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Home arrow Business & Finance arrow The art of RF (riba-free) Islamic banking and finance


To contrast the approach taken in a riba-based conventional financing with RF financing, let us consider a case study.

A family wants to buy a car for $30,000. They have only $6,000 of the purchase price. They want to approach a bank to help them finance the car. The following is a comparison between how the process would likely go in a riba-based banking setting as compared to RF banking setting.

Riba-Based Conventional Banker

1. Evaluates the application form.

2. Concludes that the family derives a good income and that they have a good balance sheet and a good credit history. Also, the banker finds that the family's cash flow could help them pay for a larger car or even to take a bigger loan without putting the $6,000 down. The reason the banker thinks this way is that the banker is interested in “selling” a larger loan to increase his loan sales volume and achieve his loan sales target set by management, to help increase the profitability of the bank and eventually to generate his commission or sales credit.

3. Decides to lend the family (i.e., rent them) money at a certain rate (interest rate) over a period of time. In fact, the banker may encourage the family — especially if they have a good credit history and good income — to stretch the repayment period for a longer time. The repayment period defined by the banker can even be longer than necessary, because (the banker says) he or she wants to help improve the family's cash flow. In fact, it also helps the bank derive more interest income from a good, qualified family as the loan repayment is extended.

4. The riba-based conventional banker may convince the family to buy a bigger and better-equipped car complete with many options that may not be necessary. This is because the larger loan amount, when amortized, will represent only a small addition to the monthly payment, and it will be taken care of by prolonging the financing period (term of the loan).

RF (Riba-Free) Banker

1. Evaluates the application form.

2. Concludes that the family derives a good income and that they have a good balance sheet, good credit history, and good tax returns. Also, the banker finds that the family cash flow is enough to cover the monthly payment for the car purchase.

3. Calls around to ask car leasing agencies — such as Hertz and Enterprise, as well as manufacturers' leasing agencies, such as the Toyota, Ford, and GM fleet leasing divisions — about the utility value of the car measured by the lease rate charged in the market.

4. Draws up an agreement with the family that complies with the RF finance legal requirements.

In this agreement, the family acts as the agent of the RF bank to buy the car. The transaction is structured such that the family would own $6,000/$30,000, or 20 percent, of the car, and the RF bank would (temporarily) own 80 percent of the car. The family agrees out of their own will to buy the bank's share of the car for the same value, or $30,000 – 6,000 = $24,000. This way, the bank does not own the title of the asset (milk ul raqabaah, as explained in Chapter 11 and based on the Shari'aa law) and is in compliance with the U.S. banking rules and regulations. The family, based on their cash flow, agrees to pay back the bank's share, interest-free over a period of, for example, three years, or $8,000 per year. This is called the return of capital (RofC). In lieu of the promise to pay back RofC, the family gives the RF bank a lien on the car. In lieu of the joint ownership of the right (perfected by the lien) to use the property, the family and the RF bank divide the income (the usufruct) from the lease among themselves in the (changing) proportion of unpaid capital.

The family and the RF banker independently survey the market to find a fair leasing rate for a similar car in the same market; the family and the finance officer each come up with three documented lease rates offered in the market. The family and the finance officer, based on the six data points about the car lease, can take the average or can negotiate a fair lease and agree to it. Here, the lease is divided in the beginning between the family (20 percent in the beginning, rising to 100 percent over three years) and the bank (80 percent in the beginning and declining to 0 percent over a three-year term). This is called the return on capital (RonC) for the RF bank.

The proprietary RF finance computer program developed by LARIBA is mechanically not much different from a regular amortization schedule. The real difference is that the variable in the LARIBA program is the car lease rate defined by the market, while the riba-based amortization schedule uses interest rate — the rental rate of money — as an input parameter. In other words, in the riba-based conventional banking model, the unknown is the monthly payment. In the RF banking service, the monthly payment is calculated based on the lease rate using the declining participation in usufruct (DPU) model, and the unknown is the rate of return on investment (ROI).

The family and the RF banker, in order to satisfy the laws of the land, sign a promissory note that documents the repayment of the debt (dayn — no time value of money) and the declining participation in the lease rate in a total monthly payment. To comply with the laws of the land, the RF banker plugs in the monthly market measured and agreed-upon rent of the facility representing the lease rate, the purchase price, the down payment, and the number of years to pay back into the LARIBA proprietary computer program. The program calculates the rate of return on investment, which is called in the RF system “implied” interest rate. This rate is disclosed to the client to comply with the Truth in Lending Act (TILA, or Regulation Z).

Please note that the resulting “implied” interest rate is not uniformly the same. It differs from one car to another, based on the leasing rate the same car would bring in the relevant market. If the rate of ROI is higher than the rate of return expected by the RF bank's shareholders and investors, the RF banker encourages the family to buy the car and would unilaterally and voluntarily reduce the monthly rental rate obtained from the market so that the monthly payment would compete with that offered by riba-based conventional banks. If the rate of ROI were calculated to be much lower than that expected by the RF bank's shareholders and investors, the RF banker would inform the family that buying this car is not a good investment, and the financing would be declined.

In the RF banking environment, the RF banker encourages the family to pay their car off as quickly as possible in order to reduce the burden of debt on the family's cash flow and free more money to save for the future and to make the family's excess cash flow a source of capital to reinvest in the community, leading to the creation of new job opportunities and economic prosperity.

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