1. MBF707: Monetary and Fiscal Framework in Islamic Finance COMSATS Institute of Information Technology (Virtual Campus)

2. Review of the Last Lecture  Belief in Divine Guidance  The Basic Difference between Capitalist and Islamic Economy  Asset-backed Financing  Capital and Entrepreneur  Present Practices of Islamic Banks 2

3. Lecture 05 Musharakah 3

4. Topics of Discussion  Capital and Entrepreneur  Present Practices of Islamic Banks Musharakah  Introduction  Legality of Musharakah and Mudarabah  Definition of Musharakah  Application of Musharakah 4

5. Capital and Entrepreneur  Capital (interest) and entrepreneur (profit) are two separate factors of production.  Islam, on the contrary, does not recognize capital and entrepreneur as two separate factors of production  Who contributes capital (in the form of money) to a commercial enterprise assumes the risk of loss and therefore is entitled to a proportionate share in the actual profit. 5

6. Capital and Entrepreneur  Capital has an intrinsic element of 'entrepreneurship', so far as the risk of the business is concerned.  Flow of the actual profits earned by the society may be directed towards the depositors in equitable proportions which may distribute wealth in a wider circle and may hamper concentration of wealth. 6

7. Present Practices of Islamic Banks  Islamic Banks did not bring any visible change in the economic set-up, not even in the field of financing  Distributive justice under the umbrella of Islamic banking are exaggerated.  Islamic banks and financial institutions-small proportion of the system.  Just three decades as against 300 years.  Not supported by the governments. 7

8. Present Practices of Islamic Banks  whole financing system is not based on the ideal Islamic principles, 8

9. Introduction  As many contemporary Muslim scholars and Islamic economists are advocating for the implementation of equity-based modes of financing, the most important contracts in this regard are Musharakah and Mudarabah.  These two modes of financing are based on the concept of profit and loss sharing.  They are true Islamic products, whereby all Muslim scholars, classical and contemporary are unanimous in its validity and permissibility.. 9

10. Introduction  Theoretically, much has been discussed about these two concepts these terms, conditions and tenets.  The following sections will discuss the modern application of these concepts as financial instruments in Islamic finance and banking practice 10

11. Legality of Musharaksh Legality of Musharakah قال الله تعالى : "و إن كثيرا من الخلطاء ليبغي بعضهم على بعض إلا الذين “ءامنوا وعملوا الصالحات وقليل ما هم سورة ص: الاية: 24 11

12. Legality Allah SWT says: “ Verily, many partners oppress one another, except those who believe and do righteous good deeds and they are few ” Sad: 24 وقال رسول الله صلى الله عليه وسلم: قال الله عز وجل: أنا ثالث الشريكين ما لم يخن أحدهما صاحبه فإذا خانه خرجت من بينهما” رواه أبو داوود 12

13. Legality  The prophets SAW said : “Allah Says: “I am the third partner of any two partners as long as neither of them betrays the other. But if one of them betrays the other I get out of them“”. Abu Daud Hadith No.3383 13

14. Musharakah ‘Musharakah’ is a word of Arabic origin which literally means sharing. In the context of business and trade it means a joint enterprise in which all the partners share the profit or loss of the joint venture. 14

15. Definition of Musharakah Technically, Musharakah is a contract between the partners to contribute capital to an enterprise or a venture, whether existing or new, or to owner of a real estate or moveable asset, either on a temporary or permanent basis. Profits generated by that venture or real estate or asset are shared in accordance with the terms of the Musharakah agreement, while losses are shared in proportion to each partner’s share of capital.” Source: (Draft of Shariah parameter reference 4:Musharakah Contract, a paper published by Bank Negara in 2010 defined Musharakah ) 15

16. Application in Modern Finance Musharakah as equity-based financial instrument is used in many areas and is applicable to a wide spectrum of business activities, it can be used in trade financing, such as import or export, project financing, syndicated asset financing, stock markets and issuance of sukuk or certificates 16

17. Application in Trade Financing (Import)  Musharakah can be applied in trade finance without complexities, since the chances of fraud, negligence and other problems are relatively lower in international trade than in other Musharakah-based projects.  A bank may enter into a Musharakah arrangement with a client who intends to import;  the bank may also appoint him as agent for acquisition and disposal of the goods after the same are imported; 17

18. Application in Import  An L/C (letter of credit) could be opened in the bank’s or the client’s name  The net profit out of this limited purpose Musharakah will be shared between the bank and the client in an agreed ratio. 18

19. Application in Export  In the case of export finance under L/C, the goods will be acquired and made ready for shipment on a Musharakah basis.  The client will prepare the export documents strictly in accordance with the terms of the L/C and undertake to indemnify the bank for any loss in case of his failure to honour his commitment. 19

20. Application in Export  Export proceeds will be distributed according to the agreed ratio.  If there is no L/C involved, the merchandise will be made ready for export under joint ownership of the bank and the client. 20

21. Application in Export The following could be the procedure for export financing on the basis of Musharakah:  The exporter receives an order from abroad to export a specific commodity or goods at a known price.  He estimates its expected profit. If he needs financing for manufacturing or procurement of the goods, the bank can provide financing on the basis of Musharakah. 21

22. Application in Export  Profit would be shared on a pre-agreed percentage.  The bank can secure itself from any negligence on the part of the exporter. However, being a partner of the business, the bank will be liable to bear any loss which may be caused due to any reason other than the negligence of the exporter.  However, in order to undertake such an operation, banks need to understand the nature of the exporter’s business and other requirements 22

23. Project Financing  In the case of project financing, the traditional method of Musharakah can be easily adopted whereby investment comes from both sides  The following may be the flow of transactions in the case of Musharakah for running business: 1.A running Musharakah Account for the client will be opened in the books of the financing bank. 2.The client’s proceeds from the sale of finished goods will be credited in the Running Musharakah Account. 23

24. Project Financing 3.The client’s cash flows generated from investment activities (for example, sales proceeds from the disposal of fixed assets) and cash flows from long-term financing activities (for example, long-term finance availed for the project) cannot be credited in the Running Musharakah Account. 24

25. Project Financing 4.At the end of each quarter or month, as the case may be, the profit earned by the client in the Musharakah will be paid to the bank. 5.The profit-sharing will be based on the computed operating profit for the same period for which the running Musharakah limit was awarded. 25

26. Syndicated Asset Financing  A group of banks may join efforts to partially finance a big enterprise or a large project.  The enterprise contributes its part of the investment to the project such as building a new factory for a car manufacturing company or another giant company.  A group of Islamic banks which join hands finance the remaining part. 26

27. Syndicated Asset Financing The enterprise runs the project on behalf of the banks. The banks and the enterprise share the profit according to the agreed ratio in the Musharakah contract and losses are borne in terms of each investors capital contribution 27

28. Application in Stocks  Business companies issue shares based Musharakah concept. The investors buy these shares and become shareholders in the company. Like the ordinary partners they are entitled to profits generated by the company based on the Musharakah agreements. Musharakah as a basis of securitization  Musharakah can easily be adopted as a basis for securitization, especially in the case of big projects where huge amounts are required. 28

29. Application in Stocks Every subscriber can be given a certificate representing his proportionate ownership in the assets of the joint business, and after the project is started by acquiring substantial non-liquid assets, these Musharakah certificates can be treated as negotiable instruments and can be bought and sold in the secondary market. 29

30. Diminishing Musharakah  In a Diminishing Musharakah contract, a party, after participation in ownership of any business or project, can liquidate his investment from the asset or the ongoing business.  DM contracts contain a sale provision, according to which, one partner makes a promise to sell his part of ownership to the other party periodically. 30

31. Diminishing Musharakah  DM is used in house financing, auto financing, plant and machinery financing, factory or building financing and all other fixed asset financing. 31

32. Summary  Capital and Entrepreneur  Present Practices of Islamic Banks Musharakah  Introduction  Legality of Musharakah and Mudarabah  Definition of Musharakah  Application of Musharakah 32

33. Thank You 33