BSB7303 – Islamic finance 2

Yumyme Chocolates

Group Assignment - Report

STUDENTS: MUSTAFA HASSAN (201102031)Hussain Ali (201100230)Abdulla Alturabi (201200498)

Tutor: Mr. Nedal El-Ghattis

JUNE 1, 2015

Table of Contents1.0 Introduction:.............................................................................................................................2

2.0 Definitions and legal - Shari’a basis for Murabaha:...................................................................2

2.1 Explanation:..........................................................................................................................2

2.2 Legal /Shari’a basis...............................................................................................................2

3.0 Advantages and disadvantages of Murabaha contract compared to other modes of finance. 4

3.1 Advantages of using Murabaha to the bank:........................................................................4

3.2 Advantages of using Murabaha to the client:.......................................................................5

3.3 Disadvantages of using Murabaha for the bank:..................................................................5

3.4 Disadvantage of using Murabaha for the client:...................................................................5

4.0 The required forms and documents used in Bank AL-Baraka:..................................................6

5.0 The procedures for providing the money:................................................................................7

6.0 The risks involved in Murabaha contract and the mitigations:...............................................10

6.1 Credit risk:...........................................................................................................................10

6.2 Market risk:.........................................................................................................................11

6.3 Operational risk:.................................................................................................................11

7.0 Conclusion:.............................................................................................................................12

8.0 References..............................................................................................................................13

9.0 Appendices:............................................................................................................................15

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1.0 Introduction:We are writing this report in order to explain the finance solution which be provided to finance the business proposal (Yumyme Chocolates factory) using Murabaha contract in bank Al-Baraka. In this report we will explain the definitions and Sharia biases for Murabaha, as well as the advantages, disadvantages, the required documents, producers and the risk involved in this process.

2.0 Definitions and legal - Shari’a basis for Murabaha:2.1 Explanation:Murabaha contract is a sale contract, in which the bank buys the asset for the client and sale it back to the client with profit. Usually the bank buys the asset in full and resale it to the client on deferred payment. (Investopedia, 2008)

2.2 Legal /Shari’a basisThe bank’s SSB is composed of six members. They are as follows: Shaikh Dr. Abdul Sattar Abu Ghudah (Chairman), Shaikh Abdulla Bin Sulieman Al Mannea (Member), Shaikh Dr.

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Abdullatif Al Mahmood (Member), Shaikh Dr. Abdulaziz Bin Fowzan Al Fowzan (Member), Dr. Ahmed Mohiyeldin Ahmed (Member), and Dr. Eltigani El Tayeb Mohammed (Secretary to the Shari’a Supervisory Board).

These members are responsible for: issuing fatwas for the Board of Directors and Management members to abide by. And review the new products, it gets reviewed by the bank’s Board Audit & Governance Commit. Lastly, al-Baraka supervisory board works closely with AAOIFI, and therefore the Murabaha contract structure has been constructed using AAOIFI standards.

As for the auditing in the bank, Mr. Hamad Abdulla the Head of Financial Control in Al-Baraka is also the Vice Chairman in AAOIFI; therefore the auditing process in the bank is very effective. In addition to that, Al-Baraka has directed the Board Audit and Governance Committee do a constant and regular auditing process on all the bank activities in order to make sure that the bank is running effectively under the AAOIFI standards. (2014 Annual Report, 2015).

Dr. AbdulSattar has compiled a list of fatwas and sharia principles to abide by for the execution of a Murabaha contract. All of these fatwas are presented based on the Quran, the Sunna (traditions, practice and sayings of Prophet Mohammed). Therefore, the following are several examples of fatwas that have been answered to provide clarification on matters as to being whether the practice discussed is halal or haram.

The first topic discussed is actually one of the most essential factors in a Murabaha contract, which is the meanings and purpose and not the words and phrases. Many banks nowadays are not properly practicing Murabaha sale. A Murabaha transaction doesn’t become sharia-compliant if the word “interest” is replaced with “profit” or “mark-up. All conditions specified by the Sharia must be observed to make sure of the Sharia’s validity. ” (Abu Ghuddah, n.d.)

Another important factor to consider is the promise. Malki jurists believe that a promise is legally binding while other schools of thought don’t necessarily believe it’s binding.

In regards to insurance, AbdulSattar believes that insurance amount should be included as part of the purchase cost but no profit should be incurred from it. In other words, it will be a cost for the customer but won’t include an additional profit cost.

In the report, it has been discussed whether an additional portion of the administrative cost can be used as commission to pay an employee. This is not allowed according to Sharia principles. Commission should be paid from the bank’s funds and not incurred as a cost on the customer.

Since a guarantor must be provided by the customer, he may wonder if the property itself can be used as a guarantee. This is impermissible because the bank doesn’t own

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the property until the settlement of its price via the contract. In addition, ownership will eventually be transferred to the customer after maturity.

Al Baraka bank may also finance its Murabaha transaction via other banks. The bank may use other modes of participation (i.e. Mudarabah or Musharaka) with profit percentages pre-agreed and then the bank carries out its transaction with the customer.

The chairman has also discussed issues related to cancelled documentary credit of Murabaha or if the purchase promise was not executed. According to the Board’s view in this matter, if the execution of the Murabaha transaction failed due to any reason in relation to the purchase promise, then the customer will have to bear the costs of the damage thereof.

3.0 Advantages and disadvantages of Murabaha contract compared to other modes of financeUnder the assumption that the factory (Yumyme Chocolates) has been bullied, and the business owner needs working capital in order to buy machines and equipment for the factory.

Giving the fact that Al Baraka Bank has four main modes of financing; Murabaha, Ijara, Istisna, and Musharaka, and doesn’t have a contract that offers cash for working capital; therefore the best alternative solution is to finance the business through Murabaha contract. (Albaraka.bh, 2015).

The following will discuss the benefits for of Murabaha for both the customer and bank when compared to other contracts:

3.1 Advantages of using Murabaha to the bank:A. The first and most important advantage of Murabaha is that the client is responsible

for maintenance and insurance of the asset as the client will be the owner of that asset, unlike Ijara in which the bank is the owner and the responsible for major maintenance and insurance. (Islamic Mortgages from Mortgages for Muslims, 2015)

B. Mudaraba mode carries a high level risk for the bank, while in Murabaha the major risk that the bank deals with is default risk. Mudaraba is extremely risky because the bank is providing working capital to the Mudaraba (customer) who undertakes the work as well as management but will only be held accountable for losses in case of negligence. Therefore, the bank will bear any losses if the Mudarib fails to generate profit given that he is not negligent nor violated the terms of the contract. In Murabaha, however, the main risk that the bank should take precautions for is default risk. The risks is minimized via a guarantor. (Albaraka.com, 2015)

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C. Al-Baraka also have a partnership with Tamkeen to used Murabaha, in which they provide financing for small to medium projects. This is beneficial for bank because in case of the customer defaults, Tamkeen will cover 50% of the loss. (Appendix 2).

3.2 Advantages of using Murabaha to the client:An advantage to the client is that Al Baraka Bank has an exclusive feature only to Murabaha contracts called revolving Murabaha. This means that the client can use a specified amount several times in case a he wishes to purchase items multiple times in a given period of time. Other types of contracts don’t include this feature.

In Murabaha, the bank will agree to finance the business at the beginning on the condition that the customer will pay back on deferred payments. This is a suitable alternative solution since he’s requesting working capital. Other forms of financing are not necessarily similar. For example, Musharaka is a partnership where both parties will have to contribute to the working capital, and this doesn’t match with customer’s needs. As a result, it cannot be used. (Islamic Finance Affairs, 2007)

3.3 Disadvantages of using Murabaha for the bank:A. A big disadvantage for the bank in using Murabaha is that the installments are fixed,

therefore the bank can’t charge extra on late payment or discounts on early payments buy they only can charge a penalty which will go to charity. (Islamic-banking.com, 2015)

B. Since the cost of the machines reqisted by the business owner will be paid by the bank in full, it can be seen as a drawback for Al Baraka Bank. The reason is that this method is far costlier than other methods such as Musharaka. With that being said, it’s very important for the bank to consider the time value of money since they are providing numerous Murabaha financing to other customers as well. (Zandi & Ariffin, 2015)

3.4 Disadvantage of using Murabaha for the client:Another unattractive feature of Murabaha finance is its inflexible payment terms. It is not permissible by Sharia to change the installments amount of the Murabaha sale. Therefore, in case the customer defaulted, he may face serious legal consequences as well as overdue repayment, the costs will all be imposed on the guarantor, while other modes of finance like Ijara, flexible payment terms is allowed. (Albaraka.com, 2015)

Even though Murabaha quote all costs plus profit in the contract, a minimum down payment of 10% has to be paid to the bank in order to carry on with the contract. This amount can be seen as a disadvantage and unattractive to customers. For this case, the customer is requesting capital financing to run the factory, which will make it difficult for the client. While In Ijara, the customer will pay the entire amount based on monthly installments and no upfront rentals (Symmetrydigital-labs.com, 2015).

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4.0 The required forms and documents used in Bank AL-Baraka:The client or the business owner that wants to be financed by Bank Al-Baraka will be required to fill in and send many documents, in order for the financing process to be completed, and these documents include:

A. Application form (appendix 1): is the first document that the client has to fill in. in this document the client will have to write in:

general and legal information about the business

Marketing strategy as well as a study of the market or the industry.

The required amount, purpose of finance and the expected results to the business performance after the finance.

Projected income statement for the business upcoming years.

Declaration by the client of the accuracy of the provided information, as well as approval of the terms and conditions of the financer.

General terms and conditions of the financing service.

B. Required documents (appendix 1): the client will be asked to attach several documents with the application form, which includes:

Company profile and Copy of the business licenses

Memorandum & article of association

Quotations of the required items and detailed facility utilisation breakup

Recent audited finical statements and Feasibility study

Bank account statement

Latest electricity bill

C. Credit Approval Routing Slip (appendix 2): this document contains the results of the study done on the finance application sent by the client, and has the approval or the rejection of the committee members responsible for this study; this document contain three main sub-documents:

Credit application review is a general study of the business background, main products and customers, as well as the recommendations and approval from

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the relationship manager, Head of credit and the committee members to this application.

Financial analysis of the income statement, balance sheet and the cash flow statement.

Corporate credit risk rating which is done based on the performance of the company in the Non-Financial and the finical factors.

D. Facilities agreement (appendix 3): is a document that contains all the terms and conditions of the finance agreement which will be done between the bank and the client, and this document covers all the previous and current facilities agreement done between the bank and the client.

E. The offer letter (appendix 4): is a letter sent to the client to accept the mentioned terms and conditions in the facilities agreement.

F. Agency contract (Wakala) (appendix 5): is a contract that gives the client the authority to make buying and selling decision on behalf of the bank, within the agreed terms and conditions.

G. Local purchase order (appendix 6): is a document that the client can used in order to ask the bank to buy the items that he/she wishes to buy, and usually contain a promise to buy from the client.

H. Invoice (appendix 7): is a document issued by the seller to the buyer and provides details of the purchased items, such as quantities and prices.

I. Payment against invoice letter (appendix 8): the client will have to send a letter to the bank and attach the invoice in order to ask them to pay for the vendor and buy the items, and in this letter the client will provide the vendor’s bank details. (Ahmed, 2015)

5.0 The procedures for providing the money:Bank al-Baraka has recently introduced a new financing service called “Small and Medium Enterprise Finance” in collaboration with Tamkeen; which is a Sharia compliant service to finance businesses through Murabaha contract.

In order for any client to apply for this service he/she will have to go through serval steps and provide serval documents in order to complete this process.

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A. In the starting stage the client will be asked to fill in an Application form (appendix 1) and submit it alongside with a list of required documents. The application form should contain general and legal information about the business, finance requirements and purpose, market study and projected income statements.

Additionally, the banks will ask the client to provide the required documents and attach it with the application from, which contains (company profile, copy of the business license, memorandum & article of association, quotations for assets required for financing and most importantly, the recent financial statements of the business and the feasibility study).

B. After receiving the application form and the required documents from the client, the bank will form a committee with members from different departments to study the application by analyzing the financial statements and the feasibility study attached with the application form, and will look into the purpose of finance in order to form a decision on whether or not they should finance the client. The committee members will analyze the following:

The business background and main activates

The business financial statements, to check the business recent performance.

The market or the related industry performance.

The purpose of the required financing amount and the upcoming plans for the business.

The feasibility study, in order to understand the business idea and it’s expected the future.

And then the members will write the analysis results in the Credit Approval Routing Slip (appendix 2) and will either sign their approval or rejection on the client application.

C. After finishing the analysis of the client’s business and the client get accepted to be financed by the bank, then the bank will send the client the Facilities agreement document (appendix 3) and the Offer Letter (appendix 4), in order for him/her to understand the conditions that the finance will be provided in; and if the client agreed he/she will have to signs the document within a certain period of time.

D. As soon as the client signs all the agreements and documents (facility agreement and offer letter); the bank then will establish a credit line for the client, in order to be able to finance him/her through it on the bases of Murabaha.

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E. The bank then will sign an Agency contract (Wakala) (appendix 5) with the client in case he/she was trustworthy, in order for the client to act as an agent of the bank and buy the required assets by himself/herself.

F. Afterwards, The Murabaha financing process will be done on two sections:

The first one is Murabaha (one off): this Murabaha is done only once and usually made at the beginning of the financing process; it could be used in order to buy something necessary to the establishment of the business such as a land or heavy machinery.

The second is (revolving) Murabaha: in this Murabaha, the bank will specify a certain amount to finance the client for a certain period and the client will be allowed to use this amount for multiple times as long as he/she pays it back in full with the agreed profit margin. Usually, the bank sign an agency contract with the client in order to give him/her the power to buy the required items on behalf of the bank and resale it back to himself/herself.

The business owner needs working capital and the only contract that can provide cash is Tawraq, but because this contract is not used in Al-Baraka bank therefore the best alternative solution will be revolving Murabaha.

G. Finally, the client will ask the bank to buy the required assets by sending a local purchase order (appendix 6) paper to the bank and will include all the details of those assets he/she requires; in addition to that the client will sign a promise to buy those assets from the bank on the bases of Murabaha and based on the agreed upon conditions.

H. Then, the client will bring an invoice (appendix 7) document from the vendor to the bank, which includes all the details of the products and the prices, and this invoice will be sent with a letter to the bank (appendix 8) asking them to pay against the invoice in cash.

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The bank then will buy the assets which the client asked for and resale it to the client with profit on the bases of Murabaha, and the asset ownership will be transferred to the client. (Ahmed, 2015)

6.0 The risks involved in Murabaha contract and the mitigations:When financing projects, Murabaha contract is mostly used than other modes of finance offered by the Islamic banks such as Mudarabah, Tawarruq and even Ijarah. However, using Murabaha contract offers some risks associated with its practice, similar to each other contracts that have its own risks involved, here are the risks in Murabaha contract when financing the chocolate factory Yumyme, which can be divided as following:

6.1 Credit risk: Credit risk occurs when the client defaults in his payments to that bank in the periods agreed on. It is defined as a serious risk where the bank cannot set specified rules or penalties for the client to overcome it, because according to the Shariaa the bank cannot increase the amount agreed upon in the Murabaha contract thus once the contract is signed it cannot be changed. However, Al-Baraka bank has some mitigation plans to minimize the risk as much as possible, from the interview made with Mr. Ahmed the manager in the credit department said that the bank will ask the client to sign postponed cheques for all the future installments from begging of the contact till its maturity. Also, this act as a last point of push on the client for the bank in case the client defaulted in payment, the bank will have this as a prove in case it contacted the authority and send him to jail. (Ahmed, 2015). Moreover, in facilities agreement of Al-Baraka (Appendix 3) in the requirements section 5th point in page 4 state that in case of late payment the bank will charge 1% each month of the required amount as a penalty and this amount will be distributed to charity purpose in accordance to the bank Sharia’a supervisory board. Appendix B credit approval routing slip shows a security measurement where, a mortgage property covering exposure by 1.3 times also, Tamkeen will cover 50% guaranteed in case of loss of project.

6.2 Market risk:Market risk starts from the economics condition of the country, it contains many factors in it which makes the market risk a serious issue for any bank within its jurisdiction. Inflation to begin with is a factor and inflation show the power of the currency, where if it increased the value of the currency will decrease meaning that the payment that the

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bank will receive will be less in value than what it gave as a loan in the first place. Other risk linked to the bank and the project is the Bahraini Food industry, the risk of availability of products and ingredients required to manufacture the chocolate products such as the wheat, milk, flour, peanuts, and chocolates flavor. also the risk of maintain these products through good air conditioned warehouse since food is very sensitive to hot weather and gets damaged with bacteria easily.

Market risk is a major risk and there many elements that contribute to its difficulty to overcome it, the only mitigation plan that any bank can do is to do a very well done feasibility study about the Bahraini food market and the project itself within its specific industry that the Chocolate Factory (Yumyme) operates in, before approving any project financing and even ask the client to bring a market analyst report about his project, also Mr. Ahmed stated that it is recommended to bring a projected financial statements of the business which will help in making decisions for approving the finance. (Ahmed, 2015). Fortunately, we can see that Bahrain economy is doing very where its average inflation rate is around 2.2 which is steady and considered to be very good for the economy and the industry. (Tradingeconomics.com, 2015).

Also, the food industry in Bahrain is growing rapidly where we have Kraft Company state factory in Bahrain, which is the ranked secondly in term of largest Beverage and Food Company in the world. Also, all the equipment and ingredients are available where Bahrain flour mill produce 120,000 tons of flour each year and 600,000 tons of sugar, moreover other companies such as Awal Dairy which is Bahraini company producing fresh milk and dairies. Therefore, the risk of establishing a chocolate factory in Bahrain is considered to be low (Bahrain.com, 2015).

6.3 Operational risk:Refers to all types of internal risks that face the Islamic banking institution, such as poor internal system, community, and processes. One major risk can be defined as the Shariaa control and audit system, as they come through doing their job in auditing some problems occurs in choosing the wrong amount of samples to see how the bank modes of finance are incompliance with the Shariaa. Al-Baraka bank seeks its best to minimize the exposure of operational risk, where Mr. Ahmed said that the bank has hired independent professionals in and created a risk committee headed by Mr. Saud Saleh Al Saleh which is showing in the annual report page 60, where through studying each risk associated with each project and financing to seek the appropriate level of risk to the level of return. (Ahmed, 2015)

Also, its annual report shows in page 62 that the board of directors selects the Shariaa supervisory board, and gives them full authority as independent body to set rules and policies and see the compliance of the bank through their auditing report. The Shari’a

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Supervisory Board report in page 78 concluded the following; all the transactions, contracts till 31st of December are incompliance with Shari’a, also the Shari’a supervisory board profit and loss allocation are confirmed by the bank basis and incompliant with Shariaa principles and rules, and finally all funds arise from prohibited sources will be mandatory by the management to deposited to charitable cause. This report was signed on 8th of February by the chairman Shaikh Dr. Abdul Sattar Abu Ghudah, and other members of the board. (2014 Annual Report, 2015).

7.0 Conclusion:In conclusion, we advise our client use the Murabaha contract that bank Al-Baraka offers as it provides the best solution to finance the Yumyme Chocolates factory. The client will benefit from the many features that this contract offers, such as revolving Murabaha and will be able to complete the project’s requirements of buying more machines for the factory.

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8.0 References2014 Annual Report. (2015) (1st ed., pp. 60, 62, 78). Manama. Retrieved from

http://www.albaraka.com/media/pdf/AnnualReports/al%20baraka%20annual%20report%20english%202014.pdf

Abu Ghuddah, D. Ijarah (Lease) (1st ed.). Al-Baraka Banking Group. Retrieved from http://www.albaraka.com/ar/media/pdf/Research-Studies/fatwa-ijara.pdf

Ahmed, Y. (2015). Credit Department Manager at Bank Al-Baraka. Al Baraka Islamic Bank, Al Baraka Tower, Diplomatic Area, Manama, Kingdom of Bahrain.

Albaraka.bh,. (2015). Al Baraka. Retrieved 31 May 2015, from http://www.albaraka.bh

Albaraka.com,. (2015). Al Baraka. Retrieved 31 May 2015, from http://www.albaraka.com/default.asp?action=article&ID=299

Albaraka.com.pk,. (2015). ABPL Auto Ijarah | Al Baraka Bank (Pakistan) Ltd.. Retrieved 31 May 2015, from http://www.albaraka.com.pk/retail-banking/consumer-finance/al-baraka-islamic-auto-finance

Albaraka.com.pk,. (2015). Corporate & Investment Banking | Al Baraka Bank (Pakistan) Ltd.. Retrieved 31 May 2015, from http://www.albaraka.com.pk/business-banking/corporate-investment-banking/

Bahrain.com,. (2015). Food & Beverages. Retrieved 31 May 2015, from http://www.bahrain.com/en/bi/key-investment-sectors/Pages/Food.aspx#.VWruiz-SySo

Investopedia,. (2008). Murabaha Definition | Investopedia. Retrieved 31 May 2015, from http://www.investopedia.com/terms/m/murabaha.asp

Islamic Finance Affairs,. (2007). Islamic Finance Basics - What is Murabaha, Ijara, and musharakah/mudarabah?. Retrieved 31 May 2015, from

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https://islamicfinanceaffairs.wordpress.com/2007/05/25/islamic-finance-basics-what-is-murabaha-ijara-and-musharakahmudarabah/

Islamic Mortgages from Mortgages for Muslims,. (2015). Islamic Mortgages- Murabaha, Ijarah and Musharaka. Retrieved 31 May 2015, from http://www.mortgagesformuslims.co.uk/islamic-mortgages-murabaha-ijarah-and-musharaka/

Islamic-banking.com,. (2015). Institute of Islamic Banking and Insurance - Murabaha on Shari'ah Ruling. Retrieved 31 May 2015, from http://www.islamic-banking.com/murabaha_sruling.aspx

Symmetrydigital-labs.com,. (2015). MCB Pakistan. Retrieved 31 May 2015, from http://symmetrydigital-labs.com/mcbuat/islamic-banking/maeeshat-murabaha

Tradingeconomics.com,. (2015). Bahrain Inflation Rate | 2008-2015 | Data | Chart | Calendar | Forecast. Retrieved 31 May 2015, from http://www.tradingeconomics.com/bahrain/inflation-cpi

Zandi, G., & Ariffin, N. (2015). Issues on Murabahah Practices (1st ed.). Kuala Lumpu: Islamic University of Malaysia. Retrieved from http://irep.iium.edu.my/3092/2/Some_Issues_on_Murabahah_Practices_in_Iran_and_Malaysian_Islamic_Banks.pdf

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9.0 Appendices:

Appendix 1

Application form

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Appendix 2

Credit approval routing slip

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Appendix 3

Facilities agreement

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Appendix 4

Offer letter

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Appendix 5

Agency contract (Wakala)

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Appendix 6

Local purchase order

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Appendix 7

Invoice

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Appendix 8

Payment latter

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Appendix 9

Brochure

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