The Tawarruq Dilemma

Islamic Banking in Malaysia is fast reaching a crossroad. While Islamic Banking continues to offer like-to-like conventional structures, the requirements by Shariah Committees and Policy Documents by Bank Negara Malaysia continues to challenge the way Islamic Banks implement and operationalise the products within a viable banking structure. Islamic Banks are becoming mindful of the need to comply fully to each policy requirements.

It is precisely this fear of being “non-compliant” to these requirements that pushes many Islamic Banks to develop the Tawarruq-based products into its most efficient form. As I have written earlier in Disruption : Islamic Contracts where I felt the Tawarruq arrangements has become the “go to” structure that Islamic Banks can easily comply with, the notion that other contracts such as Musyarakah or Ijarah or Mudharabah may now be left behind in its development due to perceived complexities. Or in some cases, difficulty to comply due to the existing banking set-up, especially in matters of risks, capital and operational processes which is intrinsically based on conventional banking infrastructure.

BUT CAN TAWARRUQ ALWAYS BE THE ANSWER?

It is generally accepted that a lot of processes in the Tawarruq arrangement can be complied with. There were strong operational support and infrastructure both internal and external, such as the London Metal Exchange (LME) and Bursa Suq Al Sila which has an efficient commodity platform specifically designed to support Tawarruq with or without commodity brokers, to the choice structure that bridges the middle-east players to most of the rest of the Islamic Banking geographies. But that is by no means that Tawarruq is a perfect solution for Banks.

Despite Tawarruq is now greatly used over the last decade or so, there are still contention points that remains amongst financial practitioners and Shariah scholars. Most scholars want to have the view that Tawarruq should be the “contract of last-resort” but what we see now are quite the opposite. It is the preferred choice being used not just for Working Capital requirements, but now also for Asset Financing, Mortgages, Trade Financing, Fixed Deposits, Structured Investments, and even Savings Account. Whenever an Islamic Bank hits a roadblock with a particular product being developed or requiring compliance to the latest rules, the tendency is always to consider Tawarruq as the solution.

If this is the approach, how much do we really need other Islamic contracts which only addresses a single problem or requirement? Shouldn’t we develop Tawarruq as far as it can take us and make other contracts as “supporting” contract to cater for specific nuances?

THE UNANSWERED QUESTIONS ON TAWARRUQ

Each year when Bank Negara Malaysia audit comes around, there will always be new compliance points to be proven and tested. Even at the level of understanding and interpreting the Policy Documents into processes and banking operations. Each Bank interprets the rules differently, and each banking set-up have different operational capabilities which more often than not, requires exceptional Shariah indulgence. So, the questions will remain unanswered whenever dispensation is obtained.

Many argue that the main issue of Tawarruq is actually the “intention” of the contract itself, and that intention is not to “trade in commodities” but to create debt via a trading transaction. This has been debated at length for many years in all types of forum, but we concede on some of the arguments by virtue of there being no other viable solution to cater for certain banking requirements. Islamic Banks, and its scholars, had to choose either:

  • Allowing for the Tawarruq arrangement with strict adherence to requirements until a solution arrives, or
  • Disallowing the Tawarruq arrangement which may result in customers being impaired in their Islamic business, which may result in the customer reverting to a conventional banking solution.

Is there a case of choosing the lesser of two evils?

Nonetheless, I won’t discourse what have been extensively discussed, but instead look at the operational issues of Tawarruq arrangements that I pick up going through the Tawarruq Policy Document. Among them that are still being debated in different forums are:

  1. The issue of Commodity Delivery – To demonstrate that the Tawarruq being practised by the Bank is real, the test of delivery of Commodity is a key qualifying factor. The Bank must have in place a mechanism that allows the customer an option to take delivery of the commodity whenever the customer calls for it, bearing in mind that may have not been the intention in the first place i.e. taking delivery of commodities. How a Bank prove this to Shariah Committee and regulators are crucial to demonstrate “real transaction” and paper transactions.
  2. The issue of Price Fluctuation – Depending on commodities, its price tend to fluctuate periodically, because these are actual live commodities being traded. Because of this, Banks have not been able to be precise in its documentation or price disclosures. Whatever price per commodity unit at 10am, it might change at  2pm, so how do you lock-in a specific price when the buy and sell of the commodity was not concluded immediately? The fact that Bursa Suq Al Sila states in its guidance notes that an Islamic Bank could not hold the commodities for more than 2 hours implies the issue of price fluctuation is a valid concern for Shariah Committees.
  3. The issue of Discrepancies of Terms – Because the Murabahah transaction in the Tawarruq arrangement is the most crucial contract, Scholars always insist on the details of the transaction to be as precise as possible to ensure what was offered was eventually rightly accepted. For example in a Personal Financing structure, the customer makes a credit application according to certain terms such as financing amount, or financing tenure, but what eventually gets approved might be a lesser amount or shorter tenure, which means differences in the initial “Agency” instruction to transact the commodity. Scholars question how do Banks re-engage customers with such “counter-offer” for their acceptance? At which point after the credit approval?
  4. The issue of Delay in Transactions – Some banks are more efficient than others. Some banks are able to conduct commodity trading on the same day while others can only do it in the next day after the day’s batch run. End of day batch runs are what conventional banking live by, and there is no motivation to conclude and consolidate all transaction in real-time; there is no requirements to do so. Batch runs allows for more systematic consolidation of records. But that becomes an issue for Islamic banks running next to a conventional banking proposition. So if an Islamic bank is limited to only end of day batch run to consolidate its records, it means the end of week transactions requirements will only be fulfilled on the next working day (across the weekend). This is a delay in the conclusion of the initial instruction given by customer to conduct Murabahah which may impact specific terms including price of commodity and its availability. There is also the danger of missing out delayed transactions as those instructions are not “current” anymore. There is a provision in the Policy Documents that “delay” in transaction should not be more than 2 days (T+2), but there are also periods where the off-days are more than that due to public holidays and other disruptions.
  5. The issue of Qard in Tawarruq – An extension of the above scenario where Commodity transactions are delayed, the next question will be “what is the status of the funds when no transaction is done?” Is it a Qard (Loan) contract until the transaction is fulfilled, or is it an Amanah (Trust) arrangement? In either case, for the scenario of Tawarruq Deposits, how do you accrue the profit for both contracts which forbids “interest” or “returns“? Profit is only realised once the Murabahah (trade) takes place. Without the trade being transacted, profit accruals can only be justified by arguing that Islamic banks should not penalise customers who, in this case, has done nothing wrong. Dispensation is always given for the reason of fairness.
  6. The issue of Agency and Dual Agency – There are still some banks that feels the Dual Agency structure contributes greatly to the notion of “arranged” Tawarruq and thus stays away from it. The Dual Agency structure is where the customer appoints the Bank as both the Buying Agent and Selling Agent. This gives the Bank the full right to conduct trading without any Customer intervention (given mandate), which makes the “ability or option to take delivery of commodity” redundant or unnecessary requirement. It effectively removes the proof of Murabahah i.e. deliverability of the Commodity.
  7. The issue of Physical Commodity – One of the main contention is the ability to ascertain the availability of Commodity. While on paper it can be evidenced but nonetheless the challenge is to ensure the Commodity is identifiable and deliverable according to quantity. Efforts have been made to split into smaller denominations whenever needed, and commodities like Crude Palm Oil (CPO) is easier to be allocated. But there is always suspicion whether this is superficial where proof of otherwise is actually much more difficult to obtain. Where is the certainty that the assets being traded are the right physical ones?

THE REAL QUESTION IS WHETHER THE ABOVE CAN REALLY BE RESOLVED

So is there any other alternatives to Tawarruq? The above questions have so far not been answered satisfactorily and scholars while do not prohibit its usage, still frown on how much Tawarruq has impacted everyday banking life. It is truly a “love/hate relationship,

I believe there is such “replacement” contract that can address most, if not all, of the above concerns. But it needed to be proofed and challenged and at the end of the day, we question such necessity and thus the rising dilemma to replace it after all the work done. Tawarruq has really taken root with so much invested in perfecting the structure, and expertise in its documents and mechanism. It solves a lot of problems, yes. But will Tawarruq be the end of innovation for Islamic Banking?

I like to think there must life beyond Tawarruq. It just needed courage to acknowledge the big task required for such massive structural changes in replacing Tawarruq. Such replacement must not just be an equal substitute but also addresses the Shariah concerns. That is the ultimate test of any Islamic Banking contract; the reason for being.

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Is There a Secret Book I Don’t Know About?

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