Reconstruing the Murabaha Facility within a Truly Islamic ...cim.kfupm.edu.sa/ibf2017/papers/5_13.pdf · Reconstruing the Murabaha Facility within a Truly Islamic Financial Architecture

Reconstruing the Murabaha Facility within a Truly Islamic

Financial Architecture

Abstract

Islamic banking is critiqued for employing a legal device in the financial sector of theeconomy to mimic conventional banking. This is attributed to the lack of dynamic Islamicrulings (ijtihad) based on the objectives of the Islamic law (Maqasid al-Sharı’ah). This paperoffers a fresh outlook by focusing on the classic credit sale facility (Bai’ al-Murabaha) in thereal sector of the economy within a framework of vendor financing. This perspective hasthe potential to price a murabaha facility at a rate lower than ongoing markup one. Thisapproach also helps us reconceptualize a financial architecture with the economies ofscale and scope. Our results are consistent with the economic fundamentals and thus theMaqasid al-Sharı’ah. We anticipate our path-breaking efforts to help the emerging Muslimnation’s economies to thrive and alleviate their status with the rest of the world.

JEL Classification: D58, G12, G20, G32, O16, Z12.

Keywords: Bai’ al-Murabaha, Interest, Keiretsu, Maqasid al-Sharı’ah, Vendor financing

1 Introduction

“. . . Islamic economics and finance is still a work in progress and has a long way to go before it canoffer a viable market-consistent alternative to the modern banking and financial system. Unlessthere is a general willingness by the. . . proponents of Islamic economics and finance to modernizetheir overall framework and put it through the rigorous scientific method of inquiry currentlyapplied in the field. . . of economics and finance, Islamic economics is likely to remain a small playerin the rapidly developing global economic system.”

(Ahmed, 2015, p. 61)

The 57 Muslim-majority countries in the world are highly underdeveloped (Kuran,1997; Ebrahim et al., 2016) as they contribute only 8.26% of the global economy despiteconstituting 23.44% of world population. In contrast, the 28 countries in the EuropeanUnion (EU), which constitute only 6.94% of world population, contribute 23.53% of theworld economy.1

In a well-known study, Kuran (1997) documents a U-shaped relationship betweenMuslim population and per capita income using 1995 data. His preliminary regressionresult poses the question: Why do Muslim-majority countries tend to be economicallyunderdeveloped as compared to the rest of the world? The static nature of Islamic rul-ings (ijtihad) is alleged to be one of the causes of underdevelopment in the Muslim world(Schacht, 1964).2,3 This hinders the Muslim world from dynamically responding to thechanges in the environment through institutional reforms.4

In the realm of finance, Ebrahim et al. (2016) assert that these rulings have been sta-tic as the deductive basis employed by the scholars through the ages has been from apurely legal perspective (involving what is termed as the ‘effective cause’–‘illah) of legaljudgement instead of the objectives of Islamic law (Maqasid al-Sharı’ah) stemming from

1The contribution is measured by the GDP in current US dollars. The figures for both GDP and popu-lation data are obtained from World Bank’s database. Due to limitation of the data source, Palestine andSyrian Arab Republic are not included. Furthermore, since 2015 the GDP data for Comoros, Gambia, Iran,Mauritania and Yemen are not available. They are replaced by 2014 or 2013 data.

2Ijtihad literally implies ‘exertion’ or ‘effort’ expended by a jurist to deduce the law, which is not evidentfrom its sources (Kamali, 2000).

3Dynamic ijtihad was espoused by the well-known jurist Ibn Qayyim Al-Jawziyyah roughly 700 yearsago. However, it was never implemented by the Muslim world due to blind adherence (taqlid) to variousschools of thought in Islam (Ibn Qayyim al-Jawziyya, Shams al-Dın Abu cAbd Allah Muhammad, 2004).

4Our paper is consistent with the views of Stulz and Williamson (2003) and Elnahas et al. (2017), whoemphasize the impact of culture (including values extracted from religious scriptures) on economic policiesand institutions.

1

economic rationale (hikmah or ‘wisdom’).5,6 The ‘effective cause’ based Islamic rulingsare most likely to be conducted through the analogical reasoning (qiyas), which are re-stricted to very limited situations. In contrast, the objective based Islamic rulings are yetto be developed on the economic rationale. This not only considers the meaning of thetexts, but also goes beyond by taking into account what does the Lawgiver’s intent in thescriptural sources.

One of the inconsistencies in the theoretical literature is that of the divergence of thetheoretical profit-sharing (quasi-equity) Islamic banking model of Uzair (1976) from thecontemporary model. The latter employs a legal device termed as the murabaha to thepurchase order (commonly called banking murabaha as explained below).7 Although thisfacility is not inconsistent with the ‘effective cause’ based rulings, yet it has extensivelybeen employed by the industry despite unfavorable implication from the context of theobjectives of the Islamic law. It is thus not surprising that the 40-year old Islamic bankingexperimentation using this legal device to solve the problem of underdevelopment of theMuslim world is being challenged (Khan, 2010).

The murabaha contract, initially allowed by the scholars to facilitate the development ofthe industry due to lack of equivalent instruments, raises several criticisms that questionits legitimacy. Critics describe the operation as a mere ineffective replication of an interest-based loan, an inefficiency that results from the complex set-ups put in place to make the

5The Islamic legal literature contrasts the rulings based on ‘effective cause’ with those based on ‘wis-dom’. For instance, the ‘effective cause’ forbidding the bartering of unequal amounts of differing qualitiesof fungible commodities is the lack of equivalence (Al-Zuhayli, 2003). In contrast, the wisdom or rationalebehind it is to avoid injustice (or ‘expropriation’ of a counterparty’s assets as stressed in the Qur’an (4:161)).The rationale-based decisions are stronger than the ‘effective cause’ based one as illustrated in this paper.

6The objectives of the Islamic law (Maqasid al-Sharı’ah) are to ensure the preservation of faith, intel-lect, life, lineage and wealth of human being (Kamali, 2000). Auda (2008) describe the Maqasid as today’smost important intellectual means and methodologies for Islamic reform and renewal. He argues that theMaqasid are introduced as basis for new opinions (ijtihad) in the Islamic law. For Chapra (2007), the Shari’ahserves the purpose of helping human beings reform themselves as well as the institutions that affect them.The re-embededness of the Maqasid in the Islamic finance practice could bridge the form versus substancegap and promote the link to the real economy, a key principle in Islamic finance.

7The murabaha sale is akin to a fiduciary forward (i.e., markup) sale at a stated profit margin (Al-Zuhayli,2003). This markup sale facility in the medieval Islamic era incorporates the concept of contemporary tradecredit, as described below. Despite the link between the two facilities, the contemporary Muslim scholarshave treated the issue of trade credit (in the real sector of the economy) as a substitute for bank credit (inthe financial sector) without contemplating the non-financial reasons behind this issue (Klapper et al., 2012;Dass et al., 2015).

2

transactions conform to the Sharı’ah.8,9 In the long-run, not only cultural (i.e., Islamic)finance but other forms of financial intermediation may also not be accepted for theirfailure to be ethical. This has major (both financial as well as social) repercussions for notonly the emerging Muslim economies but also the rest of the world. Thus, rejuvenatinggrowth of Muslim economies through an efficient financial intermediation system is yetto be conceptualized.10

Therefore, the need of the hour is to structure an efficient financial intermediationsystem consistent with the cultural values of the Muslim world. We do this by salvagingthe markup sale facility employed in the contemporary Islamic banking industry andlinking the same with the contemporary trade credit facility.11 This paper incorporates theobjectives of the Islamic law in the pricing of this facility within a truly cultural financialarchitecture and to contrast it with its conventional banking counterparts.

This study thus aims to accomplish the following. First, we structure the credit salefacility in its proper, i.e. historical, context. That is, as one providing vendor financing inaccordance with the economic intuition of facilitating trade.12 This is because murabahain early Islam was employed to increase the demand for goods sold on credit and tocomplete the markets (Sen (1998)). Our approach thus involves relating this facility withthe well-known trade credit (TC) found in the corporate finance literature (Dass et al.(2015)).13 Second, we link the classic murabaha within a universal Islamic banking ar-chitecture by employing the Japanese concept of Keiretsu (Miwa and Ramseyer (2002);

8There is a cultural/religious taboo against interest based debt contracting, which is rationalized oneconomic fundamentals as elaborated in the next section.

9To allay this criticism Thomson Reuters, in cooperation with the Accounting and Auditing Organizationfor Islamic Financial Institutions (AAOIFI), have proposed an ‘Islamic’ Interbank Benchmark Rate (IIBR)to distinguish it from an interest-based index such as LIBOR and to help the industry price its credit salefacility (AAOIFI, 2007). The creation of IIBR does not absolve it from the main criticism espoused in the cor-porate finance literature that bank credit is not really a good substitute for trade credit (Klapper et al., 2012;Dass et al., 2015). Furthermore, efficiency of the financial sector of the economy will force IIBR to convergeto conventional interest rate index (Azmat et al., 2015). We empirically confirm this in a separate exerciseon the long-run correlation between IIBR and LIBOR by using the well-known Johansen cointegration test(Johansen, 1991). This empirical exercise is available from the authors upon request.

10The efficiency of the financial intermediation (FI) system is crucial for economic welfare. This is becausefinancial intermediaries connect asset prices to the macroeconomy (Glaeser (2000)). An efficient FI systemmakes the economy less susceptible to shocks and helps it to grow faster (Blejer (2006)).

11Our Appendix A.2links the pricing of the murabaha sale with that of the trade credit facility.12The Qur’anic verse (2:275) segregates trade based financing (in the real sector of the economy) from

debt financing (in the financial sector). It encourages employment of the former while admonishing the useof the latter.

13Trade credit (TC) is defined by (Dass et al., 2015, p. 1867) as “bundling the sale of the merchandise withcredit to downstream firms.”

3

Santos and Rumble (2006)).14 Finally, we price the classic murabaha consistent with theobjectives of the Islamic law. That is, without employing an interest-based index. Thisis conducted by extending the Rashid and Mitra (1999) (R&M) analysis to illustrate themurabaha discount rate as being lower than interest rates in periods of monetary tighten-ing or financial crisis.15 Our result is consistent with these of Nilsen (2002), Fabbri andMenichini (2010) and Klapper and Randall (2011) but contradictory with Cunñat (2007),Ng et al. (1999) and Klapper et al. (2012).

This paper is organized as follows. First, in Section 2, we discuss our findings tointegrate our contributions specific to the cultural context of Islamic finance within themainstream economics and finance literature. Next, in Section 3, we theoretically price theclassic murabaha facility by employing the intuition from vendor financing (i.e., corporatefinance) literature. Finally, we conclude our study in Section 4.

2 Islamic finance cultural context v.s. the mainstream eco-

nomics

This section integrates the rich corporate finance literature on trade credit with the Islamicvalue system.

2.1 Islamic Finance View on Interest Bearing Debt

Islamic law condemns the Arabic term ‘riba’ in every transaction (El-Gamal (2006)). Ribais construed literally by the scholars as an “increase” or “excess” (Al-Zuhayli (2003)),where the legalistic terminology (based on effective cause) defines it as “trading two goodsof the same kind [genus] in different quantities, where the increase is not a proper compensa-tion” (El-Gamal, 2006, p. 49). According to this nomenclature, the interest bearing debtwhich exchanges money for money is considered as a prohibited (i.e., ribawi) transac-tion. Ebrahim et al. (2017), however, employ a rational expectations framework within a

14Keiretsu is defined by (Santos and Rumble, 2006, p. 424) as “groups of Japanese firms from the nonfinancialand financial sectors that are connected by interlocking shareholdings.”

15Rashid and Mitra (1999) (R&M) model trade credit in a partial equilibrium framework. That is, byanalyzing a firm selling goods to a buyer in the real sector of the economy. In contrast, we take a generalequilibrium approach to modelling the supply chain in conjunction with consumers thereby incorporatingthe respective supply as well as demand sides of a good. This makes our analysis quite rich in incorporatingthe conflict of interest between the two competing economic agents.

4

perspective of the objective of the Islamic law (Maqasid al-Sharı’ah) to rationalize the pro-hibition of interest bearing debt to the potential harm ensuing from the: (i) expropriationof either borrower’s or lender’s wealth;16 (ii) fragility of macroeconomy; and (iii) financialexclusion of the poor.

As interest bearing debt is deemed to be endemic of the banned riba, Islamic bankingdevelops products which do not embody any kind of “increase” or “excess” in receipt andpayment of the same genus. The employment of the banking murabaha facility is designedto circumvent the proscription of interest bearing debt. This is conducted by construinga credit sale facility as a substitute for bank debt through the sale of a good or asset(which does not share the same genus as currency) for money later. This is rationalizedas permissible by employing the Qur’anic injunction “God has permitted trade and forbiddenriba” (Q2:275).

2.2 Is Islamic Banking a New Paradigm?

Islamic banking was conceived along the lines of a mutual fund by Uzair (1976). That is,using the concept of a two-tier profit sharing medieval facility of mudharabah. This insti-tutional structure relied on a quasi-equity based model endowing growth and stability tothe financial sector of the economy. The implementation of this model of Islamic bankingwas believed to be a major breakthrough to stem the tide of underdevelopment of theMuslim world.

However, this model did not work in practice due to information and transaction costsin conjunction with a poorly functioning legal infrastructure (Khan (2010)). Some ad-justments were needed to make Islamic banking more pragmatic and competitive to itsconventional counterpart. These endeavors thus yielded the legal device of “Murabahato the Purchase Ordered” (commonly called as banking murabaha) proposed by the Is-lamic Development Bank (IDB) laureate, Sami Hamoud in 1976 (Kahf (2013)). That devicemodified the concept behind the medieval credit sale facility of classical murabaha whichsupposedly initiated a new paradigm in banking. The banking murabaha facility is cur-rently employed for liquidity management, Sukuk (Islamic bond) issuance and credit-sale

16Agency cost of debt involves expropriation of the assets of the borrower (stemming from underin-vestment) or that of the lender (stemming from risk shifting). Underinvestment refers to the tendency ofborrowers to reject profitable (i.e., the positive net present value - NPV) projects if the increase of wealthmainly benefits the financiers. Risk-shifting refers to the transfer of the downside risk by the borrower tothe financiers.

5

transactions.17 This is critiqued by (Ahmed, 2015, p. 61) cited earlier in our introduction.

2.3 The Economics of Trade Credit (TC) misconstrued in the Classic

Murabaha

The classic murabaha facility is a forward sale and is related to a credit sale discussed inthe corporate finance literature under vendor financing.18 The literature describes TCas an alternative to bank loans for the following reasons: (i) comparative advantages ofsupplier financing; (ii) price discrimination; (iii) warranty for product quality; and (iv)transaction cost. We elaborate these theories along with their empirical investigation inthe sub-section below.

2.3.1 Financing advantage perspective

Suppliers offering credit to buyers enjoy numerous financing advantages over financialinstitutions (Ng et al. (1999); Nilsen (2002); Shenoy and Williams (2017)). This is of im-portance when the rule of law is weak and firms do not have legal recourse in case of de-faults. Another issue is related to information problems and monitoring the repaymentsthat may deter the establishment of financial institutions (Fisman and Love (2003)). Weakcreditor protection and imperfect information may affect both suppliers and formal finan-cial intermediaries. However, suppliers may moderate these effects better than financialinstitutions. Thus, TC provider may have an advantage in investigating the credit wor-thiness of his clients and enforcement of repayment of the credit.

2.3.1.1 Comparative advantage in information acquisition Suppliers have a relativecost advantage over banks in the acquisition of information about the financial status ofthe buyers. Financial institutions may also collect information about the buyers. How-ever, suppliers may be able to comparatively obtain superior information quickly and ata lower cost (see Brennan et al. (1988); Biais and Gollier (1997); Itzkowitz (2015)).

17(Usmani, 1998, p. 72), an eminent Sharı’ah scholar, quotes: “It should never be overlooked that, originally,murabahah is not a mode of financing. It is only a device to escape from ‘’interest” and not an ideal instrument forcarrying out the real economic objectives of Islam. Therefore, this instrument should be used as a transitory step takenin the process of the Islamization of the economy, and its use should be restricted only to those cases where mudharabahor musharakah are not practicable.”

18The religious scholars impose a precondition on the asset reputedly being “sold” on credit. It should notbe classified as one having “ribawi” characteristics. That is, it should not constitute a medium of exchangein terms of being a currency or a commodity in medieval Islam (Al-Zuhayli (2003)).

6

2.3.1.2 Comparative advantage in contract enforcement Cunñat (2007) argues that inrelation to the limited enforceability of contracts, suppliers may have an advantage overfinancial institutions in providing trade credit to customers as they may threaten to stopfuture supplies of intermediate goods. In the case where there are few suppliers de-pending on the nature of the good being supplied, the supplier may be able to controlbuyer better compared to the financial institutions. While a financial institution may alsothreaten to withdraw future finance, it may have little immediate effect on the borrower’soperations. Furthermore, the financial institution may have limited powers to withdrawpast finances because of bankruptcy laws.

2.3.1.3 Comparative advantage in liquidating default borrowers TC provision con-fers an advantage19 in salvaging value of assets in case of default (Fabbri and Menichini(2010)). If the buyer defaults, the seller may reclaim the goods that are supplied. Finan-cial institutions can also repossess the firm’s assets to pay off the debt. However, the costsof resale may be lower for a supplier than those of a financial institution if the supplieralready has a network for selling its goods. Due to advantages in the liquidation process,the supplier would lend to a customer even if the financial institution would not.

2.3.2 Price discrimination perspective

TC allows vendors to price-discriminate its buyers based on their credit history. TC maybe advanced even if the supplier does not have a financing advantage over financial in-stitutions (Brennan et al. (1988), Petersen and Rajan (1997)).

An alternative view of this is that the supplier may not provide trade credit to a riskycustomer solely because of short-term goals, but it may have a long-term objective in thesurvival of the customer firm, thereby protecting the value of its implicit equity stake(Wilner (2000)). It is especially relevant if there are no potential substitutes for the cus-tomer. The supplier then considers the present value of the profit margins on future salesbeside net profit margin on current sales while deciding the provision of trade credit. Thesupplier may also discriminate and subsidize risky borrowers with low-interest rates sothat they may take an advantage in the future by charging higher rates to the firms that

19This comparative advantage comes at a cost as it allows the risk of the buyer to permeate up the supplychain to the seller of the good (Lian (2017)). This increase in the risk of the seller may bestow either of thetwo benefits to it: (i) an increase in the bargaining power of the supplier vis-à-vis the buyer (Fabbri andKlapper (2016); Oliveira et al. (2017)); or/ and (ii) an increase in the price of a credit facility higher than abank (Cunñat (2007); Ng et al. (1999); Klapper et al. (2012)).

7

survived.

2.3.3 Product warranty perspective

Some industries may require TC to serve as a guarantor of product quality (Long et al.(1993); and Emery and Nayar (1998)). Accordingly, the supplier may willingly providecredit for products which need more quality assurance for their inputs e.g. high-technologyor newly developed products, to allow the customer sufficient time to test the product(Long et al. (1993)). Other studies argue that the trade credit terms offered by the suppliermay serve as an indication of product quality (Emery and Nayar (1998)).

2.3.4 Transactions costs perspective

TC exists to reduce the transaction costs of paying bills on delivery (Ng et al. (1999);Nilsen (2002)). Depending on the nature of the products, transaction costs for some in-dustries may be higher as they may need more frequent deliveries of inputs than others.Instead of making a payment every time goods are delivered, a customer might want topay for them only monthly or quarterly. It will also enable a firm to separate the paymentcycle from the delivery schedule.

Another view of this involves industries with strong seasonalities in consumption pat-terns for their products. They may have to build up large inventories in order to maintainsmooth production cycles. This involves the costs of financing and the cost of warehous-ing the inventory. Therefore, firms may be able to maintain inventory position better ifthey offer trade credit over time and selectively to the customers who have a better abilityto keep inventory (Emery (1987)).

3 The Way Forward

This section first discusses the germ of the idea behind reforming the Islamic financialarchitecture by reconstruing the murabaha sale facility. We then model the same along thelines of TC offered by a seller of a generic (or a specialized) good in the real sector of theeconomy.

8

3.1 Restructuring the Murabaha Facility Within a Truly Islamic Finan-

cial Architecture

Construing the murabaha facility in the financial sector is not worthwhile as arbitragewill force any so-called ‘Islamic’ Interbank Rate to converge to the conventional rates(Azmat et al. (2015)). The best alternative is to link the murabaha to the real sector ofthe economy by employing the original economic rationale. That is in reference to thefact that, at the time of early Islam, a murabaha was employed to increase the demand forgoods sold for credit and to complete the markets (Sen (1998)). This requires us to connectour model with that of trade credit or vendor financing (see Brennan et al. (1988); Shenoyand Williams (2017)). This entails pricing the demand and supply of the trade credit by aUniversal Islamic Bank (UIB).

[Figure 1 about here]

Figure 1 illustrates the gist of the Universal Islamic Banking architecture allowing it toown an equity stake of a merchant (trader). This is consistent with the spirit of risk shar-ing in Islam (Ebrahim et al. (2017)). The merchant sells its goods on credit via murabahafacility to the customers in the real sector of the economy and prices it in equilibrium inaccordance with supply and demand mechanism, instead of an interest rate benchmark.Finally, a UIB serves a crucial role as the receivable collectors. It should be noted that thetrade credit or vendor financing literature illustrates that merchants have a competitiveadvantage over banks as discussed in Section 2.3.

Our proposed Islamic banking architecture has the following advantages in contrastto that of Uzair (1976). First, our UIB can suitably accommodate the equity-based natureof Islamic finance to stem the decline of emerging Muslim economies. In our model, aUIB is not the entity to underwrite sale-based murabaha mode of financing. It rather ownsthe equity of the merchants, which offer credit murabaha as they can evaluate the creditrisk of their customer better (see Biais and Gollier (1997)). The investment of the UIB inthe merchants is predominantly that of equity which is akin to the medieval musharakahform of financing.20 The profit/loss sharing ratio for the UIB and the firm would thentrivially be evaluated as the fractions EB

EB+EFand EF

EB+EFrespectively, where EB and EF are

the respective equity stake of the bank and firm in the supply chain.

20One may also consider a hybrid contract between an UIB and a merchant in lieu of an equity stakein the form of a preferred participating facility involving various combinations (i.e., options) of sharingincome or appreciation (see further Ebrahim et al. (2017)). However, this is beyond the scope of this paper.

9

Second, a UIB model can still utilize the murabaha contract through their linked-mer-chants as it remedies chronic issues of banking murabaha including the ownership andbenchmark-pricing problem. The former is easily tackled, as banks are no longer neededto pre-own the goods ‘sold’ by them. Instead, the goods sold are pre-owned by theirlinked-merchants. The latter is solved using the pricing model as illustrated by the supplyand demand mechanism in the following section. This solution thus re-embeds UIBs withthe real sector of the economy.21

Third, integration of business between a UIB and merchants is consistent with thetheory of comparative advantage. This is because a merchant is better at evaluating andenforcing the contract with its buyers (Petersen and Rajan (1997); Cunñat (2007)), whileUIBs are better at collecting the account receivables as they have a more established net-work system to do so. A merchant may also have information acquisition’s advantageover banks as they can obtain information about their customers promptly and at lowercost (see Biais and Gollier (1997)). A merchant also has an advantage in the event of de-fault. Though indeed, the merchant bears the cost of default like a bank does, it has theability to resale the default assets better than a bank (Fabbri and Menichini (2010)). More-over, our model illustrates economies of scale by reducing transaction costs. This holdstrue as our model implies a shorter supply chain where the IBs do not need to endure thetransportation, inspection, carrying cost, neither the risk of the product since the productis already in the warehouse of their merchant.

Fourth, Figure 1 illustrates that the merchant need not be selling only tangible goods.The merchant can also be a service provider like an accountant, lawyer etc. In this case,our UIB also increases the economies of scope.

Finally, our UIB model also mitigates the fiduciary risk thereby leading to long-termreputational enhancement of the Islamic banking industry. This is because the modelcomplies with the form as well as substance. In other words, our proposed Islamic fi-nancial architecture conforms to the objectives of the Sharı’ah (Maqasid al-Sharı’ah) as thefinancing is conducted in the real sector of the economy.

Thus, from the above advantages, we believe that our proposed model can be a cata-lyst to reviving the moribund emerging Muslim economies. Though the intuitive modeldescribed above is theoretically appealing, a number of conditions need to be addressedin order to implement it in the real world. The main challenge comes from the regulatory

21A banking murabaha exposes the financier solely to the credit risk, operational risk and market risk. TheUIB model, on the other hand, jointly exposes both the merchant as well as the financier to the credit risk,while the ownership risk of the asset resides solely with the merchant.

10

constraints in some countries, as they do not allow banks to engage in equity transactions.This is true in the specialized banking system such as that of the USA, which precludesbanks from having equity stake in the firms they serve (Boyd et al. (1998)).

Nonetheless, the proposed model best fits within the universal banking system of Ger-many where the banks are permitted to have an equity stake in addition to loans, withvoting rights and even placing their representative on the board of directors of the firmsthey serve (Boyd et al. (1998)). In addition, the model may also be implemented withinthe Japanese main banking system, which has resembled Germany’s. This is despite thepost-WWII regulation, which does not permit Japanese banks to have an equity positionin the non-bank firms of more than 5%, akin to that of the USA. In emulating the Ger-man financial system, the financial architecture in Japan resembles the ‘keiretsu’ system,where companies are related to each other and to the main bank by mutual shareholding(Benston (1994)). This structure endows universal banks: (i) the economies of scale andscope; and (ii) to be active in corporate governance (Berglof and Perotti (1994)). Thus, weenvision the universal banking models of Germany and Japan to be more appropriate toaccommodate the proposed Islamic banking architecture.

3.2 Modelling the Murabaha facility in the Real Sector of the Economy

Our goal is to develop an equilibrium model to evaluate the classic murabaha discount(profit) rate, m∗, integrating the price elasticities of the product from the perspective offirm-UIB supply chain (εs), as well as that of consumers (εc).22 We do this by extendingRashid and Mitra (1999) model, by incorporating the firm-UIB (i.e., supply) side optimisa-tion function in addition to the consumers’ (i.e., demand) side to solve for the equilibriumtrade credit rate.

We assume a single period setting where the supply chain sells Q units of a productto several consumers. The goal of the supply chain is to set the terms of its credit (i.e.,murabaha) sale as δs and a net period of n. That is, δs % discount for immediate payment ora full payment at the end of n days. The supply chain faces a variable cost of v per dollarof sales and sells at a price P to its credit customers at time n. Production is assumedinstantaneously taking place at the time of sale.

We assume further that a portion θ of customers decide to buy the goods or serviceson the spot, while a portion 1− θ buy the same on credit. Of the consumers, who opt for

22The murabaha discount rate (m) is linked with that of the trade credit one (δ) as illustrated in the Ap-pendix A.2 as follows: m = δ

/(1− δ) .

11

credit, a proportion ω pay in one lump sum on time at n, whilst 1−ω default. We furtherassume that ks and kc represent the opportunity costs of capital for the supply chain andconsumers, respectively.

In developing our analysis, we first model the optimal trade credit rate from the per-spective of the supply chain. This is followed with that of the customers. The two modelsare then simultaneously solved to determine the equilibrium trade credit rate. This isthen linked to the equilibrium murabaha rate derived in the Appendix A.2. Finally, weillustrate our model solution with numerical simulations.

3.2.1 Modelling the Supply Side

In this section we model the supply chain consisting of a joint firm-UIB entity.23 Theobjective of the supply chain is to maximize the present value of its future cash flow, Vs,with respect to the firm’s trade credit rate (δs)

maxδs

Vs s.t. : (1)

Vs = θpQ+ (1− θ)ωPQ (1+ ks)− n

360 − vPQ , (2)

where Q is the total quantity supplied and

p = (1− δs) P (3)

is the discounted price offered to cash customers. The terms on the right hand side (RHS)of equation (2) illustrate: (i) payments made by cash customers; (ii) present value (PV) ofpayments made by credit customers;24 and (iii) costs incurred by the supply chain.

To maximize Vs with respect to δs we evaluate the usual First Order Necessary Condi-tion (FONC)

∂Vs (δs)/

∂δs = 0 . (4)

Dividing the resulting expression by P gives

23This section, 3.2.1, emulates the partial equilibrium analysis of Rashid and Mitra (1999), while Sections3.2.2–3.2.4 extend the same in a general equilibrium perspective.

24ks is the opportunity cost of capital of the supply chain.

12

(1− δs −ωβ)Q∂θ

∂δs+ (1− θ) βQ

∂ω

∂δs− θQ

+((1− δs)θ + (1− θ)ωβ− v)∂Q∂δs

= 0 (5)

where we used notation β for the discount factor (1+ ks)− n

360 . This is a function of thepartial derivatives ∂θ

∂δs, ∂ω∂δs

and ∂Q∂δs

. To proceed further these three derivatives have to berationalized.

Rashid and Mitra (1999) term the first two of these derivatives as ‘behavioral specifi-cations’ as they pertain to the behavior of the consumer. The first one specifies the portionθ. It is argued that as the discount rate (δ) increases, consumers avoid buying on credit.That is, they seek alternative sources of financing and opt to pay cash for their purchases.This implies that25

∂θ

∂δ> 0 (6)

To derive the optimum trade credit rate (δ∗), the relationship between δ and θ needs to befurther specified. It must be such that when δ = 0, then θ = 0 and when δ is very highthen θ = 1. Thus, this implies that θ is an increasing function of δ and is between the twoextremes. A simple relationship capturing this is a linear one given as follows.

θ = γδ (7)

where γ > 0 is a positive constant. Furthermore, because δ = γ−1 implies that 100%of customers switch to cash purchase (θ = 1), the following range must be observed formeaningful δ-s

0 < δ < δ = min{

1, γ−1}

. (8)

The second ‘behavioral specification’ pertains to ω, the proportion of credit customers,who do not default. Unlike that of θ, the relationship of ω, with respect to change in δ isnot straight forward. Two possibilities are feasible. They are given as follows. First, con-sistent with the effect on θ, an increase in δ encourages customers to make cash payment,instead of using the trade credit facility. This lowers the numbers of credit customerswho pay on time. Second, the higher number of customers who make cash payment alsolowers the number of those who default. We argue that these two opposing effects bal-

25Because the specification of θ and ω are the same for supply side as well as for the demand side, we donot use subscripts ‘s’ in the discount factor δ in this and the next paragraph, where ω is defined.

13

ance each other, resulting in a coefficient ω which remains stable through the process ofchanging δ. This implies

∂ω

∂δ= 0 . (9)

Finally, a specification of ∂Q∂δs

must be implemented. To model the supply side this isbest apprehended by linking the quantity supplied, Q, to the elasticity of supply εs. Fromthe point of view of the supplier, a higher discount rate δs has a doubly negative effect oncash sales S = pQ. A higher discount rate δs results in a lower unit price p = (1− δs) P.Moreover, a lower unit price, p, results in a lower quantity, Q, the producer is willing tosupply. Introducing the elasticity of supply

εs =∂Q∂p

pQ> 0 (10)

we can write

∂Q∂p

> 0 =⇒ ∂S∂δs

= −PQ− Pp∂Q∂p

= −PQ (1+ εs) < 0 . (11)

Because the elasticities of supply are normally positive εs > 0, a decrease in price ∂p < 0coupled with lowered quantity offered (∂Q < 0, on the supply side) yields a lower salesfigure. Equivalently, an increase in offered discount, ∂δs > 0, yields a decrease in quan-tity offered (∂Q < 0) by the supplier which negatively impacts sales S. In contrast,Rashid and Mitra (1999) proceed with a ‘behavioural specification’ of sales net of dis-count, S (δ), before introducing the corresponding elasticity ε. However, they analysenegative elasticities, including the case ε < −1 which would have a positive impact onsales ∂S (δ)

/∂δ > 0. In fact their negative elasticities correspond to elasticities of demand,

rendering their analysis of supply side inconsistent with economic theory.Moreover, we also have

∂Q∂δs

=∂Q∂p

∂p∂δs

= −∂Q∂p

pQ

Qp

P = −εsQ

1− δs(12)

Substituting (7), (9) and (12) back into (5) and dividing by Q we obtain

(1− δs −ωβ)γ− γδs − ((1− δs)γδ+ (1− γδ)ωβ− v)εs

1− δs= 0 (13)

Multiplying both sides by 1− δ gives a quadratic equation in δ

asδ2 + bsδ+ cs = 0 , (14)

14

where

as = γ (εs + 2) , (15)

bs = −γ(

εs + 3− βs,nω (εs + 1))

, (16)

cs = γ+ vεs − βs,nω (εs + γ) , (17)

and βs,n = (1+ ks)−n/360. Roots of the above quadratic equation (14), falling within the

valid range (8) i.e. (−bs ±

√b2

s − 4ascs

)/2as ∈

(0, δ)

(18)

are candidates for the internal optimum discount rate δ∗s for the firm-UIB supply chain.Otherwise, the candidates for the optimal solution are at the boundaries of the range, 0 orδ.

3.2.2 Modelling the Consumers

From consumers’ perspective, the objective is also to maximize the present value of theirfuture cash flow with respect to the discount rate (δc). The aggregate present value offuture cash flows for all consumers is given as follows

maxδc

Vc (δc) s.t. : (19)

Vc (δc) = τPQc (p)− θ (δc) pQc (p)− (1− θ (δc))ωPQc (p) βc,n , (20)

where δc is the discount rate consumers would ideally like to be offered,

p = p (δc) = P (1− δc) (21)

is the discounted price; andβc,n = (1+ kc)

− n360 (22)

is the consumers’ discount factor, with kc the consumer’s opportunity cost of capital. Thefirst term of the equation (19) represents the perceived worth of the goods (or services)purchased by the consumers. The value of τ is positive and equals to one (i.e., unity) ifthe goods are valued at par. Their worth may also be less or more than one if they arevalued at a discount or premium respectively. The second term represents the spot pricepaid (net of discount) by the cash customers. Finally, the last term reflects the discountedcost paid by credit customers.

15

The customers’ side reflects the same behavioral assumptions as those of the supplychain in terms of θ (δc) and ω (see again equations (9) and (7)). Furthermore, consistentwith the supply side analysis, the total quantity demanded Qc (·), is assumed a functionof the effective spot price p (i.e. discounted price P).

The necessary steps to derive the optimal consumer’s discount rate mimic those weemployed for deriving the optimal supplier’s discount rate. First, to maximize Vc withrespect26 to δ we compute the demand side FONC

∂Vc (δ)/

∂δ = 0 . (23)

We divide the resulting expression by P. We then integrate the behavioural assumptions(9) and (7).

Finally, we incorporate the elasticity of demand

εc =dQc

dpp

Qc≤ 0 (24)

A higher discount rate δc impacts on the spot price of the product contingent on its priceelasticity, εc. We can express the impact of an increase in δc on sales S as

∂S∂δc

> 0⇐⇒ −PQc − Pp∂Qc

∂p> 0⇐⇒ ∂Qc

∂p< −Qc

p< 0 (25)

i.e. sales increase only if the quantity demanded increases sufficiently enough ∂Qc > 0following a decrease in price ∂p < 0. Incorporating the price elasticity of demand thistranslates into

∂S∂δc

> 0⇐⇒ εc < −1 . (26)

The demand for an elastic product (εc < −1) responds to the changes in δc more exten-sively. That is, an increase in δc leads to an increase in sales S. On the other hand, thedemand for an inelastic product (−1 < εc) is less sensitive to a change in price. That is,an increase of δc leads to a decrease in sales S.

∂S∂δc

< 0⇐⇒ εc > −1 (27)

26Analogously to Vs, the consumer’s present value Vc is also a function of P, kc, τ and n.

16

Finally, a unitary elastic good (or service) does not affect the level of sales S

∂S∂δc

= 0⇐⇒ εc = −1 . (28)

After incorporating the elasticity of demand, εc, we multiply both sides of the resultingequation by (1− δ) /Qc. This gives

τεc − γ (δ (2+ εc)− 1) (1− δ)− βc,nω (γ (1− δ) + εc (1− γδ)) = 0 . (29)

As before, to solve for δ, we recognize this is a quadratic equation in δ

acδ2 + bcδ+ cc = 0 , (30)

where

ac = γ (εc + 2) , (31)

bc = −γ(

εc + 3− βc,nω (εc + 1))

, (32)

cc = γ+ τεc − βc,nω (εc + γ) , (33)

and βc,n = (1+ kc)−n/360. Roots of the above quadratic equation (30), falling within the

valid range (8) i.e. (−bc ±

√b2

c − 4accc

)/2ac ∈

(0, δ)

(34)

are candidates for the internal optimum discount rate δ∗c for consumers. Otherwise, thecandidates for the optimal solution are at the boundaries of the range, 0 or δ.

Compared to the quadratic equation for suppliers (14), the quadratic equation for con-sumers (30) incorporates the demand side price elasticity εc < 0, the consumer’s opportu-nity cost of capital kc (via the consumer’s discount factor βc,n), as well as the consumer’sperceived worth of good’s τ. Coefficients {ac, bc, cc} structurally mirror those for the cred-itor’s, {as, bs, cs}. However, there is a change in sign which reflects their demand side role.

3.2.3 Market Clearing Condition

For markets to clear, the bid (δc) and the ask (δs) prices of trade credit should equal alongwith their respective quantities bought on credit. This yields:

δs = δc = δ . (35)

17

Since prices of financial facilities and discount rates are inverse of each other, the aboveequation implies that the bid price equals the highest buy order, while the ask price equalsthe lowest sell order. The above requirement can be combined with conditions (14) and(30) for the supply chain side and consumers’ side, respectively. In general, when ks 6= kc,εc < 0 and εs > 0, these two quadratic equations can be integrated to one to isolate themarket clearing trade credit rate (δ). We accomplish the same by subtracting one from theother

aδ2 + bδ+ c = 0 . (36)

where the quadratic equation’s coefficients can be simplified as follows

a = ac − as = γ (εc − εs) (37)

b = bc − bs = −γ(

εc − εs − βc,nω (εc + 1) + βs,nω (εs + 1))

(38)

c = cc − cs = τεc − vεs − βc,nω (εc + γ) + βs,nω (εs + γ) (39)

This quadratic equation provides an optimal equilibrium value of trade credit rate incor-porating the price elasticity from the firm’s as well as that of the customers.’ Thus a δ∗

can be obtained from27

δ∗ =(−b−

√b2 − 4ac

)/2a ∈

(0, δ)

. (40)

The above rate is used to evaluate the optimal murabaha discount rate (derived in theAppendix A.2) as follows

m∗ =δ∗

1− δ∗(41)

Thus our result given by equation (41) is similar in spirit to that of Lam and Chen(1986, p. 1146), who state that “For a value-maximizing firm, the optimality condition for pric-ing requires the marginal value of accounts receivable to the marginal value of the cost of produc-tion.”

3.2.4 Key Result

Proposition 1 The classic ‘murabaha’ discount rate is a function of not only the prevailing op-portunity costs of capital of both the merchant-UIB supply chain and the consumers but alsoincorporates the price elasticities of the product. This has the potential to yield a ‘murabaha’ rate

27We ignore the higher value of δ∗ as it is greater than 100% and does not make economic sense.

18

even lower than the opportunity costs of capital of not only the financiers but also the consumer.28

Since the elasticities of consumers are heterogeneous in the real world, this allows the merchant toprice-discriminate among their customers.

Proof. This is illustrated with a numerical simulation in the Section 3.2.5 below.This above result contradicts the banking murabaha rate derived employing the sim-

ple textbook formula of market interest rate plus a risk premium. The reason for ourimproved result is because the merchant’s supply chain operates in the real sector of theeconomy, whilst the contemporary ‘Islamic’ bank operates in the highly efficient financialsector where arbitrage forces it to offer market driven rates (See again Azmat et al. (2015)).

Furthermore, the above innovative proposition responds to the call for reform andfor developing alternatives to traditional murabaha by many academics and scholars, re-embedding thus the Maqasid in the practice of Islamic finance. This also in line withthe Quranic verse (2:275) “God has permitted trade and forbidden riba.” Our results havemajor ramifications as they imply that Islamic rulings (ijtihad) made by contemporaryIslamic scholars are limited to the legal compliance of transactions rather than a morecomprehensive approach based on the Maqasid. This is because they lacked dynamicijtihad espoused by Ibn Qayyim al-Jawziyya, Shams al-Dın Abu cAbd Allah Muhammad(2004). In other words, our results imply a rethink of Islamic finance.

3.2.5 Numerical Simulation

[Table 1 about here][Figure 2 about here]

3.2.5.1 The effect of price elasticity on the optimum classic murabaha discount rateWe assume the following exogenous parameters of the model: ω = 97%; ks = kc = 15%;v = 75%; τ = 1; n = 90 days; and γ = 30. Table 1 and Figure 2 summarise δ∗-s and m∗-sobtained from equations (40) and (41) for demand and supply price elasticities from therange εc ∈ [0,−2] and εs ∈ [2, 0], respectively. We compute a grid of optimal values ofthe discount coefficient for elasticities spaced at equally distant nodes, i.e. ∆εc = ∆εs =

0.5. Our results illustrate the generally negative relationship between the levels of priceelasticity and the optimum classic murabaha discount rate. This effect is most prominent

28This highlights the concern of bankers who contend that they are not able to offer significantly lowerinterest rate than the captive finance companies of manufactures as they have been subsidized by theirparent firm (see Sen (1998)).

19

in the case of the price elasticity of the Firm-UIB supply-chain. The lowest murabaharate is achieved when price elasticity of the firm-UIB and that of the consumers are high(equal to 2 and −2, respectively). In this case, the optimum annualized trade credit rateis 11.41%, which is equivalent to 12.87% of optimum annualized classic murabaha markuprate, m∗y. On the other hand, the highest one occurs when the price elasticity of both firmand customers are equal to zero (inelastic). In this case, the equilibrium trade credit rateis 13.28%, which is tantamount to 15.31% of murabaha markup rate.29

The result also confirms our proposition, that the murabaha rate can be even lowerthan the opportunity cost of capital. This is because in our simulation, almost all annu-alized optimum trade credit rate, δ∗y, and markup rate, m∗y, for different elasticities arelower than 15% of k. All m∗y are lower than k except when εs equals to zero.30 This isworth noting that, from the perspective of the firm-UIB supply chain, opportunity cost ofcapital, ks, is equal to the minimum rate charged by banks to their debtors, in the case ofbanking murabaha. In practice, however, Islamic banks even charge a higher rate than thisopportunity cost, i.e. opportunity cost plus risk premium.

[Figure 3 about here]

3.2.5.2 Comparative static analysis: the effect of variation in the opportunity costs onthe optimal murabaha rate Figure 3 illustrates the impact of different levels of k-s onm∗y.31 The figure suggests that the relationship between k-s and m∗y is an increasing quasi-linear function. An increase in k leads to a rise in m∗y due to time value of money. Theprice elasticities (εs and εc) have almost no effect on the slope of the curve. However,different values of ε shifts the curve downward for the more elastic product, and upwardfor the less elastic one.

[Table 2 about here]

Furthermore, Table 2 depicts that there are some cases (highlighted in italic font)where m∗y is lower than k. These occur when (i) k and/or (ii) ε increase. In the basecase, when k equals to 11%, m∗y is always higher than k for all values of εs and εc, exceptwhen εs equals to 2. However, when k increases to 12%, then m∗y for the lower elasticity

29See Figure 2, where the optimal markup rates, m∗y-s , are represented as a semi-opaque downward-sloping surface).

30See again Figure 2, where most of the optimal markup rates, m∗y-s , lie below the opportunity cost ofcapital k = 15% (the latter is represented as a transparent horizontal surface).

31Assuming that ks = kc = k.

20

of supply of product, i.e. εs = 1.5, becomes also lower than k for all levels of elasticityof consumers, εc. Finally, when k increases to 16%, then m∗y becomes lower than k for allcombinations of elasticity levels. Thus, the higher the value of discount rate k, the lower isfeasibility of the murabaha pricing rate, i.e. m∗y < k. This shows that m∗y is more stable thank especially in the case where k increase rapidly such as in an inflationary environment.

The latter condition, for instance, may be observed by taking into account the case ofδ∗y for k = 14%. In this case, m∗y for inelastic supply, i.e. εs = 0, is still higher than k;however, for unitary or elastic supply, i.e. εs equals to 1 or more, m∗y becomes lower thank. In addition, for inelastic supply, i.e. εs equals to 0.5, m∗y is higher than k particularlywhen the consumers are inelastic, εc = 0. When the demand gets more elastic, i.e. εc < 0,then m∗y becomes lower than k. Thus, the more elastic is the product (from the perspectiveof both firm-UIB and consumers), the higher is the possibility of m∗y < k. In conclusion,this supports our proposition that “there is a potential to yield ‘murabaha’ rate even lower thanthe opportunity costs of capital”, i.e. when k and/or ε are high.

[Tables 3 & 4 about here]

3.2.5.3 Comparative static analysis: relaxing the assumption of k Our propositionstill holds even when we relax the assumption of k = ks = kc. Tables 3 & 4 show m∗y fordifferent values of ks and kc. Table 3 exhibits the m∗y when ks = 11% while kc is variedbetween 11% and 16%. In contrast, Table 4 sets kc constant at 11%, while varying ks. Thesetwo Tables point out a congruent result where the condition m∗y < ks ∩m∗y < kc holds inthe all various price elasticities when ks or kc go beyond 11%.

In conclusion, our numerical simulation generates optimum murabaha rate that is afunction of not only short-run costs of capital but also price elasticities and the other pa-rameters. That is, m = f (ks, kc, εs, εc, v, τ, ω, γ). Through the numerical simulation, wealso illustrate our proposition that “there is a potential to yield ‘murabaha’ rate even lowerthan the opportunity cost of capital of the merchant.” This supports the argument that vendorfinancing (or classic murabaha) is more superior than bank loan (or banking murabaha) asit may be able to provide more stable credit rate over the time with variation in prevailinginterest rate (see Ng et al. (1999)). Constrained customers shift to vendor financing partic-ularly in the period of monetary contractions in which banks may not be able to offer thecredit with competitive rates. This result is in harmony with that of Nilsen (2002), Fab-bri and Menichini (2010) and Klapper and Randall (2011) but contradictory with Cunñat(2007), Ng et al. (1999) and Klapper et al. (2012).

21

This advantage of classic murabaha is observed in the real world with market imper-fections. That is, where there is endemic asymmetric information and where borrow-ing rate is higher than lending rate. Our modeling, however, also allows merchants tohave advantages even when they operate in an efficient financial system through price-discrimination involving the price elasticity of both supply and demand. This result is inconformity with Brennan et al. (1988).

3.2.5.4 Robustness check: Relaxing the assumption of γ

[Table 5 about here]

Our numerical simulation initially assumes the value of γ = 30, where is a positivenumber relating the murabaha rate (m) to the proportion of customers who buy the goodson the spot (θ). Our results are robust even when this assumption of γ is reduced. Table5 illustrates the optimum murabaha rate under various demand and supply elasticitieslevels when γ equals to 10 and 20 in Panels 1 and 2 respectively. With the lower valuesof γ, the numbers of m∗y that are higher than opportunity cost, k, (m∗y > k) drop to onlyone case in contrast to 4 cases in our base case numerical simulation illustrated in Table1. Thus, reducing the assumption of γ improves our results by lowering the optimumclassic murabaha rate to the ones produced in Table 1. This result is consistent with ourpreposition.

Furthermore, our results also suggest that elasticities play a more significant role inexplaining the variability of m∗y under lower values of γ. This can be inferred from theincrease in spreads between the highest and the lowest value of m∗y in our simulationunder the lower γ conditions.32 The spreads between the two for γ values of 30, 20, and10 respectively are 2.44%, 3.60% and 6.87%. Thus, a higher level of γ selected in our basecase numerical simulation yields more robust results. This is because a higher value of γ

weakens the effect of εs and εc on m∗y, thereby yielding a higher possibility of m∗y > k.

4 Conclusion

This study is an attempt to redress the underdevelopment of the Muslim economies byrecommending an efficient financial intermediation in line with the objectives of the Is-

32The highest m∗y occurs when εs = εc = 0, while the lowest one occurs when εs = 2 and εc = −2.

22

lamic law. Islam does not hinder economic development; however, the lack of dynamismin the religious rulings has deterred the progress of these economies.

The contemporary Islamic banking practice mimicking its conventional counterpartrepresents the static perspective of the religious establishment. To move forward, wepropose a universal banking architecture, which links financiers with merchants in thereal sector of the economy. We then price the credit sale facility by extending the vendorfinancing literature. Our alternative structure offers economies of both scale as well asscope. We hope that our result will stimulate a rethink in Islamic finance thereby leadingto an increase in its efficiency. This will make emerging Muslim economies more resilientto risk, thereby rejuvenating the growth of these economies and helping them get paritywith the rest of the world.

References

AAOIFI (2007). Accounting, auditing and governance standards for Islamic financialinstitutions. Manama: Accounting and Auditing Organization for Islamic FinancialInstitutions.

Ahmed, E. (2015). Religion and ethics-based economic and financial system: A survey ofinsight into Islamic economics and finance. Journal of Finance Issues 14(1), 51–63.

Al-Zuhayli, W. (2003). Financial Transaction in Islamic Jurisprudence, Volume 1. Beirut: Daral-Fikr.

Auda, J. (2008). Maqas. id Al-Sharı’ah: A Beginner’s Guide. Herndon, VA, USA: The Interna-tional Institute of Islamic Thought.

Azmat, S., A. S. Azad, H. Ghaffar, and I. Bhatti (2015). Why interest-free Islamic bankingis not free from interest? Working Paper, Deakin University.

Benston, G. J. (1994). Universal banking. The Journal of Economic Perspectives 8(3), 121–143.

Berglof, E. and E. Perotti (1994). The governance structure of the Japanese financialkeiretsu. Journal of Financial Economics 36, 259–284.

Biais, B. and C. Gollier (1997). Trade credit and credit rationing. The Review of FinancialStudies 10(4), 903–937.

23

Blejer, M. I. (2006). Economic growth and the stability and efficiency of the financial sector.Journal of Banking and Finance 30, 3429–3432.

Boyd, J. H., C. Chang, and B. D. Smith (1998). Moral hazard under commercial and uni-versal banking. Journal of Money, Credit and Banking 30(3), 426–468.

Brennan, M. J., V. Miksimovic, , and J. Zechner (1988). Vendor financing. The Journal ofFinance 43((5), 1127–1141.

Chapra, M. U. (2007). The Islamic Vision of Development in the Light of the Maqas. id Al-Sharı’ah.

Cunñat, V. (2007). The credit: supplier as debt collectors and insurance providers. TheReview of Financial Studies 20(2), 491–527.

Dass, N., J. R. Kale, and V. Nanda (2015). Trade credit, relationship-specific investment,and product market power. Review of Finance 19, 1867–1923.

Ebrahim, M. S., A. Jaafar, P. Molyneux, and M. O. Salleh (2017). Riba and Islamic finance.Working Paper, Durham University Business School, England, UK.

Ebrahim, M. S., M. O. Salleh, and M. O. Sheikh (2016). Institutional status and the under-development of the Muslim world: A juridicio-philosophical critique. Working Paper,Durham University Business School, England, UK.

El-Gamal, M. A. (2006). Islamic Finance: Law, Economics, and Practice. New York: Cam-bridge University Press.

Elnahas, A. M., M. K. Hassan, and G. M. Ismail (2017). Religion and mergers and ac-quisitions contracting: The case of earnout agreements. Journal of Corporate Finance 42,221–246.

Emery, G. W. (1987). An optimal financial response to variable demand. The Journal ofFinancial and Quantitative Analysis 22(2), 209–225.

Emery, G. W. and N. Nayar (1998). Product quality and payment policy. Review of Quan-titative Finance and Accounting 10, 269–284.

Fabbri, D. and L. F. Klapper (2016). Bargaining power and trade credit. Journal of CorporateFinance 41, 66–80.

24

Fabbri, D. and A. M. C. Menichini (2010). Trade credit, collateral liquidation, and borrow-ing constraints. Journal of Financial Economics 96, 413–432.

Fisman, R. and I. Love (2003). Trade credit, financial intermediary development, andindustry growth. The Journal of Finance 58(1), 353–374.

Glaeser, E. L. (2000). Comment and discussion: Real estate and the macroeconomy. Brook-ing Papers on Economic Activity 2, 146–150.

Ibn Qayyim al-Jawziyya, Shams al-Dın Abu cAbd Allah Muhammad (2004). Iclam al-muwaqqic ın can rabb al-calamın (Information for those who write on behalf of the Lord of theWorlds). Beirut: Dar Al-Kotob Al-ilmiyah.

Itzkowitz, J. (2015). Buyers as stakeholders: How relationships affect suppliers’ financialconstraints. Journal of Corporate Finance 31, 54–66.

Johansen, S. (1991). Estimation and hypothesis testing of cointegrated vectors in gaussianvector autoregressive models. Econometrica 59(6), 1551–1580.

Kahf, M. (2013). Islamic Finance Contracts. Washington: CreateSpace Independent Pub-lishing Platform.

Kamali, M. H. (2000). Principles of Islamic Jurisprudence. Selangor, Malaysia: Ilmiah Pub-lishers.

Khan, F. (2010). How ‘Islamic’ is Islamic banking. Journal of Economic Behavior & Organi-zation 76, 805–820.

Klapper, L., L. Laeven, and R. Rajan (2012). Trade credit contracts. Review of FinancialStudies 25(3), 838–867.

Klapper, L. and D. Randall (2011). Financial crisis and supply-chain financing. In J. Chauf-four and M. Malouche (Eds.), Trade Finance During the Great Trade Collapse, pp. 73–86.Washington DC: The World Bank.

Kuran, T. (1997). Islam and underdevelopment: An old puzzle revisited. Journal of Insti-tutional and Theoretical Economics 153(1), 41–71.

Lam, C. H. and A. H. Chen (1986). A note on optimal credit and pricing policy underuncertainty: A contingent-claims approach. Journal of Finance 41(5), 1141–1148.

25

Lian, Y. (2017). Financial distress and customer-supplier relationships. Journal of CorporateFinance 43, 397–406.

Long, M. S., I. B. Malitz, and S. A. Ravid (1993). Trade credit, quality guarantees, andproduct marketability. Financial Management 22(4), 117–127.

Miwa, Y. and J. M. Ramseyer (2002). The fable of the keiretsu. Journal of Economics andManagement Strategy 11(2), 169–224.

Ng, C., J. K. Smith, and R. L. Smith (1999). Evidence on the determinants of credit termsused in interfirm trade. The Journal of Finance 54(3), 1109–1129.

Nilsen, J. H. (2002). Trade credit and the bank lending channel. Journal of Money, Credit,and Banking 34(1), 226–253.

Oliveira, M., P.-R. Kadapakkam, and M. Beyhaghi (2017). Effects of customer financialdistress on supplier capital structure. Journal of Corporate Finance 42, 131–149.

Petersen, M. A. and R. G. Rajan (1997). Trade credit: Theories and evidence. Review ofFinancial Studies 10(3), 661–691.

Rashid, M. and D. Mitra (1999). Price elasticity of demand and an optimal cash discountrate in credit policy. Financial Review 34, 113–126.

Santos, J. A. C. and A. S. Rumble (2006). The American keiretsu and universal banks:Investing, voting and sitting on nonfinancials’ corporate boards. Journal of FinancialEconomics 80, 419–454.

Schacht, J. (1964). An Introduction to Islamic Law. Oxford: Clarendon Press.

Sen, A. (1998). Seller financing of consumer durables. Journal of Economics & ManagementStrategy 7(3), 435–460.

Shenoy, J. and R. Williams (2017). Trade credit and the joint effects of supplier and cus-tomer financial characteristics. Journal of Financial Intermediation 29, 68–80.

Stulz, R. M. and R. Williamson (2003). Culture, openness, and finance. Journal of FinancialEconomics 70, 313–349.

Usmani, M. T. (1998). An Introduction to Islamic Finance. Karachi, Pakistan: Jamia Darul-Uloom.

26

Uzair, M. (1976). Some conceptual and practical aspects of interest-free banking. IslamicStudies 15(4), 247–269.

Wilner, B. S. (2000). The exploitation of relationship in financial distress: The case of tradecredit. The Journal of Finance 55(1), 153–178.

A Appendix

A.1 Glossary of Arabic Terms

Bai’ al-Murabaha A credit sale (at a stated profit margin)Hadith Tradition of Prophet MuhammadHikmah WisdomIjtihad Exertion expended by a jurist to deduce Islamic

rulings that are not evident from the original sourcesof the Sharı’ah namely the Qur’an andthe Sunnah (described below).

’Illah Effective causeMaqâsid al-Sharı’ah Higher objectives of the Islamic lawMudharabah Restrictive Profit sharing medieval partnershipMusharakah Profit and loss sharing medieval partnershipQiyas Analogical reasoningQur’an The holy book of IslamRiba An injunction protecting property rights, which is

narrowly interpreted as usury or interestRiba al-nasi’ah Riba of delayed paymentRibawi A debilitating exchange of financial claimsSharı’ah Islamic lawSukuk Islamic BondSunnah The body of traditional, social and legal custom ,

and practice of the Islamic community. Along withthe Qur’an and Hadith (recorded sayings of theProphet Muhammad) it is a major source ofSharı’ah or Islamic law.

Taqlid Blind adherence to a school of thought in Islam

27

A.2 Modelling Markup versus Discount

Customers can either pay the discounted price p = (1− δ) P immediately or they can payP in n days. Therefore

P =p

1− δ

On the other hand, in the markup approach terminology, if p is the current price, then

P = p (1+m) (42)

where m is the markup rate. It follows that

p1− δ

= p (1+m)⇐⇒ 1− δ =1

1+m(43)

⇐⇒ δ = 1− 11+m

=m

m+ 1(44)

⇐⇒ m =1

1− δ− 1 =

δ

1− δ(45)

Consequently, we can keep as a base either {P, δ} or {p, m}.

28

A.3 Tables

Table 1: Optimum annual classic murabaha rates under various elasticities. Para-meter εc expresses price elasticity of demand, while εs represents price elasticity ofthe supply-chain. δ∗y is annualised optimum trade credit rate, which is calculated byδ∗y = 100 × (1+ δ∗)360/n (see Nilsen (2002)), while m∗y represents annualised optimum

murabaha rate, where m∗y = δ∗y/(

1− δ∗y)

. All rates (δ∗y, m∗y) are expressed in percentagesper annum [%/p.a.]. The exogenous parameters assumed here are as follows: ω = 97%;ks = kc = 15%; v = 75%; τ = 1; n = 90 days; and γ = 30.

εc

0 −0.5 −1 −1.5 −2εs δ∗y m∗y δ∗y m∗y δ∗y m∗y δ∗y m∗y δ∗y m∗y2 11.65 13.19 11.59 13.11 11.53 13.03 11.47 12.95 11.41 12.87

1.5 12.06 13.71 11.99 13.63 11.93 13.55 11.87 13.47 11.81 13.391 12.46 14.23 12.40 14.15 12.34 14.07 12.27 13.99 12.21 13.91

0.5 12.87 14.77 12.80 14.68 12.74 14.60 12.68 14.52 12.62 14.440 13.28 15.31 13.21 15.22 13.15 15.14 13.09 15.06 13.02 14.97

29

Table 2: Illustrating cases where the optimum annual murabaha rates (m∗y) are lowerthan opportunity costs of capital. This table assumes ks = kc = k. The numbershighlighted in bold font are solutions where: m∗y < k. All rates (m∗y) are expressedin percentages per annum [%/p.a.]. The exogenous parameters assumed here are asfollows: ω = 97%; v = 75%; τ = 1; n = 90 days; and γ = 30.

k = 11 k = 12εc εc

εs 0 −0.5 −1 −1.5 −2 0 −0.5 −1 −1.5 −22 10.93 10.86 10.79 10.72 10.64 11.50 11.42 11.35 11.27 11.20

1.5 11.42 11.35 11.28 11.20 11.13 11.99 11.92 11.84 11.77 11.691 11.92 11.85 11.77 11.70 11.62 12.50 12.42 12.35 12.27 12.19

0.5 12.43 12.35 12.28 12.20 12.13 13.01 12.93 12.86 12.78 12.700 12.94 12.86 12.79 12.71 12.64 13.53 13.45 13.37 13.30 13.22

k = 13 k = 14εc εc

εs 0 −0.5 −1 −1.5 −2 0 −0.5 −1 −1.5 −22 12.06 11.99 11.91 11.83 11.76 12.63 12.55 12.47 12.39 12.31

1.5 12.57 12.49 12.41 12.33 12.26 13.14 13.06 12.98 12.90 12.821 13.08 13.00 12.92 12.84 12.76 13.65 13.57 13.49 13.42 13.34

0.5 13.59 13.52 13.44 13.36 13.28 14.18 14.10 14.02 13.94 13.860 14.12 14.04 13.96 13.88 13.80 14.71 14.63 14.55 14.47 14.39

k = 15 k = 16εc εc

εs 0 −0.5 −1 −1.5 −2 0 −0.5 −1 −1.5 −22 13.19 13.11 13.03 12.95 12.87 13.76 13.68 13.60 13.52 13.43

1.5 13.71 13.63 13.55 13.47 13.39 14.28 14.20 14.12 14.04 13.961 14.23 14.15 14.07 13.99 13.91 14.81 14.73 14.65 14.57 14.48

0.5 14.77 14.68 14.60 14.52 14.44 15.35 15.27 15.19 15.10 15.020 15.31 15.22 15.14 15.06 14.97 15.90 15.82 15.73 15.65 15.56

30

Table 3: Optimal annual murabaha rates under various opportunity costs of capital.The opportunity cost of capital of the supply chain (ks) is fixed at 11% p.a., while thatof the consumers (kc) varies between 11 to 16 % p.a. All rates (m∗y) are expressed inpercentages per annum [%/p.a.]. Note: The numbers highlighted in the bold font aresolutions where: m∗y < kc. The exogenous parameters assumed here are as follows:ω = 97%; v = 75%; τ = 1; n = 90 days; and γ = 30.

ks = 11% p.a. kc

εs εc 11 12 13 14 15 160 0 12.94 13.23 13.53 13.82 14.11 14.41

0.5 0 12.43 12.72 13.01 13.30 13.59 13.881 0 11.92 12.21 12.50 12.78 13.07 13.36

1.5 0 11.42 11.71 11.99 12.28 12.56 12.842 0 10.93 11.22 11.50 11.78 12.06 12.330 -0.5 12.86 13.16 13.45 13.74 14.03 14.32

0.5 -0.5 12.35 12.64 12.93 13.22 13.51 13.791 -0.5 11.85 12.13 12.42 12.70 12.99 13.27

1.5 -0.5 11.35 11.63 11.92 12.20 12.48 12.762 -0.5 10.86 11.14 11.42 11.70 11.98 12.250 -1 12.79 13.08 13.37 13.66 13.95 14.24

0.5 -1 12.28 12.56 12.85 13.14 13.43 13.711 -1 11.77 12.06 12.34 12.63 12.91 13.19

1.5 -1 11.28 11.56 11.84 12.12 12.40 12.682 -1 10.79 11.07 11.34 11.62 11.90 12.170 -1.5 12.71 13.00 13.29 13.58 13.87 14.16

0.5 -1.5 12.20 12.49 12.77 13.06 13.35 13.631 -1.5 11.70 11.98 12.26 12.55 12.83 13.11

1.5 -1.5 11.20 11.48 11.76 12.04 12.32 12.602 -1.5 10.72 10.99 11.27 11.54 11.82 12.090 -2 12.64 12.92 13.21 13.50 13.79 14.07

0.5 -2 12.13 12.41 12.70 12.98 13.26 13.551 -2 11.62 11.91 12.19 12.47 12.75 13.03

1.5 -2 11.13 11.41 11.68 11.96 12.24 12.522 -2 10.64 10.92 11.19 11.46 11.74 12.01

31

Table 4: Optimal annual murabaha rates under various opportunity costs of capital.The opportunity cost of capital of the consumers (kc) is fixed at 11% p.a., while thatof the supply chain (ks) varies between 11 to 16 % p.a. All rates (m∗y) are expressed inpercentages per annum [%/p.a.]. Note: The numbers highlighted in the bold font aresolutions where: m∗y < kc. The exogenous parameters assumed here are as follows:ω = 97%; v = 75%; τ = 1; n = 90 days; and γ = 30.

kc = 11% p.a. ks

εs εc 11 12 13 14 15 160 0 12.94 13.23 13.53 13.82 14.11 14.41

0.5 0 12.43 12.72 13.01 13.30 13.59 13.871 0 11.92 12.21 12.50 12.78 13.07 13.35

1.5 0 11.42 11.71 11.99 12.28 12.56 12.842 0 10.93 11.22 11.50 11.78 12.05 12.330 -0.5 12.86 13.16 13.45 13.74 14.03 14.33

0.5 -0.5 12.35 12.64 12.93 13.22 13.51 13.801 -0.5 11.85 12.14 12.42 12.71 12.99 13.27

1.5 -0.5 11.35 11.64 11.92 12.20 12.48 12.762 -0.5 10.86 11.14 11.42 11.70 11.98 12.260 -1 12.79 13.08 13.37 13.67 13.96 14.25

0.5 -1 12.28 12.57 12.86 13.14 13.43 13.721 -1 11.77 12.06 12.35 12.63 12.92 13.20

1.5 -1 11.28 11.56 11.84 12.13 12.41 12.692 -1 10.79 11.07 11.35 11.63 11.91 12.180 -1.5 12.71 13.00 13.30 13.59 13.88 14.17

0.5 -1.5 12.20 12.49 12.78 13.07 13.35 13.641 -1.5 11.70 11.99 12.27 12.56 12.84 13.12

1.5 -1.5 11.20 11.49 11.77 12.05 12.33 12.612 -1.5 10.72 11.00 11.28 11.56 11.83 12.110 -2 12.64 12.93 13.22 13.51 13.80 14.09

0.5 -2 12.13 12.42 12.70 12.99 13.28 13.561 -2 11.62 11.91 12.20 12.48 12.76 13.05

1.5 -2 11.13 11.41 11.70 11.98 12.26 12.542 -2 10.64 10.92 11.20 11.48 11.76 12.04

32

Table 5: Robustness check of results under varying γ values. Optimum classic murabaharates under the various elasticities. Parameter εc expresses price elasticity of demand,while εs represents price elasticity of the supply-chain. δ∗y is annualised optimum tradecredit rate, which is calculated by δ∗y = 100× (1+ δ∗)360/n (see Nilsen (2002)), while m∗yrepresents annualised optimum murabaha rate, where m∗y = δ∗y

/(1− δ∗y

). All rates

(δ∗y, m∗y) are expressed in percentages per annum [%/p.a.]. Note: The numbers highlightedin the bold font are solutions where: m∗y > k. The exogenous parameters assumed hereare as follows: ω = 97%; v = 75%; ks = kc = k = 15%; τ = 1; n = 90 days; and γ = 30.

Panel 1: γ = 10

εc

0 −0.5 −1 −1.5 −2εs δ∗y m∗y δ∗y m∗y δ∗y m∗y δ∗y m∗y δ∗y m∗y2 8.95 9.82 8.66 9.48 8.37 9.13 8.07 8.78 7.78 8.44

1.5 10.00 11.11 9.71 10.75 9.42 10.39 9.12 10.04 8.83 9.691 11.08 12.45 10.78 12.08 10.49 11.71 10.19 11.35 9.90 10.98

0.5 12.17 13.85 11.87 13.47 11.57 13.09 11.27 12.71 10.98 12.330 13.28 15.31 12.97 14.91 12.67 14.51 12.37 14.12 12.07 13.73

Panel 2: γ = 20

εc

0 −0.5 −1 −1.5 −2εs δ∗y m∗y δ∗y m∗y δ∗y m∗y δ∗y m∗y δ∗y m∗y2 10.97 12.32 10.85 12.17 10.73 12.02 10.61 11.86 10.49 11.71

1.5 11.54 13.04 11.42 12.89 11.30 12.73 11.17 12.58 11.05 12.431 12.11 13.78 11.99 13.62 11.87 13.47 11.75 13.31 11.63 13.16

0.5 12.69 14.54 12.57 14.38 12.45 14.22 12.33 14.06 12.20 13.900 13.28 15.31 13.15 15.14 13.03 14.98 12.91 14.82 12.79 14.66

33

A.4 Figures

Figure 1: Universal Islamic Banking Architecture.

35

B: Figures Figure 1 Universal Islamic Banking Architecture

This figure depicts the proposed universal Islamic banking architecture. The lines are described as the following.

Equity stake (a) Credit sale (b) Credit payment (c)

Islamic Bank

Merchant A

Merchant B

Merchant C

Buyer

Buyer

Buyer

Buyer

Buyer

Buyer

(a)

(b)

(c)

34

Figure 2: Optimum classic murabaha markup rates across various price elasticities.Note: m∗y, εc and εs represent the optimum annualized murabaha markup rate andthe respective elasticities of demand and supply. This Figure illustrates: (a) that themurabaha rate, m∗y, can be lower than the opportunity cost of capital (representedas a horizontal transparent surface at the k = 15% level) for most of the consideredlevels of price elasticity εs, εc; (b) the generally negative relationship between the levelsof price elasticity εs, εc and the optimum classic murabaha discount rate m∗y; (c) theminimum/maximum of murabaha rate (m∗y = 12.87% and m∗y = 15.31%, respectively)achieved at the highest/lowest (in absolute values) price elasticity point for the firm andconsumers (εs = −2, εc = 2 and εs = εc = 0, respectively).

35

Figure 3: The effect of opportunity costs of capital (k) on murabaha rates m∗y for variousprice elasticities. Note: m∗y, k, εc and εs represent the optimum annualized murabahamarkup rate, the opportunity cost of capital and the respective elasticities of demand andsupply. This Figure illustrates that the more elastic is the product (from the perspectiveof both suppliers and consumers), the higher is the possibility of obtaining a murabahadiscount rate lower than the opportunity cost of capital (m∗y < k).

my* =k

ϵs=-ϵc=2

ϵs=ϵs=0

ϵs=-ϵc=1

5 10 15 20

5

10

15

20

k [% p.a.]

my*[%p.a.]

36