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Tuesday, 1 January 2013

Cost-plus Finance Allowed, Interest Prohibited in Islam

The argument that earning profit is like earning interest by lending money (where profit is fixed like the rate of interest on loan) is indeed an age-old debate which has also been pointed out 1,434 years ago in the holy Qur’an.

“Those who devour usury will not stand except as one whom the Evil one by his touch hath driven to madness. That is because they say: “Trade is like usury,” but Allah Hath permitted trade and forbidden usury. Those who after receiving direction from their Lord, desist, shall be pardoned for the past; their case is for Allah (To Judge); but those who repeat (the offence) are companions of the Fire: They will abide therein (for ever).” (Al Qur’ān 2:275)

Money lenders have been trying to claim that earning through trade is like earning interest on loan, but ‘by permitting trade and prohibiting interest’ Islam clearly declined the disbeliever’s view that ‘trade is like usury’. Murabaha is basically a trade activity (quite different from lending money on interest) because under Murabaha the financier purchases and sells goods on credit after adding a margin of profit over the cost of purchase; whereas under interest based lending financier does not take part in any economic activity, but just lends money and gets back along with interest over principal amount after a set time.

There are around 10 Qur’ānic verses and 23 Hadith on prohibition of Interest (Riba) of different nature. According to Shariah, Riba technically refers to the “premium” that must be paid by the borrower along with the principal amount as a condition for the loan or for an extension in its maturity. So, Riba has the same meaning as interest in conventional banking in accordance with the consensus among all Islamic schools of thoughts. There are two major types of Riba in Shari’ah.  The first (Riba al Nasiah) describes prohibition of lending money on interest whereas the second (Riba al Fadl) prohibits all unfair commercial transactions that leads to exploitation. Since Murabaha does not fall under any category of Riba described in Hadith, it cannot be rated alike lending on interest. Furthermore, there are operational differences between lending money on interest and cost plus finance.

Lending Money on Interest

Cost Plus Finance (Murabaha)

Financier lends money to earn interest over principal amount without bearing risks associated with the borrower’s economic activity. Financier practically doing trade by purchasing and selling goods on credit at a price set after adding profit margin over cost of purchase. Money is considered a kind of asset and accumulation of monetary asset is made out of monetary asset without changing its form from money to goods. Money is treated as means to measure value of goods and medium of exchange. Value of goods may enhance only after selling the bought goods to customers. Financier has nothing to contribute towards Government revenue. Financier pays sales tax on trade volume to the Government. Financier does not interfere in business activity of the borrower and does nothing to help the borrower get competitive prices for sought goods or commodities. Financier bargains with the supplier to avail discount in price of goods so as to offer competitive prices of the goods to the customers. Financier has nothing to do with quality of the goods sought by its customer. Financier bears associated risks on quality of the goods sold to its customer. Through lending loan on interest the Financier increases customer’s demand force which may inflate the economy with limited resources for suppliers. Purchase and sale by financier boosts production process and flow of liquidity from the customers to the bank and reduces inflation by slicing purchasing power. Rate of interest on loan amount is related to time factor. There is no interest and the price value of sold goods is not related to time factor. Borrower needs to repay the instalment of interest and principal on due dates. Customer is supposed to repay part of total price value of goods on due dates. Financier does not allow the borrower to reschedule the instalment on due dates even in case of any genuine financial crisis. Penalty may be charged for that. In case of genuine financial crisis, the financier does allow the buyer to reschedule the due instalment dates without any penalty. Financier need not to get any registered sale tax number. Financier needs to obtain registered sales tax number. Financier has nothing to do in collection and submission of sales tax. Financier used to pay and charge sales tax; and submit to sales tax department. Financier need not to have any purchase officer with specialisation in trade. Financier does need to have purchase officer with specialisation in trade.      

Besides above operational differences, it is important to analyse and evaluate the impacts of interest based lending and cost plus finance on the economy. Interestingly, Cost Plus Finance has the potential to increase economic growth by pushing consumption, production and Government revenue with putting customers demand forces under control with flow of liquidity from customer to bank segment. 

We can evaluate the differential impact of interest based lending and cost plus finance by a hypothetical study. Suppose there are two types of banks in our economy. One is lending on interest and the other is offering cost plus finance. Both can offer same rate of returns to their depositors (e.g. 8% annual interest or dividend to the depositors) and charges 15% annual interest on loans or adds 15% profit margin (over cost of purchase) in case of cost plus finance. Since bank extending cost plus finance with intention to get competitive quote for the goods, bargains with the supplier and pass on the discounts to the buyer, it helps the customer pay less for availing required goods; and also provides more revenue for the Government.

The practice of cost plus finance by banks can help us to -

Increase in consumption (as the consumer takes goods from bank on credit) to increase potential for economic growth rate. Decrease in prices as purchase of goods by bank allows the supplier to produce more; and increase in productivity with constant demand would lead to fall in prices. Control in demand side inflation because the customer does not get liquidity rather would need to repay value of bought goods back to the bank; and the customer needs to transfer access of income over expenditure to repay cash to the bank.

We hope that the RBI would introduce cost plus finance under Para banking as an optional product with intention to keep inflation under control with increase in economic growth rate. Hopefully, money lenders would not argue again and again that trade is like lending on interest.

(Radiance Views Weekly / 31 Dec 2012)

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Many advantages of Islamic banking

As Oman's first Islamic bank is set to commence operation in few weeks, I would like to know whether Sharia-compliant banks will be able to offer loans at a lower cost? What are the advantages of an Islamic banking customer viz-a-viz its conventional counter-parts?
Salem al Habsi, Seeb (by e-mail)

A: When pricing their products, Islamic banks will have to consider various factors, viz. rate-ceilings imposed by the Central Bank; cost of funding; operating costs; volume of transactions and competitive conditions in the banking industry. Rate-ceilings imposed by the Central Bank apply to both conventional and Islamic Banks, hence this factor cannot influence the pricing of Islamic bank's loan favourably or unfavorably. Cost of funding for an Islamic bank is likely to be higher than a conventional bank which may have been in existence for a longer period, has a network of branches and a large customer base. 

A new Islamic bank will need to develop its brand name, open branches and attract customers with a fresh start and may have to offer higher profit rates to attract new customers. This will result in higher cost of funding for Islamic banks. Operating costs are also expected to be higher for Islamic banks being new to the market. They're hiring staff at a premium to the market. Also establishing new business is generally costlier than existing business. Additionally, Islamic banks are required to hire Sharia' Scholars to work on their Sharia' Board, Sharia' Auditors and Sharia' Compliance staff, which the conventional banks are not required to hire for delivery of their products and services. 

These higher operating costs for Islamic banks will squeeze their profit margins even further. Volume of transactions for Islamic banks are expected to be low in the initial years, resulting in higher unit cost of offering products to the customers. 

Since all of these factors work in favor of the existing conventional banks, they give them an advantage over Islamic banks in pricing their products more competitively. When Islamic banks will enter the market, the conventional banks would like to defend their territories, markets and customers and given the advantages in cost they enjoy over Islamic banks, they can price their products quite aggressively to ensure they retain the market share. 

On the other hand, Islamic banks can follow the "market penetration strategy" and price their products lower to attract new customers and win market share. 

In the initial years therefore, they may incur operating losses to gain market share. If Islamic banks follow this strategy, it will benefit the customers since their products will be priced lower than their conventional counterpart.

The biggest advantage the customer of an Islamic bank enjoys is faith-based, giving him the satisfaction that he is dealing with Sharia-compliant products and services. Economically or financially, the pricing of products offered by both Islamic and conventional banks is likely to be at par, in order for them to stay competitive in the market.  

Can you give me some insights into the qualification required to become an employee of an Islamic bank? Is there any specialised course for Islamic banking professionals? If so, give me contacts of those institutions offering such programmes within the country of outside. 
 Ibrahim Ali Khan, Sohar (by e-mail)

A: Staff in Islamic banks are required to be proficient both in banking and Islamic Modes of Financing with some knowledge of Fiqh-ul-Muamalat. There are several institutions around the world which offer professional qualifications in Islamic Finance, some of which are listed below:     

DIFC –based Universities like CAS School, INCEIF Malaysia,  CIMA Islamic Finance Certification programme UK, various universities in the UK offering diplomas or graduate programmes in Islamic Finance, Institute of Islamic Banking & Insurance UK, Dar-ul-Ulum, Karachi and University of Karachi.

Due to shortage of people properly qualified in Islamic Finance, most Islamic banks hire professionals from conventional banks and train them in Islamic banking. Various training organisations have therefore, sprung up to address training needs of staff in Islamic banks.

(Times Of Oman / 31 Dec 2012)

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Indonesia: Minimum Down Payment Set for Islamic Financing

In a move to help curb consumer financing growth, the Finance Ministry has set stricter down payment requirements on Islamic financing for automotive purchases. 

The new regulation, which will apply to all non-bank Islamic financing institutions, requires a down payment of 20 percent for two-wheeled vehicle purchases and a 25 percent down payment for four-wheeled vehicles. The purchase of commercial four-wheeled vehicles — such as trucks or buses — requires a 20 percent down payment. 

Previously, down payment requirements had not been regulated for Islamic financing companies, with firms typically requiring either no down payment or a down payment of no more than 10 percent. 

The Finance Ministry has since June imposed similar down payment requirements for conventional financing of automotive purchases. 

However the failure to regulate Islamic financing left a loophole that allowed customers to take advantage of lower, unregulated rates. 

“This regulation is aimed to prevent such regulatory arbitrage between conventional and Islamic financing companies,” said Yudi Pramadi, the Finance Ministry spokesman, in a release on Friday. 

“It will create a level playing field for all financing companies,” Yudi said. 

The new regulation will go into effect on Tuesday, the same day the new Financial Service Supervisory Agency (OJK) will take over the job of supervising non-bank financial institutions. 

This responsibility had previously been handled by the Finance Ministry’s Financial Institution Supervisory Agency (Bapepam-LK). 

Bank Indonesia, the central bank, issued down payment regulations for Islamic banks in November, requiring a 25 percent down payment for two-wheeled vehicle purchases and a 30 percent down payment for four-wheeled vehicles, bringing the Islamic banking requirements in line with automotive down payment requirements implemented by their commercial counterparts since June. 

The central bank’s new regulation, however, will not go into effect until April 1. The central bank will not hand their supervisory authority over banks to the OJK until January 2014. 

(Jakarta Globe / 31 Dec 2012)

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