Murabaha

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Murabaha
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Murabaha (also murabahah) - is a sale contract in Islamic commercial law in which the seller tells the buyer exactly what the goods cost him and how much profit he adds on top. Muhammad Taqi Usmani describes it as a sale "pure and simple", whose only distinguishing feature is that "the seller in murabahah expressly tells the purchaser how much cost he has incurred and how much profit he is going to charge in addition to the cost"[1]. If the seller quotes a lump-sum price with no reference to cost, the deal is a different sale (musawamah), even when it is just as profitable.

On its own, then, murabaha is nothing more exotic than cost-plus pricing with full disclosure. It became the workhorse of Islamic banking once two elements were bolted on: the customer's prior promise to buy, and deferred payment. A bank buys an asset the client needs and resells it at cost plus an agreed margin, payable over months or years. Whether the resemblance stops at the surface is the question that has followed the contract for half a century.

Background

Islamic law forbids riba, which most contemporary scholars equate with any predetermined increase on a loan of money. Trade, by contrast, is permitted, and profit from trade is legitimate. That contrast is the whole logic of murabaha. A bank may not lend 100 and ask for 110 back. It may, however, buy goods for 100 and sell them for 110 on credit, because what it earns is a trading profit on something it owned and whose risk it carried, not a charge for the use of money.

Cost-plus sales appear in classical Islamic jurisprudence; their banking use is modern. The construction known as murabaha to the purchase orderer (sometimes "banking murabaha") took shape in the 1970s and spread together with the first commercial Islamic banks in the Gulf, Malaysia and Pakistan. Within a couple of decades it had become the dominant financing technique of most Islamic banks, far ahead of the profit-and-loss sharing contracts (musharakah, mudarabah) that theorists of Islamic economics had expected to lead.

Usmani, one of the leading jurists of the field, was blunt about this. Murabaha, he wrote, "is not a mode of financing in its origin" and should be treated "as a transitory step towards the ideal Islamic system of financing based on musharakah or mudarabah"[1]. The industry largely did not take the hint.

Conditions under Sharia

The rules matter more here than in almost any other contract, because a small deviation turns a sale into a disguised interest-bearing loan. Usmani calls murabaha "a border-line transaction"[1]. The main conditions, as summarised in standard Islamic finance literature, are:

  • Existence and lawfulness of the goods. The subject of sale must be a real, identifiable commodity that is permissible to trade. Usmani lists overheads, paying bills, settling the client's debts and buying currencies as purposes for which murabaha cannot be used[1].
  • Ownership and possession by the seller. The bank must own the asset and hold it physically or constructively before reselling it. Constructive possession means the risk has passed to the bank even if the goods sit in a warehouse elsewhere. "There should be a time in which the risk of the commodity is borne by the financier"[1], however short. Selling what one does not yet own is void.
  • Disclosed cost and agreed markup. Both the cost and the profit must be known to the buyer at the time of contract. The markup can be expressed as a lump sum or as a percentage of cost.
  • Fixed price. Once agreed, the price cannot be raised because the buyer pays late, and the buyer cannot demand a reduction for paying early. A bank may voluntarily give a rebate, provided it is not a contractual term[1].
  • No rollover. A murabaha debt cannot be extended for a new term at a new markup, as a conventional facility might be. That would be charging for time on an existing debt, which is riba.
  • Late payment. To discourage default, the buyer may undertake to pay a sum to charity if he pays late. That money must not become income of the bank[1].

Murabaha to the purchase orderer

In everyday bank practice the sequence looks roughly like this:

  1. The client identifies goods (a machine, a vehicle, raw materials) and a supplier, and asks the bank to finance them.
  2. The client signs a promise to buy the goods from the bank once the bank has acquired them, at cost plus an agreed profit. A security deposit (hamish jiddiyyah) may be taken.
  3. The bank buys the goods from the supplier, either directly or through an agent, often the client himself.
  4. The bank takes possession, physical or constructive, and bears the risk of loss.
  5. The bank offers the goods to the client; the client accepts; the murabaha sale is concluded and the client now owes the deferred price.

The awkward step is the promise: made fully binding on both sides, it would amount to selling goods the bank did not yet own. The International Islamic Fiqh Academy of the OIC addressed this in 1988 (Resolutions 40-41). It held that murabaha to the purchase orderer is permissible when the seller has the goods in its possession and carries the risk of loss; that a unilateral promise is morally binding and becomes legally enforceable when the promisee has incurred expenses in reliance on it; and that a mutual promise binding both parties is not permitted unless one of them keeps an option, since that "is like an ordinary sale contract"[2].

Agency is the other weak point. If the client buys as the bank's agent, his two roles must be kept apart; Usmani warns that appointing the client as agent "renders the arrangement dubious" and should be avoided where direct purchase is possible[1].

AAOIFI Shari'ah Standard No. 8

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), based in Bahrain, publishes Shari'ah standards that many regulators and banks adopt as reference rules[3]. Shari'ah Standard No. 8, "Murabahah", covers the transaction from the client's initial request and promise through the bank's acquisition of the asset, its possession and the sale itself, to guarantees for collecting the resulting debt. It deals with the promise, the security deposit, the bank's use of agents and the treatment of late payment. Its general direction follows the conditions listed above: the bank must acquire title and bear risk before selling, the cost and profit must be disclosed, and the deferred price cannot be increased afterwards.

Commodity murabaha and tawarruq

Classic murabaha finances an asset the client actually wants. Commodity murabaha is used when the client wants cash. The bank buys a commodity (frequently a metal traded through a broker) and sells it to the client on deferred terms at cost plus profit. The client immediately sells the commodity to a third party for spot cash. The result: the client holds cash today and owes a larger amount later. This chain, buying on credit in order to sell for cash, is called tawarruq. Banks use the same structure in reverse to take deposits and to place liquidity with one another on the interbank market.

In April 2009 the International Islamic Fiqh Academy (Resolution 179, Sharjah) confirmed that classical tawarruq, where a person independently buys and resells, is permitted. It ruled organised and reverse tawarruq prohibited "because they involve explicit, implicit or customary collusion between financer and finance seeker", amounting to "a trick for obtaining a present cash for a larger amount in future debt which is ribā"[4]. Some national Sharia boards still allow it under conditions, mainly as a liquidity tool, so practice differs between jurisdictions.

How murabaha differs from a conventional loan

Aspect Murabaha Conventional loan
Legal nature Sale of an asset on deferred payment Loan of money
What the financier earns Trading profit (markup) on goods it owned Interest for the use of money
Asset risk Borne by the bank between purchase and resale Never borne by the lender
Price after signing Fixed; no increase for late payment Interest keeps accruing on arrears
Early repayment No contractual rebate (voluntary only) Usually lower total interest
Rollover Not allowed Common
Purpose Must finance a specific lawful asset Can be general-purpose cash

Cash flows can be identical. Legal substance isn't: the bank is a seller with a seller's liabilities, though that only matters if the steps are carried out for real.

Accounting treatment

Under AAOIFI accounting standards the topic is covered by FAS 28 "Murabaha and Other Deferred Payment Sales", approved in 2017 and effective from 2019. It replaced the older FAS 2 "Murabaha and Murabaha to the Purchase Orderer" and FAS 20 "Deferred Payment Sales"[5]. In broad terms the seller recognises the asset as inventory while it owns it, then on sale records a murabaha receivable and recognises the profit not all at once but over the credit period. Unearned profit is shown as deferred profit and netted against the receivable. FAS 28 doesn't cover commodity murabaha and tawarruq; AAOIFI announced separate work on those.

Banks reporting under IFRS have no Islamic-specific standard. A murabaha receivable is a financial instrument under IFRS 9[6]. Because the contractual cash flows are fixed amounts of principal plus a time-based return, such receivables are normally held at amortised cost, and income is recognised with the effective interest method, which practitioners rename the "effective profit rate". In the books, then, murabaha looks exactly like a loan.

Example of murabaha financing

Hypothetical example; figures chosen for illustration and verified numerically.

A small manufacturer needs a packaging machine. The supplier's price is 100,000. The manufacturer asks an Islamic bank for murabaha financing over 24 months.

  • The bank buys the machine for 100,000 and takes delivery.
  • It sells the machine to the manufacturer for cost plus 10%, i.e. 110,000, payable in 24 equal monthly instalments.
  • Monthly instalment: 110,000 / 24 = 4,583.33.

A markup of 10% over two years looks like 5% a year. It isn't, because the debt is paid down monthly. The comparable rate is the internal rate equating cost with the instalments:

\[ 100\,000 = \sum_{k=1}^{24} \frac{4\,583.33}{(1+r)^k} \]

Solving gives a monthly rate of about 0.777%, or a nominal annual rate of about 9.32% (an effective annual rate of about 9.73%). In other words, the 10% markup behaves like a flat rate of 5% a year, and its true cost is close to double the headline.

How does it compare with a bank loan? A conventional 24-month annuity loan of 100,000 at 9% nominal would require payments of 4,568.47 a month (total interest 9,643.38); at 9.5% the payment is 4,591.45 (interest 10,194.78). The murabaha sits between the two. Same money, same timing.

Profit recognition follows the same arithmetic. Spread with the effective rate, as in a loan amortization schedule, the bank books 776.96 of profit in month 1 and only 35.34 in month 24. Of the 10,000 total, about 7,320.21 falls into year one and 2,679.79 into year two. After twelve payments the gross receivable is 55,000, of which 2,679.79 is still deferred profit, leaving a net receivable of 52,320.21.

Now the difference. If the last instalment arrives three months late, a lender would charge interest on it; the murabaha price stays at 110,000, and any late-payment sum goes to charity. And if the client wants to settle in month 12, the contract does not entitle him to a discount on the remaining 55,000, although many banks grant one voluntarily (in the example, a rebate of exactly 2,679.79, the profit not yet earned, would leave the bank with precisely its effective return).

Use in trade and asset finance

Murabaha fits wherever a client buys something identifiable:

  • Trade finance: raw materials and inventory, often with a confirmed letter of credit for imports.
  • Asset finance: vehicles, machinery, equipment, sometimes real estate.
  • Retail banking: car and household-goods financing competing with the consumer loan.
  • Corporate banking: working capital and syndications via commodity murabaha.
  • Liquidity management: interbank placements and deposits.
  • Capital markets: murabaha receivables cannot be traded at anything but face value, because selling a debt at a discount is riba. That's why murabaha-based sukuk are usually mixed with tangible assets.

Criticism

The most common objection is simple: if it looks like a loan, prices like a loan and is accounted for like a loan, what exactly has changed? Mahmoud El-Gamal called this replication of conventional products through permitted contracts "Sharia arbitrage", arguing that it keeps the form of Islamic law while paying lawyers and brokers to reproduce the substance of interest, often at a higher cost to the client[7]. Feisal Khan reached a similar conclusion from the side of banking practice: Islamic banks rely overwhelmingly on fixed-return debt-like contracts rather than on profit-and-loss sharing[8]. Chong and Liu, studying Malaysia, found that Islamic deposit rates moved with conventional rates, which suggested to them that Islamic banking there was not very different from conventional banking[9].

Benchmarking is the sharpest form of the argument. For decades banks set murabaha markups with reference to LIBOR, typically LIBOR plus a spread. Usmani admitted that this "certainly makes the transaction resemble an interest-based financing, at least in appearance", but held that it does not invalidate a genuine sale, much as a soft-drinks trader who copies the profit rate of his brother's liquor business does not make his own trade unlawful[1]. He urged the industry to build its own benchmark. When LIBOR was wound down (the last synthetic US dollar settings were published on 30 September 2024[10]), contracts that had referenced LIBOR moved to the new risk-free rates such as SOFR or SONIA, which are interest rates too. The dependency survived the reform.

Two more objections recur. In commodity murabaha the metal is often bought and sold within minutes, so the risk the bank "bears" is close to nil. And a fixed-margin contract shares no business risk with the entrepreneur, which was the original promise of Islamic finance.

Advantages of murabaha

  • Gives Muslim individuals and firms financing they can accept in conscience, without paying interest.
  • Transparent: cost, margin and total price are known on day one and cannot rise, with no compounding on arrears.
  • Ties finance to a real asset and a real purchase, so it can't fund pure speculation.
  • Easy for banks to price, document and supervise; credit analysis is the same as for familiar instalment products and can use existing credit risk management and collateral management practice.

Limitations of murabaha

  • Not suitable for general cash needs, refinancing or paying off existing debt, unless tawarruq is used, which many scholars reject.
  • Asset risk and legal ownership, even if brief, create operational and sometimes tax costs (double transfer taxes on property in some countries).
  • Late payers cannot be charged compensation that the bank keeps, so default is cheaper for the debtor than in a conventional credit sale.
  • The fixed price rules out floating-rate pricing within one contract.
  • Receivables cannot be sold at a discount, which limits securitisation.
  • A sloppy file (sale before purchase, backdated invoice) can make the contract void in Sharia terms.

Related approaches

  • Musawamah: a negotiated sale where cost is not disclosed.
  • Bai' bithaman ajil: the Malaysian name for long-term deferred-payment sales of the murabaha type.
  • Ijarah: leasing, in which the bank stays owner during the lease.
  • Musharakah and mudarabah: profit-and-loss sharing partnerships.
  • Conventional analogues: hire purchase and instalment credit priced on a profit margin.

References

Footnotes

  1. ↑ Usmani M.T., An Introduction to Islamic Finance, Idaratul Ma'arif, 1998, chapter "Murabahah" (incl. "The Use of Interest-Rate as Benchmark" and "Conclusions")
  2. ↑ International Islamic Fiqh Academy, Resolution Nos. 40-41 (2/5 and 3/5), Kuwait, 10-15 December 1988
  3. ↑ AAOIFI, Shari'ah Standards, aaoifi.com, Shari'ah Standard No. 8 "Murabahah"
  4. ↑ International Islamic Fiqh Academy, Resolution No. 179 (5/19), Sharjah, 26-30 April 2009
  5. ↑ AAOIFI, Accounting Standards, list of issued FAS and note on superseded standards; AAOIFI announcement of FAS 28 approval, September 2017
  6. ↑ IFRS Foundation, IFRS 9 Financial Instruments
  7. ↑ El-Gamal M.A., Islamic Finance: Law, Economics, and Practice, Cambridge University Press, 2006
  8. ↑ Khan F., How 'Islamic' is Islamic Banking?, Journal of Economic Behavior & Organization, 2010, pp. 805-820
  9. ↑ Chong B.S., Liu M.H., Islamic banking: Interest-free or interest-based?, Pacific-Basin Finance Journal, 2009, pp. 125-144
  10. ↑ Financial Conduct Authority, About LIBOR transition, fca.org.uk
Murabaha — recommended articles
Sukuk — Cost-plus pricing — Credit sale — Flat interest rate — Effective annual interest rate — Consumer loan — Interbank market
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