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4.1 RISKS AND THEIR MITIGATION TECHIQUES UNDER ISLAMIC BANKING

4.1.1 MURABAHA (COST PLUS MARK-UP)

This is not an interest-bearing loan; it is an acceptable form of credit sale under the sharia, it is similar to a rent to own arrangement structure. The Bank and the prospective buyer then agree upon a sale price plus mark-up (an agreed upon profit for the Bank usually a percentage of the cost price of the asset). It is important to note that to prevent riba, the Bank cannot be compensated in addition to an agreed upon terms of the contract. For this reason, if the buyer defaults on the payment, the Bank cannot charge penalties.

Under the Murabaha product or facility, there are 5 major issues associated with risks.

1. Where the Bank buys goods and delivery is not ensured or specified:

i. This is a market risk faced by the Bank, goods are bought by the Bank on behalf of the customer, to avoid instances where the Bank buys goods and the customer refuses to buy goods and the customer refuses to pay to buy or pay for the goods, the mitigation technique carried out by the Bank is a promise to purchase and a Hamish jaddiya which is known as down payment (a down payment is initial payment paid by a customer to a Bank as part payment ) is paid by the customer to avoid this risk.

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ii. For conventional Banks, goods are not purchased by the Bank, cash is given to the customer inform of loan to purchase the goods themselves, whatever the client decides to do with the money is the problem of the client and not the Bank, and there is no promise between the Bank and the client.

2. Possession and ownership:

i. In jaiz Bank, a possession and ownership is a contract is associated with sharia non-compliance risks, this risks is as a result of the Bank not adhering to the principles of sharia. A sale and purchase schedule is made by the Bank determining how payment is made as a way of mitigating the risk, when final instalment will be made and when possession and ownership of goods will pass.

This is a 3rd party agency contract where an agent is employed, and he serves as a middle man between the Bank and the customer.

ii. Conventional Banks also give loans in facilities, they engage in business where goods some are specified, they mostly lend out cash or purchase facilities like cars and houses for their customers depending on the market price of that facility and change in market price is not ignored. Defaults also attracts serious penalty like seizure of the facility in case of houses, and return of current market price of the commodity plus interest.

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Commercial Banks do not face this risk because it relates to sharia compliance and conventional Banks are not bound by principles of the sharia. And conventional Banks do not have agency contracts in terms of loans.

Also this is a market risk for commercial Banks which has been mitigated with a technique which only applies to conventional Banks.

3. Diversion of funds/ cash through facility fraudulent buying:

i. This is another sharia non-compliance risk, the mitigation process carried out by the Bank is purchase of such specified goods personally, the Bank is the evidenced buyer with receipt of payment carrying the Banks name, the purpose of this is to avoid breach of contract by the customer, the Bank ensures that customer does not default and siphon the money for a different transaction.

ii. Conventional Banks however do not concern themselves with the way a client spends the loan given to the Bank, the conventional Bank is only concerned about its profit, so long as the loan is paid back with its due interest, how the loan was spent doesn’t matter.

4. No profit at overdue periods as it can never be restructured with charging profit continually: this means that the Bank shall not charge continual profits over a certain period of time.

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i. The risk associated with this in Islamic Banking is the balance sheet risk; these risks are mitigated through careful structure and return of sales revenue and imposing penalty which ultimately goes to charity.

These proceeds go to charity because the Bank does not accept interest and so such penalties shall not reflect in the balance sheet of the Bank.

ii. Reverse is the case for conventional Banks, because charging interest on loans is one of its profits making process.

This balance sheet risk is the balances of the company’s year end balances, the Islamic Banks will not have profit from interest in their year-end balance, as this goes against the number one principle of Islamic Banking i.e. prohibition of interest. Conventional Banks accept interests as it is one of the major sources of revenue for them, and profit from interest also reflect in their year-end balances.

5. Sale price cannot be increased at any point, even if market prime rate increases: the market prime rate is a term applied in many countries to reference an interest rate used by Banks. This prime rate is set by the federal open market committee which meets 8 times per year to set targets.

i. This is a rate of return risk under Islamic Banking, the mitigation process is that mark-up is defined considering historic market price; the mark-up doesn’t

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increase considering future market price but the market price at the time of the contract.

ii. In conventional Banking future prices are taken into consideration because, the Bank is profit oriented, losses are not considered.

Conventional Banks work with market prices, prices of commodities fluctuates due to increase in the market, interest also increases. In Islamic Banks future prices are not considered because initial sale price cannot be increased.