One of the major applications of the Murabaha contract in Islamic banking is “documentary credit”. Murabaha is used as part of an L/C opening. Whenever a merchant wants to finance the importation of good, he can approach an Islamic bank to open a murabaha L/C. The bank, applying Murabaha, will (after doing credit evaluation etc.) will ask him to sign on a written promise that he will buy these goods on deferred payment once the because the ownership of the bank and that he is willing to pay an agreed upon mark-up to the bank. The bank will then open the L/C for its own benefit. The Uniform Customs (UCC) indicates that the owner of the goods in transit are the one to his order the goods are sent and whose name is mentioned in the shipping document. The bank will inform the exporter once a L/C is opened for the account of the bank that it is the bank that is buying the goods. This do it violate established rules of the UCC. Once goods are received at the harbor (or airport etc.) they will then be sold, by the bank to its client, who will be given an authorization to clear them through customs. Cost of L/C opening as well as all other incidental expenses including any foreign exchange transaction cost will be added to the purchase price of the goods for purpose of calculating the markup and the total cost.
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Clearly Murabaha L/C is useful when the client needs finance, i.e. don't have liquidity to settle the L/C value at the time of receipt of documents. Otherwise, a standard sight L/C will suffice. However, many Islamic banks opt for opening all their L/C’s on Murabaha basis. This is because experience show that, while bank client is sure at the time of opening the L/C that he will be able to pay his dues once documents were received, sometimes he goes for an overdraft to do that. An Islamic bank will not be able to avail an overdraft facility for him. Then the bank will find itself in a difficult position. This because an Islamic bank is not allowed to lend money on interest, nor to provide an overdraft to a client. To avoid such eventuality, bank will open all its L/C’s on Murabaha basis. Goods will be the ownership of the bank. If the client is capable of making the payment, the good will be sold to him on cash with minimal profit (not exceeding L/C opening fees). If he is not, then they will be sold on deferred payment basis at a mark-up. In the first instance (i.e., if a sight L/C is opened), goods can’t be sold by the bank to the client for they are already his ownership.
Source: An Introduction To Islamic Banking, Shaykh Dr Mohamed Ali Elgari. Republished with permission.
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