Risk Identification – Murabaha
1. Murabaha
to the Purchase Ordered
An MPO transaction is a complex web
of contracts between the customer and the bank that entails three types of
relationships:
·
Promisor-Promisee
·
Buyer-Seller/Principal-Agent
·
Debtor-Borrower
The use of an MPO exposes Islamic
Financial Institutions (IFIs) to various risks including credit risk, market
risk and operational risk. The interaction of several exposures necessitates
the development of an understanding of how risks arise and the best strategies
for mitigating risks.
For risk identification, MPO
transactions are divided into two phases: phase one starts from the time the
customer signs the promise agreement and runs to the time he enters into a
murabaha contract. Phase two begins from the time a murabaha contract is signed
and runs up to the full repayment of the debt.
1.1 Phase One: Promise Agreement ➔ Murabaha Contract
The first thing the customer does after
receiving the approval on his MPO application is to sign a promissory purchase
agreement whereby he promises to buy the subject matter of the murabaha after
the bank has acquired it from the supplier. Some of the risks that exist in MPO
depend in part on whether the promise agreement is binding or non-binding; and
so does the level of specific risks. In phase one, IFIs are exposed to
operational risk, counterparty risk, market risk, and legal risk.
The
two main risks encountered during this phase of the murabaha transaction are:
·
The risk that the customer breaks his promise
and refuses to purchase the subject matter of the MPO from the bank, resulting
in losses for the bank (counterparty risk).
·
The risk that the bank will suffer losses as a
result of defects or damage to the object of sale after the bank acquires it
from the supplier but before selling it to the customer (operational risk).
In binding murabaha, IFIs usually manage counterparty risk by requiring the deposit of earnest money from the customer.
A bank cannot guarantee the fulfillment of the contractual agreement nor can it
compel its customer to honor his word; it can only impose a security to ensure
compensation in the event of loss arising from the breach of agreement.
As a result, earnest
money can help reduce the risk of breaking a binding promise but it does not
eliminate it. The customer may still refuse to fulfill his obligation if the
cost of compliance outweighs the cost of breaking one’s promise.
For example, consider a company that
exports cement to a neighboring country. In response to rising demand, the
company decides to expand operations and approaches the bank with a promise to
purchase the equipment needed. Immediately after the bank acquires the
equipment from the supplier, violence erupts between opposing factions in the
neighboring country and threatens to escalate into a civil war. As a result,
the company decides to put expansion plans on hold. In this situation, the
company may be better off compensating the bank for its losses rather than
buying the equipment and ending up with the costs of idle capacity.
However, the risk of
breach of agreement cannot be reduced through the use of earnest money in non-binding murabaha. It can only be managed through sale-or-return contracts.
Under this type of arrangement, the bank has the right to return the object of
sale to the supplier within a specified time period. The risk of loss or
damage, however, is passed to the bank from the time it takes possession of the
object of sale until it returns it to the supplier.
The second source of
uncertainty for the bank takes place between the time the bank takes possession
of the object of sale and the time the murabaha contract
is signed. Because the object of sale may have defects, or may be damaged, lost
or destroyed during this time interval, the bank is exposed to operational risk. One way to reduce the time period
between the two sales to a minimum and to mitigate this type of risk is to
assign the customer as the bank’s agent in taking possession of the object of
sale from the supplier after checking for defects and damages and conforming
specifications. This will almost eliminate the possibility that the customer
will refuse to purchase the goods because of defects or damages. Once the
object of sale is in possession of the agent, the murabaha contract can
immediately be signed.
A non-binding murabaha gives the customer
the option but not the obligation to buy the subject matter of the MPO. If the
customer breaks his promise and
refuses to buy the
object of sale, the bank is exposed to counterparty risk that could result in a market risk. In this situation, if the bank is
unable to return the murabaha
object of sale to the
original seller, it is forced to find another buyer dispose of these unwanted
goods. The bank could be at risk of suffering losses if prices fluctuate or if
market conditions force it to sell at a discount.
Suppose a company
signs a non-binding promise agreement with the bank for the purchase of 10,000
tons of iron ore for the price of $150/ton. If, immediately after the bank
purchases the commodity for $135/ton, prices drop to $130/ton and the client
refuses to fulfill his promise, the bank could suffer losses amounting to USD
50,000. Among the incentives that compel customers to honor their word is the
concern for their reputation among banks and most importantly their interest in
not jeopardizing the business relationship with the bank they are dealing with.
In cross-border murabaha, the bank can also be exposed to foreign exchange risk (market risk) when the currency the
bank uses to pay suppliers is different from the currency it receives from its
customers. The bank can manage this risk by agreeing with its customers to
price and receive payments in local currency while exchanging the local
currency for foreign currency to pay suppliers. In that event, the bank
protects itself reasonably well against exchange rate fluctuations, provided
the murabaha is binding and the bank pays the supplier in cash.
However, the bank could face losses if it buys on credit.
1.2 Phase Two: Murabaha Contract ➔ Debt Paid in Full
The bank may be
exposed to credit
risk at any time between
the signing of the murabaha contract and the time the debt is paid in full. It
may suffer losses if its customer fails to repay the debt on time and in full.
Accordingly, IFIs are more likely to be exposed to credit risk when the
maturity schedules on their financing facilities are longer: there will be a
greater chance that, despite the customer’s willingness to fulfill his
obligations, he will not be able to pay the debt in full due to unforeseen circumstances.
If the borrower defaults, the payments that the bank is expecting are at risk.
The management of credit risk is more
complicated in MPOs in comparison to conventional loans due to a number of
factors including: (1) the inability of the bank to roll over the debt; and (2)
the prohibition of charging interest on missed payments. Since murabaha is a
sale contract, it is impossible to extend the maturity of an MPO by a second
MPO. Debt cannot be the object of sale of a second MPO. Moreover, banks
cannot be compensated for late payments but can only impose penalty fees to be
donated to charity. Thus, the bank will not be able to earn any
additional return on rescheduled or delayed payments. Since the bank
expects to receive cash flows on specific dates, when a customer defaults, the
bank is exposed to the risk that it will not have sufficient funds to meet its
obligations: the bank is exposed to liquidity risk.
