Sheikh Mohammad Khater Initiative

For Contribution in the Development of Islamic Banking

Date: 08 March 2015

Version: 1

Auto Murabaha
Applied Islamic Finance

Basic Steps
Functionality
Requirements
Sharia Rulings

Yousuf Azim Siddiqi

Introduction:
With no doubt, Islamic banking has evolved considerably over the past 3 decades.
Although the over-all size of Islamic banking is much smaller than the conventional (i.e.
standard) banking which is 4 centuries older but the fact cannot be overlooked that application of
Islamic jurisprudence (over fourteen centuries old) in modern banking practices was itself one of
the biggest achievements the legal minds could have thought of.
Despite the solutioning provided by Islamic banks, under the focused guidance of Sharia
scholars sitting on different Sharia Supervisory Boards, it was disheartening to hear and
experience that existing or upcoming Islamic banks are unaware of some of the basic Sharia
techniques which can solve many issues faced on daily basis.
There is no doubt that Sharia Standards published by Accounting and Auditing
Organizations for Islamic Banks (Bahrain), or more commonly known as AAOIFI, were one of
the greatest joint-efforts to codify Islamic commercial law after the enactment of Al-Mejelle
(during the last century of Ottoman Empire). However a normal banking professional remains at
disadvantage to benefit from these standards due to its complex regulatory flavor. Moreover
modern banking pronouncements in Arabic references are nothing but hidden jewels for English
speaking banking professionals.
The efforts made by some contemporary Sharia scholars (especially Mufti Muhammad
Taqi Usmani and Dr. Abdulsattar Abu Guddah) and some training institutions to simplify and
demystify the Islamic banking concepts like Murabaha, Ijarah, Mudaraba Istisna, Musharaka etc.
are nothing but mesmerizing and outstanding. However the need remains to take these steps
further through introduction of concept of Applied Islamic Finance where the banking
professional is exposed to Islamic juristic reasoning and some helpful techniques can be shared
with them which can address some profitability issues or mitigate any minor or major Sharia
risks.
To start with, our first paper is on Auto-Murabaha which is undoubtedly, one of the
most common products in Islamic banking. God willingly, we will be releasing more than a
dozen papers. Also new versions will unearth more jewels and endeavor to raise the previous
standards. Kindly ensure that any Sharia rulings mentioned in these papers do not, necessarily,
reflect the official opinion of either AAOIFI or Sharia Boards of my present or past employers.

Sheikh Mohammad Khater (1913-2004): Born in Dakahlia Governorate (Egypt).

A famous and well-respected Egyptian scholar who on different judicial positions
in Egypt starting from 1943 till his appointment as Grand Mufti of Egypt on 31st
October 1970. Post his retirement he guided Faisal Islamic Bank on the Sharia
matters and was among the pioneers in this field. To applause the sincere efforts
made by Sheikh Mohammad Khater in serving the cause of Islamic banking, we
are pleased to name this initiative (of developing of Islamic banking) after him. We pray our
efforts further enhance the knowledge base of Islamic financial jurisprudence and guide the
practitioners, consumers and regulators to the right path.

Auto Murabaha
Subject of Financing/
Underlying Asset:
Relevant Parties

Purpose:

Movable transport tools like cars, bicycles, airplanes, ships,

scooters, boats, trains, motorbikes etc. 1 (collectively referred as
Car).
Car dealer i.e. the Dealer
Financier i.e. the Islamic Bank
Obligor i.e. the Customer
New Acquisition i.e. the Customer is willing to buy the Car for
his or her use.

Basic Steps:

Some Islamic banks treat financing of small boats as a part of Goods Financing purely due to credit reasons.

Auto Murabaha
Stage 1: Price Quotation & Promise to Purchase:

Functionality with Requirements:

Stage 1: Price Quotation & Promise to Purchase:
The Customer will approach the Dealer to obtain a price quotation with details of the Car.
Upon submission of relevant credit documents, the Customer signs Promise to Purchase with the
Islamic bank wherein he undertakes to buy the Car on Murabaha basis if the same was made
available by the Islamic bank.
Complete Description in the Price Quotation:
Although the price quotation does not have any significant Sharia standing on its own,
but sometimes the main documentation (i.e. LPO or Murabaha contracts) rely (through
reference) on the Price Quotation. In such cases, incomplete description could lead to invalidate
the Murabaha transaction.

Addressing Quotation to the Islamic Bank:

As it is understood that Islamic Bank is going to purchase the Car from the Dealer then in
ideal situation, the Price Quotation should be addressed to the Islamic Bank. However in many
cases the Customer fails to obtain Price Quotation in favor of the Islamic Bank.
Adjustment of Down payment:
In some cases, the Dealer asks for a price for issuing the Price Quotation which will be
non-refundable and cannot be adjusted in the final payment of the Car.
Interestingly, any non-refundable amount taken by the Dealer cannot be accommodated
as Urboon (earnest money) since the Dealer might not own the Car at the time of claiming this
money.
Moreover this amount cannot be taken as Hamish Jiddiah (security deposit) because such
amount should adjust only the actual loss incurred by the Dealer in case the sale (by the
Customer or the Islamic Bank) did not go through.
Existence of the Subject of Financing:
Transfer of constructive or physical possession of the Car to the Customer is necessary at
the time of signing Murabaha Contracts (i.e. Step 3). In case, it was evident that the subject of
financing (especially in the case of heavy machinery or ships) would be constructed and then
delivered at later stage then Auto Murabaha cannot be applied. Alternatively Auto-Istisna (to be
released later on) can be applied in such cases.
Type of the Customer:
As far as retail banking is concerned so Sharia restrictions in selecting the type of
customers are fairly limited because Islamic banks can extend Auto Murabaha to any sort of
individual irrespective of his religion or his source of income provided it is in line with legal and
regulatory requirements.

Auto Murabaha
Stage 1: Price Quotation & Promise to Purchase:

On the other hand, Islamic banks are not permitted to extend Auto Murabaha to corporate
entities which are involved, as part of core business, in non-Sharia compliant activities. This
means Islamic bank cannot extend Auto-Murabaha to a banking or financial institution. Similarly
it impacts business with music channels, liquor manufacturer or night-clubs. Although financing
can be extended to their individual employees but not directly to these entities since it will result
in supporting the non-Sharia compliant business.
Eliminating Chances of Collusion:
Auto Murabaha is a Sharia compliant structure of financing which should not be
misused in order to achieve goals like borrowing funds from the Islamic Bank against interest.
To abstain the Customer from committing any act of collusion, Islamic Bank should ensure that
it is not buying the Car from Mr. A and then selling it to Mrs. B where Mr. A is, for example,
spouse of Mrs. B. In most of the cases such financing request implies that Mrs. B has no real
need or intention to buy the Car. Rather Mr. A will get USD 25,000 and Mrs. B will be liable to
pay back USD 30,000. However the car will remain, effectively, in the use and ownership of the
Mr. A who will secretly settle Mrs. Bs financial obligations towards the Islamic Bank!
Similarly chances of collusion do exist where the original seller and the buyer are direct
relatives. However chances of collusion could be ruled out if it was ascertained that both the
parties have independent financial status and do not want to collude the Islamic bank for getting
USD 25,000 on spot which will be paid back USD 30,000 on deferred payment.
Fulfilling the Promise:
Usually the Customer signs Promise to Purchase which implies that the Customer will
purchase the Car once made available by the Islamic bank. This does not imply that a sale
transaction has already taken place. The Customer cannot oblige the Islamic bank to sell the car
to him even if he is ready to abide by his own promise. Promise to purchase in Auto-Murabaha is
a unilateral promise which is binding on the Customer and should not be confused with
bilaterally binding promise which is a forward sale. Some Islamic banks try to tone down the
language of Promise to Purchase by stating that the Islamic bank is under no obligation to enter
into Murabaha in case Customers financial credentials do not meet with banks credit
parameters. This implies that the Islamic bank is, eventually, under obligation to enter into
Murabaha in case the Customer qualifies with banks credit parameters. Unfortunately this
approach is not acceptable as per Sharia since it is nothing but bilaterally binding promise which
is classified as forward sale.

Auto Murabaha
Stage 2: Issuing LPO

Stage 2: Issuing LPO:

Islamic Bank will issue Local Purchase Order (LPO) in favor of the Supplier. Upon
successful signing or executing of the LPO, the ownership of the Subject of Financing will be
transferred from the Dealer to the Islamic Bank. This stage is extremely crucial since the seller
cannot enter into sale of specific assets prior to acquiring ownership of the same.
Delay in signing LPO:
To better serve the Customer, Islamic bank has to ensure that LPO is signed in a very
smooth and efficient way. Islamic banks can seek acceptance from the Dealer through facsimile
or electronic messaging.

Transfer of Risk:
As given above, signing of LPO by the Islamic Bank and the Dealer implies that any risk
associated with the Car will be transferred from the Dealer to the Islamic Bank. And the Islamic
bank remains facing this risk till the time Murabaha is not signed with the Customer. Sometimes
people argue insurance coverage not only mitigates the asset risk rather it, almost, nullifies the
risk. It is true that systematic risk management through insurance reduces Islamic Banks risk
exposure but the fact remains that there are many hidden factors which are not covered by all the
insurance policies. For example recent events of piracy near Somalia changed the way insurance
companies were ready to cover the losses or damage of sea goods sailing through the Indian
Ocean. Also many insurance companies restricted themselves from covering any losses due to
terrorist attacks. Moreover losses or damages due to government failure (like electricity
breakdown) are usually not covered under a standard insurance policy.

No Delay in Transfer of Risk:

As per Sharia, it is not permitted for the seller to delay transfer of risk of specified
assets. For example, the seller cannot tell the buyer that his car (Nissan Altima with plate number
41060) is sold to him but the risk will be transferred to the buyer after one month. Risk transfer
(of specified asset) from the seller to the buyer should be on immediate basis. Similar way,
Islamic bank cannot purchase the Car from the Dealer but put a condition that risk of the
specified (i.e. selected) car will be transferred to the Islamic Bank once the Customer is available
in the branch to sign Murabaha agreement.
Bailment Arrangement:
Upon executing LPO, Islamic Bank has the right to claim delivery of the Car from the
Dealer. However Islamic Bank neither has resources nor interest to maintain an inventory of
thousands of cars in its own warehouses. In the initial days of Islamic banking, some banks used
to claim from the Dealer the physical delivery of the purchased car and get them parked under
their own warehouses. However this turns out to be a quite risky exercise which can cost the
Islamic Bank even loss up to the entire value of the Car. To avoid any operational and legal
complications, Islamic Bank prefers to leave the car with the Dealer wherein the Islamic Bank

Auto Murabaha
Stage 2: Issuing LPO

acts as bailor and the Dealer as bailee under bailment arrangement. Usually there are no charges
for custody services.

Completeness of the Details:

Some Islamic Banks rely on the initial Price Quotation (issued at Stage 1) while drafting
the LPO. In case the original price quotation was incomplete or contain incorrect information
then LPO would be invalid. This could have severe legal consequences since the Islamic Bank
will end up selling what it has not purchased from the Dealer.

Conditional Sale:
Sometimes Islamic banks do not obtain Promise to Purchase from the Customer. Rather
Islamic banks prefer to execute conditional sale with the Supplier. This implies that subject of
financing is sold on a condition that within, for example, 10 days the Islamic bank has the right
to cancel the deal. Although the original evidence from the Prophetic tradition is specified with 3
days of conditional sale, but Hanafi jurists concluded that conditional period has no restriction in
terms of number of days provided it is agreed between the seller (i.e. the Dealer) and the buyer
(i.e. the Islamic Bank).

Auto Murabaha
Stage 3: Murabaha Sale to the Customer

Stage 3: Murabaha Sale to the Customer

Upon signing of LPO, Islamic Bank sells the Car against a disclosed profit amount:
Murabaha Price = Cost of Acquisition + Profit of Murabaha
The Cost of Murabaha does not include the cost of production (incurred by the Dealer) or
the cost of funding (incurred by the Islamic Bank). Rather it refers to the cost incurred by the
seller (in this case, the Islamic Bank) in acquiring the Car.
Risk of Underlying Asset:
Upon signing of Murabaha contract, all risks associated with the Car will be transferred
from the Islamic Bank to the Customer. From risk management perspective, this is a crucial
moment which should be taken care off on quick and immediate basis. Many Islamic banks delay
in signing Murabaha with the Customer which can cause potential financial loss to the Islamic
Bank.
Determination of Profit Amount:
Islamic Bank has to disclose to the Customer the cost of acquiring the Car from the
Dealer. Similarly Islamic Bank has to disclose the total amount of profit it is going to make from
this transaction of sale. This amount of profit has to be specific and fixed. Although Islamic
Bank can agree, at the time of accepting Promise to Purchase, that rate of Murabaha profit will
be, for example, LIBOR+3%. But on the date of signing Murabaha, LIBOR rate should be
checked and an exact percentage of profit should be
mentioned.
Claiming Fees from the Buyer:
While processing a loan transaction, conventional
banks charge an upfront amount as a processing fee which
is independent from the interest and principal to be paid by
the Customer through EMI settlement.
Since Murabaha is a sale transaction so it is not
permitted, as per Sharia, for the seller (i.e. the Islamic
Bank) to charge anything other the profit. And importance
of this fee cannot be understated since Islamic banks wish
to maintain over-all long term profitability of the financing
(through profit component of EMIs) separate from the
commissions which are paid upfront to the relationship
managers or sale staff. Hence it is suggested to club any
kind of such fees as a part of Murabaha profits. However
profits are divided into Deferred Profit (which is recovered
over the life of the facility) and Additional Profit (which is
paid up front by the Customer). This could be further
clarified by the illustration given on the right:

Auto Murabaha
Stage 4: Murabaha Price Settlement

Stage 4: Murabaha Price Settlement

Settlement of Murabaha Price:
The entire Price of Murabaha can be settled in any of the three ways:
-

100 on deferred payment basis

Partially on spot and the reminder on deferred payment;
100% on spot.

Since Auto Murabaha is used as a financing structure so it usually involves deferred

settlement of a portion of Murabaha price. Nevertheless spot Auto Murabaha can be used by
Islamic banks in such cases where the cash-buyer (i.e. the Customer) is not able to approach the
Dealer directly. In such cases, Islamic Bank can purchase the Car from the Dealer and then sell
the Car on spot payment with an agreed upon Murabaha Price to the Customer.
It is worth mentioning that Deferred Sale is different from Murabaha. Hence Auto Murabaha
being a complex financial arrangement combines Murabaha Sale along with settlement on
Deferred Sale terms.

Late payment charges:

The Murabaha Price due post signing the Murabaha contract is fixed and cannot be
increased, even with mutual consent of the Islamic Bank and the Customer. This is due to the
fact that deferred Murabaha Price turns into a debt and any increase over the debt is considered
as interest.
The Islamic Bank is allowed to claim any actual and direct cost incurred in recovering the
Murabaha Price. Sometimes Islamic banks, mistakenly, consider salaries of collection
department staff as a part of direct cost. However the cost, which the Customer (as debtor of
Islamic Bank) is supposed to pay, is confined to the cost which the Islamic Bank incurred
directly due to the act of default by the particular customer. It is immaterial whether the amount
is large or very tiny. But it has to be direct and actual. Hence the Islamic Bank is allowed to
recover legal charges incurred by the Islamic Bank in filling any legal suit.
It is evident that not all the banking customers, who delay (and not default), are intending
to go for the harsher route of legal complications. Sometimes customers delay in settling on time
due to habitual laziness in making payments on time. Also some customers want to take undue
advantage of the bank. Such cases happened where Customers knew that Islamic Bank are
helpless not to charge any amount beyond the Murabaha Price as stated in the Murabaha
contracts. Hence Sharia Boards suggested including a clause in the Murabaha agreements where
the Customer agrees to pay a specified amount for charitable causes. And such undertaking to do
charity can be made obligatory according to opinion by Maliki jurists like Imam Abdullah Bin
Nafae and Mohammad Bin Ibrahim Bin Dinar. Further the clause was rectified to include that
this undertaking will be affective on Islamic Banks demand. Hence during financial hardship or
economic crises, Islamic Bank has the right to waive claiming such amounts from those
customers who defaulted due to genuine reasons.

Auto Murabaha
Stage 4: Murabaha Price Settlement

Fixed returns:
Returns (i.e. Murabaha Profits) cannot be increased once Murabaha contract is executed.
Any effort to reduce the same will be a simple case of profit waiver where no legal or Sharia
complications occur and it could be happen unilaterally from Islamic Banks side. However
when the Islamic Bank realize that Murabaha Profits are not justified against the life of the
facility or due to over-all economic crises then the Islamic Bank has no Sharia right to amend
the Murabaha Profits. Usually Murabaha Profits on Auto Murabaha are settled within maximum
8 years. Hence Islamic Banks take into consideration any chances of sudden fall in the over-all
financial performance of the bank or the economy.
There is one individual opinion by Imam Hassan Ibn Ziyad (of Hanafi School of
jurisprudence) who allowed the buyer and the seller to amend the price of Murabaha even when
the subject of contract has already perished. Few years back, Bank Al Bilad hosted a discussion
panel for Murabaha with variable returns. The most stimulating article was the one by Sheikh
Yusuf Al Shubily who defended the same opinion but with wider and modern juristic reasoning.
The same will be dealt in detail in our upcoming paper: Property Murabaha.

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