Islamic Finance - Relevant for ACCA Paper F9 and P4 An introduction to the Islamic faith A brief introduction to the Islam faith would help a better understanding of Islamic finance . Islam
Islam literally means submission to Allah. It refers to the religion of Allah (God) i.e. the worship of Allah alone. A person whose religion is Islam is a Muslim. A person becomes a Muslim by declaring the Shahada. Just as Islam regulates and influences all other spheres of life for Muslims, so it governs the conduct of business and commerce. Muslims have a moral obligation to conduct their business activities in accordance with the requirements of their religion. They should be fair, honest and just towards others. A special obligation exists upon vendors as there is no doctrine of caveat emptor (‘buyers emptor (‘buyers beware’) in Islam. It is a duty of Muslims to earn a living and there is no impediment to honest and legitimate trade and business. Islam upholds contractual obligations and the disclosure of information as a sacred duty. Sharia’a
Alternative spellings include Shari’a , Sharia, Syari’ah , Syari’a, Syaria. The term Sharia’a has two meanings:
(i) (ii)
Islamic Law, and the total of divine divine categorisations of human human acts acts (Islam).
The second meaning of the term means that Sharia’a rules do not always function as rules of law in the Western sense, as they include obligations, duties, and moral considerations not generally thought of as ‘law’ in the W estern sense. Sharia’a rules, therefore, admit both a legal and moral dimension. A ‘Sharia’a ‘Sharia’a-compliant -compliant ’ product meets the requirements of Islamic law.
Are Islamic banks international? Yes they are! For example, a Google search (10 February 2011 [most recent available]) identified 32 Islamic banks operating in The United Kingdom. This list does not include conventional banks which also offer Islamic financial services. The principles of Islamic finance
The basis for all Islamic finance then lies in the principles of the Sharia, or Islamic Law, which is taken from the Qur'an, and the Islamic form of finance is as old as the religion of Islam itself. The main principles of Islamic finance in more detail are detailed below. Riba (interest) is prohibited. Any predetermined payment over and above the actual amount of principal is prohibited. Islam allows only one kind of loan whereby the lender does not charge any interest or additional amount over the money lent.
Profits or losses must be shared. The principle here is that the lender must share the profits or losses arising out of the enterprise (‘investment’) for which the money was lent. Islam encourages organisations and individuals to invest their money and to become partners in the business, instead of becoming creditors. Islamic finance is based on the belief that the provider of capital and the user of capital should share equally the risk of the business venture, whether they are manufacturing industries, service companies or simple trade deals. Translated into banking terms, the bank’s depositor (the lender to the bank), the bank and the borrower (perhaps business entity) should all share the risks and the rewards of financing business ventures. Risks are shared. One of the important features of Islamic finance is that it promotes risk-sharing between the providers of funds (investors) and users of funds (entrepreneurs). In Islamic financing both the investor (say, the bank) and the entrepreneur share the results of the project in an equitable way. In the case of profit, both share this in agreed proportions. In the case of loss, all financial loss is borne by the capital supplier (say, the bank) with the entrepreneur being penalised by receiving no return (wage or salary) for his endeavours. Inflation cost should not be borne by the borrower. The Islamic opinion is against the charging of any premium (interest) for the cost of inflation. Islam scholars contend that although it is unfortunate that the lender (say, the bank) has lost some value, this is not the fault of the borrower (say, the entrepreneur) hence the borrower should not be burdened with this excess. (This is done conventionally by the use of interest rates. One reason why long term loans bear higher interest than short terms loans is because of the reduction in purchase power caused by inflation over time.) Making money out of money is not acceptable. Making money from money is not Islamically acceptable. Money, in Islam, is only a medium of exchange, a way of defining the value of a thing. It has no value in itself, and therefore should not be allowed to generate more money, via fixed interest payments, simply by being put in a bank or lent to someone else. Emphasis is on productivity. Under the Islamic profit-and-loss (PLS) philosophy the provider of the capital (say, the bank) will receive a return only if the project succeeds and produces a profit. Therefore, it is reasoned, an Islamic bank will be more concerned about the soundness of the project and the business acumen and managerial competence of the entrepreneur. Speculation and uncertainty is prohibited. Under this prohibition any transaction entered into should be free from uncertainty, risk and speculation. Contracting parties should have perfect knowledge of the counter values (goods received and/or prices paid) intended to be exchanged as a result of their transactions. Also parties cannot predetermine a guaranteed profit (such as interest). Options, and futures are considered as un-Islamic and so are forward exchange transactions, given that forward exchange rates are determined by interest rate differentials.
The concept of interest ( r i b a ) and how returns are made by Islamic financial securities In the conventional literature, interest is seen as the time value of money , as described by the common expression: "time is money ". However, Islamic scholars contend that time is not money. Money in Islam is seen simply as a medium of exchange - with no intrinsic value in itself - so it is impermissible to lend money and earn a guaranteed rate (interest) on the money. The Arabic word riba literally means "an addition to" or "excess" over the original price of the good or service. Technically, it means an increase over the principal in a loan transaction or in exchange for a commodity accrued to the owner (lender) without giving an equivalent counter-value or recompense (‘iwad ’), in return, to the other party. Any risk-free or ‘guaranteed’ rate of return on a loan or investment is riba. Riba in all its forms is prohibited in Islam. In conventional terms, riba and ‘interest’ are used inter -changeably, although the notion extends beyond mere interest. Riba encompasses various forms of (what to Islam is) illicit gain of which bank interest is one example. Riba comes in several varieties:
Interest, in all modern banking transactions, falls under the purview of Riba. As money in the present banking system is exchanged for money with excess, it falls under the definition of riba. Usury of debt which can occur as an excess or increment in addition to the principal, which is incorporated as an obligatory condition of the giving of a loan. Alternatively, it occurs when an excess amount is imposed on top of the principal if the borrower fails to repay on the due date. More time is permitted for repayment in return for an additional amount. If the borrower fails to pay again, a further excess amount is imposed, etc. (For example, this occurs conventionally with credit card loans, interest is paid on the principal borrowed and then interest is paid on the outstanding interest, and so on.) Riba is also described as an unlawful excess in the exchange of two counter-values where the excess is measurable through weight or measure. The concept is based on some Ahadith according to which if gold, silver, wheat, barley, dates, and salt are exchanged against themselves, they should be spot and be equal and specified. If these conditions are not found, this transaction will become riba al-fadl. For example, if 50 grams of gold jewellery with intricate work requiring hours of labor is exchanged on the spot for 40 grams of simple gold, then this is riba. Another example would be the exchanging of $10,000 today for, say $11,000 five years’ from now. Charging for the time value of money is deemed to be riba and is not acceptable Islamically. There is no place for discounted cashflow calculations when evaluating investments. (Note: Ahadith are narrations concerning the words and deeds of the Islamic prophet Muhammad.)
In Islam, riba is one of the most abhorrent of all sins and is absolutely prohibited. The obvious question is: ‘if Islamic banks cannot charge interest then how do they make a return? ’ The answer is quite complicated because there are numerous different ways that Islamic financial institutions obtain a reward. In an Islamic bank, the money provided by depositors is not lent, but is invested on their behalf in ways that will earn profit in one way or another. The depositor is rewarded by a share of that profit, after a management fee is deducted by the bank. Figure 1 contrasts conventional finance with Islamic finance.
A range of short and long term Islamic financial instruments available to business
In Islamic financing there are broadly two categories of financing techniques: 1. Islamically-permissible deferred sales contracts - M u r a b a h a , Ijara , S u k u k The first group is what are known as ‘deferred sales contracts’. Islamic jurists have ruled it valid to sell a non-monetary asset immediately, with a deferred price, possible paid in instalments, greater than its cash price. The rationale for this ruling is that the seller of an asset for a price to be paid in future, is sacrificing a benefit in order to make the asset available to the person who is buying it with a deferred payment. Thus the increase in the deferred price may be viewed as compensation to the seller, and not interest (riba). The jurists ruled these sales valid as long as the contract is independently specified and contains no ignorance. 2. Profit-and-loss share (PLS) contracts – M u s h a r a k a , M u d a r a b a The second group of Islamically-acceptable contracts is profit-and-loss share contracts. A PLS contract means that the outcome is sharing based and cannot be predetermined. Shareholders are only repaid if profits are made and if no profits are made then no payouts take place.
We will consider what is involved in each of these five forms of Islamic finance.
- Deferred sales contracts group Murabaha This form of finance refers to the sale of assets or goods at a price. This includes a profit margin agreed to by both parties. The purchase and selling price, other costs, and the profit margin must be clearly stated at the time of the sale agreement. The bank is compensated for the time value of its money in the form of the profit margin. This is a fixed-income loan for the purchase of a real asset (such as real estate or a vehicle), with a fixed rate of profit determined by the profit margin. The bank is not compensated for the time value of money outside of the contracted term (i.e., the bank cannot charge additional profit on late payments); however, the asset remains as a mortgage with the bank until the default is settled. The M u r a b a h a mortgage
It might be clearer to understand if we use the example of a Murabaha mortgage. M u r a b a h a mortgages work in this way:
An individual/family finds a house to purchase and agrees a sale price with the seller. As with any mortgage, the individual then arranges a mortgage with his or her Islamic lender (say bank). Typically, the individual will have to provide about a 20% deposit of the purchase at this time (November 2013). The bank will then buy the property and immediately resell it to the individual for a higher price. (Note: the bank will make a profit on the transaction and will not charge interest). When purchased, the property is registered in the name of the borrower, and the sale between the borrower and the bank is recorded in the Murabaha Contract . The individual will then pay back the lender the resale price in fixed instalments until the property is fully repaid (owned). Note: the repayment remains the same regardless to what happens to the level of interest rates - this is because the individual is paying the bank its profit, not interest. In philosophical terms it is the house (the service) that is earning the profit, and not the money that is used to buy the house which would be the case when interest is paid on the borrowed amount. The difference between the original purchase price and the higher price at which the property is resold to the individual (buyer) provides the Islamic lender with a profit that is (some say) compliant with Islamic law. If the borrower is late on their payments, the bank cannot charge any late penalties. The profit portion is prorated, and the bank normally agrees to accept lesser profit should the borrower choose to pay off the contract early. Example of M u r a b a h a mortgage
Purchase price of house ($)
300,000
Profit added by bank (and agreed by both parties) ($)
100,000
Total amount ($)
400,000
Deposit (20% x $300,000)($)
- 60,000
Amount to be paid by borrower ($)
340,000
Duration of mortgage - 15 years (months)
180
Mortgage payment per month ($)
1,889
Owner sells the house after 10 years (120 months) for $380,000 Principal ($)
300,000
Less paid: 120 months x $300,000/180 ($)
200,000
Principal still owed to bank ($)
100,000
Profit to bank outstanding (profit is prorated) ($)
0
At the resale point the owner would receive a net receipt of $380,000 $100,000 = $280,000 (For interest, Murabaha mortgages are not popular in the UK, and very few Islamic lenders offer them. The main reason for this is that a very large initial amount of capital is normally required by the borrower [upwards of 20%] and the lending term is typically no more than 15 years, making it difficult to afford for most borrowers. The diminishing Musharaka mortgage is more popular and we look at this later.) Note: It does not matter what happens to changes in interest rates the calculations of the Murabaha mortgage are not affected.
The M u r a b a h a loan in business It is seen from the mortgage example above that the ‘ Murabaha can be defined as an: ‘arrangement wherein two parties negotiate, agree to specific terms of a sale contract and promise each other to consummate it’ . According to this contract one party ‘orders’ another to buy a specific commodity and then sells to him on a Murabaha basis. There are four elements to this contract as follows:
1. An order by a prospective buyer (say, the company) to an intermediary (say, a bank) to buy a specific commodity from a seller promising to buy it from the bank for a profit. Sharia’a scholars consider this order as an invitation to do business. It is not a commitment. 2. If the bank accepts this invitation he is bound to ensure he can locate the commodity (usually under the advice of the company), buy and own it via a true and legitimate contract. 3. The bank then makes an offer to the prospective buyer (the company) after the commodity has been bought and owned by the seller. 4. The prospective buyer (the company) has the option to buy the commodity or renege on their promise. If the company agrees to buy, then a Muabaha contract is formed. 5.
The contract works in the same way shown for the mortgage above.
Is the profit margin the same as interest (riba)? It may appear, at first glance, that the mark-up is just another term for interest charged by conventional banks. Interest, it could be argued, is thus being admitted through the back door. Yet the legality of the traditional type of Murabaha is not questioned by any of the schools of Sharia’s law . Is the M u r a b a h a contract Islamically compliant?
What makes the traditional Murabaha transaction Islamically legitimate is that the bank first acquires the asset for sale at profit, so that a commodity is sold for money and the operation is not a mere exchange of money for money. In other words the bank is the seller and not the provider of funds. In the process the bank assumes certain risks between purchase and sale: for example, a sudden fall in price could see the company refusing to accept the goods at the agreed higher price. That is, the bank takes ownership responsibility for the goods before it is safely delivered to the company. The services rendered by the Islamic bank are therefore regarded as quite different from those of a conventional bank which simply lends money to the company so that it can then buy the goods itself.
Lease finance (ijara ) Ijara is a form of leasing. It involves a contract where the bank buys and then leases (rents) an item – perhaps a consumer durable, for example – to a customer for a specified rental over a specific period. The duration of the lease, as well as the basis for rental, are set and agreed in advance. The Islamic lender (e.g. a bank) normally retains ownership of the item throughout the arrangement and retains ownership at the end of the agreement. What makes the ijara lease different from the murabaha contract, is that with the ijara the lender (say, the bank) retains ownership of the assets or goods involved. Ijara-wa-iktana is similar to Ijara, except that included in the contract is a promise from the customer to buy the equipment at the end of the lease period, at a pre-agreed price. Rentals paid during the period of the lease constitute part of the purchase price. Often, as a result, the final sale will be for a token (nominal, or low) sum.
In more detail, under the Ijara scheme of financing, the bank purchases a real asset (the bank may purchase the asset as per the specifications provided by the prospective client) and leases it to the client. The period of lease, which may be from three months to five years or more, is determined by mutual agreement, according to the nature of the assets. During the period of lease, the asset remains under the ownership of the bank but the physical possession of the asset and the right of use are transferred to the lessee. The bank and the lessee agree upon a lease payment schedule based on the amount and terms of financing. (The ijara form of lease is not unlike the conventional ‘finance lease’.) Figure 2 , shows the steps involved in an Ijara financing operation.
Is the ijara contract islamically compliant?
What makes the traditional Ijara transaction Islamically legitimate is that the Sharia’a allows a fixed charge (profit) to be charged on renting tangible assets as opposed to charging interest on financial assets because, by converting financial capital into tangible assets (by buying the asset), the lender has assumed risks . This is one of the key elements making a transaction Islamically acceptable. Under this mode of finance the bank bears the risk of an economic recession or reduced demand for the assets. Leasing also has been justified on the grounds that by retaining ownership the bank runs the risk of premature obsolescence. The rental equipment is often used in a transient manner and the lessor (bank) is charged with the responsibility for maintenance. In the case of rental the lessor is also charged with the responsibility for coping with the asset’s obsolescence, so that it may be regarded as a service -oriented business. This element of risk is a key component in making Ijara acceptable within Shari a’a.
Debt finance (s u k u k ) Islamic capital markets are made up of two components: (i) stock (share) markets, and (ii) bond markets. Here we are concerned with the bond markets. In particular it is sukuk that have become the accepted Islamic alternative to conventional bills, bonds, and notes, and hence are the major focus in the way that substantial funds are raised.. Conventional capital market instruments such as treasury bills, bonds, and notes are unacceptable from a sharia’a Islamic legal perspective as they involve interest payments and receipts. Interest is equated with riba, an ‘unjust’
addition to the principal of a debt, and is seen as potentially exploitative. Islamic economists prefer equity to debt financing because of the risk-sharing characteristics of the former, which is viewed as fairer to all parties. They are also concerned about the injustices that often arise with excessive indebtedness, as in the case of developing country debt, or simply the higher interest charges often faced by those with no collateral to offer and the poor more generally. Nevertheless, government and corporate borrowing is unavoidable, and can indeed be beneficial if the finance is used productively for investment that can contribute to employment and prosperity. Bank lending, however, commits assets on a long-term basis and reduces liquidity. The advantage of using capital market instruments to raise finance is that investors can exit at any time (by selling their bonds on the market) rather than waiting for assets to mature. Furthermore, conventionally the investment banks that arrange the issuances earn fees and do not have to commit their own resources, unless the bill, bond, or note issue is not taken up, in which case, as underwriters, they will have to purchase the issuance. There are no sharia’a objections to financial markets, only to the interest-based instruments which are traded in the markets. The way a typical s u k u k bond works. The stages are:
1 The issuer (say the company) will sell the bonds (in the form of financial certificates) to an investor group (which can be made up of individual investors), who will own them. (This the same as the conventional way that bonds are sold to investors for cash.) 2. The investor group will then rent the certificates back to the issuer (company) in exchange for a predetermined rental return. This is because the traditional Western interest paying bond structure is not permissible. However, like the interest rate on a conventional bond, the rental return may be a fixed or floating rate pegged to a benchmark, such as LIBOR. (Note: the rent is not necessarily ‘fixed’ at issue date.) 3. The issuer (company) makes a binding promise to buy back the bonds at a future date at par value. A sukuk may be a new borrowing, or it may be the Sharia-compliant replacement of a conventional bond issue (i.e. borrowing to repay a loan). 4. Sukuks must be able to link the returns and cash flows of the financing to the assets purchased (with the same finance). The issuing authority (the company) therefore needs to identify existing or new assets acquired to the finance raised from the Sukuk investors via transference to a Special Purpose Vehicle (SPV) . (This is because trading in debt is prohibited under Sharia. As such, financing must only be raised for identifiable assets.) The Sukuk investors then have a proportionate beneficial ownership in these assets, which they are effectively renting to the company. (A Special Purpose Vehicle (SPV), in the case of Sukuk bonds, is the attempt to isolate risk of an investment from the main company by maintaining its assets and liabilities on a separate balance sheet.) 5. Sukuk structures do contain covenants specifying the underlying capital structure mix with restrictions on underlying debt concentration (i.e. gearing level). 6. The issuer (company) is obliged to pay the bond holder 100 per cent of the redemption amount and a periodic distribution amount regardless of how the underlying asset performs. Rent of the SPV asset financed is being paid to the investors, not profit or interest. The purpose for the issue of Sukuk varies and can include project finance, general corporate funding for working capital or expansion, corporate refinancing, asset securitisation and acquisition finance. (Note: Asset securitisation is where an asset-backed security (such as a bond) is issued and whose value and income payments are derived from and secured (or "backed") by a specified pool of underlying assets.) Are S u k u k structures Sharia’a compliant? Sukuk structures are Sharia’a compliant because assets are effectively purchased by investors (by the use of a Special Purpose Vehicle’) and th en rented/leased back to the company. Interest is not paid. The impact of Sharia’a compliance will necessitate funds raised through Sukuk -financing to be utilised in generating
appropriate returns while avoiding high risk investment opportunities, and other ‘unsuitable’ activities such as gambling and alcohol production. . The fact is that Sukuk are backed by hard assets limits the possibility of issuer (company) default.
Profit-and-loss share (PLS) contracts - M u s h a r a k a The Musharaka contract is the first (of two) form of Islamically-acceptable contracts that is a profit-and-loss share (PLS) contract. Again, it might make the explanation easier if we relate it to the mortgage of a house. The diminishing M u s h a r a k a mortgage – "lease to own“
The vast majority of the Islamic mortgages available in the UK are based on the Musharaka diminishing principle , which can loosely be described as "lease to own". Musharaka mortgages work like this:
An individual/family finds a house to purchase and agrees a sale price with the seller. As with any mortgage, the individual then agrees the amount of the mortgage with his or her Is lamic lender (say bank). The bank will then purchase the property outright. The individual then enters into two agreements with the bank To pay back the purchase price of the property in fixed monthly instalments, usually over 20 - 25 years . Note, this is only the purchase price of the property. To also pay an agreed amount of rent each month – this provides the bank’s profit . The rent is set annually, and decreases each year in line with the gradual repayment of the purchase price of the property. As the individual makes monthly payments, his or her share of the property will increase as the bank's share decreases. Assuming the individual pays a 10% deposit, at the start of the agreement the bank will typically have a 90% share and the individual will have a 10% share. With each payment the individual makes, he or she will pay rent for use of the bank's share of the property and acquire an additional share for themselves.
When the purchase price has been completely repaid to the bank, ownership of the property is fullytransferred to the individual. Using this system, individuals/families can borrow as much as 90% of the purchase price of the property, and repay it until they own the house while providing the lender (bank) with a profit that is legitimate under Islamic law (Sharia). Note: exact details of any mortgage scheme vary between lenders.
Example of a diminishing M u s h a r a k a mortgage
Purchase price of house ($)
300,000
Deposit (20% x $300,000)
- 60,000
Amount borrowed ($)
240,000
Duration of 20 year mortgage (months)
240
It is agreed by both parties (bank and borrower) that rent (which is the bank's profit) will be prorated at 35% of initial amount borrowed based on year beginning value. Therefore the rent payable for the first year would be ($240,000 x 0.35)/20 years = $4,200. First year's mortgage Repayment of principal $240,000/20
12,000
Bank's rent (profit) (see above) ($) Year's payment ($) Monthly payment $16,200/12
4,200 16,200 1,350
Second year's mortgage Repayment of principal $240,000/20 Bank's rent (profit) (($240,000 - $12,000*)/$240,000) x $4,200 Year's payment ($) Monthly payment $15,990/12
12,000 3,990 15,990 1,333
* $12,000 was repaid from the loan in the first year which means that the householder's value in the property has increased and the bank's share in the property has reduced. The rent paid by the householder would reduce on a prorata basis. Twelfth year's mortgage Repayment of principal $240,000/20 Bank's rent (profit) (($240,000 - $132,000**)/$240,000) x $4,200 Year's payment ($) Monthly payment $13,890/12
12,000 1,890 13,890 1,158
** 11 years' x $12,000 = $132,000 were repaid in the first eleven years which means that the householder's value in the property has increased and the bank's share in the property has reduced. The rent paid by the householder would reduce on a prorata basis. If the property was sold for $400,000 at the end of the twelfth year the cash receipts for the householder would be as follows: Receipt (for sale of property) ($)
400,000
Repayment of principal outstanding ($240,000 - $144,000)
- 96,000
Net cash receipt ($)
304,000
Note: It does not matter what happens to changes in interest rates the calculations of the diminishing Musharaka mortgage are not affected.
Venture capital (Musharaka) M u s h a r a k a means sharing. The word Musharaka means sharing, and is used to describe those joint business
enterprises in which the partners share the profit or loss of the venture. Unlike an interest- based product (where
interest must be paid/received), there is no guaranteed rate of return on the investment with musharaka, as income is based on the profit earned by the joint venture, and may possibly result in losses. Musharaka means partnership. We have seen (with the mortgage example) that musharaka is a form of partnership between an Islamic bank and its clients whereby each party contributes to the partnership capital, in equal or varying degrees, to establish a new project or share in an existing one, and whereby each of the partners becomes an owner of the capital on a permanent or declining basis and is owed his due share of profits. However, in business, losses are shared in proportion to the contributed capital. It is not possible to stipulate otherwise. M u s h a r a k a can take the form of an unrestricted and e qual partnership. Musharaka implies partnership in a
venture, and can be defined as a form of partnership whereby two or more persons combine either their capital (perhaps a bank) or labour (say, the entrepreneur) together, to share the profits, enjoying similar rights and liabilities. It can take the form of an unrestricted and equal partnership in which the partners (the bank and the entrepreneur) enjoy complete equality regarding the areas of capital, management and right of disposition. Each partner is both the agent and the guarantor of the other. An alternative is a more limited partnership
A more limited investment partnership occurs when two or more parties contribute to a capital fund, either with money (say, a bank), contributions in kind or labour (the entrepreneur). Each partner is only the agent and not the guarantor of his partner. This version is the most common form of Musharaka. Two form of m u s h a r a k a . There are two forms of musharaka used in business:
(i) Diminishing M u s h a r a k a This is a Musharaka in which an Islamic bank agrees to transfer gradually to the other partner its (the Islamic bank’s) share in the Musharaka, with the effect that the Islamic bank’s share declines and the other partner’s share increases until the latter becomes the sole proprietor of the venture. (This was exemplified by the mortgage discussed above.) (ii) Constant M u s h a r a k a This is a Musharaka in which the partners’ shares in the capital remain constant throughout the period, as specified in the contract. (The figures in Table 1 illustrate this type of contract.) Profits are shared in a n agreed manner and losses are borne in proportion to capital contributions. For both versions of Musharaka the partners share profits in an agreed manner and bear l o s s e s in proportion to their capital contributions. As in Mudaraba, (covered later) the profits can be shared in any equitably agreed proportion. The bases for entitlement to the profits of a Musharaka are capital, active participation in the Musharaka business and responsibility.
Profits must be distributed among the partners in the business on the basis of proportions agreed by them in advance. The profit share of every party must be determined as a proportion or percentage. Losses must, however, be shared in proportion to the capital contribution. On this point all Islamic jurists are unanimous. (Therefore if the basis of entitlement is based on capital [contributed by the bank] and labour and know-how [contributed by the entrepreneur], the loss will be borne entirely by the bank.) M u s h a r a k a is seen as being more equitable than an interest-based loan. This type of investment is seen as
distributing the risks, and the profits, more equitably between the investors than a simple interest- based loan. Thus rather than receiving a fixed rate of say, 10%, whether the profits on the enterprise are 3% or 300%, the investor will benefit in relation to the success of the venture. Practical examples of M u s h a r a k a - when used for financing working capital. Musharaka is widely used as a technique for Islamic financial institutions to provide finance to commercial enterprises. For example, the concept of Musharaka can be used to structure a working capital facility for a company, where that company has a record of profitability.
A Musharaka working capital facility would operate much like a conventional working capital facility. The Islamic financial institution would provide funds to its customer, usually by the deposit of the funds to the customer’s account with the financial institution. The customer would access those funds in the ordinary course of its business.
The difference however, is that instead of debiting the customer’s account with a predetermined rate of interest, the Islamic institution would periodically debit the customer’s account for an amo unt equal to a predetermined rate of profit , subject to adjustment on a regular basis, usually quarterly.
At the end of the financial year, the profits are calculated. If the amount due to the Islamic financial institution (say, a bank) exceeds the provisional profit already debited from the account, the amount not paid to the Islamic institution will be credited to a special reserve account which the company will create in its books. Conversely, if the amount due to the financial institution is less than the provisional profit already collected by the Islamic institution, the special reserve account will be reduced by the amount of the excess payment to the Islamic institution. Upon the termination of the Musharaka financing, a final income statement is prepared and, at that time, any balance in the special reserve account is shared by the financial institution and the customer in accordance with the ratio they have agreed upon at the inception of the contract. If, during a financial year, the company generates losses, the special reserve account is reduced by the amount of those losses. If the balance of the special reserve account is insufficient to make good such losses, the customer may ask the Islamic financial institution for a refund (in whole or in part) of the provisional profits previously paid to the Islamic institution. Some figures might aid understanding of these points.
Table 1 : Example of a M u s h a r a k a business loan contract
Assume the following: The accounts shown are in the books of the business (company) Amount borrowed on a 2-year loan contract ($)
750,000
Profit sharing is on an equal basis
50% - 50%
Profit target
10% p.a.
Annual 10% profit based on contract value (0.1 x $750,000)
75,000
Profit will accrue evenly throughout the investment period: 18,750
Quarterly profit: $75,000/4
Results and accounting action: Actual profit Year 1
Paid to bank
Special Reserve Account
$
$
$
$
Q1
23,600
9,375*
23,600 - 18,750 =
4,850
Q2
26,800
9,375
26,800 - 18,750 =
8,050
Q3
21,870
9,375
21,870 - 18,750 =
3,120
Q4
15,100
9,375
15,100 - 18,750 =
- 3,650
16,400
9,375
16,400 - 18,750 =
- 2,350
Year 2 Q1
Q2
22,500
9,375
22,500 - 18,750 =
3,750
Q3
24,100
9,375
24,100 - 18,750 =
5,350
Q4
22,300
9,375
22,300 - 18,750 =
3,550
172,670
22,670
* $18,750/2 = $9,375 per quarter paid to bank (50%-50% arrangement) At he conclusion of the loan ('close out') the Special Reserve Account would be paid by a payment of $11,335 ($22,670/2) to the bank and a credit of $11,335 to the business profit and loss (and corresponding debit to the Special Reserve Account). Both partners would have received 50% of the total profits, i.e. $86,335 ($172,670/2). The figures are: Bank
($9,375 x 8 qrs) + $11,335 =
$86,335
Company
$172,670 - $86,335 =
$86,335
The figures would be different (and more complicated) if the contract was based on a diminishing Musharaka contract whereby the loan was repaid in part annually and the profit requirement was reduced by the amount repaid. (See the diminishing Musharaka mortgage example shown previously.) Note: The Examiner of ACCA Paper F9 has stated that calculations will not be set in the exam. However knowledge of the different forms of Islamic finance are required, and examples of figures./calculations help to clarify what is entailed. Islamic finance has just entered the ACCA Paper P4 exam (in 2013) and the Examiner has not made the same assurance about calculations.
What makes Musharaka scholars) are:
Sharia’a
compliant? The basic principles of Musharaka (as agreed by the majority of
Financing through Musharaka never implies lending money; rather it means active participation in the business/venture/project. The investor or financier must share both profits and losses incurred by the business, to the extent of their financing. (Note: only to the extent of their financing, so if the bank has provided 100% of the capital the business bears no share of the loss.) Partners (say, bank and business) are at liberty to determine the ratio of profit allocated to each one of them. This may be different from the ratio of capital investment. However, the partner who excludes himself from the management of the business (usually the bank) cannot claim more profit than the ratio of his capital investment. Losses suffered by each partner must be exactly in proportion to his capital contribution.
Equity finance (Mudaraba ) Loss is only borne by the owner of capital. Mudaraba is a form of business contract in which one party brings capital and the other brings personal effort and time to a business transaction. The proportionate share in profit from the business deal is determined by mutual agreement. But a loss, if any, is borne only by the owner of the capital, in which case the entrepreneur gets nothing for his labour.
Profit is shared in pre-agreed ratios. As a financing technique adopted by Islamic banks Mudaraba is a contract in which all the capital is provided by the Islamic bank while the other party manages the business. The profit is shared
in pre-agreed ratios, and loss, unless caused by negligence or violation of terms of the contract by the entrepreneur, is borne by the Islamic bank. The bank passes on this loss to the bank depositors, known as investment account holders. The Mudaraba may be represented as a profit sharing contract. To repeat, there is no loss sharing in a Mudaraba contract. Profit-and-loss sharing is what takes place with the Musharaka contract (which we discussed above). The Mudaraba contract may better be represented as being a profit sharing contract. M u d a r a b a is sometimes referred to as a sleeping partnership. The party supplying the capital (say, a bank) is
called the Rab-ul-Maal . The other entrepreneur party is referred to as the worker or Mudarib who actually runs the business. As a matter of principle the Rab-ul-Maal (the bank)does not have the right to interfere in the management of the enterprise. This is the sole responsibility of the Mudarib. However, he (the bank) has every right to specify such conditions that would ensure better management of his money. That is why Mudaraba is sometimes referred to as a sleeping partnership. There are t w o types of M u d a r a b a :
(i) Restricted M u d a r a b a . Under this scheme the Rab-ul-Maal (the bank) may specify a particular choice of business or a particular place of business for the Mudarib (the entrepreneur), in which case he (the bank) must invest the money in that particular business or place. (ii) Unrestricted M u d a r a b a . Under this alternative scheme, the Rab-ul-Maal (the bank) gives full freedom to the Mudarib (the entrepreneur) to undertake whatever business he deems fit. However, the Mudarib cannot, without consent of the owner of the capital, invest money wherever he wants to. The Mudarib is authorised to do whatever is normally done in the course of business. However if the Mudarib wants to undertake something which is beyond the normal routine of business, he cannot do so without express permission from the Rab-ul-Maal (the bank). Two-tier M u d a r a b a . Islamic bankers have adapted and refined the Mudaraba concept to form what is known as the ‘Two-tier Mudaraba’. In this arrangement, the Mudaraba contract has been extended to include three parties:
(i) the depositors as financiers (ii) the bank as an intermediary (iii) the entrepreneur who requires funds. The bank acts as an intermediary (or Mudarib) when it receives funds from depositors, and as a financier (Rab-ulMaal ) when it provides the funds to entrepreneurs. Main conditions associated with a M u d a r a b a contract. The main conditions associated with a Mudaraba contract are as follows:
The Islamic bank receives funds from the public on the basis of unrestricted Mudaraba. There are no constraints imposed on the bank concerning the kind of activity, duration, and location of the enterprise when it invests the capital provided. However, Mudaraba contract cannot be applied to finance activities which are forbidden by Islam. Such a contract would be considered null and void. (Note: the bank could be any form of financier.) The bank has the right to aggregate and pool the profit from different investments and share the profit (after deducting administrative costs, capital depreciation and Islamic tax) with depositors, according to a specified formula. In the event of losses, the depositors lose a proportionate share or the entire amount of their funds. The return to the bank or financier (Rab-ul-Maal ) has to be strictly maintained as a share of profit . The bank applies the restricted form of Mudaraba when funds are provided to specified entrepreneurs. The bank has the right to determine the kind of activities, the duration, and the location of the projects monitor the
investments. However, these restrictions may not be formulated in a way so as to harm the performance of the entrepreneur. When a project is undertaken, the bank cannot interfere with the management of the investment nor take part in the daily operation of the business. Thus loan covenants and other such constraints, considered usual in conventional bank lending, are not allowed in PLA-based Islamic banking. Under a Mudaraba, the Rab-ul-Maal (the bank) cannot demand any guarantee from the Mudarib (the business/entrepreneur) such as insisting on a return of the capital with a fixed profit, since the relationship between the Rub-ul-Maal and the Mudarib is a fiduciary one (i.e. there is a legal relationship between the two parties). The Mudarib (the entrepreneur) is deemed to be a trustworthy person. Accordingly, the bank cannot require any guarantee such as security and collateral from the entrepreneur in order to insure its capital against the possibility of an eventual loss. Such a condition would make the Mudarib’s contract null and void. The Mudaraba contract should assign a profit rate for each party. The rate should be a ratio (e.g. 70%/30%), and not a fixed financial amount. Assigning a fixed financial amount to either party invalidates the Mudaraba due to the possibility that the ultimate profit realised may not equal the sum so stipulated. Before arriving at a profit figure the assets of the Mudaraba venture should be converted to money and the capital should be set aside. Only what remains is profit. The Mudarib (the entrepreneur) is entitled to deduct all business-related expenses from the Mudaraba capital. The liability of the financier (Rub-ul-Maal ) is limited exclusively to the capital provided. On the other hand, the liability of the entrepreneur (Mudarib) is also restricted, but in this case to his labour and effort. Nevertheless, if negligence or mismanagement can be proven, the entrepreneur (Mudarib) may be liable for any financial loss and be obliged to remunerate the financier (Rub-ul-Maal ) accordingly. The entrepreneur (Mudarib) shares the profit with the bank (Rab-ul-Maal ) according to a previously agreed profit division. Until the investment yields a profit, the bank (Rab-ul-Maal ) is able to pay a salary to the entrepreneur (Mudarib). The salary is determined on the basis of the ruling market salary rates. Table 2 provides an illustration of a standard Mudaraba transaction.
Table 2 : Standard M u d a r a b a contract
Assume the following for a one-year contract: Sales value of contract (i.e. when completed) ($)
250,000
Mudaraba value (i.e. amount of loan) ($)
180,000
Profit sharing (agreed by both parties) Profit target (based on value of contract) 11% profit based on contract value ($250,000 x 0.11) Bank agrees to award the Mudarib (company) for good performance to be deducted from bank's share
50% 50% 11% p.a. 27,500 95%
The profit amounts are calculated below as follows: Main contract sales value ($)
250,000
Mudaraba value ($)
180,000
Net profit ($)
70,000
Rab-ul-Maal's (bank's) profit $70,000/2
35,000
Mudarib's (company's) profit - 50% - 50% ($)
35,000
The Rab-ul-Maal (bank) will award the Mudaraba (company) 95% of nits 'super profit', thus: $35,000 - ($27,500/2) = $21,250 x 0.95
20,188
Rab-ul-Maal's (bank's) overall profit: $35,000 - $20,100
14,812
Mudarib's ( company's) overall profit $35,000 + $20,188
55,188
Mudaraba's profit
70,000
Rab-ul-Maal's (bank's) profit percentage: $14,812/$70,000
21.1%
Mudarib's (company's) profit percentage: $55,188/$70,000
78.9% 100%
Rab-ul-Mall's (bank's) return on initial investment: $14,812/$180,000)
8.2%
... What makes Mudaraba
Sharia’a
compliant?
Because of his work, the Mudarib (the entrepreneur) becomes entitled to part of the profits of the venture and this is an important characteristic in terms of the Sunnah. Islamic jurists rely on the precedent of the contract of Mudaraba concluded by the Prophet Mohammad with Khadija prior to his marriage to her to support the Mudaraba mode of finance. Islamic banks use the same mode with businesses seeking finance whether they are dentists, doctors, engineers, traders or whatever. The bank provides the necessary finance as a capital owner in exchange for a share in the profit to be agreed upon.
How to remember Islamic terms It is not easy to remember what the different terms used in Islamic finance mean if the Examiner asks, and how they are different, particularly if the words are not in a familiar language. The following tips might help you.
