ISLAMIC FINANCIAL SYSTEM: SHARIAH PROHIBITS DISCOUNTS, PREMIUMS IN DEBT TRADING

Pakistani-Note

Dominant Shariah opinion prohibits selling debt for a price other than its face value. This prohibition covers both discounts and premiums in the sale and purchase of debt.

Thus an individual, corporate or any other institution (eg government) is not allowed to sell to a third party the debt a debtor owes to it, for a price other than the face value of the debt. Furthermore, there is a clear prohibition on selling debt for debt even if the two (deferred counter-values) are equal.

There is a simple rationale behind it. Islam does not allow re-pricing of debt even if it is between the initial creditor and debtor. This is so because pre-agreed (contractual) re-pricing of debt is likely to give rise to the pre-Islamic practice of interest, known as riba, which Islam prohibited.

Although a creditor enjoys discretion to offer an early payment rebate to the debtor, Shariah does not allow formalising this discretion in the original debt agreement between the two parties. In the case of late payment by the debtor, classical Shariah opinion disallows a penalty, although the contemporary Shariah view is flexible.

In modern day practice of Islamic banking, default penalty is allowed, as long as it is used only as a deterrent to wilful non-payment or delay. In practice, this means that the creditor should not benefit, directly or indirectly, from the amount of the penalty, rather it should be given away as charity. Discretionary rebate is normally applied to early payment but may also be exercised if payments remain in accordance with the contractual schedule. It is equally permissible (rather preferred) for the debtor to pay more than he borrowed, as long as it remains discretionary on the part of the debtor and there is no contractual agreement on it.

In both the rebate and penalty cases, effectively the debt agreement is re-negotiated – potentially shortening the contract in the case of rebate and prolonging in the case of late payment or default.

THIRD PARTY

Although re-pricing and limited re-negotiation of debt contracts is possible between a creditor and debtor even in Islamic finance, the mechanisms of doing so do not allow creditors to sell their debt in a meaningful way to a third party for a discounted price.

For example, consider bank A that owns a Murabaha asset with a face value of $100, which was created by selling a Shariah-compliant asset to client C on a deferred payment basis. Applying the prohibition of discounted trading in debt, bank A can sell the Murabaha asset (debt in the form of receivable) to a third party B for a price no other than $100, which must be paid on the spot (by B). If A wants to sell this debt to B for a lower price, say $90, it could do so only after unilaterally forgiving (or writing off) $10 from the debt owed by C, and then selling the remaining debt for its face value of $90. Of course, this makes little sense for B who would otherwise wish to benefit from the discount.

Having said that, there might be cases where parties A and B still wish to proceed with the transaction, which would be in compliance with Shariah.

DEBT COLLECTING AGENT

While discounted sale of debt is prohibited, Shariah allows partial transfer of debt through agency-based debt collection. Thus, it is permissible for creditor A to appoint a third party B as its agent to collect its debt receivable against a fixed fee and/or variable rate determined by B’s performance.

In practice, a combination of undiscounted trading in debt and the agency-based debt collection contracts can affect the economic effects of discounted trading in debt.

For example, a corporate owning a debt-based portfolio worth $100 may wish to “sell” it off by selling 50% of it to a third party for its face value, ie, $50. In addition, it appoints the same third party as its agent to collect the remaining 50% of the debt from its debtors against an agency fee of 50% of the amount collected.

This combination of debt sale and debt collection gives rise to a Shariah-compliant way of achieving the economic effect of selling $100 worth of debt, with a 25% discount.

SHARIAH VS CONVENTIONAL

There are two differences between this Shariah-compliant solution and the conventional discounted trading in debt. First, during the term of the contract between the creditor and its agent, the debt (50% of the total in this example) remains on the creditor’s balance sheet until it is paid off (ie, it is collected by the agent).

Second, the combination of (undiscounted) sale of debt and agency for debt collection is a performance-based arrangement, as the amount of “discount” very much depends on the recovery and collection of debt. If the agency fee was a fixed percentage of the amount recovered, the combination model would offer a variable “discount” depending on the performance of the agent.

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