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by Hussain G. Rammal
Introduction
Virtually unknown three decades ago, Islamic financing is now practiced around the world. Since its official launch in the 1970's, Islamic financial institutions have witnessed rapid international growth in both Muslim and Non-Muslim countries (Dudley 2001).
Although the concept of Islamic finance has existed for centuries, it only came into prominence during the last century (De Jonge 1996, p.3). The first successful application of Islamic finance was undertaken in 1963 by Egypt's Mit Ghamr Savings Banks, which earned its income from profit-sharing investments rather than from interest (Lewis & Algaoud 2001, p.5). By the 1970's, the push for Islamic finance had gained momentum. In 1973 the conference of foreign ministers of Muslim countries decided to establish the Islamic Development Bank with the aim of fostering the economic development and social progress of Muslim countries in accordance with the principles of Shari'ah (Saeed 1996, p.13). This marked the first major step taken by Muslim governments in promoting Islamic finance.
Shari'ah law (Islamic law based on the teachings of the Koran) prohibits the followers of Islam from conducting any business involving Riba (interest). This means that Muslims cannot receive or pay interest, and they are, therefore, unable to conduct business with conventional financial institutions (Jaffe 2002). The creation of Islamic financial institutions came about as a method for servicing this niche market.
In order to compete with conventional modes of financing (interest-based financial instruments), Islamic financial institutions developed products that would fulfill the Shari'ah obligation and provide the same value as conventional bank products (Malaysian Business 2001). The main Islamic financial products include profit-and-loss sharing (Mudaraba and Musharaka), cost plus mark-up, and leasing. The focus of this article is to analyze the profit-and-loss sharing instrument of Musharaka and the way it is implemented. The article begins by briefly describing the profit-and-loss sharing system, followed by a detailed analysis of Musharaka. The article then looks at the application of Musharaka as a home financing instrument, and concludes by analyzing the current issues affecting Musharaka, and the criticism leveled against it.
Profit-And-Loss Sharing System
Although Islam excludes interest earnings from financial activities, it does not necessarily mean that the financier cannot earn a profit. In order to do so, the financier has to ensure that gains made on the original amount are directly related to the risk undertaken on the investment (Siddiqui 1987). If there is no risk involved, the gains made represent interest rather than profit.
In order to understand how the Islamic system differentiates between profit and interest, one has to look at the differences in the economic ideology. In a capitalist system, capital and entrepreneurs are treated as two separate factors of production. The return on capital is interest, whereas the entrepreneur, who risks losing money, earns a profit. While interest is a fixed return for providing capital, profit can only be earned after distributing the fixed return to land, labor and capital (in the form of rent, wage and interest). Thus, the capitalist system seems to favor those who lend capital to entrepreneurs by providing them a secure return, entrepreneurs bear the risks of incurring losses and still making interest payments on borrowed capital.
In comparison, Islamic economic system does not consider providers of capital and entrepreneurship as separate factors of production. It believes that every person who contributes capital in the form of money to a business venture assumes the risk of loss and therefore is entitled to a proportional share in the actual profit (Siddiqui 1994, p.99). The system is protective of the entrepreneur, who in a capitalist economy would have to make fixed interest repayments even when the venture is losing money. (Usmani, M.I. 2002, p.13). Capital has an intrinsic element of entrepreneurship, so far as the risk of the business is concerned and, therefore, instead of a fixed return as interest, it derives profit. The greater is the profit earned by a business, the higher the return on capital will be. With no fixed interest repayments, profit in an Islamic economic system would be higher than in the capitalist economy. The system ensures that profits generated by commercial activities in the society are distributed equally amongst those who have contributed capital to the enterprise.
Another difference between the two economic systems lies in the way money is used. In economic terms money has no intrinsic value; it is only a medium of exchange, therefore, earning interest on a medium of exchange without bearing any risks does not sit well in the Islamic system (Rahman 1994, p.14). Islamic financing is, therefore, an asset-backed financing. When a financier contributes money on the basis of the profit-and-loss sharing instruments, it is bound to be converted into assets having intrinsic value (Usmani, M.T. 1998, p.19).
The profit-and-loss sharing system has its roots in the ancient form of financing practiced by Arabs since long before the advent of Islam. After the introduction of Islam, this system was permitted to continue and was legitimatized as a finance instrument. For this historical reason, scholars consider profit-and-loss sharing financial instruments to be the most authentic and most promising form of Islamic contracts (Ariff, 1982). Mudaraba (finance trusteeship) and Musharaka (equity partnership) are two such financial instruments based on the profit-and-loss sharing system, where instead of lending money to an entrepreneur at a fixed rate of return, the financier shares in the venture's profits and losses (The Economist 2001).
Musharaka
The literal meaning of the word Musharaka is sharing. Under Islamic law, Musharaka refers to a joint partnership where two or more persons combine either their capital or labor, forming a business in which all partners share the profit according to a specific ratio, while the loss is shared according to the ratio of the contribution (Usmani, M.I. 2002, p.87). It is based on a mutual contract, and, therefore, it needs to have the following features to enable it to be valid:
In Musharaka, every partner has a right to take part in the management, and to work for it (Gafoor 1996). However, the partners may agree upon a condition where the management is carried out by one of them, and no other partner works for the Musharaka. In such a case the "sleeping" (silent) partner shall be entitled to the profit only to the extent of his investment, and the ratio of profit allocated to him should not exceed the relative size of his investment in the business.
However, if all the partners agree to work for the joint venture, each one of them shall be treated as the agent of the other in all matters of business, and work done by any of them in the normal course of business shall be deemed as being authorized by all partners (Usmani, M.I. 2002, p.92).
Musharaka can take the form of an unlimited, unrestricted, and equal partnership in which the partners enjoy complete equality in the areas of capital, management, and right of disposition. Each partner is both the agent and guarantor of the other. Another more limited investment partnership is also available. This type of partnership occurs when two or more parties contribute to a capital fund, either with money, contributions in kind, or labor. Each partner is only the agent and not the guarantor of his partner. For both forms, the partners share profits in an agreed upon manner and bear losses in proportion to the size of their capital contributions (Lewis & Algaoud 2001, p. 43).
'Interest' predetermines a fixed rate of return on a loan advanced by the financier irrespective of the profit earned or loss suffered by the debtor, while Musharaka does not envisage a fixed rate of return. Rather, the return in Musharaka is based on the actual profit earned by the joint venture. The presence of risk in Musharaka makes it acceptable as an Islamic financing instrument. The financier in an interest-bearing loan cannot suffer loss, while the financier in Musharaka can suffer loss if the joint venture fails to produce fruits (Usmani, M.T. 1998, p.27).
Musharaka In Home Financing
When used in home financing, Musharaka is applied as a diminishing partnership. In home financing, the customer forms a partnership with the financial institution for the purchase of a property (Saeed 2001). The financial institution rents out their part of the property to the client and receives compensation in the form of rent, which is based on a mutually agreed fair market value. Any amount paid above the rental value increases the share of the customer in the property and reduces the share of the financial institution.
The application of diminishing Musharaka in home financing can be illustrated with the help of the following example, which the LaRiba bank in the U.S. follows:
Let us assume that a potential buyer is interested in purchasing a home worth $150,000. The buyer approaches an Islamic financial institution for the purchase of the property and puts 20 per cent of the price ($30,000) as down payment (the down payment required differs between financial institutions. In some cases it is as low as 5 percent ). The financial institution pays for the other 80 per cent of the price ($120,000). This agreement results in 20 per cent of the home ownership belonging to the client and the remaining 80 percent to the financial institution.
The next step for both parties would be to determine the fair rental value for the property. One way to determine the rental value is for both the client and financial institution to survey the market to obtain estimates for similar properties in the same neighborhood and negotiate an agreement. This fair rental value will remain constant over the life of the agreement. For this example, we will assume $1,000 per month as the rental value.
A rental value of $1,000 means that the client will pay $800 as rent for the 80 per cent share the financial institution holds. The two parties then agree on the period of financing. In this example we will assume that the financing period is 15 years (180 months). Based on the rental value and the financing period, the financial institution then determines the fixed monthly payments the client would have to make to own the house.
In the event of non-payment of rent from the client, the financial institution has to take into consideration the reason for the non-payment. If the client has a valid excuse for non-payment, the financial institution has to show leniency so that the client does not feel over-burdened, and the client should give more time to make the payment. In theory, if the financial institution charges any extra amount as compensation for the late payment, the amount would be considered as interest and therefore is not permitted in Islam. If there is no genuine reason for the late payment, the financial institution can ask the client to make a payment to a charity as penalty (Usmani, M.T. 1998, p.172). This prohibition of charging late fees makes it even more important for Islamic financial institutions to carefully evaluate each application before entering into an agreement.
Criticism Of Musharaka
Musharaka is sometimes criticized as being an old instrument that cannot be applied in the modern world. However, this criticism is unjustified. Islam has not prescribed a specific form or procedure for Musharaka. Rather it has set some broad principles which can accommodate numerous forms and procedures (Usmani, M.T. 1998, p.29). A new form or procedure in Musharaka that would make it suitable for modern financial needs cannot be rejected merely because it has no precedent in the past. In fact, every new form can be acceptable as long as it conforms to the principles laid down by Shari'ah. Therefore, it is not necessary that Musharaka be implemented only in its traditional form (Usmani, M.T. 1998, p.30).
Another criticism leveled against Musharaka is based upon the issue of profits being guaranteed by some financial institutions. Even though Musharaka is considered to be the most authentic form of Islamic financing, the risk associated with sharing losses means that it is not as popular as the other modes. To make the product more appealing to the customer, some financial institutions have started guaranteeing profits in Musharaka. By doing so, these institutions are contravening the basic law of Islamic finance that requires linking rewards to risks (Warde 2000, p.5). If profits are guaranteed, the risk factor is eliminated, making the profit resemble interest. Although these actions may help Islamic banks grow in the short-run, the long-term costs (harm to reputation and authenticity) will outweigh the benefits. Such moves also provide ammunition to the critics of the system, who are already questioning whether the system is nothing more than an interest-based system operating under the guise of profit (The Economist 1994).
Conclusion
Although not as popular as other Islamic financial instruments, Musharaka is still considered to be one of the most authentic forms of Shari'ah approved financing. Recognising the problem that some financing instruments used by Islamic financial institution closely resemble interest-bearing instruments, Muslim scholars have voiced their opinion that more profit-and-loss sharing instruments should be developed and used. In recent times there have also been calls for Muslim countries to follow the lead of Iran and Pakistan, where their governments have enforced the Islamic financial system as the only available finance option. The push for such actions to be taken means that Musharaka's use as an Islamic financial instrument will continue to rise in the future. Also, by relying on Musharaka for financing projects, Islamic financial institutions can erode any fears that Islamic financial institutions are essentially providing interest-bearing products under the guise of profit and mark-up has hurt their reputation. This is important for the survival and future growth of Islamic finance.
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