Murabaha is a technique used to sell commodities without breaching Islamic rules that ban lenders from making money through interest. It involves the seller clearly and honestly stating his costs so the buyer knows what profit the seller is making. Although it is a more reliable and predictable method, other techniques may be preferred or even required as they share the risks more equitably.
The need for techniques such as Murabaha stems from sharia, which is seen as the supreme law by followers of Islam, in some cases ahead of national laws. The precise interpretation of sharia can vary across different branches of Islam. One of its rules is a ban on riba, an Arabic word for usury. It bars traders from increasing their capital without providing services that, depending on interpretation, can ban interest, profits or both.
In general trading, Murabaha is a simple way around these constraints. It simply means that the seller provides the prospective buyer with details of their costs and the amount of mark-up, or profit, that the seller will make. One of the requirements for using this technique is that the details provided must be accurate and honest.
In financing, the Murabaha technique can be used for loans. Such loans are not considered interest-bearing. Instead, they are technically considered a sale of the goods the borrower wants to pay with the loan money.
The lender will take legal ownership of the goods until the loan money has been repaid in full. Because the lender's profit must be agreed in advance, the lender can't receive any additional charges, such as late-payment penalties. Instead, any such penalties must be donated to charity.
The Murabaha should not be confused with two other types of financing under sharia. One is known as mudarabah and involves the lender and the borrower forming a partnership. The lender, known as rabb-ul-mal, provides all the money — in effect, the loan — while the borrower, known as the mudarib, provides the expertise, meaning the money is used for a business purpose. Any profits from the business are distributed between the two sides in an agreed ratio, which is usually how the lender gets his money back. Another method, the musharakah, works in the same way but the lender must put forward some of the money used in the project.
Banks generally will either prefer to use these latter two methods if it is possible, or may require doing so. To Western banks, this seems odd because it gives less security that the money will be returned or that the bank will make any cash. However, under sharia, these methods will be preferred or required, as they are seen as sharing the risks between the bank and the customer.