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 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

 

Real Cost of Tawarruq

Recently, the topic of Tawarruq & Commodity Murabahah has been popular in the industry as both BNM and Shariah scholar have been asking operational questions on the implementation of Tawarruq arrangement in the industry. It seems, even with the Policy Documents, there are still some divergence in terms of operations and understanding of the minimum Shariah requirements for Tawarruq. Each financial institutions have their own operational abilities and processes that differs from one another; to have a standardised platform may be a bigger challenge than imagined.

The rise of Tawarruq in recent years should really not be a surprise to many observers. We are seeing that most financial institutions in Malaysia now consider a Tawarruq structure a “must have”, because there really is no options as other Banks also deals in it. It has become norm, and while scholars might take a view that Tawarruq should be a “last resort” option, there have been so much effort invested into making Tawarruq an efficient machine. Just take a look at the Bursa Suq Al Sila and what it is capable today.

Question : Is it Cash or Committed Limit?

The latest consideration of Tawarruq is on the treatment of Tawarruq funds after the transaction. What is it exactly and how is it been managed within the Bank, with the Capital Adequacy Framework for Islamic Banks (CAFIB) implemented a few years ago (latest update this year 2017). In particular, when a customer is approved a certain limit (let’s say $1,000,000) and a single Tawarruq is done for $1,000,000 for the line (instead of multiple small Tawarruq for each usage of the amount within the $1,000,000 limit), where does the money goes, and what is it exactly in the eyes of Sharia?

To clarify, upon the completion of Tawarruq, real money of $1,000,000 is generated. Cash. It is not a “line” in the conventional terms, but it is money (actual cash) now belonging to the customer. He can draw out the money anytime.

But the practice is that the money is kept in the Bank’s books unless requested by the Customer, and by keeping this the Bank will give a “rebate” on the money kept in the Bank, similar treatment as if a “principal payment” is made (although it is re-drawable). In the meantime, the Bank utilises the money (taken as principal payment made) for its own banking business activities.

The question that I believe we will have to eventually address are on the following:

  1. The Tawarruq is done on a single transaction for the full amount, therefore it is a full release of capital (i.e. fully funded). As such, it should have a “capital charge” consideration if it is not fully utilised by the customer. Bank has released fully the funds to customer (therefore Bank should be entitled to earn a full profit on the amount). The formula for profit would be $1,000,000 x Profit Rate – Cost of Capital. Note the Cost of Capital is on the full amount.
  2. Then, the subsequent mechanism instead is as follows: since the customer did not fully utilise the funds, the customer is given a “rebate”. For example the customer only uses $50,000 of the $1,000,000. The formula for rebate is that ($1,000,000 less $50,000 = $950,000) x Profit Rate x period unutilised. Banks earn full Profit Rate on $50,000 and gives rebate based on $950,000.
  3. Of course, Banks will utilise the $950,000 meanwhile but at what I imagine are for short-term instruments because the $950,000 is customer’s money (i.e. committed amount) and can be requested at anytime. Bank needs the funds to be as liquid as possible. So the Bank do not earn a lot from this “short term investment”.
  4. Also, there is concurrent discussion as to when the amount is kept and used by the Bank, what is the underlying contract used for this “unutilised, principal payment which is drawable on demand” amount? Is it kept by the Bank as Qard (loan), Wadiah (safekeeping), Amanah (trust) or can it be taken as Tawarruq deposit (monetised obligation) or Mudharaba (investments)? Different Banks have differing views on this, but I suspect BNM is trying to standardise this understanding and practice.
  5. But more importantly, while the Bank is giving customers “rebate” on the amount they do not utilise (but committed by the Bank), is there also “rebate” on Cost of Capital then? It seems unfair when it doesn’t. Tawarruq proceeds are deemed fully drawdown (based on full amount) and incurs full Capital Charge but is earning returns based on “only” the utilised amount. The rebate formula is very specific, and it does not contain the amount for “rebate” Capital Charge.

In the conventional Banking world, this is not so much of an issue. Their approach is simple: if the amount is “committed” to the customer, 2 things will happen:

  1. Once the amount is drawdown i.e. utilised by the customer (lets say $50,000 utilised of the $1,000,000), then full price is charged on the $50,000
  2. On the amount unutilised i.e. $950,000 the Bank will charge a “Commitment Fee” of 1.0% per annum (or any negotiated rate) on the unutilised (but committed) portion. While 1.0% per annum do not usually cover the full Capital Charge on the $950,000 it somewhat compensates the charge as the Bank (because $950,000 is still a “limit” and not Cash payout) can still use the unutilised amount in its day to day banking activities i.e. investment in short term financial instruments.

Scholars generally do not agree with the concept of Commitment Fees, and there is specific BNM guidelines prohibiting the charge of Commitment Fees in these specific scenarios.

The Capital Charge factor

I still think there is a disconnect somewhere that while we aim to achieve the same end result by the practice of Ibra’ i.e. “Rebate”, but with Capital Cost coming into play, it may eventually seem that the cost of running an Islamic Banking business can be higher than a conventional Bank. It really depends on how we interpret the guidelines and the treatment on Tawarruq especially the single Tawarruq structure where the full amount is transacted i.e. whether it is a full Capital Charge or otherwise.

I know what BNM usually advise i.e. it is a full Capital Charge. But this concurrently means, without Commitment Fees on the unutilised Customer portion, it may result in extra costs for the Bank. Now I am not suggesting we introduce Commitment Fees for Islamic Banking; this idea of Commitment Fees is a conventional banking concept for recovering opportunity costs, which may not sit well under Shariah consideration.

But in the world we operate today (where each $$$ is risk weighted to a cost), this translates to “Actual Costs” incurred by the Bank, based on the interpretation for the “single full amount Tawarruq transaction”. And Shariah may want to consider this as it is a real “Actual Costs” and not opportunity costs. By letting the money sit still, the Bank incur real, actual costs which is not recoverable as per guidelines. It may have started as “recovering opportunity costs” but if you really think about it, this is above opportunity costs. Maybe in the conventional space, they may even revise Commitment Fees to recover BOTH Opportunity Costs as well as Capital Charge.

So, my question is this: should both the industry and Shariah scholars re-look at the basis of Commitment Fees (in the context of how Tawarruq works), or re-think about the “Rebate” mechanism and perhaps have an adjusted formula to factor in a “Rebate on the Capital Charge”?

Can Shariah consider this mechanism to recover a real cost incurred by an Islamic Bank?

In the meantime, Happy Ramadhan to all, and may you have blessed month ahead.