Wednesday, August 10, 2005

Time Value of Money and Murabahah/BBA profits


In conventional loans, the contractual interest rate is the sum of

· interest rate of deposits
· overhead/transaction cost
· inflation premium
· default risk premium

In the case of al-bai-bithamain ajil (BBA) facility, the Shariah can only recognize the overhead and profit margin elements. Both usually only command about 2% and 1% respectively. For smaller banks, the lack of scale economies may see higher overhead cost than larger size banks. Overall, the mark-up element should amount to about 3%.

However, banks must also impute the cost of deposit factor. Since, no promise to pay hibah and mudarabah profits is given, this naturally implies that Islamic banks need not worry about determining the contractual rate of return to depositors. But how can this be if they can declare upfront how much profit they want from each of the murabahah and BBA sale made?

For example, the bank sells an asset for $200,00 on BBA credit term. Accordingly, the BBA or murabahah contract gave customers the right to know the cost price. It is then not difficult to see that given the terms of maturity of say, 20 years, the profit rate per annum should amount to 10% with a nominal mark-up of $100,000.

But now, the question is how should the bank explain the $100,000 profit they make from the BBA sale as legitimate (halal)? Recall the ‘iwad or equivalent contervalue is the condition for a lawful sale. Any increase, according to the majority of jurists in the Shafi’, Hanafi, Maliki, and Hanbali schools must contain ‘iwad.

To benefit from these increases, Islamic banks must be able to provide something of equal value in return. Hence, when someone pays $200,000 on BBA financing at $100,000 cost price, what is the nature of ‘iwad he receives from the bank in exchange for the $100,000 profit?

Certainly, if the transaction is made on the spot or cash basis, problem on the nature of lawful and unlawful gains should not have risen since no time element is involved here. Which means that the bank purchases the goods at direct or wholesale price, it assumes the risk of ownership. While doing so, the bank sells the goods to the customer for $200,000 on cash term.

The legitimacy of the profit made is irrelevant since the bank has indeed delivered the ‘iwad equivalence. This shall be in the form of:

· its ability to make the goods available in the market
· absorbing market risks and risk of ownership (daman milkiyah).

In the former, we are looking at the valued-addition( kasb) factor, while latter describes the ghorm or risk-taking aspects of sale.

However in the BBA sale, it seems that the $100,000 profit is created on the basis of time factor alone. To some extent, we failed to understand how a profit rate of 10% can be determined ex ente when concurrently Islamic banks cannot declare ex ente the rates of return on deposits.

Even if we accept the assumption that the 10% profit per annum charged on every BBA sales arises from 1) cost of deposits, say 3% 2) overhead 2% and 3) inflation premium margin 1%, what then explain the additional 4% stipulated in the contract.

In conventional loans, the 4% can easily be explained by credit or default premium.. This risk premium or spread will vary according to the type and maturity of loans coupled with the credit ratings of borrowers. Normally, bank will charge higher spread when risk of defaults is higher. But these can only hold for loans (qard) and not sale (al-bay’)?

So, what can indeed explain these extra profits that Islamic banks took from BBA sales. If the answer is about risk of default, then certainly it is not about ‘iwad. The risk of default is about the game of waiting for payments and problem of collections. It does not concern market risk. It may be easy to say that profit from BBA is halal since BBA is a not a loan but a sale (al-bay’).

But one has been misled to think that BBA is a spot sale. The mark-up from spot sale is lawful since it contains ‘iwad but can we imply the same for BBA credit sale when no tendency of ‘iwad can be detected there ? This is true since the profit created from BBA is a consequence of waiting i.e. time value. In this sense, the Shariah advisors seemed to have approved gains arising from time value via BBA financing.

13 Comments:

Blogger Edib Smolo said...

Assalamu alaykum!

I would like to give a comment on your latest article.

I believe that the BBA contract is very much lawful from an Islamic perspective. However, I do acknowledge that there are some problems with it.
Firstly, there is a problem of determining the price for the BBA product; say apartment. We are faced with the future and cannot be sure about the price. It can be only estimated based on the market analysis.
Second problem arises from the first one. The price should be determined on the spot and cannot be changed afterwards, so there is no flexibility as in conventional banks. Sometimes, a customer is able to pay the price prior to the maturity period, but he is still obliged to pay full amount. In conventional loan, a customer would pay less if he manage to pay loan earlier, but in Islamic economics the price is fixed and therefore he has no choice, unless the bank has policy to reduce the price according to the time it is paid. However, for this I am not sure.

That’s all from me. I hope I did some job. J

EDIB SMOLO
G0417671

8:53 PM  
Blogger Abduh said...

Muhammad Abduh:

Assalamualaikum warahmatullah wabarakatuh.

I think BBA is one of the best alternative for the muslim to have goods that he/she cannot buy because in BBA when he/she want to buy a goods, he/she knows the initial cost of buying the goods and I think it is very fair and clear contract so we know how much profit that bank get when we buy the goods from the bank. the plusses from BBA also, we can pay the goods in credit and the mark up that bank add from the selling based on the risk of bank cannot guarantee that the buyer have to buy the goods, the profit that bank get from BBA also have to share with the depositor, also in fixing the mark up in BBA, because Islamic have to compete with other Islamic banks even other conventional banks so sometime Islamic bank have to fix the mark up similar or near to interest rate. So, overall we cannot blame Islamic banks that fix high mark up in BBA because it is also because the ummah that not realize the benefit from Islamic banking product and ummah still hoping the high rate of interest or profit if they put their money in Islamic banks. maybe it is one of the problem why Islamic banks still cannot run their Islamic banking products based on its real law or based on Qur'an and Sunnah.

12:51 AM  
Blogger Prof. Saiful Azhar Rosly, Ph.D said...

You need to argue why BBA contract is lawful. You seem to say the opposite when an inquiry is made about setting an unknown future BBA price. How could the jurist confirm that the BBA contractual price (i.e. sttaed today) reflected the real price at maturity? good remark.

2:14 AM  
Blogger weni hawariyuni said...

In this case, I have opinion that the product of al-bai-bithaman ajil (BBA) is indirectly contains the interest (riba) in the credit term. This is because from the example, it tells us that the bank get profit $100.000 from the nominal mark up 10 percent. It means that in BBA , we can not see it is including the ‘iwad in credit term case. However, I agree with BBA product in spot sales or by cash. Unfortunately, in this case the Shariah advisorseemed to have approved the financing via BBA sales without give the details reason or the transparency reason of approving the BBA product. I just want to give my comment for Islamic banking that they have to give the reason about the permission of BBA product and I hope the Shariah advisor also involving in giving the explanation to the public. I think to my self for this term, the profit which the bank get from the BBA is irrelevant due to the lack of ‘iwad. We could say that BBA product almost the same with conventional product. The different is that BBA product get the permissible from the Shariah advisor but for the application is just the same with the conventional. Based on my point of view that Islamic banking must be serious in handling this thing so that the people especially Moslem people have no doubt in buying BBA product.

9:22 PM  
Blogger nira said...

Time value of money provides an idea that money available at the present time is worth more than the same amount in the future, due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. This is also referred to as "present discounted value".

For example, assuming a 5% interest rate, $100 invested today will be worth $105 in one year ($100 multiplied by 1.05). ; conversely, $100 received one year from now is only worth $95.24 today ($100 divided by 1.05), assuming a 5% interest rate. Islamic economic institutions, not just the Islamic bank but all those connected with Islamic banking, claim to operate on the basis of "zero interest."
However, the fundamental characteristic of charging interest (i.e. charging a premium, on the principal amount of a loan, for the time value of the loaned money) is not truly eliminated in Islamic banking, but rather the interest is merely hidden and relabeled.

For example, consider the practical reality of purchasing a vehicle from an Islamic bank under an allegedly "zero interest" loan. The procedure, generally, is that the client tells the Islamic bank which vehicle he or she would like to own. The Islamic bank then purchases that vehicle in its name, and sells it to the client at a marked-up price, under an agreement that the new marked-up price of the vehicle must be paid in a certain number of installments of a certain time period. Thus a $20,000 car might cost $35,000 if purchased from an Islamic bank at "zero interest," 5 year loan. Of course, the bank charges the extra $15,000 on top of the $20,000 cost of the car because money has a time value (that is to say, a payment of $20,000 5 years from now is worth less than a payment of $20,000 today). This is also why a $20,000 car could cost $35,000 if the purchase were financed by an interest bearing loan issued by a non-Islamic financial institution.

Hence, by paying interest on loans to those who postpone current spending i.e. creditors, the interest system guarantees identical pleasures to that when one chooses to consume today. As mentioned in your article, this practice of people taking and receiving riba (at the present point of time) are indeed those who are in loss (khusran) in a sense that they work against the law in nature.

Usually, this time value of money is compensated to the lender by the lender charging the borrower interest on the principal amount of the loan. In the case of Islamic banking, the lost time value is compensated by charging a mark-up on the home or vehicle that the client might be seeking to purchase by way of a loan. The vehicle or mortgage usually remains in the name of the bank, until the principal loan including the mark-up has been paid (in a BBA financing situation).

Based on the current practice, the Shariah advisors seemed to have approved gains arising from time value via BBA financing. But the issue is as to whether the ‘overly charged’ mark-up profit vs riba through interest charges in conventional banking dissimilar? What will be the impact to the society / ummah or an economy? Don’t either ‘overly charged’ mark-up profit or riba load the borrower with debt obligation for inappropriate period of financing tenure? Does unfairness a trait of Islam? Does BBA reflects the rationale / spirit of Islamic Banking objectives? Wallahualam.

12:46 AM  
Blogger leeanne said...

Assalamualaikum..
It is sad to see that our current Islamic banking products especially BBA financing among others is still argued and doubted over its validity and thus has been similarized with the conventional practice. For the truth is, BBA is a valid sale contract if its application is in accordance to its true essence and pillars. No need for me to elaborate here about its mechanism since Dr.Saiful has explicitly explained it in the article. The main question here is that how could the Shariah Board approve the gains of $100,000 which is double that of the cost price of the property? If we look at the main objective of the application of BBA, it is to provide a financial product that is trusted by the customers especially by the Muslims to facilitate them in their consumption and production activities, among others. More so for those who do not have any financial means to better up their living. They need the financial assistance more than the bank needs the profit it gets from the product. Therefore, it is totally wrong for the Islamic banks to gain hugely by imposing higher price on the customers since this clearly violates the objective of Syariah, i.e. protecting the public interests.
Another point is that the way the price of the BBA is calculated gives rise to doubts and speculation, not only by the Muslims, but also the non-muslims leading to the conclusion that the products offered by the Islamic banking are no more than mere replications of the conventionals. Instead of interest, the increase is called profit rates or rents. When we look closely at the calculation of the product price, it is similar to the calculation of interest especially the part which has no ‘iwad factor. If it is justified that the increase is due to time value of money, how can that be since any increase to the price of a product in a credit sale contract because of the waiting factor is considered as riba? Of course we accept the increase over the cost price of a product in the case of spot sale since this is the profit margin for the seller due to his ability to deliver the equal countervalue (‘iwad) factor. Also, the same note is addressed to the increase in a payment of loan by a debtor to the creditor (Qard Hassan), provided that this increase is not stipulated by the creditor upfront and not a contractual one. This increase is allowed since Islam recognize the positive time value of money. It is interesting to read the analysis given in the articles of prof. El-Gamal in this case where the overly-charged prices are for the pockets of the lawyers and the Shariah jurists concerned. Not to be overly-judgmental but this remains an opinion because only the Shariah advisors know the reason of why they approve such pricing, and of course Allah is the Most-Knowing in the hearts of all things, hidden and clear. It is up to these advisors to give transparent answer and better make it quick because the customers out there are becoming more distrustful and doubtful over the role and real motives of Islamic banking each day.
This is merely my view from a limited understanding..Wallahu ‘Alam..

7:56 PM  
Blogger siti hajar samsu said...

Assalamualaikum…..

When we talk about any banking product with the purpose of financing, certainly it does involve time value of money. In conventional financing it is based on loan (qard) approach, while BBA is a sale (al-bay) contract approach. BBA is a particular type of sale and not a mode of financing because according to shariah, mudarabah and musyarakah is the best mode of financing in Islam. And now the issue is the profit created by Islamic banks from BBA sales which led seller charged higher price in a credit sale. And again, as it is believe that in order to make lawful profit it must contains iwad namely effort(kasb), risk taking (ghorm), and risk of ownership(daman milkiyah).

An explanation of the additional percent in the profit created (cost deposit + overhead + inflation premium+ %?) is still concerned about time given to the purchaser. At the surface, it seems to be logical it relates to the time value but in a way to see it differently we must really understand the shariah principles of prohibition of riba. Given that Islam has treated money and commodities differently, so that as long as seller and purchaser accepts to buy it even at the increases price, the profit created is presume to him permissible. No issues of haram arise here.

This view is supported by Muhammad Taqi Usmani which stated that it is recognized as riba if any excess amount charged against late payment where the subject matter is money on both sides. And clearly it is not applicable for commodity which has intrinsic utility. Moreover, the price is fixed for commodity over time. As far as it’s concerned, the additional percent in the contract may be quite acceptable we presume for trustee charge from the purchaser like in Unit trust business. Wallahualam….

11:12 PM  
Blogger Edib Smolo said...

Time Value of Money

Reading your book I came across the article about Time Value of money in which you have said that Islam recognizes time value of money. Partially I agree with this issue since we are talking about fiat money that is currently in circulation all over the world. It is very much in line with the Qur'anic verse from Surah Ar-Rahman (55:26) where Allah s.w.t. says "Everything on this earth will perish". This is true for this fiat money since it is directly related to the money supply, interest rate and the performance of the economy (mainly export and import). However, if we are talking about gold dinar than the time value, in my opinion, is not applicable. This is Allah's law of nature to make the gold precious metal which will be limited in the supply and its price is very much stable in the market.

Relating back to your article here, in my opinion, I may not agree with the statement that this credit sale is halal. The reasons are as follows: First, the bank does not directly buy the house or the property and therefore does not get the ownership (milkiyyah). Later on, the bank buys it from a customer who already invested some money. They do this purposely just to acquire the ownership and may it lawful. For me, it seems like playing with the laws of Allah s.w.t. and reminds me of the practices of the Jews who played with the rules when where catching the fishes. Second, if a customer defaulted on the payment he is forced by the law as we could see from some legal cases in Malaysia.

In order to solve this problem the following should be done. The bank should buy the house (a property) directly from the market and acquire the full ownership. Then it will take full risk of that property and it will not take anything as mortgage. In this case, if a customer defaults on the payment the bank is left with its property and the money paid by the customer should be paid back, except the amount which will be taken as the cost for using that property during that period and the administrative costs.

I hope I have given you some hints and points which will be interesting with regard to this issue.

EDIB SMOLO
G0417671

10:31 AM  
Blogger noor anum sarah bt johar ariffin said...

The widespread application of al-bay’ bithaman ajil (BBA) contract in the Islamic banking business today requires a serious reexamination. This is to see that the welfare of consumers is protected, which all Islamic contracts must provided for. It is made by way of making the existence of ‘iwad in profit arising from BBA or murabahah transactions evidently clear.The requirement of ‘iwad (equal countervalue or compensation) in the contract of sale (al-bay’) is one of the cornerstone of Islamic theory of profit depicted well by the legal maxim “al-ghorm bil ghonm”, (no reward without risk) and “al-kharaj bil daman” (in any benefit lies a liability).By defination al-bay’ bithaman ajil is a mark-up sale in which payments are delayed and made in equal instalments.A BBA legal documentation must reflect the true nature of sale (al-bay’) contract. The terms and conditions of al-bay’ such as the purchase and selling prices, the rights and duties of a seller and buyer, consideration, etc. must be included. Any uncertainties and ambiguities about the principles of a sale contract can tantamount to a contract to be rendered null and void. It is also observed that an Islamic bank that practices al-bai-bithaman ajil seems to only champion its rights without conferring duties of equivalent values to the buying party. Apparently, it has transfer relatively all the risks and liabilities to the customer thereby leaving it i.e the bank with practically no risk to bear while securing profits which is fully guaranteed by way of executing a sale contract i.e. al-bai-bithaman ajil.

10:26 PM  
Blogger Orawan said...

Since Islamic Finance is not a new subject in Islamic Economic but it is still inefficiency in implementing in our society, due to the overall economic system in the world always depends Western system in term of to make much as much benefits, this act possible leads to marginalize value judgments, i.e. interest system that bulk of people practiced and implemented in economic in now a day. Therefore, to face the challenging of those things we need to criticize which one can be applied in our system in line of do not contradict with our principle and concept of Islam. While we need creativity to produce an alternative to implement in framework of Islamic economic. Modern Islamic economic: the contract ( Aqad) approach is given a precisely and clearly concept for Islamic finance in implementing one.

Orawan Heemmahmad
G0515464

2:36 AM  
Blogger Md.khademul Islam said...

By defination al-bay’ bithaman ajil is a mark-up sale in which payments are delayed and made in equal instalments.A BBA legal documentation must reflect the true nature of sale (al-bay’) contract. The terms and conditions of al-bay’ such as the purchase and selling prices, the rights and duties of a seller and buyer, consideration, etc. must be included. Any uncertainties and ambiguities about the principles of a sale contract can tantamount to a contract to be rendered null and void.
BBA contract is very much lawful from an Islamic perspective. However, I do acknowledge that there are some problems with it.It is sad to see that our current Islamic banking products especially BBA financing among others is still argued and doubted over its validity and thus has been similarized with the conventional practice.
The main objective of the application of BBA, it is to provide a financial product that is trusted by the customers especially by the Muslims to facilitate them in their consumption and production activities, among others. More so for those who do not have any financial means to better up their living. They need the financial assistance more than the bank needs the profit it gets from the product. Therefore, it is totally wrong for the Islamic banks to gain hugely by imposing higher price on the customers since this clearly violates the objective of Syariah, i.e. protecting the public interests. Another thing is that the way the price of the BBA is calculated gives rise to doubts and speculation, not only by the Muslims, but also the non-muslims leading to the conclusion that the products offered by the Islamic banking are no more than mere replications of the conventionals. Instead of interest, the increase is called profit rates or rents.

Md.Khademul Islam, G0429917

10:34 PM  
Blogger syahidah pertama said...

in my opinion, musharakah muthanaqisah(MM) is much better than BBA because in MM we got the ownership earlier..

8:16 PM  
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