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The trend in Islamic consumer financing in Malaysia

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Points of Essence:

  • Malaysia started offering innovative Islamic consumer financing products with the basic principles of Murabaha, Qard al hasan, Ijarah & Bai Bithaman Ajil (BBA).
  • For over the years,  BBA had been the sole principle used for an Islamic home financing product until only recently when Musharakah Mutanaqisah (MM) begun to emerge as an alternative to BBA.
  • MM was brought into prominence here by Kuwait Finance House which broke the BBA monopoly. It came at a right time when BBA was so entangled in legal controversies, not to mention its Shariah validity being questioned by foreign Islamic scholars.

By Norliza Mohammed

The Islamic revival of the 1970s in the Muslim world is generally regarded as the catalyst in establishing an Islamic alternative to the conventional financial system to fulfill the financial needs of Muslims throughout the world. As Muslims worldwide become more conscious of the need to strictly adhere to the prohibition of riba (usury) as stipulated by the Shariah, the Muslim community began to embark on the development of an Islamic system of banking and finance. The roots of Islamic finance in Malaysia can be traced back in 1963 with the formation of the Pilgrimage Fund Board as a savings fund for Malaysian Muslims to set aside part of their income to cover the costs of performing the annual pilgrimage to Mecca. The funds are invested in productive sectors of the country’s economy for a return that is free from riba. In 1980, the participants of the Bumiputra (Indigenous people) Economic Congress passed a resolution asking the government to allow the Pilgrimage Fund Board to establish an Islamic bank. The call was reiterated the following year at the national seminar on the Islamic development concept.

In response, a national steering committee was formed to make a detailed report on the various aspects of establishing and operating an Islamic bank in Malaysia. For this, the panel used the operating framework of the Faisal Islamic Bank in Egypt and Faisal Islamic Bank in Sudan as guidance. On the 5th of July 1982, the committee submitted its report to the government stating that the establishment of an Islamic banking institution is not only viable but also highly recommended.

In paving the way for the establishment of Islamic banking in Malaysia, Parliament passed the Islamic Banking Act 1983 which came in force on the 7th April 1983. It provided for licensing and regulating the Islamic banking business and modeled on the then Banking Act 1973(since replaced by the Banking and Financial Institutions Act 1989). It basically retains the normal practices of prudent banking and vests the central bank (Bank Negara Malaysia or BNM) with powers of supervision and regulation over Islamic banks as in the case with other licensed banks.

The major difference between the two laws is that the Islamic Banking Act stipulates that an Islamic bank will have to engage in Islamic banking business defined as banking business whose aims and operations do not involve any element which is not approved by Islam. To ensure this, a provision in the Islamic Banking Act requires an Islamic bank to establish a Shariah advisory body to advise it on its operations to ensure that they do not involve any element which is not approved by the religion.

The first Islamic bank in Malaysia is Bank Islam Malaysia (BIMB), incorporated on the 1st March 1983 and opening for business on the 1st July the same year with an initial paid up capital of RM80 million (US$25 million). It offers Shariah compliant services that are similar to those of conventional banks. Since its inception in 1983, BIMB has vastly expanded and in 1992 was listed on the main board of the Kuala Lumpur Stock Exchange (now Bursa Malaysia). In keeping with its long term vision of establishing an Islamic financial system operating alongside the conventional banking system, BNM launched the interest-free banking scheme (IFBS) in 1993 under which financial institutions based on conventional banking are allowed to offer Islamic banking products and services subject to specific guidelines. Initially, three banks participated in the scheme. Since then the number has increased tremendously with 32 more joining IFBS. Furthermore, in October 1999 Bank Muamalat Malaysia was formed as the second Islamic bank in the country. With the success of IFBS and the continuing growth of Islamic banking institutions in Malaysia, BNM’s aspiration in implementing a dual banking system of Islamic banking operating side by side with conventional banks fast became a reality and has helped identify Malaysia as a major force in the global Islamic financial market. Today, Islamic banking and finance in Malaysia through the abundance of Islamic products and services offered by almost every major financial institution in Malaysia has become a popular choice of the Malaysian public as a defi nite source of consumer financing. Islamic consumer financing, particularly home financing, has been widely regarded as a viable alternative to conventional consumer banking even with non-Muslim Malaysians.

Overview of early Islamic consumer financing in Malaysia

During the formative years of Islamic banking and finance in Malaysia, pioneering Islamic financial institutions such as BIMB had introduced a variety of innovative Shariah compliant consumer financing products to the market. They provide a viable solution to the public who require interest-free financing as opposed to the conventional method of banking. Notwithstanding this, the Islamic banking system shares similar functions as the conventional banking system.

In Islam there is a clear prohibition of riba but the contract of exchange or Al-Bai or sale is declared to be legitimate. Although the contract of exchange, traditionally and conventionally, is not financing in character, it has been actively deployed as one of the major instruments for Islamic financing worldwide. Hence, one of the clear differences between Islamic banking and conventional banking transactions is that Islamic banking transactions are predominantly based on buying/selling or contract of exchange whereas conventional transactions are based on lending contracts.

Islamic finance operates under a number of Islamic principles. Among those widely used by Islamic banks during their initial years of operation are:

  • Murabahah asset financing – This refers to the sale of goods at a certain price where the sale includes a fixed profit margin agreed to by the parties. Technically, it is a resale above the cost price such as on profit. The agreement of the sale includes in clear terms the actual purchase price of the goods and the profit margin. The bank would purchase from the vendor the goods required by the customer and then sell them at a mark-up price as previously agreed on as a cost plus basis profi t contract. Under the Murabahah concept the bank does not share either profits or losses but assumes the role of an intermediary between the vendor and the customer. This mode of financing was one of the most commonly used during the early period of Islamic banking and finance in Malaysia as the Murabahah contract allows for the financing of inventories and fixed assets. For BIMB, Murabahah is used as a mode of short term financing and formed the bulk of BIMB’s financing operations in its formative years.
  • Ijarah – Ijarah, which literally means “to give something on rent,” Ijarah refers to a lease contract under which the bank or fi nancial institution leases certain goods, equipment or building to its customer against an agreed fixed charge or rental. It is based on a contract between the lessor and lessee for the use of a specific asset. The ownership of the asset is maintained by the lessor-bank while its possession and use is conferred to the lessee-customer on payment of specified rentals or charges over a specified period of time. Ijarah makes possible the leasing of business essentials such as factory and warehouse space including equipment. It represents an important mode of financing and is one of the most frequently used instruments in Islamic banks as it is almost similar to conventional leasing. It also represented a major activity for BIMB during its early years of operation.
  • Qard Hasan – “Qard” is defined as the transfer of ownership of an asset or money from the original owner to others on condition that it will be returned to the owner in the same condition, form and value. In other words, Qard Hasan is an interest-free loan facility where the borrower is obliged to repay only the principal amount of the loan unless the borrower agrees to additional charges to the principal amount at his own discretion. Islamic banks cannot afford to tie up a significant part of their resources for extending Qard Hasan as they have to maintain good profitability to be able to compete with other institutions for mobilizing the savings of the community. The non-profit nature of this loan facility makes it an extremely high risk transaction for the banks and as such, the facility is rarely offered without the bank practicing cautious discretion. The high operating cost coupled with the high risk factor makes the transaction unfeasible for banks to offer as a full scale consumer financing like the Ijarah or Murabahah. Nonetheless Qard Hasan funding is often provided to charity institutions to finance their activities. It is also often provided as a way of facilitating existing business partnerships.
  • Bai Bithaman Ajil the premier consumer financing Facility Bai Bithaman Ajil (“BBA”) is a contract of exchange for the sale and purchase of goods on a deferred payment basis where the agreement includes a predetermined profit margin in the purchase price. It provides the purchaser the benefit of a deferred payment scheme for long term financing and in turn the deferred price of the sale of the goods carries additional profits for the seller-Bank. Widely recognized as the primary mode of Islamic consumer financing in Malaysia, the BBA facility enjoys a dominant role in the Malaysian financing market. The impact of BBA to consumer financing in Malaysia is especially significant in the Islamic home financing sector where BBA has the lion’s share of the market. The client or customer pays a deposit (“Arboon”), which is normally 10% of the property selling price offered by the developer. The customer then seeks a bank’s financing facility to complete the purchase. Under the property purchase agreement (PPA) the bank buys the property from the customer. The purchase price is the financing facility (for example 90% of the remaining purchase price of the property) which the bank pays directly to the developer. Simultaneously, the bank and the customer sign a property sale agreement (PSA) whereby the bank sells back the property to the customer at a mark-up (“profit”) on deferred payment by the customer. To further understand the operation of a BBA financing, assuming that a customer wishes to buy a house priced at RM200,000 (US$61,385), he puts a down payment of 10% or RM20,000 (US$6,142) and the bank agrees to finance the remaining 90% or RM180,000 (US$55,085) using the BBA method. Assuming that the annual profit rate (APR) charged by the bank is 10% a year and the duration of financing is 20 years, the Islamic bank buys the house for RM180,000 and then sell it to the customer at a profit, with deferred payments over the 20-year period. The monthly payment for this financing is RM1,737.04 (US$533) and payable for 240 months which adds up to RM416,889.35 (US$128,000) in total. The difference of RM236,889.35 (US$72,494) is the total profit for the Islamic bank from this transaction. The success of BBA in Malaysia is unsurprising as the Malaysian population is of Muslim majority. With the competitive pricing offered by Islamic financing institutions compared to conventional financiers, Islamic home financing has broadened its appeal to non-Muslims as well. While the BBA is widely used in Malaysia, Indonesia, Brunei and a few other countries, it has been subjected to much controversy among Islamic scholars worldwide with regard to its permissibility; with most of the Middle East scholars rejecting it. BBA is actually an extension of the Murabahah (cost plus) contract and share the same roots. Both financing facilities employ the deferred payment scheme whereby the commodity exchanged is delivered immediately but the sale price (with profit) is paid in installments over a period – for BBA it is a longer period and for Murabahah, it is generally a shorter period. Among the criticisms made against BBA financing:

– Similarity to conventional loans – In the conventional system, home financing is of course usually interest-based and forbidden in Islam but the current BBA home financing is not much different. Instead of charging the customer interest, the Islamic financier charges a profit derived through a buy-and-sell contract but regretfully, the profit rate is dependent on the market interest rate due to arbitrage activities. Therefore, while the BBA is practiced as Shariah compliant in some countries, it is nonetheless similar to the conventional mode with the profit rate tracking the market interest rate. Some jurists even consider the BBA concept to be a means to circumvent the prohibition of charging interest rates rather than being a different concept altogether.

– BBA as an actual contract of exchange – Under the BBA concept, the bank is required to hold ownership of the asset and therefore all liabilities as well. But the legal documentation indicates that the bank’s role as actual owner is not definitive. Hence the similarity with conventional fi nanciers who are free from liabilities. Initially the common practice of Islamic banks was to provide for novation agreements in the BBA financing documentation which make it clear that the bank purchases the asset from the vendor and subsequently sells it to the customer. However, this practice is currently discontinued due to operating difficulties faced by the bank on the issue of liability.

– BBA financing tenure – One of the biggest criticisms against BBA is on the terms of tenure which critics consider to bring hardship to the customer. Under the current BBA concept, the profit margin as predetermined by the bank is fi xed for the entire duration of financing and the profit margin is capitalized upfront unlike under conventional financing. Hence customers wanting to redeem the balance of financing before the expiry of the financing period find that the amount is far higher than in conventional financing. However, Islamic banks are known to give rebates for early repayment but the amount is not mentioned in the financing documents and is at the absolute discretion of the bank.

– Default in payments – The current BBA financing has attracted controversy with regard to the amount of payment of the financing in the event of a default by the customer. The legal documentation provided by most banks to facilitate the BBA financing provides for the customer to settle the whole selling price inclusive of the profit margin which is capitalized upfront. Critics consider the profit margin claimed by the bank for the entire financing tenure after termination of the BBA on default as unwarranted and unjustifiable. Moreover, Malaysian courts have ruled against such practice. As a result of mounting criticism against BBA and recent decided cases in Malaysia, the market players have been advised to innovate products which are free from controversy. In 2006, some Islamic banks started to introduce new Islamic banking product for consumer home financing based on the Islamic equity principle of Musharakah Mutanaqisah.

Musharakah Mutanaqisah the new trend

The term “Musharakah” is derived from the Islamic fiqh concept of “Shirkah” which means sharing or partnership. There are basically two main types of Musharakah:

  • Shirkat-ul-Milk: joint ownership by two or more persons or parties in a particular property or asset.
  • Shirkat-ul-Aqd: a contract between two or more persons or parties on a common business objective. The sole purpose is to share profits and losses arising from a jointly owned enterprise in line with the Shariah.

Nature of Musharakah financing – A form of partnership between the Islamic bank and it clients whereby each party contributes to the capital in equal or varying degrees to establish a new project or share an existing one, and whereby each party becomes an owner of the capital on a permanent or declining basis and have a due share of profits. Losses are shared in proportion to the contributed capital. It is not permissible to stipulate otherwise.

Types of Musharakah financing

a) Constant Musharakah – the partners’ share in Musharakah capital remains constant throughout the period; and

b) Musharakah diminishing to ownership – one party has the right to purchase the other party’s share which declines until one become the sole proprietor of all the capital (Musharakah Mutanaqisah).

Diminishing Musharakah/Musharakah Mutanaqisah (MM)

This is a Musharakah/partnership in which the Islamic bank agrees to gradually transfer to the other partner its share in the Musharakah so that the Islamic bank’s share declines and the other partner’s share increases until the latter becomes the sole proprietor of the venture.

MM is a partnership contract where the bank and customer form a partnership to purchase a certain asset with the bank’s share diminishing on the gradual payment by the customer. The MM financing concept can be illustrated thus:

a. The customer enters into a partnership agreement with the bank for the purchase of an asset.

b. The customer makes a payment for the initial share, e.g. 10%, for co-ownership with the balance of shares provided by the bank.

c. The bank immediately leases its 90% share under the Ijarah concept where the customer agrees to pay rental for the lease.

d. The customer subsequently redeems the bank’s share by payment of the rentals in installments as agreed upon in the MM contract. The rent payable to the bank also reduces proportionately.

e. The customer’s share gradually increases upon each periodic rental payment until eventually the asset is fully owned by the customer and the bank’s share is entirely diminished.

MM in Malaysia

The MM financing concept was introduced in March 2006 by Malaysia’s first foreign Islamic bank, Kuwait Finance House, upon approval by the central bank. In fact, MM is not a recent innovation and has long been practiced in the Middle East. However, with the overwhelming popularity of BBA financing, MM never had a foothold in the Malaysian Islamic financing market until recently. Today, with the mounting criticism against BBA and more awareness of its benefits as opposed to its BBA and conventional counterparts, MM financing is gradually shaping up as a fi rm competitor in the Islamic consumer financing market. Compared to its conventional or BBA financing counterparts, MM has several major advantages:

Juristic preference over BBA – A major advantage is that MM financing is supported by most Muslim jurists as an acceptable and Shariah compliant form of financing, unlike the BBA which jurists, particularly those from the Middle East, do not recognize as being Shariah compliant some even considering it to be prohibited. In most countries outside Malaysia, MM is widely recognized as the primary mode of consumer financing. In 2006 BNM’s Shariah Advisory Council recognized MM as a viable form of financing to be offered in Malaysia. Value saving for customers – In contrast to BBA, MM financing provides a more flexible financing structure as the customer can own the asset earlier by redeeming the principal faster from the bank without the need to formulate rebates as in BBA. Therefore, problems faced by the customer regarding the tenure do not arise as the profit margin is not capitalized unlike in BBA. Customers may enjoy much better savings for early redemption unlike in BBA where, if a customer redeems the financing half way through its tenure, the amount to be redeemed exceeds the amount of the original financing.

Variable profit rate – MM has the advantage of having a variable profit rate as the rental rate can be revised periodically to reflect current market conditions unlike BBA where the bank is tied to a fixed profit rate for the whole duration of the financing tenure. The bank is able to manage its risks and liabilities better as the rental payments can be adjusted upon each periodic installment.

Comparison between MM and BBA

In summary, the main differences between the MM and debt-type BBA financing are as:

1. There are two separate contracts under the MM method. One is a Musharakah where the client is a partner and the second is an Ijarah which involves the leasing of the property. The BBA, on the contrary, follows the Murabahah concept of buying and selling property.

2. Under BBA, the selling price of the house does not reflect the market value since the mark-up for the deferred payment is quite substantial. On the contrary, the value of the house under MM always reflects the market price and the rental is determined by the market rental values.

3. The return to the BBA is based on a fixed selling price (which uses the prevailing interest rate as the benchmark). But under MM, the financer need not be tied to a fixed profit rate throughout the financing tenor as the rental rate can be revised periodically to reflect current market conditions. Indeed, as argued earlier, the rental can be tied to some economic variables like rental index or house price index.

4. The financier can manage the liquidity risks better as rental payments can be adjusted at the end of each subcontract period. This is not possible under the fixed-rate BBA as the profit rate is a constant throughout the entire tenor of financing.

5. Compared with BBA, the MM differs in the balance of financing at any point in time before the end of the contract. Under MM the balance can never be larger than the original price of the house. The rebate for early redemption under BBA cannot be specifically stated in the contract.

6. The MM is a more flexible financing structure than the BBA as the customer can own the property earlier by redeeming faster the principal sum of the financier without the need to compute rebates as in BBA.

7. Currently many customers feel that the BBA is similar to the conventional loan with some “disadvantages” for the customer particularly for early redemption.

8. MM is accepted internationally as Shariah compliant, whereas the BBA is recognized predominantly in Southeast Asia namely, Malaysia, Indonesia and Brunei.


Indeed, the writer believes that MM is a better alternative compared to BBA and conventional housing loans. As discussed earlier, the BBA is very much similar to the Murabahah contract, that is, based on a buy-and-sell principle, while the MM consists of a Musharakah (partnership) contract and an Ijarah (rental) contract where the equity of the financier follows a diminishing balance method. MM is well accepted and implemented worldwide while BBA was disapproved by the Shariah in the Middle East. Apart from being Shariah compliant, it is a clear alternative to avoid interest (riba) and can reduce the cost of house financing and ultimately the duration of financing.

Hence, MM is seen as a just and fair contract as compared to the conventional loans and the BBA. There should not be any interest charge or ‘advance’ profit involved in the MM contract because it is purely based on rental payments of property and the redeeming of the financier’s shares. MM is also an alternative to BBA because it promotes the migration from debt-based financing to equity-based financing. It is more advantageous to the consumers or society as a whole. In some decided cases, the BBA concept as adopted in Malaysia has been criticized by judges, and has become a serious concern to all consumers particularly the Muslims who are supposed to benefit from Islamic products.

To date, the development of Islamic banking and finance in Malaysia has been encouraging enough to sustain the country’s objective to be an international Islamic financial center. Nevertheless, more people will need to be trained to have in-depth understanding of Islamic banking and finance and its principles. This will serve to encourage product innovation and also educate corporate players, the business community and general investors on the benefits of Islamic banking and finance.

Source: Islamic Finance News.


Written by Suapi Shaffaii

July 9, 2008 at 7:11 am

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