Article

by Michael Peiris

The following core concepts are the basics of an Islamic trade module that is being widely discussed and reported to have been put into practice by several countries. In view of the apparent successes achieved by various banks in different parts of the world, especially the countries where Shari'ah law is in force, there is a demand in other countries to provide banking facilities that are in line with Shari'ah banking.

Taking into consideration the large trade volumes routed through banks by clients practising the Islamic religion, a number of banks from non-Muslim countries including Sri Lanka have provided a window for Shari'ah-compliant banking. The number of banks offering this, as well as the number of customers relying on Shari'ah banking, is expected to increase in the years to come. In this context, it would be useful to discuss Shari'ah banking in order to understand future banking needs, especially with regard to trade finance.

Some of the relevant terms are as follows:

1. Murabah - sale of goods to another party for a price that includes the cost and a mutually agreed profit;

2. Musharakah - partnership with profit & loss sharing. All parties in this agreement provide capital and share profit in a mutually agreed ratio and losses in the ratio of their capital contribution;

3. Wakalah - agency arrangement: One party appoints another party to perform certain tasks for the benefit of, and at the risk of, the principal;

4. Zaman - a payment or performance guarantee issued in support of a third party;

5. Istisna - sale of goods with deferred delivery: payment made either upfront or in installments, for delivery of goods at a future date according to specifications and time frames agreed between the parties concerned.

Import finance

Article 2 of UCP 600 says that an issuing bank is permitted to establish letters of credit on its own behalf. This provision allows banks to import goods consigned to them and to have the absolute ownership of the goods. For many years, there has been a regulation in Sri Lanka that goods could be consigned to the order of a local bank for both export and import transactions. This regulation, although no longer a hard-and-fast rule, has now become an accepted practice in Sri Lanka. Almost all of Sri Lankan banks continue to call for bills of lading drawn to their order with an underlying interest to retain title to the goods in a trade transaction. The provisions contained in UCP 600 and the prevailing practice in the market have created an ideal situation for Murabah financing in Sri Lanka.

Murabah financing

The concept behind Murabah financing allows one party to sell goods to another party with an agreed profit. It goes without saying that one must first own the goods to make a sale.

In a scenario in which goods are consigned to the order of a bank, the ownership of the consignment automatically remains with the bank. In another words, the bank retains the title to the goods with an option to transfer them in consideration of a sale price, thereby transferring the ownership of the goods to a prospective buyer.

With regard to letter of credit transactions, the importer comes to an agreement (Wakalah) with the bank to purchase goods from the bank that has imported under its name as per the requirement of the buyer. This agreement is more or less similar to that of the letter of credit application used by banks for opening letters of credit. The Wakalah (agreement) will permit the importer to act as the agent of the bank to source the merchandise and negotiate terms as desired by him. This method will also allow the buyer to remain competitive in the market in terms of price, quality and timely delivery of goods.

In this type of transaction, a bank also might consider a total financing facility without any other collateral, and, for its trustworthy corporate and retail clients, may only be content with title to the goods. In financing this kind of transaction, a bank may work out its funding costs depending on the duration of the facility and the volatility of currency involved in the transaction, and may include a percentage of profit after taking into account the cost and the risks involved.

Musharakah financing

Musharakah financing is a concept that supports an arrangement to share profit and loss in a transaction. Under a Musharakah arrangement, the parties involved contribute capital, share profit in a mutually agreed ratio and take losses in the ratio of capital contributed. This method of payment can be conveniently applied to facilities based on collateral in the form of either cash or assets (movable or immovable).

In an L/C transaction where a certain percentage of a cash margin is used as collateral, the bank would expect a lesser percentage of profit than that from an L/C opened with no margin. In the event the bank decides for any reason to dispose of the goods due to nonpayment by the importer, in order to reduce the loss incurred by the bank, the importer can either forego its entire share of the margin or a portion of it placed at the time of opening the letter of credit.

When a bank decides to finance the entire import transaction under Musharakah, it can go to the extent of retiring the import bill through import financing, adhering to its concept of sharing profit and loss. Under normal circumstances, a bank may consider granting an import loan (trust receipt/ pledge loan) for an agreed percentage of the value of the goods.

Application of customary import financing in the form of Musharakah financing for the benefit of the sectors that wish to avoid borrowing on interest is possible and may even be encouraged for the growth of the banking industry. However, there appears to be a misconception among practising bankers that once the bank and the customer sign an agreement (Istisna) using the Musharakah financing concept, the agreeing parties cannot deviate from the original agreement. In reality, the customer might face a situation where he would find it difficult to dispose of the goods held in pledge due to a price fluctuation in the market. In such a situation, selling the goods at the agreed date might force both the bank and the customer to take a huge loss, since both have agreed to share the profit and the loss. To meet such contingencies, the agreement could make a provision to extend the facility further for a mutually agreed period.

D/A and D/P

Not only letters of credit but also documents for collection on both D/P (Documents against Payment) and D/A (Documents against Acceptance) can be accommodated under either Murabah or Musharakah financing. It all depends on the agreement between the bank and the client. If the importer wants to purchase the goods relating to the documents sent to the bank for collection, he need only agree with the bank that the goods will be consigned by the suppliers to the order of the bank. The Uniform Rules for Collection (URC 522) in article 10 provide specifically for this type of arrangement, which stipulates that goods should not be dispatched directly to the address of a bank or consigned to, or to the order of, a bank without prior agreement on the part of that bank.

Under Murabah import financing, a bank will deliver the documents against payment of the bill's value plus its profit (commission). In the case of customers who need time to settle bills, a bank may consider either a trust receipt or a pledge facility against a Zaman (guarantee) undertaking to pay within a specific period or against an Istisna agreement, thereby undertaking to pay in installments on a deferred date.

Export finance: Murabah

The concept of Murabah is to sell goods for a profit at a mutually agreed price. In a typical post-shipment finance transaction, an exporter has his bill discounted/purchased by his bank to meet the working capital requirements necessary to continue his export business. In this situation, banks will credit proceeds arising from the bills after taking their profit by way of discounts. This is not an unusual phenomenon, but an ongoing international practice.

Generally, the discounting facilities are granted after making due assessment of the clients, buyers, commodities and the political and economic situation of the buyer's country. These salient features will continue to play a major role even under Murabah finance, since the emphasis in this type of transaction is on making a profit, and any deviation from standard practice can have a negative impact on the profitability of a transaction.

Meanwhile, banks will continue to retain title to the documents until the final buyer pays the bill and takes charge of the documents. Generally, the bills that are not under letters of credit are discounted/purchased with recourse to the sellers (exporters). This too can be retained under Murabah through a bill of exchange or by obtaining a general letter of indemnity equal to a Zaman undertaking to pay the bill in case of default by the buyer. The undertaking usually provides for the bank to dispose of the goods to any other party to reduce its losses.

Export finance: Musharakah

The concept behind Musharakah financing is to share profit and losses in a transaction. In an export transaction where payment is arranged through a confirmed letter of credit or against a bill of exchange avalised by a bank, the Musharakah concept can be put into practice without making any major changes to the prevailing procedure.

In view of the secured nature of the transaction, banks would likely be willing to offer attractive rates for the purchase of bills under letters of credit and bills avalised by the buyer's bank. Hence, the seller will receive more profit from the transaction than from a transaction referred to in the previous paragraph. Under this type of transaction, a bank might be willing to take less profit, taking into account the secured nature of the transaction. This financing is arranged without recourse to the exporter, and therefore the exporter's loss is greatly minimized.

The Shari'ah concept can be applied for pre-shipment as well as postshipment finance. The most common facility obtained by exporters at the preshipment stage is a packing credit. In a packing credit agreement, an exporter agrees to buy the raw materials for manufacture of the goods with bank finance and sets off the financial facility with the proceeds of the export bill presented to the bank for purchasing or discounting. This type of conventional pre-shipment facility may be structured in a manner described in Istisna, whereby the bank agrees to pay upfront for the goods the exporter agrees to sell to it in the form of presentation of documents at a future agreed date.

Conclusion

A Shari'ah financing module could be adopted to finance international trade without deviating from existing practices. I believe any process can successfully be implemented if there is a level playing field. To create one for trade transactions requires considerable time and effort by the parties involved, especially in an environment in which commodity prices are determined by market forces. Although one would expect that equivalent goods in different countries would cost the same in a free market after conversion into a particular currency, in practice this is not the case. Therefore, the profit opportunities from cross-border trade are limited.

Unless it involves a forward exchange contract, fixing a profit in advance for a facility in an international trade transaction will not create a level playing field. When entering into a forward exchange contract, a bank might tend to fix an unusually increased volatility rate for the currency in a transaction to ensure that it would not lose its profit margin. This might force the importer under Shari'ah to either withdraw from the market or abstain from selling, as he may be unable to compete with other importers who are free to dispose of their goods at a lesser price and still have a profit. This requires the attention of the parties when entering into an agreement.

Michael Peiris is a banking consultant with the International Chamber of Commerce in Sri Lanka. His e-mail is michael.peiris@yahoo.com