How Murabahah and Salam help Islamic banks to make money?

In-Depth Analysis

I had planned to commence our discussion on the third sale contract in Islamic finance called Istisna from today. However, a reader wants to know the uses of the already-discussed Murabahah and Salam sale contracts by Islamic banks and financial institutions in their day-to-day operations and how they make money by not applying interest but utilizing these two contracts and the other Shariah contracts which we shall be discussing in this space going forward. So, first we shall find out the uses of the Murabahah contract in contemporary Islamic banks and financial institutions. Readers would recall that we have already had a wide-ranging discussion on the undesirable use of the Murabahah contract in the so-called Tawarruq transactions. Therefore, I shall concentrate on more genuine applications of the Murabahah contract in the following passages. Since Murabahah is a sales contract in nature, the Islamic banks and financial institutions apply it as an effective trading tool. The widespread use of the Murabahah contract takes place in the trade finance transactions where customers may need raw material for their factory or finished goods for sale in their outlet but are unable to purchase them against cash. In this situation, the Islamic bank shall first purchase the goods from the supplier either by paying cash if it is a local market transaction, or by establishing the letter of credit (or LC as it is commonly known) in case the goods are to be imported from abroad. Once the Islamic bank acquires the title and possession to the goods, it sells them to the customer on a deferred payment basis by entering into the Murabahah contract and at a price which includes the Islamic bank's cost (purchase price of goods, direct labor and transportation expenses, customs duty if applicable) and any other expenses directly related to the consignment plus an agreed amount the Islamic bank would like to earn from the customer on the transaction as its profit. Another use of the Murabahah contract which is fairly common in the retail banking sector of Islamic finance in compatible jurisdictions is the car Murabahah contract. The conventional bank lends money to the customer in the form of a car loan; the customer in turn buys the car by utilizing the loan and the bank charges interest on the loan amount. The customer pledges the car as security to the bank during the repayment period. Returning to the subject, an Islamic bank fulfills a customer's automobile acquisition need by not lending him the money as an interest-bearing loan but by first purchasing the car from the dealer, thereby becoming a bona fide owner of the car with a valid title and possession by paying the purchase price to the dealer from its own pocket. It is only after becoming the owner that the Islamic bank sells the car to the customer at a price which includes its cost and the profit margin agreed with the customer. By Islamic finance compatible jurisdictions I mean the countries which do not levy the value added tax (VAT) at the goods and services tax (GST) on a Murabahah transaction. Remember, Murabahah by default is a sales transaction and hence a candidate for such taxation. Imagine, if every Murabahah transaction carried out by Islamic banks was taxed, who would want to go to Islamic banks for such costly financing? This is the reason that in order to be compatible to Islamic financing transactions, several jurisdictions have declared the waiver of the VAT/GST on Islamic sales contracts, including Murabahah, so as to provide a level-playing field to Islamic banks vis-a-vis the conventional banks. On a daily basis, millions of Murabahah transactions take place all over the globe for the purposes of trade and car financing (or for any other purpose) and millions complete their tenure successfully. In the process, Islamic banks and financial institutions continue to make money for their shareholders and depositors in the shape of a Murabahah profit. One important aspect which must always be kept in mind is that no matter in which part of the world the Murabahah contract is used by a seller and a buyer, its ground rules including permissibility of goods, sequence of steps and disclosure requirements relating to cost and profit applied by the seller will never change.