Equity- related islamic banking products

Chapter.3

Equity- related Islamic Banking Products.

3.1. Introduction:

According to John B Taylor a growth in product innovation, an increase in the number of financial institutions offering Islamic finance products, and an expansion of Islamic banking beyond the Islamic countries to the UK, Switzerland, the United States, and elsewhere is not a myth.Islamic banking and financial institutions have developed a wide range of techniques in compliance with Shariah The products that modern-day Islamic bankers have created are very similar to conventional products. The most relevant Islamic modes of financing can be categorised into equity and debt related techniques. Let us examine the significance of these Equity related products in contemporary world products.

3.2. Mudarabha:

The word mudarabah is derived from the Arabic word Dharabahfi al ard, which means going and working to earn a livelihood. “Mudarabah” is a special kind of partnership where one party provides the capital while the other party manages the business. The person who invested the money is called “rabb-ul-mal” and the person who is responsible for management and work is called “mudarib”.The role of a Mudarib may be an amen (trustee), Wakeel(agent) or a Shareek (partner) There shall be an agreement between two partners whereby one party has the knowledge, equipment and manpower while the other has financial strength. They join together to form a temporary partnership to execute a specific project work, and agree on sharing the expected profit.

It is to be noted that under Mudharabah, the role of a bank will be Rab-ul-mal as well as Mudhrib. For example: , When the bank mobilizes funds from a depositor the role of bank shall be a Mudarib. But when the bank utilizes the fund by investing into a venture then the position of the bank shall be a Rab-ul-mal.

3.2.1 Types of Mudarabah:

There are two types of Muradabha. They are:-

  • Al Mudarabah Al-Muqayyadah (Restricted Mudarabah) and
  • Al Mudarabah Al Mutlaqah (Unrestricted Mudarabah).

Under Restricted Mudarabah a particular business may be specified by the bank in which business may be undertaken.

Under the unrestricted mudarabah the customer- entrepreneur is free to invest capital provided by the bank in any business he deems fit.

3.2.3 Profit loss sharing under mudarabah:

It is one of the significant features of this product that Profit is shared in accordance with the terms of the mudarabha agreement and losses are to be borne only by the bank unless the losses are due to the Mudarib's misconduct, negligence, or breach of the terms and conditions of the contract. It is also to be noted here that the liability of the bank is limited liability. It is limited to the extent of its investment of the project.

The following chart will illustrate the profit & loss sharing under mudarabah

3.2.3 Termination of Mudarabah:

When the specified period in the contract expires, the mudarabah will be ended. It can also be terminated at any time by either of the two parties with a prior notice to the other party. However, when entering the muradabah, the parties can agree contrary to the above rule.

3.2.4 Concept in practice:-

There are many products in practice under mudarabha concept. One of the main deposit products which is mostly used for mobilizing funds is Participatory deposit. It is a core deposit product within Islamic Banking. It is considered as the Islamic counterpart of the conventional fixed deposit. The significant feature of participatory deposit is that even if the customer withdraws the deposit before maturity he may be eligible for profit share.Pewani Savings Account and Mudarabha savings account at Bank Islam is a well-accepted product under mudarabha.

The other famous product under Mudarabah is ‘Trustee Partnership'. Under this practice, the bank (Rab-ul-mal) contributes the capital and the customer- entrepreneur (mudarib) provides the expertise, management and labour. The bank will assess the performance and risk of the project going wrong under its partner thus ensuring that the partner is capable of performing the project satisfactorily upto completion.While profit is shared according to a pre- agreed ratio, losses are entirely absorbed by the Bank.Project Finance provided by the Islamic Bank of Philippines is a successful demonstration of this concept.

Some MudarabhaFinancing structures are presented below:

Structure 1:

1

Bank Customer/depositor

2

4

Investment/asset

3 5

Profit

Positive negative

Source: Obaidulah M, “Islamic Financial Services”, (Scientific Publishing Center, Jeddah, Saudi Arabia, 2005).

  1. Activity 1: Depositor and Bank discuss terms of mudaraba; Depositor provides funds to Bank;
  2. Bank invests funds in assets and projects and manages its operations;
  3. Business generates positive or negative profits;
  4. Profits if positive are shared between Depositor and Bank as per a pre-agreed ratio;
  5. Profits if negative are absorbed by Depositor; effectively bringing down the value of the asset created with its investments and the value of the deposit.

3.2.5 Some criticism on Mudharabha:

Modarbha is considered as an Islamic mode of financing but historically it is not true. At the age of 25, Prophet Muhammad (Peace be upon him) entered into a business contract with Khadija even before the revelation he received. In that contract the position of Prophet Muhammad (Peace be up on him) was a Mudarib.

It is also noted that in the conventional Modharabha arrangement, Mudarib bears no loss even if he is the only reason of loss. When a loss occurs, the Mudarib acts like an employee of the business and when the profit occurs, he shares in the profit.

Based on the practice established by Prophet Muhammad (Peace be upon him) money flows from a rich financial entity to a small business entity. But in the case of current Islamic banking practices, the flow of funds is from a small pool of investors to a large financial entity. Moreover due to the following reasons a businessman may not prefer mudharabha contracts;

  • The need to keep and reveal detailed records,
  • The difficulty to expand a business financed through mudarabah because of limited opportunities to re-invest retained earnings and/or raising additional funds,
  • The entrepreneur's inability to become the sole owner of the project.

3.3. Musharaka:

The term Musharaka based from Arabic origins literarily means sharing. Shirkah is the root of this word, which means being a partner.Under Islamic jurisprudence, Musharakah means a joint enterprise formed for conducting some business in according to the ratio of the contribution.It is considered as an ideal alternative for interest based financing because of its far-reaching effects on both production and distribution.

3.3.1 Basic Rules of Mushrakah:

Musharaka is a mutual contract between a bank and a client, so all the mandatory ingredients of a valid contract must be present.In Musharaka, both client and bank has the right to take part in the management of a business and to work for its success.However, one can be a “sleeping” partner, subject to the condition that he will be entitled to the profit only to the extent of his investment.Both the bank and client shall be treated as agents for matters within a business, and if any of them have done any work in the normal course of a business, they shall be deemed as being authorised by the other

3.3.2 Types of Musharaka:

There are two kinds of Musharaka- they are Shirkat-ul-Milk (co-ownership) and Shirkat-ul-'Aqd (contractual partnership). Shirkat-ul-Milk is a joint ownership of both bank and client in a particular property. Shirkat-ul-'Aqd is the second type of Shirkah which means "a partnership effected by a mutual contract".

3.3.3. Concept in present day banking practice:

One of the main Islamic Banking products under the concept of Musharaka is a Joint Venture Facility.Under this product, both Bank and client discuss a business plan and jointly contribute to the capital of the project. Here both client and bank jointly set up the business venture and manage its operations. All the responsibilities should be shared as per a pre agreed ratio. While all the profits are shared as per a pre agreed ratio, all losses are shared in proportion to capital contributions. There is another type of practice under which the bank could be a sleeping partner.Commercial and Industrial Property finance provided by Al-Baraka Islamic Bank is an example of a Joint Venture Facility under Musharakha.

3.3.4. Termination of Musharakah:

Musharakah can be terminated under anyone of the following events:

  1. Both bank and customer have a right to terminate the Musharakah at any time after giving a prior notice.
  2. If the client dies during the period of Musharakah then the contract of Musharakah shall be terminated. However his heirs have the option to continue with the contract of the Musharakah.
  3. If the client becomes insane or incapable of affecting the commercial transaction then the bank can terminate the contract.

3.3.4. Profit loss sharing under Musharkah:

One of the most significant features under Musharaka is that profits are shared between the bank and the customer in a pre-agreed ratio. Losses are shared strictly in proportion to their respective capital contributions.It is to be noted here the liability of both Bank and client is unlimited

3.3.5. Termination of Musharakah without closing the business:

It is another significant feature of a Joint Venture Musharaka that the contract may be terminated without closing the venture. If a situation arises whereby either of the parties wants to terminate the Musharakah, while the other party prefers to continue with the business, the contract can be terminated by mutual agreement. In such a situation the party who wants to continue the business has the right to buy the share of the leaving party. However, the price of the share of the leaving partner must be determined by mutual consent. If there is any dispute regarding the valuation of the share then the leaving partner may compel other partners on the liquidation or on the distribution of the assets themselves

3.3.6. Some criticism on Musharakah:

In a joint venture Musharakah contract, if the clients are dishonest then the instrument can be exploited by not paying any return to the bank by showing that the business did not earn any profit. Moreover a loss can also be claimed.It is another drawback of this mode of financing that by making financier a partner of the client; the financier will be able to understand the business secrets of the client. Moreover both party's have a right to withdraw from Musharakha with a prior notice so such a withdrawal from a project may have material consequences for the project.

A simple mushrakah structure is presented below:

1

Client Bank

Business Venture

3

2 4

Profits

Positive Negative

Source: Obaidulah M, “Islamic Financial Services”, (Scientific Publishing Center, Jeddah, Saudi Arabia, 2005).

  1. Activity 1: discussion between bank and client regarding the business and contribution of capital.
  2. Client and Bank jointly set up the business venture and manage its operations.
  3. Profits should be shared as per a pre- agreed ratio.
  4. Loses are shared in proportion to capital contribution.

3.5. Difference between musharaka and Mudarabah:

Musharaka

Mudarabah

Bank and client invest together

Only Bank invests.

Both bank and client participate in the management of the business and work for it.

Bank has no right to participate in the management which is carried out by the Client only.

Both bank and client share the loss to the extent of the ratio of their investment.

Only Bank suffers loss because the client does not invest anything. This is subject to a condition that the client has worked with due diligence.

The liability of the both bank and client is normally unlimited.

The liability of Bank is limited to the investment unless he has permitted the client to incur debts on his behalf.

Bank and client jointly own the assets in proportion to their respective investment. Even if profit has not been accrued, through sales all partners benefit from the appreciation in the value of the assets.

While all the assets shall be owned by Bank client is entitled to share of profit.

Source: <http://www.islamicfinanceinfo.com/islamic-finance-concept/banking/11-savings-and-investment?start=3> accessed on 09/03/11.

3.4.Diminishing Musharaka:

Diminishing Musharaka (DM) is another form of Musharaka that is a recent innovation.According to this concept, an Islamic bank and an entrepreneur may develop a joint venture that could later lead to sole ownership of the entrepreneur.

Under this mechanism a bank and his client participate either in the joint ownership of a property or equipment, or in a joint commercial enterprise. Further, the share of the bank shall be divided into a number of units and the clients shall purchase the share one by one periodically. By this process the clients own share will increase and it continues until the client purchases all units of the bank. When the client purchases the last unit of share, he becomes the sole owner of the property or commercial enterprise.The main advantage of Diminishing M is that through partial return of capital by client, the bank's share in the equity is diminished each year.

3.4.2 Concept in practice:

It is (what) one of the most popular housing products under Islamic banking. It is an alternative to conventional mortgage.A client who wants to purchase a house with inadequate funds can approach the bank under DM. Both bank and client buy a house jointly where twenty per cent of the price is paid by the client and 80% of the price is paid by the bank. Thus the bank owns 80% of the house while the client owns 20%. After purchasing the property jointly, the client uses the house for his residential requirement and pays rent to the financier for using his share in the property.

At the same time, the share of the bank shall be further divided into eight equal units, each unit representing a 10% ownership of the house. The client as per his promise will purchase these units. Once the client starts to purchase the units, the share of the financier gets reduced. Therefore, the rent payable to the financier is also reduced to that extent.

This process goes on in the same method until the client purchases the whole share owned by the Bank. At the end, the share of the bank will be 'zero'.Baiti Home Financing-i provided by Bank Islam is a practical example of this concept.

3.4.1. Criticism on Diminishing Musharaka:

One of the criticisms against diminishing musharakha is that because of predetermined prices there is no certainty thus seeking help in riba. Another criticism is that it ignores the appreciation or depreciation in value of the property.

3.6. Conclusion:

To conclude, in this chapter we have discussed about the significant features of equity related Islamic banking products in the contemporary world. Mudarabah and Musharaka are the main equity related products. These are unique to Islamic Banking. Both are widely used for commercial investment and project financing. Mudarabah is a core deposit product in Islamic banking for mobilizing various funds. Musharaka is a good tool for those having a project but not sufficient money. Diminishing Musharaka is another equity related product that is a recent innovation. It is an important tool in housing finance. It is a well-accepted alternative to conventional mortgage. Though there are few disadvantages on these products it is significant as an alternative to conventional banking.