed rate structure or floating rate structure. If the structure is a fixed rate structure, it looks similar to the above. If is floating rate structure, then there is a need to put up a Ceiling Rate (a maximum rate that Shariah allows us to charge) for the purpose of the Aqad, where the certainty of price is required.  However, once the Aqad has been concluded (Selling Price is contracted), the day-to-day running of the financing is charged at the Effective Profit Rate (usually below the Ceiling Rate) which is reflective of the prevailing market rates. Which is what the conventional banking products are charging. This makes the actual amount paid for Islamic Banking product at par with conventional banking products. The difference between the Ceiling Rate and the Effective Profit Rate is not charged on the customer therefore given as a Rebate on price (Ibra’). For example, if the Ceiling Price for the Aqad is 10% and the Effective Rate for day-to-day is 6.0% (ie customer is charged only 6.0%), then the difference of 4.0% is a pricing rebate to the customer. So, is Islamic products more expensive? No. It is on par after pricing Rebate. In fact, having a Ceiling Rate provides additional “protection” for an Islamic Banking customer i.e. during times of high volatility of Base Rate / Funding Rate, the Ceiling Rate serves as a rate protection for the customer. For example, should the all-in rate of the financing increase to be 13% or 14.0%, the customer’s rate will not exceed the Ceiling Rate of 10%, therefore saving the customer the excessive rate during periods of uncertainty. So, during period of high volatility of rates, the Ceiling Rate will not be exceed thus making the product cheaper than the Conventional product.
  3. More Documents – I acknowledge that some Islamic products do require additional products as a package. But as for main documents, where the most charges are incurred including stamp duties, are usually the same as any conventional banking product. Maybe there are earlier perception that because of the Selling Price based on Ceiling Rate, the stamp duty will be more expensive. It is not true. Stamping will still be made based on the principal amount even for an Islamic facility. Furthermore, secondary documents are usually stamped at nominal amount i.e. $10 per document. The additional documents for Islamic product, if we assume requires 5 additional, will cost the customer $50 extra. That is not significant.  So, is Islamic products more expensive? For documents, maybe. But it is dependant on structure and the additional documents will be stamped nominal value.
  4. Early Settlement Rebate – I probably understand and agree with this point, provided it was made 15 years ago! Traditionally, when a customer takes a loan with a conventional bank and want to do an early settlement after a few months, an early settlement penalty was charged. For an Islamic Banking products, when BBA was offered many years ago, the method was to give a “reduced discretionary rebate” on the unearned profit. This means maybe some Islamic Banks want to earn the same early settlement penalties (like a conventional bank) via a reduced rebate as rebates are by nature, discretionary in the eyes of Shariah. However in 2011, BNM issued a specific guidelines on the treatment of rebate for early settlement of Islamic sale-based financing products. The guidelines ensures that the rebate given is mandatory, with a specific formula to be adhered to. The guidelines also included the required disclosures for transparency purposes. In short, Islamic Banks cannot charge early settlement compensation (only a couple of scenario where it is allowed) and the rebate given must follow a strict formula. So, is Islamic products more expensive? There might be a case for this argument before 2010 (for early settlement cases only) but with the Ibra guidelines issued in 2011, the product would possibly result in at par or cheaper than a conventional bank product.
  5. Commodities Trading Fees – This is a recent phenomena. A lot of structures are riding on the popular Tawarruq structure, and this structure involves the buying and selling of commodities via brokers or established trading platform and there are Trading Fees being charged. Generally, for retail consumers, the trading fees are absorbed by the Banks; you will never notice it. But for Large Corporates dealing in hundreds of million deals, a trading fee may be noticeable. However, these fees are also deemed small enough to be ignored. The standard trading fees at Bursa Malaysia is $15 for every $1,000,000 commodities traded. That’s 0.0015% charge. For a $100 million transaction, the trading fee will only be $1,500. I have not seen any Corporate customers refusing to pay this trading fees. And there are some brokers who are even charging lesser rates. So, is Islamic Banking more expensive? Only for Tawarruq, there is additional costs but for the quantum, I do not believe 0.0015% is considered significant, or expensive.

It really is testament that the men and women in the industry were always looking to enhance, resolve and improve on contentious practices to serve the public. The products were always evolving to be better for the consumers. In fact, I believe we are at the stage that some of the offerings under Islamic Banking is CHEAPER than the conventional banking products due to certain fees and charges and treatment on the account are instructed by Shariah Committee.

IT IS A PERCEPTION THAT NEEDS CORRECTION. IT IS NOT CLEAR WHICH PART OR PRODUCT FEATURE THAT THE PUBLIC PERCEIVES AS MORE EXPENSIVE. IS IT THE RATE, THE PRICE, THE PENALTIES?. IS THERE ANY UNFAIR TERMS LEADING TO THIS PERCEPTION.  

COULD ISLAMIC BANKING FINANCING PRODUCTS ACTUALLY BE CHEAPER THAN CONVENTIONAL LOANS?

In some scenarios, I do believe so.

There are many areas that is governed by Shariah decisions formulated to protect or benefit customers for fairness. Especially in areas of fees and charges and compensation. IF YOU WANT TO KNOW MORE ABOUT ISLAMIC BANKING PRODUCTS BEING CHEAPER THAN A CONVENTIONAL BANKING PRODUCT, CHECK OUT MY COMING POST.

I really hope someday someone will pass me this mystery book to read. We are in 2017 and so much have changed in the past decade. Huge and big regulations have been introduced and most of it with heavy input and consideration from the Shariah Advisory Council (SAC) of BNM. These are learned individuals that I believe are not greatly motivated by money. There are huge responsibilities on their shoulders thus the decisions made will be for the benefit of customers in mind.

Again, I invite readers to provide me with the latest findings where it is believed that Islamic Banking is more expensive than conventional banking products. Let us discuss and evaluate them based on actual facts.

Wallahualam