Sunday, July 13, 2008

Commentary on Bai' Bithaman Ajil

Assalamu ‘Alaikum

Commentary on Bai' Bithaman Ajil

A sale where the payment of the price is deferred. This is the most familiar concept of Islamic Financing so much so it has almost become the de facto definition of Islamic banking in Malaysia. Which is a shame because Islamic Financing is so rich in concepts other than Al Bai' Bithaman Ajil.
Known as Bai' Muajjal here in the Middle East; the early fathers of Islamic Banking in Malaysia considered this name to be used in 1983 but knowing the propensity of Malaysians to make jokes out of names they wisely dropped the idea. So Bai' Muajjal became Bai' Bithaman Ajil. Bai' means sale, Thaman means price and Ajil means deferred. How does it work? Well the principle is very simple. If you want the Islamic Bank to finance your purchase of a house, they will first buy it from the seller, pay cash and then sell it to you where you pay the price to the Bank in instalments. Here comes the first objection to Bai' Bithaman Ajil or BBA, people say why should the price be different between paying cash and paying deferred. I think those with this school of thought does not think things through deep enough. They are alluding of course to the similarity with riba financing where the longer you take to pay the higher you pay. They forgot about the concept of opportunity cost. In other words there is a cost in allowing people to pay deferred instead of paying cash. A simple example will illustrate this. Let’s say you are an ‘abid, a very religious man who forsake worldly life and spend time only in the worship of Allah. Your sole source of income is to sell a piece of batik cloth daily in the market. You will buy the batik cloth from the friendly merchant for RM2 and sell it in the market for RM3.With the RM1 profit you buy your daily food and return home to worship Allah. Tomorrow you use the RM2 in hand to buy your batik cloth and go to market again to sell it for RM3. This is what you do everyday until one day an equally poor man came to the market to buy your batik cloth and ask to pay the price in instalments over 3 days i.e. RM1 per day commencing the day of the purchase. You use the RM1 he paid as first instalment to buy your food and so you have no money the next day to buy your cloth from the merchant. So on day 2 you do not trade; you receive another RM1 being the second instalment from the buyer, you use it to buy food and so you still have no money to buy the cloth. So on day 3 you still do not trade; you receive your final RM1and spend it on food. On day 4 you have no money to trade and no money to buy food. What have you done wrong? You have not taken into account the opportunity cost of allowing people to buy from you on credit. In other words your price is the same cash or credit. See the folly? Of course this is a simplistic example but it does illustrate the concept of the opportunity cost of allowing people to buy on credit. You should have charged more for a credit sale to allow you to continue to do business.

The next objection may be, fine, but why do the Islamic bank take up so much profit such that for a house that cost RM200,000 one may end up paying RM400,000 over a period of 20 years. There are many aspects to this issue. Firstly an Islamic Bank is first and foremost a business. It is not a charitable organization. The money it extends in financing does not belong to the Bank it belongs to depositors and shareholders who demand a return.

So it has to price its financing to yield a return to its stakeholders. If it prices its financing below market then there is a danger investors will say Islamic banking is not viable compared to conventional banking. The second aspect is, is it really expensive? The truth is if you take a conventional loan and add the total interest over 20 years to the principal you’d find the sum total you pay will not be far different from the total amount you’d pay under Islamic Banking.

So why is there a lingering suspicion and outright accusations that Islamic Financing is expensive? This is the result of a number of things. A misconception of the facts combined with an inability of Islamic Bankers to explain the real situation. Let’s take house financing the usual facility where Islamic banking is accused of being more expensive than conventional financing. Islamic house financing is usually fixed rate in nature; conventional financing is floating rate. Therein lies the first clue, not comparing like with like. At times when base lending rate is low conventional financing does appear cheaper than fixed rate Islamic financing. The reverse is true when base lending rates are high. However complainers only seem to remember when conventional financing is relatively cheaper; they forget the times when Islamic financing is cheaper. However even those who understand the difficulty of comparing fixed rate with floating rate have a lingering suspicion that fixed rate is more expensive. In the days when I was still with an Islamic Bank I remembered tasking my team to research the subject and put to rest the question once and for all. We went to Bank Negara to dig the statistics. At the time, roughly late nineties, Islamic Housing Financing was at fixed rate of 10% p.a for 20 years whilst conventional financing was 1.5% + BLR for 20 years. Our task was to determine who was cheaper. To make this comparison we need to know what average base lending rate was over the last 20 years or the period such statistics are available. Bank Negara statistics told us that Average Base Lending rate is 9.25% p.a. Now the answer became very clear to us. Islamic House Financing at fixed rate of 10% p.a over 20 years is equivalent to 0.75% p.a.+ Average BLR whilst Conventional Financing over 20 years is at 1.5% p.a. + BLR. Which one is cheaper?




  1. slm...
    i have a question..
    based on the BBA concept, is there any protection for the customer in the case of unfinished project?

  2. Wa "Alaikum salam,
    Nope absolutely none. The banks engineered it to be that way! See also my other article on 'Of Islamic Financing and Abandoned Housing.'