Diminishing Musharakah By Mahmood Shafqat Senior Joint Director -Islamic Banking Department - SBP At AlHuda: Centre of Islamic Banking & Economic Workshop Sheraton Hotel – Karachi. The views expressed in this presentation are those of the author and do not necessarily represent State Bank of Pakistan

Diminishing Musharakah - Introduction Basic Structure Presentation Outline Diminishing Musharakah - Introduction Basic Structure Shariah Principles Illustration

Diminishing Musharakah-Introduction

Musharakah “Shirkah” means “Sharing” in the terminology of Islamic Fiqh. Musharakah is basically a kind of partnership in which the partners join together with their contributions for the common objective of undertaking business and trade in accordance with the principles of Shari’ah.

Types of Shirkat It has been divided into two kinds: SHIRKAT-UL-MILK It means joint ownership of two or more persons in a particular property. SHIRKAT-UL-’AQD Which means “a partnership effected by a mutual contract”.

Based on Shirkat-ul-Milk Means joint ownership in a property Diminishing Musharakah Based on Shirkat-ul-Milk Means joint ownership in a property Three components Joint ownership of the Bank and customer Customer as a lessee uses the share of the bank Redemption of the share of the Bank by the customer

Mode of Fixed Asset Financing Diminishing Musharakah is commonly used for the purpose of financing of fixed assets by various Islamic banks. House financing Car Financing Plant and machinery financing Factory/Building financing Agriculture land financing All other fixed Assets

Musha means undivided ownership of the asset Lease of Musha It is allowed to lease Musha to other joint owner.

Basic Transaction Structure

CUSTOMER Joint Ownership BANK Musharaka Rent The customer approaches the Bank with the request for Project/Machinery/House financing The Bank enters into a Musharakah (Joint Ownership) agreement with the customer and both of them pay their respective shares to the seller of the asset. Customer pays rent for the use of banks share in the property

Gradual Transfer of Ownership Joint Ownership Musharaka BANK CUSTOMER Gradual Transfer of Ownership The customer approaches the Bank with the request for Project/Machinery financing The Bank enters into a Musharakah (Joint Ownership) agreement with the customer and both of them pay their respective shares to the seller of the asset. Customer pays rent for the use of banks share in the property Ownership of the asset is gradually transferred to the customer upon payment of asset price.

Gradual Transfer of Ownership Joint Ownership Musharaka BANK CUSTOMER Gradual Transfer of Ownership The value of Bank’s share in Musharakah property is divided into units, which it sells to the customer. Units will be worked out by dividing Bank’s financed amount by number of months for which finance to be allowed. With each purchase of unit by the customer, the Bank’s share in the Musharakah property starts diminishing, whereas customer’s share starts increasing, correspondingly. Finally, the customer becomes the sole owner of the property after having purchased all units from the Bank, along with the rentals thereon.

Shariah Principles

Shariah Principles To create joint ownership in property is called Shirkat-ul-Milk and is expressly allowed by all schools of Islamic Jurisprudence. All Muslim Jurists agree on the permissibility of the Financier leasing his share in property to client and charging him rent i.e. the permissibility of leasing one’s share to his partner. There is difference of opinion among leasing one’s share to a third part But there is no difference on permissibility on leasing to a partner.

Shariah Principles Promise of client to purchase units of share of financier is also allowed. The Transactions cannot be combined in a single arrangements and they have to be executed independently. This is because it is a well settled rule of Islamic Jurisprudence that one transaction cannot be made a condition for another. Instead of making the transactions a pre-condition for one another there can be one-sided promises from one party to another

Shariah Principles Argument: In the case of promise to sell units of share by financier one might argue that if the promise to sale has been done before entering into actual sale This is practically putting a condition on the sale itself Answer: There is a difference between: Putting a condition on a sale and making a separate promise , without making it a condition. In case of condition, the sale will be valid only if the condition is fulfilled.

Diminishing Musharakah-Considerations Joint  Joint Title    Title Holder Profit Rate Fixed/Variable Prepayment Allowed Yes Refinance Available Asset Risk Late Payments Control able Consideration Flexibility Available

The arrangement is composed of the following transactions House Financing Based on Diminishing Musharakah The arrangement is composed of the following transactions 1. To create joint ownership in property 2. Giving share of financier to client on rent 3. Promise of client to purchase units of share of financier 4. Purchase of financier’s units 5. Adjustment of rental according of share of financier in property

Diminishing Musharakah can be used for financing with the following conditions The agreements of joint purchase, Lease and selling of units should not be tied-up together At the time of purchase, sale should be effected through offer and acceptance Preferable to purchase each unit on market value, but permissible to purchase at agreed price

Legal Documentation 1. Diminishing Musharakah Agreement – Islamic Housing Finance Agreement   Purpose: This is the main agreement that establishes Bank’s share in the Musharakah Property. Components: - Both parties share      - Musharakah Property detail 2. Monthly Payment Agreement (Rent Agreement) Purpose: This agreement is signed after Main Musharakah Agreement. Bank gives out its share to the customer via this agreement.   Components: - Rent Schedule - Formula of calculation

Legal Documentation 3. Undertaking to Purchase Musharakah Units   Purpose: This is an undertaking by the customer to purchase Bank’s Musharakah units. Components:      - Normal Sale Price - Additional Unit Purchase Price  4.    Undertaking to Sell Musharakah Units   Purpose: This is an undertaking by the Bank to sell Bank’s Musharakah units from time to time.

Completed and signed Application Form Copy of CNIC Required Documents Personal Information Completed and signed Application Form Copy of CNIC Copy of Co-Applicant's CNIC / Passport 2 Passport size photos of Applicant / Co-Applicant's Copy of rental docs (if applicable) Copy of Paid Utility Bills Borrowers Basic Fact Sheet Copy of Recent Credit Card Bills

Copy of recent Pay Slip / Employer Letter Required Documents Income Information Copy of recent Pay Slip / Employer Letter Employer Certificate for salaried employees incl. tenor / designation / salary Last 6 months Bank Statement Copy of Management Accounts (if applicable) Bank Statement of Business In Case of Co-Applicant the Income Related documents will also be required for the Co-Applicant as well.

Required Documents Business / Professional Information 3 Years Proof of Business (eg: Tax Return/Bank Certificate) Professional Association Membership Certificate / Practice License Professional Degree / Certificate Property Documents Copy of all related Property Title Documents Approved Building Plan

Equitable mortgage of the financed property. Security Equitable mortgage of the financed property. Any additional security as may be determined by Bank. Such security may be required if the standing of the borrower does not meet the credit underwriting requirements of Bank.

An Illustration

Step by Step Guide Step 1: Application Form Submit the filled & signed application form & cheque for Processing Fee & External Agency cost   Step 2: Required Documents Attach all the required document Step 3: Address Verification Bank will verify the Applicant Residential & Office Addresses and Addresses of the References submitted

Step by Step Guide Step 4: Income Estimation For Businessman / Self Employed Individuals Bank's External Consultant may determine customer’s monthly income. For Salaried Individuals Bank will verify the Income with customer’s employer Step 5: Legal opinion A legal opinion will be obtained on the property documents Step 6: Property Valuation Appointed Valuation Agency will evaluate the property to determine its market value.

Step by Step Guide Step 7: Credit Approval & Sanction Letter After customer have fulfilled all Credit requirement satisfactorily, bank will give a conditional Sanction letter   Step 8: Account Opening Customer will be required to open an account in bank by submitting a filled account opening form Step 9: Signing of House Finance Agreement Customer sign Islamic House Finance Agreement and other legal documents. For Building/Renovation/Replacement of house Original Property documents will be handed over to the bank at this stage.

Step by Step Guide Step 10: Transfer of Property & Disbursement In Home Buyer Cases Bank's Sales officer & authorized lawyer will accompany customer & Seller of the property to the Registrar office for Property Transfer.   Original Property documents will be handed over to the Lawyer who, after verification of the document, will handover the Pay Order to the Seller and will complete the legal formalities on Bank's behalf

How much time do you take to approve the case? Common FAQs What method of Islamic Financing is used in House financing? What makes Islamic House financing Shariah compliant and how does it differ from a conventional mortgage? Why is the profit margin charged by Bank correlated to the conventional mortgage market trends? How much time do you take to approve the case? Is this rent variable or fixed?

Common FAQs For how many days can I delay my monthly installment? What would be the Bank’s approach, if I fail to pay my monthly installment? Do you have any alternative for Insurance? What is the process for early payment / termination of property?

Key FAQs at this point How is the fundamental nature of the contract a co-ownership and not a loan? The nature of the contract is a co-ownership and not a loan because the transaction is not based on the lending and borrowing of money but on the joint ownership of an asset. Bank’s shares in the cost of asset being purchased, i.e. the house or in case of a replacement contract bank purchases a portion of the house from consumer and become a co-owner.

Key FAQs What is the difference between the profit Bank charges and the interest charged in conventional mortgages? In conventional mortgages the interest charged is a mark-up on the money lent. The profit charged by Bank is the utilization payment for the consumer’s use of bank’s share throughout the life of the contract. The profit is predetermined based on market trends.

Email: mahmood.shafqat@sbp.org.pk THANK YOU Ph: 021-9212509, Fax: 021-9212472 Email: mahmood.shafqat@sbp.org.pk http://www.sbp.org.pk/departments/ibd.htm