Most of the Islamic financing products in the market are “Sale Based” financing. The products are structured based on Islamic concepts such as Murabahah, Bai Bithaman Ajil (BBA), Bai Inah, and Tawarruq which involve buying and selling aqad of an underlying asset between banks and customers. Upon completing a buy and sell aqad with an Islamic bank, a customer’s debt will be created. The debt amount that the customer has to pay to the bank on a deferred payment basis is known as Bank Selling Price.
A Bank Selling Price comprises of financing amount plus the profit margin that a bank books upfront when a financing facility is provided to a customer. For example, the Selling Price of a 5 year financing of RM 100,000 with a fixed rate of 6% comes out to be RM 115,996.80. In this case, the profit margin is RM 15,996.80. Banks will gradually earn the profit margin as banks’ incomes. The earning process will commence on the first day the financing amount is disbursed to the customer and will last until the day the account matures. The maturity date depends on the tenure of the financing. The balance of the profit margin at any point in time which the bank has not earned as income yet is known as Unearned Profit.
When a customer wants to early settle his/her sale based financing debt, a discount will be given to the customer. The discount is known as Ibra’ (rebate). The maximum rebate amount equals to the Unearned Profit amount at the point of the debt settlement. During early days of Islamic Banking in Malaysia, the rebate depends on bank’s discretion. However, Bank Negara Malaysia has issued a Guidelines on Ibra’ (Rebate) for Sale-Based Financing, effective 1st November 2011, which makes it mandatory for banks to grant rebate to customers who settle their financing before the end of the financing tenure.
While rebate on early settlement is probably the most widely discussed and best understood by many, it is actually only one types of rebates applicable to sale based Islamic financing. There are other types of rebates which are related to Grace Period Profit (GPP), Variable Rates Financing and Staff Financing. IT System for Islamic financing products will have to cater for all these rebate types.
Grace Period Profit (GPP) Rebate
Sale based Islamic financing for property under construction will have GPP factored into the Selling Price. The GPP is the upfront profit margin for the progressive disbursement period. The GPP amount is calculated based on full financing amount. Typically, for financing of a property under construction, banks will disburse the financing amount to developers progressively based on claims by the developer which is tied to the percentage completion of the property. Banks will then accrue the GPP to be charged to customer based on actual disbursed amount. Since GPP that is booked upfront is based on full financing amount but the GPP that is charged to customer is based on actual disbursed amount, there will be unutilized GPP amount when the financing is fully disbursed. The unutilized GPP amount will also be given as discount to customer as a GPP rebate.
Variable Rates Financing Rebate
Some of the sale based Islamic financing products are based on variable rates. In this case, Selling Price will be computed based on a Contracted Profit Rate (CPR) but accrual of profit to be charged to customer is based on variable rates (base financing rate plus or minus some spread). The actual rate that is used to accrue profit for bank earning at any point in time is known as Effective Profit Rate (EPR). Throughout the tenure of the financing, EPR can fluctuate following the base rate changes. This means, EPR can be lower than, equal to or higher than CPR. When EPR is higher than CPR, bank can only charge customer the CPR. However, when EPR is lower than CPR which is normally the case, there will be a difference between profit contracted upfront and the actual profit charged. The difference in the contracted profit and actual profit charged will be discounted from customer’s payment to bank. This discount is known as variable rate financing rebate.
Staff Financing Rebate
One of the benefits working in banks is staff financing facility which normally charges discounted rate compared to what normal customers have to pay. In the event the staffs no longer work in the bank, they will have to pay the same rates which other customers have to pay. In order to avoid having to deal with another set of legal documents when staffs’ resign from a bank, banks could compute Selling Price based on normal customer profit rate, similar to the case of contracted profit rate in the variable rate financing. For as long as the staffs work with the bank, bank could set the EPR as the staff rate. The difference between bank earning calculated based on CPR and EPR is known as staff financing rebate.
In summary, based on the various scenario above, rebate or ibra’ plays an important role in structuring sale based Islamic financing. Likewise, an IT system to support sale based Islamic financing must provide flexibility to handle all types of rebates.
My column as appeared in THE MALAYSIAN RESERVE 14 July 2014