Prof Saiful Azhar Rosly
Ever since the establishment of Islamic banks in the 1970s, the difficulty in executing actual buy and sell transactions as the Quran commanded in the verse “Allah has permitted al-bay but prohibits riba” (Al-Baqarah 275) has spurred the industry into using questionable products that resemble interest-bearing loans as evident now in tawaruq munazzam and earlier in bay al-enah.
Much of this unfortunate development in Islamic banking has to do with its deposit-taking function. Doing so requires the bank to follow stringent Basel Accord capital requirement against any risky positions it took in the business such as equity, leasing and trading positions. The trading business, namely buy and sell is the focus of this discourse. In addition to high capital charges, it is also besieged by inventory costs that can escalate bank overheads. These two problems can justify the lack of interest in the buy and sell model also known as murabaha by purchase order (MPO) or true sale murabaha financing (TSMF) as it requires the bank to hold risk of ownership of the purchased asset before making the credit sale to the customer. This is Stage 1 in TSMF. In Stage 2, the bank sells the asset to the customer based on murabaha financing contract at a certain profit rate. Impact of financing charges can be disastrous to consumers. It will make Islamic banks less competitive as the capital charges and inventory costs will be transferred to the consumers. The way out is to address each of the problems, namely capital charge and inventory costs.
Capital Charges: The best way to avoid the holding of capital charges is to embrace the new Islamic Financial Services Act enacted in Malaysia in 2014 which other Muslim countries can learn from and emulate. The Act requires Islamic banks to categorize their funding sources into 1) deposit funds and 2) investment funds. Exposures using deposit funds are subject to regulatory capital charges as opposed to investment funds as risks are absorbed by Investment Account (IA) holders. Investment funds are equity funds akin to mutual funds or unit trust funds whereby capital and income protection are not accorded to investors (BNM Investment Accounts, 2014). The Act will put an end to the use of investment accounts as deposit funds which may attract Shariah non-compliance risks when these investment accounts are perceived as deposit funds that award depositors a legal claim on the principal and earnings.
This certainly does not reflect actual use of the profit-loss sharing principle. Investment account funds should also open new opportunities for Islamic banks to venture into trading arrangements that can spur the halal supply chain with positive impact on real sector development which supports value-based intermediation (VBI) system promoted by Bank Negara Malaysia (BNM, 2017). Under the Investment Account system, Islamic banks that are keen to adopt the true-sale murabaha financing will not be required to hold additional capital to cushion the exposures against unexpected losses as business risk will be borne by investment account holders. The matching of risk-appetite of investors and the true-sale murabaha financing (TSMF) and other equity exposures can be made possible through the new intermediation function of Islamic banks as wakeel.
Inventory Costs: In dealing with inventory costs, one workable model of TSMF is the adoption of the drop ship business. Drop shipping is a supply chain management method in which the retailer does not keep goods in stock but instead transfers the customer orders and shipment details to either the manufacturer, another retailer, or a wholesaler, who then ships the goods directly to the customer. In this way, the retailer who is the Islamic bank can keep down overhead and inventory costs to the minimum.
Based on Diagram 1 below, the customer pays a murabaha price of $220 on a 1 year installment payment at 10% annual profit rate which he pays cash for $200 at any on-line merchant. In this way, the bank can acquire $50 profit from Stage 1 and $20 from Stage 2. This is a viable option to Islamic banking since overheads and inventory cost can be minimized as well of avoiding credit and business capital charges as the dropship business is now funded by the Investment account fund. The bank may have to hold capital for operational risk however, since it is running the transaction based on the wakala contract where mismanagement and negligence of the wakeel can occur that can threaten funds’ performance. On a positive note, the drop ship business can also help Islamic banks enter into Halal Supply Chain business and specialize say, in the supply of certain unique goods much desired by Muslim consumers such as Hajj accessories, modest apparels, halal food ingredients and many more potential food commodities.
Further development of the Drop Ship murabaha financing (DSMF) model requires solving the matching problem of assets and liabilities in the mobilization of IA funds and the application of drop ship murabaha financing. Marketing research for DSMF is highly crucial to ensure its viability within an intermediation oriented banking framework. While it poses less capital stress on the bank, it is critical to set proper policies in managing default and debt recovery as many of the items sold are consumption goods that hold little value after use.
Special underwriting assessment of customers need to be prudently prepared with distinct pricing formulations to capture the unique credit risk arising from installment sale in Stage 2. The mobilization of IA funds may require the investigation of factors that motivate potential investments which can include risk appetite, expected returns and governance of funds. Equally important is the fund management fees of the bank who acting as a wakeel to the IA fund holders will charge for the professional service rendered. Fees are expected to reflect banks’ multiple wakala roles in fund mobilization, financing and identification of wholesalers, suppliers and distributers taking part in the drop ship business as well as any other online modalities that are deemed fit for application.