Introduction

Islamic Banking and financing has for a long time been considered a product for the Islamic states. As such Malaysia is considered one of the most renowned and established in its laws and practice of Islamic banking and in particular Islamic property financing. However, after the financial crisis it is assessed that Islamic banks seemed to have been less affected prompting conventional banks and its customers to consider Islamic financing as an alternative to conventional financing.

In Kenya, some the conventional banks have introduced or are in the course of setting up Islamic finance products in a bid to attract that segment of the population that would prefer financial services consistent with Islamic laws.

Main features of Islamic banking

In a nutshell, Islamic banking is a system that follows Islamic Laws (Shariah) principles and Islamic-based economics which are derived from a number of sources, including the primary source of the Qur'an. These principles include:

  • Interest - The payment and receipt of interest (riba) under Islamic law is prohibited and any obligation to pay interest is considered void. Islamic principles require that any return on funds provided by the bank be earned by way of profit derived from a commercial risk taken by the bank.

  • ​Speculation- Contracts which involve speculation (maisir) are not permissible (haram) and are considered void. Islamic law does not prohibit general commercial speculation (which is evident in most commercial transactions), but prohibits speculation which is akin to gambling, particularly gaining something by chance rather than by productive effort.

  • Unjust enrichment/unfair exploitation- Contracts where one party gains unjustly at the expense of another are considered void. Late payment penalities or default payment charges that are customary under a conventional facility agreement are likely to be considered to be unjust enrichment under Sharia law.
  • Uncertainty- Contracts which contain uncertainty (gharrar), particularly when there is uncertainty about the fundamental terms of the contract, such as the subject matter, price and time for delivery, are considered void. For instance, conventional insurance arrangements would be prohibited as it is uncertain whether the insured event will occur or not.

The Islamic principles therefore dictate that money lending (interest-based) as well as investing in businesses that are considered haram (unlawful) are prohibited. The concept of Islamic finance lies in providing financing to consumers based on pre-determined profits rather than dealing with interest. Generally therefore, to consumers, whether Muslim or otherwise, banks providing Islamic finance products have much greater social and moral responsibilities to ensure that the said products are fair to the customer.

Islamic Banking Products

In order for banks and their clients to comply with Sharia, over the past decades, specific products have been developed that avoid the concept of interest and imply a certain degree of risk-sharing. Among the most common Islamic banking products are but not limited to Murabaha, Mudaraba, Musharaka, Ijara, Amanah, Tawarruq (reverse murabaha), Bai salam, Istisna’a, Sukuk and Takafu.

 How does Islamic property financing work?

Our focus in this brief shall only be on the Murabaha Facility since it is the popular method of Islamic property financing. The bank will buy the property in question from the supplier (either directly or through an agent) and will then sell the property to the customer at an agreed marked-up price. The profit generated by the bank on the marked-up sale price is a profit derived from a sale transaction and is not therefore prohibited as riba. The marked-up sale price may be payable immediately or deferred for payment at a later date.

Technically, it works in similar fashion to a conventional home loan where the customer pays 10% down payment (customer’s equity) and the bank will finance the balance of 90% (bank’s equity). Key differences from conventional home loan include:

  • Sale and purchase- Various changes in terminology follow from the fact that murabaha constitutes a sale and purchase and not a loan. For example, the borrower is referred to as "the customer " rather than "the borrower" and the return is referred to as the "profit amount" rather than "interest". More substantive differences also follow: for example, the bank may wish to disclaim any implied warranty as to title or condition of the asset or its fitness for the customer's purpose.

  • Bank's return- Like interest, the profit amount is typically calculated by reference to a benchmark, such as LIBOR or KBR, plus a margin. However, the requirement for certainty means that the calculation provisions may require some adjustment.

  • Prepayment- Under a conventional loan facility the borrower can usually prepay part of the sum borrowed, to save interest. This is not straightforward under a murabaha because the profit amount is pre-determined. However, the banks will typically have discretion to refund part of the deferred purchase price in the event of prepayment.

  • Commitment fees- The prohibition on riba means that commitment fees (that is, fees for making money available) are not permitted. As a consequence, banks typically insist on very short availability periods under a murabaha (for example, a month) after which term the offer lapses.

  • Late payments and default- The charging of penalties or fees for late payments or other defaults under a murabaha is controversial. Most Islamic institutions accept them as a way of encouraging the customer to meet its obligations, providing that they are donated to charity. In some cases the bank may be entitled to deduct any actual costs it suffers as a result of the default before making the donation.

  • Indemnities- As the bank will own the asset under a murabaha for a period of time (albeit a brief one), the bank will be exposed to risk on the asset. This risk is usually mitigated by ensuring that the bank owns the asset for the shortest possible period of time and can be insured against using takaful. The customer will usually indemnify the bank against any costs or claims arising in relation to the asset other than those that arise from the bank's ownership of the asset.

Reasons you should take up the Murabaha Facility

a.       Anyone can apply for the Islamic financing because it is not restricted to Muslims only. Nevertheless, your application for Islamic financing will be harder if your occupation is considered by the lending institution as not “halal” i.e. trading in pork related products or running a casino.

b.      The facility is pegged on the principle of certainty; the bank’s return (profit) as well as the repayments thereof are determined at the onset of the transaction and will not change during the life of the facility. This in my view is preferable to the variable interest rate applicable to the conventional home loan.

c.       In the event of default the murabaha facility provides a pre-determined default amount payable to the bank who would in turn donate to a charity. This is unlike the conventional home loan where on default a default interest rate is applicable on the total outstanding amount and is calculated from the date the amount was due to the date of actual payment.

d.       Islamic finance offers an alternative avenue for financing where conventional finance is denied. Unlike the conventional facilities, Islamic finance is open to any innovations that are in congruence with its fundamentals. It is not a closed system. Accordingly, customers may approach a bank for an Islamic finance facility where the same was denied by the conventional facility. The bank's Sharia board or Sharia committee (comprising of eminent Islamic Scholars) would scrutinize the customer's proposed transaction to ensure compliance with Islamic precepts and on their approval the customer would access the financing.