Payment delays and defaults
Published: Jul 4, 2010 23:54 Updated: Jul 4, 2010 23:54
The question of late payments, defaults and compensation is potentially just as problematic for Islamic banking and finance as it is for the conventional financial sector.
The major difference is that Islamic banks cannot penalize defaulters or late payers through the interest mechanism because it would be against the ethical principles of Islamic finance which expressly prohibit the giving and receiving of Riba (interest). The Shariah objection to interest that is fixed and pre-determined and the borrower or partner is liable to pay interest no matter what his or the business performance is. In Islamic finance, investors and users of capital share in the risk and reward of an enterprise or transaction, with the bank acting as a Mudarib, the manager.
Islamic financial institutions and their Shariah advisories have long tried to grapple with the issue of delayed payments or defaults, but thus far there is no universal consensus across jurisdictions in this respect. These issues affect almost all types of products - ranging from consumer finance, home loans, leasing and hire purchase, credit and charge cards, to corporate finance, SMEs and sukuk.
If one considers so-called Islamic credit cards, these have been issued by some Malaysian banks under the Bai Al-Inah concept, which is controversial and rejected by Shariah scholars in the Middle East and Pakistan. Others have a pre-payment credit card, where the bank does not charge any interest or pay any interest if the card is in debit or credit according to pre-agreed limits. Other Islamic banks require their cardholders to have feeder savings accounts which would take care of any situation resulting in missed or delayed payments.
In fact, in the last year during the height of the credit crunch and financial crisis, the sukuk market was badly affected not because of the soundness of the structures per se, but because of the quality of some of the issuers and the asset pools. The issuances that were in default were East Cameron Gas Sukuk in Louisiana in the US, The Investment Dar Sukuk, the Saad/AlGosaibi Sukuk, the Green Belt Sukuk. There were also a few stress sukuk such as Nakheel and one or two others in Dubai, where a periodic payment had to be rescheduled but was eventually met.
However, Malaysia in early June 2010 launched official guidelines and resolutions on compensation, rebates and late payment charges relating to Islamic banking and Takaful. These resolutions and guidelines, which came into effect on June 7, 2010, according to Bank Negara Malaysia (BNM) the central bank, are applicable to all Islamic banking institutions licensed under Islamic Banking Act 1983; all banking institutions licensed under Banking and Financial Institutions Act 1989 which participate in Islamic banking scheme; and all development financial institutions prescribed under the Development Financial Institutions Act 2002, which participate in the Islamic banking scheme.
BNM's Shariah Advisory Council (SAC), which is the apex or Shariah authority of last resort for the Malaysian Islamic banking industry, has over the last few months been deliberating on Ta'widh (compensation), Ibra'(rebates) and late payment charges.
In January this year, BNM's Shariah Advisory Council at its 95th meeting held on preliminarily decided that Ta'widh may be imposed on late payment of financial obligation arising from exchange contracts (such as buy and sell and hire purchase) and Qard (loan).
Nevertheless, the council stressed that Ta'widh may only be imposed upon the lapse of the repayment period agreed by both contracting parties. The amount of compensation received, however, may be recognized as income by the seller/financier/creditor on the basis that it is imposed as compensation for actual loss incurred by the seller/financier/creditor. Perhaps most importantly, the rate of compensation would be determined by the central bank and not the parties in the transaction.
In a crucial follow-up meeting last month, the BNM Shariah Advisory Council, further decided that for Ibra' (rebate) for Financing based on buy and sell contracts in line with the need to safeguard Maslahah (the public interest) and to ensure justice to the financiers and customers, Islamic banking institutions are obliged to grant Ibra' to customers for early settlement of financing based on buy and sell contracts (such as
Bai' Bithaman Ajil (BBA) or Murabaha).
BBA (deferred payment) is perhaps the most popular Islamic consumer finance contract in Malaysia and is used for mortgages, hire purchase, trade finance, and even to pool as receivables against which commercial papers are issued by corporates for refinancing and balance sheet purposes or to raise working capital.
However, the council also ruled that in order to eliminate uncertainties pertaining to customers' rights in receiving Ibra' from Islamic banking institutions, the granting of rebates must be included as a clause in the legal documentation of the financing. Once again the rebate formula will be standardized by Bank Negara Malaysia.
Bank Negara Malaysia's Shariah Advisory Council also ruled that the imposition of late payment charges by Islamic banking institutions that comprises both the concepts of Gharamah (fine or penalty) and (compensation) is allowable. This says the council would be "as a deterrent mechanism against cases of default by customers in discharging their financial obligation arising from Islamic contracts."
However, the council warned that the fine or penalty cannot be recognized as income to the bank and as such cannot be included in its balance sheet. The fine or penalty has to be donated to specified and transparent charitable organizations or causes.
In contrast, Islamic banking institutions may recognize compensation as income on the basis that it is imposed on the customers as compensation for the actual loss incurred by the Islamic banking institutions.
Islamic finance encourages dispute resolution through arbitration and mutual discussion. An Islamic financial institution is obliged to try to resolve defaults or late payments through refinancing or restructuring, and any imposition of late payment charges and fines should be a last resort and should consider the customers' financial capability and motives.
During the credit crunch in 2009, mortgages suffered badly in the West and in some emerging markets. In Malaysia and Bahrain, for instance, Islamic mortgage providers such as CIMB Islamic Bank or Sakana Holistic Housing Solutions, both dedicated Shariah-compliant housing finance providers, have had almost no repossessions, partly because the mortgage providers were obliged to extend grace periods, or restructure the financing or in a very few cases help sell the property at the request of the mortgagees.