In the name of Allah, the Compassionate, the Merciful

CHAPTER - 3

M USHARAKAH - DEFINITION & EARLY DEVELOPM ENT

CHAPTER- 3

Musharakah - Definition andEarly Development

M usharakah is derived from the Arabic root verb Shirkah. In Arabic,

Musharakah refers to partnership between two or more persons. It

is defined by the Majallah Al-Ahkam-i-Adliyah as “an agreement

for associations on the condition that the capital and its benefit be common

between two or more persons”1.

This sort of financing is of sharing in which parties to the contract

participate with their money or efforts or skills or a combination of them as

may be provided for in the Musharakah investment agreement. The latter

definition is more comprehensive and gives a wider scope of activities than

the former one. Therefore, Musharakah is a form of business arrangement

in which a number of partners pool their financial resources to undertake a

commercial transaction, such as buying and selling of goods or dealing with

banking activities e.g. letter of credit2.>

It is one of the Islamic alternatives to the conventional financing

methods, based on profit and loss sharing concept in contrast to the debt

based financing. However, no specific law has so far been enacted in the

Gulf Arab States to regulate the conduct of Musharakah arrangements as

performed in Islamic banking. Hence no legal definition as in the case of

Mudarabah, can be given.

1 The Mejelle: Majallah el-Ahkam-i-Adliyyah and a complete code on Islamic Law, Lahore, 1969, p. 217.

2 Ahmad Al-Suwaridi, Finance o f International Trade in the G ulf Brill, 1994, p. 78.

Various scholars have however defined it in various ways. It is defined

by Nawazish Ali Zaidi as “a mode of bank financing based on the principle

of profit and loss”1.

According to Saad A. Harran, Musharakah (or Sharakah) can be

defined as a “form of partnership where two or more persons combine their

capital or labour together, to share the profits, enjoying similar rights and

liabilities”2.

Hamid Zangench, defines Musharakah (Musharakat) as a partnership

arrangement between the bank and an individual or a firm to start a new

line of business. In this case, assets of the business entity belong to all

partners and profits will be shared according to each Musharakat

(Musharakah) agreement3.

Maulana Taqi Usmani also considers Musharakah as “a word of

Arabic origin”, which in the context of business and trade means a joint

enterprise in which all the partners share the profit or loss of joint venture4.

In another definition he feels that “Musharakah is a specific form of a

Sharkah, which means “sharing” of various kinds including Shirkah al-Milk

(joint ownership of two or more persons in a particular property), Shirkah

al-Aqd (a partnership in business effected by a mutual contract)”5.

Musharakah is normally restricted to a particular type of Shirkah, that is,

Shirkah al-Amwal, where two or more persons invest some of their capital

1 Musharakah Financing for Working Capital, UBC Economic Journal, vol. 5, No. 6 , 1986 n.d., P 11

2 S. A. S. Harran, Islamic Finance: Partnership Financing, Pelanduk Publications, Kuala Lumpur, 1993 pp. 28-29.

3 Zangench Hamid, “Islamic Banking Theory and Practice in Iran”, Comparative Economic Studies (Association for Comparative Economic Studies); 1989, vol. 31, issue 3, p. 67.

4 M. T. Usmani, An Introduction to Islamic Finance, Idratul Ma’arif Karachi Pakistan;, pp. 48- 49.

5 Idem

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in a joint commercial venture. However, sometimes it includes Shirkah al-

Amal also where partnership takes place in the business of success.

Ayse Yose, defined Musharakah,” as an agreement between two

parties to provide capital, jointly for a project and share resulting profit and

loss. Agreement to undertake a project can be made between a financial

institution and a company or an entrepreneur or between two financial

institutions. If one party actually manages the project then that party

receives compensation for the agreement plus shares of profit.1.

3.1 Musharakah as ‘Partnership’

In Musharakah, the bank shares with the client both profit and loss,

proportionately to the contribution of each in the investment cost (i.e., each

party contributes by a certain percentage to the total cost of the required

investment and when a profit/loss is realized it is shared by both partners) .

3.2 Musharakah as Equity Participation (Partnership Financing)

This is a classical partnership agreement. All parties included

contribute towards the financing of a venture. Thus it is a capital-capital

partnership in which all parties contributes cash or goods and other property

to the capital but not labour or credit solely3. The parties share profits on a

pre-agreed ratio while losses are shared according to each party’s equity

participation. Here again the reason is because in Islam, one cannot loose

1 Ayse Yose, “Islamic Financial House in Turkey”, Journal o f the Academy o f Business and Economics, January 2003, pp. 5.

2 Mustafa Gamal-el-Din Abdulla, “Partnership (Musharakah): A New Option for Financing Small Enterprises”, Arab Law Quarterly, vol. 4, No. 3, Brill, 1999, p 262.

3 Gaffar Abdulla Ahmed, “The Implication of using Profit and Loss Sharing Modes of Finance in the Banking System, with Particular Reference to Equiity Participation (partnership) Method in Sudan”, Humonomics, vol. 24, No. 3, Emerald Group Publishing Limited, 2008 pp 182-206.

what they did not contribute. Management of the venture is carried out by

all, some or just one party members.

3.3 Musharakah (as a joint venture)

Musharakah is analogous to a classical joint venture, where both

entrepreneur and investor contribute to the capital (assets, technical and

managerial enterprise, working capital etc.) of the operation in varying

degrees and agree to share the returns (as well as the risks) in proportions

agreed to in advance. Traditionally, this form of transaction has been used

in capital of medium and long-term duration1

Generally the term Musharakah refers to financing adopted by Islamic

banks, it is an agreement under which the Islamic bank provides funds

which are mingled with the funds of the business enterprise and others. All

providers are entitled to participate in the management but not necessarily

required to do so. The profit is distributed in predetermined ratio’s where as

the loss is borne by each partner in proportion to his contribution.

In the framework of business trade, Musharakah refers to a joint

enterprise in which all the partners share the profit and loss of the joint

venture. It is an ideal alternative to interest based financing, with far

reaching effects on both production and distribution. The return in the

Musharakah contract is based on the actual profit earned by the joint

venture, while the financer in a regular interest bearing loan cannot suffer

loss, the financer in Musharakah can suffer loss .

Lewis and Algaoud give us the following definition of a Musharakah

1 Zamir Iqbal, “Islamic Financial Systems”, Finance and Development, IMF, June, vol. 34, No.2, 1997, pp. 44.

2 Mohd. Abdel Hamid,, “Islamic Banking”, Honors Essay submitted to Carleton University.Ottawa, Ontario, Sep. 9, 2005, p. 19-20

contract: “The Musharakah is a form of partnership where two or more

persons combine either their capital or labour together to share the profits,

enjoying similar rights and liabilities”1. In this view, it could as well be

defined as a joint venture business between the provider and the user of the

fund where both risk and return will be shared2. The scholar has tried to

visualize this contract in Fig. 1.

Pre-agreed proportion to investment

Pre-agreed proportion to investment

Fig. 1 : The Musharakah (Partnership) Model

1 M. K. Lewis and Algaud L.M; Islamic Banking, Alderschot: Eiger 2001, p. 43.2 Vandewghe Barbara, Institutions in Islam and Economic Implication, Dissertation presented to

University of GHENT, Faculty of Economics and Business Administration, 2005-06, p. 34.

As shown, every partner here, the bank and the customer, brings in a

production factor or capital funding, which makes them both co-owners.

Consequently, every partner is in an ‘active partner’ and participates

actively in the management of the joint venture and they both share in

profits and losses of the joint venture. The sharing in profit is based on a pre

agreed ratio, which can be based on the amount of investment but is in most

of the cases based on the actual profit. The sharing of losses, in contrast, is,

in any case required by the Shari ‘ah to be fined according to the amount of

investment. It seems that on this point, all Islamic jurists are unanimous1.

It should be clear that the bank, instead of being a lender, becomes a

partner. Consequently, Musharakah is not different from conventional

equity financing. In a conventional economy, a capital seeking firm has the

option to sell shares or equity parts on the capital market, the buyers or

owners of the shares have an equity participation in the firm and their

returns are based on the performance of the firm, proportional to the amount

of shares which he has. Moreover, if one has a significant amount of shares,

one has possibility to participate in the management and control of the

firm2.

In fact when we include the depositors into the banking system as the

third party and still suppose a Musharakah contract between the bank and

the entrepreneurs or enterprise, then the bank provides the working capital

and notes of participation are sold to investors to supply financing. The

depositors, however, share in the profit and losses of the project but have

1 Vendeweghe Barbara, op. cit., p. 35.2 Idem

f i l l

nothing to say in its management. Consequently, they are non-voting

shareholders1.

Musharakah is thus the most desired form of financing in the eyes of

Shari‘ah. All the essential elements promoted by Shari‘ah are to be found

at the forefront of a Musharakah contract. It involves the absence of

interest, the presence of risk, the spirit of sharing profits and losses; the

direct linking of capital investment to underlying assets based transaction

and much more.

3.4 Types of Musharakah Financing

Partnership financing (equity participation) can be categorized

according to the duration of the project,2 it can be of either indefinite

period, as it is in the case of the stock of the joint companies, or a definite

(short, medium or long) period as it is in case of participation finance

through Musharakah when only it is for specific period or shares in

partnerships when profit only and not the capital gain is targeted.

A short term financing is usually for financing of working capital for

one production period, season, fiscal ySar, or even a certain operation which

involves production period ranging between 3 and 12 months

duration3.Thus the short-term and impermanent Musharakah agreement is

normally for one short-term and specific purpose, such as the purchase and

sale of a machine or a commodity. Both the bank and its partner contribute

1 Idem2 El Bhasri, M.E.T and Adan “Examples of Partnership Financing for Microenterprise-the case

of Sudanese, Islamic Bank”,, n.a., 1997. In Harper M.(ED) , Partnership Financial Credit Systems, ITDG Publications, Rugby, pp 13-18.

3 S.A.S. Al- Harran, “Musharakah Financing: Concept and Applications”, in S. A. S. Al-Harran, (Ed), Leading Issues in Islamic Banking and Finance, Pelanduk Publications, Kualalumpur, PP,l-24;S.A.S. Al- Harran, “Musharakah Financing: Time for Long-Term Islamic Financing”, in Al- Harran, (Ed), op. cit., pp 25-32.

to the capital but it is the partner who undertakes the management of

buying, selling, marketing and account keeping related to transaction. The

banks function is to finance its share of the transaction, provide necessary

banking services like the opening of letters of credit where necessary, and to

monitor the progress of the Musharakah through the current account and

other periodic progress reports from the partner1. Most of the impermanent

normal Musharakah is usually used for commercial purpose.

A commercial Musharakah contract is useful for an Islamic Bank as it

is liquidated quickly, turnover of the capital is higher and therefore, the

return will also be generally higher, the banks activities advancing finance

on the basis of commercial Musharakah to a large number of ventures:

serves to diversify and minimize risk in its investment operations .

The short-term Musharakah can be divided into four categories :

financing of a single transactions, financing of working capital, sharing in

the gross profit only, running Musharakah accounts on the basis of daily

products4.

Long term partnership can be definite or continuous Musharakah5

which is known as permanent Musharakah or Musharakah da'ama or

Diminishing6 or Decreasing Musharakah known as Musharakah

Mutanaqisah. They are discussed below:

1 M. T. Usmani, op. cit., pp. 12 .2 Gaffar Abdalla Ahmad, “The Implications of Using Profit and Loss Sharing Modes of Finance

in the Banking System, with particular reference to Equity Participation (partnership) Method in Sudan”, Humanomics,, vol. 24, No. 3, Toronto Canada,Emerald Group Pub., 2008, pp 182- 206.

3 M. T. Usmani, op. cit., pp. 13.4 Idem5 Financing to the end of the project's life time.6 Where in the bank’s share in the partnership is diminished gradually through repayment

In this case, a bank participates in the equity of a company or a project

and receives an annual share of the profits on a pro-rata basis. The

termination and the length of the contract is not specified, making it

suitable for financing projects where funds are committed over a long

period1. This financial technique is thus referred to as continued

Musharakah.

The contribution of the partners under this mode may be of unequal

percentage of capital for the purpose of establishing a new income

generating project or to participate in an existing one. In permanent share

the partner receives his share of the profit accordingly. This type of a• • 2partnership is intended to continue until the company is dissolved .

However, one can exit the partnership by selling his share of the

capital to another investor. Permanent Musharakah is used by Islamic banks

in many income generating projects. They can provide financing to their

customers, in exchange for ownership and profit sharing in the proportion

agreed upon by both parties. In addition, the bank may leave the

responsibility of management to the customer-partner and retain the right of

supervision and follow up.

The three steps to establish Permanent Musharakah are discussed

below :

Permanent Musharakah

leaving the project to be wholly owned by the client at the time of the liquidation of the financing contract.

1 Mohd Hamid, “Islamic Banking”, Honors Essay submitted to Carleton University, Ottawa, Ontario, September 9, 2005.

2 M. K. Lewis and L.MAlgaoud, “Islamic Banking”, Alderschot: Eiger, 2001, p 51.

I 19 1

a) Partnership in Capital1 : The bank tenders part of the capital

required in its capacity, as a partner and authorizes the

customer/partner to manage the project. The partner tenders part of the

capital required for the project and is entrusted with what he holds

from the bank funds.

b) Results of the project: The intent of the project is growth. However,

the project may be profitable or it may loose money.

c) The Distribution of wealth acquired from the project: In the event

a loss is incurred, each partner bears part of the loss proportionately to

his share in capital. In the event the venture is profitable, earnings are

divided between the two parties (the bank and the partner) in

accordance with the agreement.

The following is a discussion of the legal rules that apply to the

Musharakah relationship.

Rules of Permanent Musharakah

a. It is a condition that the capital provided by each partner is specific,>

existent and easily accessible. It is inappropriate to establish a

company with borrowed money, for the purpose of profit.

b. It is permissible for partners to have unequal ownership in the

project. The percentage of ownership is set forth in the agreement.

c. It is condition that no capital of the company is in the form of money

or valuables. Some of the jurists permit contributing merchandise as

invested capital2. However, the merchandise must be evaluated, and

1 This partnership is the capital-capital partnership in which all parties contribute cash or goods and other property to the capital but not labour or credit solely.

2 Legal Doctrines of Partnership (Shirakah) are discussed in chapter two.

the value agreed upon by all parties. Once the value has been

established and stipulated in the contract as such.

d. It is impermissible to impose condition forbidding one of the

partners from work. The company is built on honour and each

partner implicitly permits and gives power of attorney to the other

partner(s) to dispose off and work with capital as is deemed

necessary to conduct business. However, it is permissible for one

partner to have full responsibility for the operations of the company,

provided he is granted this authority by the other partners.

e. A partner, as a trustee of company, finds funds in his possession and

is held responsible for their proper use. It is permissible to take a

mortgage or a guarantee against company assets, but it is

impermissible to take security for profit or capital.

f. It is a condition that each partner’s share of the profit be known to

avoid uncertainty. Also it is required that the ownership interest be in

percentage terms and not a fixed sum, because this would violate the

requirements of a partnership. >

g. In principle, profit must be divided among partners in ratio’s

proportionate to their shares, in capital but some of the Jurists permit

variation in profit shares, so long as it is agreed to by all of the

partners. This may be the case when one of the partners is more

dexterous and more diligent and does not agree to parity, so variation

in the sharing of profits becomes necessary.

h. In principle, a partnership is a permissible and non-binding contract.

Thus if a partner wishes, he could rescind the agreement provided

that occurs with the knowledge of the other partner or partners..On

the other hand, some of the jurists take the view that partnership

contract is binding up to the liquidation of capital or the

accomplishment of the job accepted at the contract.

Application of Permanent Musharakah

Permanent Musharakah is helpful in providing financing for large

investment in modem economic activities. Islamic banks can engage in

Musharakah partnerships for new or established companies and activities in

determining the methods of production, cost control, marketing the other

day to day operations of a company to ensure the objectives of the company

are met. On the other hand they can also choose to either directly supervise

or simply follow up on the overall activities of the firm. As part of the

agreement, Islamic banks will share in both profits and losses with its

partners or clients in operations of the business.

Musharakah Mutanaqisah /Diminishing Musharakah'.

Being a derivative of Musharakah, Diminishing or Digressive or

Decreasing Musharakah or Musharakah Mutanaqisah is a special form of

Musharakah. While “Mutanaqiscfh” is taken from the word

( ) which means to decrease

gradually1. Diminishing Partnership is a financing product based on

revenue sharing. Musharakah Mutanaqisah technically is cooperation

between two persons, working on the project that will diminish the interest

of one party gradually1. This product was developed by Perbadanan

1 Munawir Ahmad Warson, Al Munawwir Kamus Arab, Indonesia, Yogyakrta : Krapyak Press, 1996, pp. 128.

2 Dodik Siswantoro, Hamidah Qoyyimah, “Analysis on the Feasibility Study of Musharakah Mutanaqisah Implementation in Indonesian Islamic Banks,”http://islamiccenter.kaau.edu.sa:/ pp 88.

1 22 I

Usahawan Nasional Berhard (PUNB) in Malaysia1 and Lariba2 Institute at

London, and approved in the first Islamic Banking Conference held in

Dubai on 23-25 Jumad Sani 1399 A.H. According to this concept, a

financers/bank and his client participates either in the joint ownership of a

property or a equipment, or in a joint commercial enterprise. The bank

participates as a financial partner in full or in part, in a project with a given

income forecast. An agreement is signed by the partner and the bank, which

stipulates each party’s share of the profits. However, the agreement also

provides payment of a portion of the net income of the project as repayment

of the principal financed by the bank. The partner is entitled to help the rest.

In this way, the bank’s share of the equity is progressively reduced and the

partner eventually becomes the full owner.

When the bank enters into a Diminishing Musharakah its intention is

not to stay in the partnership until the company is dissolved. In this type of

partnership the bank agrees to accept payment on an investment basis or in

lump sum, an amount necessary to buy the bank’s partnership interest. In

this way, as the bank receives payment over and above is share in

partnership projects, its partnership ̂ interest reduces until it is completely

brought out of the partnership.

After the discharge, the bank withdraws its claim from the firm and it

becomes the property of the partner. The decreasing partnership

arrangement is an Islamic Bank innovation. It differs from the permanent

partnership only in continuity. It appears that there are four steps of the

diminishing partnership. Those are mentioned below :

3 www.punb.my.com

4 www.lariba.com

1. Participation in capital: The bank tenders part of the capital

required for the project in its capacity as a participant and agrees

with them gradually selling its share in capital back to the partner.

The partner tenders part of the capital required for the project and

agrees to pay the agreed amount in return for the ultimate, full

ownership of the business.

2. Results of the project: The intent of project is capital growth. The

project may be profitable or loose money.

3. The distribution of the wealth accrued from the project: In the

event of loss each partner bears his share in the loss in his exact

proportionate share of capital. In the event the project is successful,

when shares are distributed between the two partners (the bank and

the customer) in accordance with the agreement.

4. The bank sells its share of capital: The bank expresses its

readiness, in accordance with the agreement, to sell a specific

percentage of its share capital. The partner pays the price of the

percentage of capital to the bank and the ownership is transferred to

the partner.

This process continues until the bank has been fully compensated for

its capital share of the business. In this way the bank has its principal

returned plus the profit earned during the partnership and vice versa.

Musharakah Mutanaqisah /Diminishing Musharakah can take one of

the following forms:

1st Form: In this form in an independent contract, the bank agrees with

a) Steps of Diminishing Musharakah/Musharakah Mutanaqisah

Uil

the customer on the share of capital and the conditions of partnership.

2nd Form: In this form, bank participates in financing all or part of the

capital requirements in exchange after sharing in the prospective earnings.

In addition the bank gains the right to retain the remainder of the income

for the purpose of applying it towards the capital provided by the bank.

3rd Form: In this form, the bank and the partner's ownership are

determined by stocks comprising the total value of the asset (real estate).

Each partner (the bank and the customer) gets its proportionate share

of the earning accrued from the real property. On an annual basis,

the partner may purchase a prescribed number of the bank’s shares until

such time that the partner becomes the sole owner of the real property.

b) Rules for Musharakah Mutanaqisah:

In addition to all the legal rules that apply to the permanent

partnership which also apply to the decreasing partnership, the following

rules are must to be observed:

1. It is a condition in the partnership that it shall not be a mere loan>

financing operation. In other words, there must be shared

ownership and all the parties must have in the profits or losses

incurred during the period of partnership.

2. It is a condition that bank must completely own its share in the

partnership and all rights of ownership with regard to

management of the business. In the event that bank authorizes its

partner to manage the business the bank shall have the right of

oversight supervision and follow up.

3. It is impermissible to include in the contract of decreasing

I 25 1

partnership a condition that adjudges the partner to return to the

bank the total of its share in capital in addition to profits accruing

from that share because of resemblance to Riba (usury).

4. It is permissible for the bank to offer a promise to sell its share in

the company to the partner, if the partner pays the value of the

shares. The sale must be concluded as a separate deal with no

connection to the contract of the company.

Application of Diminishing Musharakah I Musharakah Muntasiqah

The Decreasing Musharakah is suitable for the financing of industrial

business that has regular income. It can be considered to be the appropriate

mode of finance collective investment. In this management, the bank earns

periodic profits throughout the year and it encourages the partner to

participate in the joint investment. In addition it fosters individual

ownership by allowing the partner to gradually buy the bank’s ownership

interest. In terms of society as a whole it connects the course of economy

by developing a mode of positive partnership instead of the negative role of

indebtion. In addition it assists in the. equitable distribution of societies’

wealth. A simple Diminishing Musharakah financing model

structure is presented in the Fig. 2

Fig. 2 : Diminishing Musharakah financing model

Activity

1. Client and bank discuss business plan and jointly contribute to

capital of the venture;

2. Client and bank jointly set up the business venture and manage

its operations, sharing the responsibilities as pre-agreed terms:

business generates positive or negative profits;

3. Profits if positive, are shared between client and bank as per a

pre-agreed ratio; the profit share of client flows into bank too,

towards partial redemption of latter’s capital contribution;

I 27 I

4. Profits if negative are shared between client and bank in

proportion to their respective capital contribution; effectively

bringing down the asset value while keeping their respective

shares in it unchanged.

3.5 The Nature of Musharakah Contract

In Islamic law, individuals are free to use any form of contractual

arrangements for their economic transactions provided that the prerequisites

of contracts, such as the amount of the commodity, the price of exchange

value, and the time period of the contract are specified. In addition the

contract should include no trace of usury, or fraud, nor should it involve the

transfer of illegal objects1.

The present permissible forms of contract in Islamic law were not

innovated at the rise of Islam, they were rather in practice long before that

date. The Prophet of Islam ill! jLa selected from the set of then

available contracts those that confirm with the above prerequisites, and

wrote of dealing with the rest, which resembled more of a gamble rather

than a sale contract2.

Each legitimate type of contract bears certain characteristics3. It suits a

particular use quite well and is not easily substituted for others. However,

the Musharakah arrangement is the most general and versatile form of

agreement. It can be used for all productive and service activities in which

the parties involved jointly share the benefits and costs of the enterprise.

1 Kazem Sadr, “The Role of Musharakah Financing in the Agricultural Bank of Iran”, Arab Law Quarterly, vol. 14, No. 3 (1999), Brill p. 247.

2 Idem3 Fahim Khan, “Comparative Economics of some Islamic Financing Techniques”, Research

Paper No 12, Islamic Development Bank Jeddah, Saudi Arabia, 1991.

28 1

Both parties easily obtain a clear notion of the terms of the contract and in

addition, can readily include their own terms1.

Musharakah, however is not an enforceable contract, each party has

the right to nullify it before the due time. It was suggested as legitimate but

avoidable contractual arrangement in the interest. Free banking law (in Iran)

(IFBL) initially; however, 1988 by an amendment of law, the agreed terms

were made mandatory through a companion of enforceable contract. Since

then it has been used as an enforceable agreement2.

3.6 Accounting treatment of Musharakah

The Musharakah investment in banks stipulates that the capital

provided by banks shall be in the form of a chequing account like a cash

credit or overdraft account, allowing the facility for withdrawal and deposit

of funds at the convenience of a company. Irrespective of the amount of

limit or line of credit the totals of daily products of Musharakah account

calculated or actual utilization shall form the basis for sharing in profit or

loss declared by a company during its accounting year. The capital of a

company for the purpose of profit or loss sharing shall also be reckoned on

totals of daily products of the following:

• Paid up capital.

• All reserves.

• Inappropriate profits.

• Any other capital/borrowings on which interest is not paid.

1 Kazem Sadr, op. cit.., p. 247.

Declaration of profits

All companies usually prepare their final accounts once a year. Bank’s

share on Musharakah investment thus shall become receivable only once in

a year, but banks in Pakistan are following the practice of paying return to

their savings accounts holders and in some cases to term depositors at the

end of every half year in June and December. To enable banks to pay half

yearly profits to their PLS depositors, it has been stipulated that companies

shall provisionally pay bank’s share in profits at the projected rate at the end

of each calendar quarter. The final adjustment shall however be made from

the payment of profits for the last quarter of companies accounting year. If

the profit earned by a company is more than the projected figures a little

earned is less than projected, bank shall be paid a smaller sum at the end of

the last quarter. To encourage prompt payment of bank’s share in profits it

has been provided that prompt payment rebate at V2 % per 90 days shall be

allowed.

Situation of loss

A company which has been*provided Musharakah investment by a

bank may also show a loss despite projections of profit. The possibility of

this is, however, very remote for two reasons. Firstly, it will be indicative of

a serious misjudgment of risk on the part of the investing bank, secondly

the amount of interest that a company used to pay to a bank on its interest

based loans in previous years, is not to be paid now. For instance, if a

company had borrowing of Rs.10 million on interest from a bank, the

savings on account of interest alone will amount to about Rs.1.4 million

which will now add to the pre-tax annual profits of the company. If this

company earns only rupee one as its pretax annual profit, it will still not be

treated as a company in loss. Companies showing recurring losses stand no

chance of being financed by banks on the basis of Musharakah. When

dealings on interest are outlawed in due course such companies will have to

meet their financing requirements only by enlarging their equity, if possible.

Checks have also been provided in the Musharakah investment agreement

to guard against situations of loss resulting from non-business reasons.

Accounting of Loss

If a company suffers a loss it will be shared by the bank in strict

proportion to the totals of daily products of the bank’s Musharakah

investment and company’s capital. The accounting for lost can be done in

two years. If a company has an existing reserve the company’s share in loss

calculated in the above manner can be debited to its reserves and the banks

share in loss debited to the Musharakah investment account of the bank in

company’s books. The bank, in turn shall debit the amount or loss to it’s

PLS income account, affording credit of Musharakah investment account of

the company in bank’s books. The balance in Musharakah investment

account shall thus stand reduced to the extend of bank’s share in loss.>

If a company does not have reserves where the amount of company’s

share in loss may be debited, the loss will have to be carried over in the

balance sheet as a fictitous asset as it cannot be debited to company’s

capital. If the bank’s share in loss is wiped off the company’s balance sheet

by debiting the amount to bank’s Musharakah investment account and the

company’s share in loss is carried over in the balance sheet, it shall not

amount to an equal treatment and also not reflect the true position of the

company’s affairs.

On this reasoning, the banks have preferred to adopt a standard

procedure for accounting of loss in Musharakah arrangements. The loss

suffered by a company may be carried forward as a fictitious asset in the

company’s balance sheet in accordance with usual accountingpractice but

the bank’s and the company’s shares in loss shall be indicated separately.

Bank’s Musharakah investment account in the company’s books shall be

reduced to the extend of bank’s share in loss and the company shall issue

redeemable shares for the amount in favour of the bank which will balance

the liability side of the company’s balance sheet.

The following example will illustrate:

Suppose

Company’s share capital

Bank’s Musharakah investment

Company suffers a loss of

(A) Balance Sheet of A.B. & Co Ltd

Rs. 40 Million

Rs. 10 Million

Rs. 1 Million

Capital

Bank’s Musharakah Investment

Liabilities>

Rs 40,000,000

Rs 1,000,000

Assets

Loss

I) Company’s ShareRs 800,000

II) Bank’s ShareRs 200,000

Total Rs 50,000,000 Total Rs 1,000,000

Note: Loss has been shared in strict proportion o f their respective investment

(B) Balance Sheet of A.B. & Co. Ltd.(after passing loss accounting entries)

Liabilities Assets

Loss

I) Company’s Share

Capital Rs 40,000,000

Redeemable Shares Rs 200,000 Rs 800,000Sub Total Rs 40,200,000

II) Bank’s ShareRs 200,000

Bank’s Musharakah Investment Rs 9,800,000

Total Rs 50,000,000 Total Rs 1,000,000

The amount of loss suffered by a bank shall be debited to bank’s PLS

Income account and credited to Company’s Musharakah Investment

Account in Bank’s Books and the balance in the Company’s account in

bank’s books shall be reduced from Rs 10,000,000 to Rs 9,800,000.

On receipt of redeemable shares the bank shall hold the shares against

proforma account entries passed in its books as under:

Debit - Shares held against PLS Loss

Credit - PLS Loss against Shares as per Contract.

Suppose, in the following year the company earns a profit. The

company and the bank mutually agree to adjust the previous loss partially

or fully against the current profits. If the loss is fully adjusted all shares

issued to the bank in the previous year shall stand redeemed. The

company’s capital will revert to the original figure of Rs. 40 million. The

company will credit the amount equal to shares redeemed to Musharakah

I 33 I

investment account of the bank in Company’s books which will increase to

Rs. 10,000,000 from Rs. 9,800,000. The bank will debit the Musharakah

investment account of the company in bank’s books by Rs 200,000 and

credit the amount to bank’s PLS income account. After the shares issued to

the bank are redeemed, proforma account entries in bank’s books shall be

reversed. The important point to note is that the bank actually reduced its

PLS income account with the amount of loss in the relevant accounting

period and subsequently received the profit in the accounting period in

which it was actually earned. The issuance of shares for loss is counter

balancing accounting entry and not a conversion of loss into investment. It

may also be treated as a portion of Musharakah investment set aside on the

credit side of the company’s balance sheet as a contra entry to the bank’s

share in loss outstanding on the debit side. Until the previous loss in the

Musharakah arrangement has been wiped off, the possibility of a

company’s declaring a dividend the shares issued in favour of a bank shall

have been redeemed.

3.7 Measurement of bank’s share in Musharakah capital at the timeof contracting

• Capital provided in cash is measured by the amount paid or made

available to the partner on account of Musharakah.

• Capital provided in kind is measured at fair value of the assets

and any difference between the fair value and the book value is

recognized as profit or loss.

• Expenses incurred are not to be considered part of Musharakah

capital, unless otherwise agreed by both parties1.

1 Ayub, Opcit., p. 345.

i341

Measurement at the end of financial period

• Share in constant Musharakah capital is measured at historical

cost;

• Share in diminishing Musharakah is measured at historical cost

after deducting the share transferred to the partner. Such transfer

is made by sale at fair value (in DM on Shirakat al Aqd). The

difference between the book values and the recovered amount is

recognized in the income statement of the bank;

• If Musharakah is terminated or liquidated, any amount that

remains unpaid is recognized as a receivable due from the

partner.

Recognition of the Islamic bank’s share in profits or losses

• Profits or loss on Musharakah transaction which commence and

culminate during the same financial period are recognized at the

time of (constructive) liquidation:

• The Islamic banks share of profits on Musharakah financing that

continues for more than one financial period is recognized to the

extent of profit distribution and share of loss is deducted from the

Musharakah capital;

• The treatment mentioned in the above point shall apply to a

diminishing Musharakah after taking into consideration the

decline in the Islamic banks share in Musharakah capital and its

profits or losses;

• Share of profits is recognized as receivable due from the partner

\ 35 I

if he does not pay the Islamic banks due share profit after

liquidation or settlement of account is made;

• Loss incurred due to negligence or misconduct of the partner is

recognized as a receivable due from the partner1.

• Recognition of the bank’s share in Musharakah capital at the

time of the contract.

• Recognized when it is paid to the partner or made available to

him on account of Musharakah.

• Presented as “Musharakah financing” in the financial statements.

3.10 Guarantees in Musharakah

All partners in Shirkah maintain the assets of the partnership as a trust

therefore; no one is liable except in cases of breach of contract, misconduct

or proven negligence. Negligence will be considered to have occurred in

any of the following three cases:

i) a partner does not abide by the terms and conditions of the

contracts;

ii) a partner works against the norms of the concerned business; and

iii) the established ill-intension of a partner.

Here the profit or even capital of any partners cannot be guaranteed by

the co-partners. However, one partner can demand from another partner to

provide any surety, security or pledge to cover the cases of misconduct and

negligence2.

1 Ayub, opcit., p. 346.2 Accounting and Auditing Organization for Islamic Financial Institutions, AAOIFI, 2004-5a,

Therefore, in the case of a Musharakah agreement between a bank

and the business community, the bank, as apart of risk management and for

the judicious use of funds of the depositors; can obtain adequate security

from a partner against his misconduct, breach of contract and negligence (if

any)1.

3.11 Third party guarantee in Musharakah

Any third party can also provide a guarantee to make up the loss of

capital of all or some of the partners. This is subject to the conditions.

i) The third party should not be legally and financially related to the

Musharakah by owing more than 50 per cent of the capital of the

guaranteed joint venture.

ii) The guaranteed joint venture should not own more than half of

the capital of the guarantee providing entity.

iii) The Shirakah contract should not be conditional on such a

guarantee.

iv) The guarantee should not be provided for any consideration in>

other words, fulfillment of promise by a third party is not a

condition for validity of the contract.

It is important to observe that the third party’s undertaking is actually

a “promise to guarantee” and does not create the right for the beneficiary to

relate the Shirakah contract with fulfillment of the guarantee. The partners

in whose favour third party guarantee is given can neither claim that

Shirakah should become null and void nor can they refuse to meet the

Standard on. Musharakah, Clauses 3/1/4/1, 3/1/4/2.1 Ayub, op. cit.., p. 318.

obligations under the contact on the grounds that they had entered into

Shirakah taking into account third party’s undertaking to guarantee the

profit or the capital1.

3.12 Types of modern Musharakah and its conditions

The modem business concerns being mn on the basis of

Musharakah are as under:

1. Partnership : It is regulated by:

a. Partnership rules framed by the government.

b. Business practices prevailing in the business community.

2. Limited Company: This type of Musharakah is strictly controlled by

the statutory rules framed by the government. Its commercial activities

are, however, influenced by the business practices (Urf).

3. Cooperative societies: This Musharakah is also governed by

statutory mles. Its commercial activities are influenced by the

practices prevailing in the business community.

The above modem Musharaktih principally resembles Shirkah al-

Inan. The details are however, considerably different due to change of Urf

and other factors including modem commercial techniques, economic

conditions and legal requirements2.

3.13 The Basic Rules of Musharakah

Musharakah refers to a joint partnership where two or more persons

combine either capital or labour, forming a business in which all partners

1 AAOIFI, 2004-5a, standard onMusharakah, clause 3/1/4/3, pp 203, 220, 221.2 Al-Hassan,“Islamic Micro Fimnce-Musharakah Financing Model”. 1995.hptt://www. Islam

bank, community.

I 38 I

share the profit according to a specific ratio while the loss is shared

according to the ratio of the contribution1. Hence Musharakah is relatively

established by the parties through a mutual contract, it needs to have to

have all the ingredients of a contract. For example

> Existence of Mutaaqideen (partners).

> A partnership of Musharakah cannot be constituted without

the presence of partners.

> Legal capacity of partners (akhiyah).

> Partners must be sane and mature: the contract must take

place with free consent of the parties without any fraud,

duress or misrepresentation.

But there are certain features which are peculiar to the contract of

Musharakah. They are summarized below:

1. Management: Musharakah is run and managed by the will and

equal rights of participation of all the partners. Different aspects of

the Musharakah are:

a) Every partner in Musharakah has the right to take part in its

management and to work for it2. 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

Musharakah. In such case the “sleeping” (silent) partner shall

be entitled to the profit only to the extent of his investment,

' M.T. Usmani, Meezabank’s Guide to Islamic Banking, Karachi, Pakistan, Darul Isha’at, 2002,p.87.

2 M. T. Usmani, Islamic Finance, Musharakah andMudarabah, http://www.darululoom.edu;A. L. M. Gafoor, Interest-Free Commercial Banking, Malaysia, A.S. Nuurdeen, 1996, pp.52- 53.

i 39 I

and the ratio of profit allocated to him should not exceed the

relative size of his investment1 in the business.

b) However, if all the partners agree to work for the joint

venture, each 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 .

When a contract of Musharakah is made the condition of agency is

automatically presumed to be in existence in the contract the actual

possession of a partner over a property of the Musharakah business is

considered as possession of other partners in as much as if a partner

purchases half portion of a specific good for himself and half portion, there

for the Musharakah. When he takes possession of that specific good, this

possession will be considered as possession of all the partners. If

however, a partner purchases some goods for him self only, it is

exclusively for him and not for the Musharakah business .

c) Every partner enjoys equsjl rights in all respects in the

absence of any condition to the company,

d) Any condition regarding participation and administration of

the Musharakah and variation in the share of profit in this

ground is valid. The contract of Musharakah is not invalid on

grounds of condition of non-participation in the Musharakah

business, but on the ground that a share in the profit exists.

1 M. T. Usmani, Islamic Finance op. cit., p. 12.2 M. T. Usmani,. Meezanban’s Guide to Islamic Banking, op.cit., p. 20.,3 Al-Hassan, op. cit., p. 78.

\ 40 I

Thus Musharakah 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 other1.

Though in all modem forms of Musharakah, the partners enjoy equal

rights, as mentioned above, but in the limited companies and cooperative

societies the shareholders delegate their powers (rights in case of

administration etc. to some among them to be called directors or given any

other appropriate title. In a partnership concern the partners, by mutual

agreement, distribute among themselves their responsibilities, duties and

jobs.

Some other powers and rights of partners are :

• The right to sell the mutually owned property since partners is

representing each other in Shirkah and all have the right to buy and

sell for business purposes.

• The right to buy raw material or other stock on cash or credit

using funds belonging to Shirkah\o put into business.

• The right to hire people to carry out the business if needed.

• The right to deposit money and goods of the business belonging to

Shirkah as depositor trust where and when necessary.

• In right to use Shirkah"s fund or goods in Mudarabah.

• The right of giving Sharikah’s funds as hiba (gift) or loan, if one

partner or purpose of investing in the business has taken Qard-e-

1 M. K. Lewis, & M. L. Algauod, Islamic Banking, Cheltenham, U.K. Edward Elgar, 2001, p.13.

Hasana, then paying it becomes liable on all the partners.

Distribution of profit

The basis for entitlement to the profits of a Musharakah is capital

active participation in the Musharakah business and responsibility.

i) Profits are to be distributed among the partners in business on

the basis of proportions settled by them in advance. If

no such proportion has determined, the contract is not valid

in Shirkah.

ii) The share of every party in profit must be determined

as a proportion or percentage. No fixed amount can be

settled for any party1.

Therefore, if A and B enter into a partnership and it is agreed

between them that A shall be given 10,000/= per month as his share in the

profit and the rest will go to B, the partnership is invalid. Similarly, if it is

agreed between them that A will get 20 per cent of his investment, the

contract is not valid. The correct basis for distribution would be an agreed

percentage of the actual profit accrued to the business.

If an amount in lump sum or a certain percentage of the investment has

been agreed for any one of the partners, it must be expressly mentioned in

the agreement that it will be subject to the final settlement at the end of the

term meaning thereby that any amount so drawn by any partner shall be

treated as ‘on account payment’ and will be adjusted to the actual profit he

may deserve at the end of the term2. But if no profit is actually earned or is

1 M. N. Siddiqui, Partnership and Profit-Sharing In Islamic Law, The Islamic Foundation Liecester, 1985, pp. 22-23.

2 M. T. Usmani, op. cit. pp. 203-220.

less than anticipated, the amount drawn by the partner shall have to be

returned1.

Limited companies and cooperative societies distribute their project

according to the capital of the share holders. Of any share holder

participants actively in these modern Musharakah, he is paid for it and

such payments are regarded as the expenditure of Musharakah. This is

modem Urf and there is nothing un-Islamic in theory2.

Liability of loss

All the jurists are unanimously of the view that the loss should be

borne by the partners according to the ratio of their investment. This

principle of loss sharing in Shari‘ah is based on the saying of Sayedna

Ali bin Talib (RA).

“Profit is based on the agreement o f the parties; but loss is always

subject to the ratio o f investment”3.

Therefore, if a partner has invested 40 per cent of the capital, he must

suffer 40 per cent of the loss not more or less, and any condition to the

contract shall render the contract invalid4. This happens in all forms of

Musharakah (i.e., limited companies, cooperative societies and

partnership), where the loss is borne on the basis of capital invested.

There can be little doubt after the citation above of the unanimity of the

principle. The jurists have categorically laid down that a party which has no

capital invested in an enterprise, does not have to share its loss. From the

1 M. T. Usmani,“Islamic Finance”, op. cit.p 24.2 S. A. S. Al-Harran, op. cit p. 79.3 Ibid., p. 80.4 Ibn Qudamah, Supra,op.cit., p. 147.

explanation of the jurists, it is clear that it is not possible after investment

of capital to avoid the risk of loss in the enterprise. Being a direct

consequence of the prohibition of interest in Islam the jurists point out that

this is because of the fact that loss means destruction of a part of the capital

and hence as it occurs, is a liability of the owner of capital alone.

According to modem commercial practices, however, the loss does not cut

down the respective capitals of the partners or share holders, but remains

as it is in the accounts books of the Musharakah in order to be adjusted

against the future profits. It is pertinent to note that while adjusting the loss

against future profits the accounting procedure automatically works in a

manner so as to bear the capitals subsequently1.

Basic Rules of Capital Investment

Capital to be invested by the partners may be unequal. For the

majority of the jurists the capital invested by each partner should be in

liquid form2, i.e., in the shape of currency and not in the form of goods. The

condition for capital to be in the form of currency only was imposed

when it was difficult to refer to the goods in terms of currency. This was>

true in the days of barter systems when the jurists framed the rules, but new

goods are generally referred or counted in terms of currency. This

condition should therefore be waived. In limited companies and

cooperative societies the capital is invested in the form of equal units of

currency called shares and intended partners buy as many shares as they

wish. This practice has universally been accepted as Urf and is

therefore according to Islamic principles. Thus the capital in Musharakah

is summarized as below: The capital invested should be

1 S. A. S. Al-Harra n, op. cit., p. 80.2 M. T. Usmani, op. cit., p. 208.

• Quantified (Ma ‘lum): meaning how much, etc.

• Specified (,Muta'ayan): specified currency, etc.

• Not necessarily be merged: The mixing of capital is not required.

• Not necessarily be in liquid form: capital share may be

contributed either in cash/liquid or in the term of commodity the market

value of the commodity shall determine the share of the partner in the

capital.

Termination or Maturity of Musharakah

Being a nonbinding contract, any partner can withdraw his share from

the partnership at his will. But the partners can agree on any time frame of

Musharakah business.

In the past, the need for early termination of Shirkah contracts

normally did not arise due to the short life and liquidation nature of joint

enterprises that were of the nature of caravan trade. The classical jurists,

therefore, did not feel any need to impose any restrictions on withdrawal of

the partners. Latter jurists have contended that in case of a partnership

among more than two persons, the contract remains intact even after

withdrawal by any partner1.

Musharakah was also generally formed on short term basis, mostly of

a joint venture type. It was therefore easy for a partner to withdraw from

Musharakah. The withdrawal did not create many problems such as the

1 Muhammad Khadid Al-Atasi„ Sharah Majallah alAhkam al Adliah, Maktaba Islamic Quetta, (1403) A.H. quoted by Ayub, p. 319.

taxation of capital expenditure, the continuous nature of business activities

and goodwill1.

Conditions to terminate the Musharakah

i) When the purpose of forming Shirkah is achieved in the case

of a specific purpose Musharakah. While the profit will be

distributed according to the agreed profit distribution ratio,

any loss will be borne by each partner according to the ratio

of his investment .

ii) Musharakah or in cash form all of them will be distributed

pro rata between the partners. But if the assets are not

liquidated, the partners may agree either on the liquidation of

the assets, or on their distribution of partition between the

partners as they are. If there is a dispute between the partners

in this matter, i.e., one partner seeks liquidation while the

other wants partition of distribution of the non-liquid assets

themselves, the latter shall be preferred, because after the

termination of Musharakah, all the assets are in the joint

ownership of the partners, and a co-owner has a right to seek

partition or separation, and no one can compel him on

liquidation. However if the assets are such that they cannot

be separated or partitioned, sc as machinery, then they shall

be sold and the sale proceeds shall be distributed3.

iii) If any one of the partners dies during the contract of

Musharakah, the contract of Musharakah with him stands

1 S. A. S. Al-Harran, op. cit., p. 802 Ayub, op. cit.,p 3183 Ibn Qudamah. Supra, op.cit.,n.\, pp. 133-134.

terminated. His heirs in this case, will have the option either

to draw the share of the deceased from the business, or to

continue with the contract of Musharakah1.

iii) If any one the partners becomes insane or otherwise becomes

incapable of effecting commercial transactions, the

Musharakah stands terminated2.

iv) When whole of the Musharakah capital is exhausted or lost.

v) When any partner is prevented or prohibited from exercising■7

his legal powers over his property .

Termination of Musharakah without closure of business

If one of the partners wants termination of the Musharakah, while the

other partner of partners like to continue with the business, this purpose can

be achieved by mutual agreement. The partners who want to run the

business may purchase the share of the partner who wants to terminate his

partnership, because the termination of Musharakah with one partner does

not imply its termination between the other partners4.*

However in this case the price of the share of the leaving partner must

be determined by mutual consent, and if there is a dispute about the

valuation of the share and the partners do not arrive at an agreed price, the

leaving partner may compel other partners on the liquidation or on the

distribution of the assets themselves.

The question whether the partners can agree, while entering into the

1 Idem.2 Idem .3 Ayub, op. cit, p. 3194 See al-Fatawa-al-Hindiyyah,op.cit., vol. 2, pg 335-336.

contract of Musharakah on a condition that the liquidation or separation of

the business shall not be effected unless all the partners, or the majority of

them wants to do so, and that a single partner who wants to come out of the

partnership shall have to sell his share to the other partners and shall not

force them on liquidation or separation1.

Most of the traditional books of Islamic Fiqh seem to be silent on this

question. However it appears that there is no bar from the Shari‘ah point of

view if the partners agree to such a condition right at the beginning of the

Musharakah. This is expressly permitted by some Hartbali jurists. This

condition may be justified especially in the modem situations, on the

ground that the nature of business, in most cases today, requires continuity

for its success, and the liquidation or separation at the instance of a single

partner only may cause irreparable damage to the other partners .

If a particular business has been started with huge amounts of money

which has been invested in a long term project, and one of the partners

seeks liquidation in the infancy of the project, it may be fatal to the

interests, as well as to the economic growth of the society, to give him such>

an arbitrary power of liquidation or separation. Therefore such a condition

seems to be justified and it can be supported by the general principle laid

down by the Prophet Mohammad fiUj in his famous Hadith:

“All the conditions agreed upon by the Muslims are upheld except aj

condition which allows what is prohibited or prohibits what is lawful

In the present complicated commercial practices legal requirement and

public control entangle Musharakah for a considerable period so deeply and

1 M. T. Usmani, op. cit, p. 211.2 M. T. Usmani, “Islamic Finance”, op.cit., pl3.3 Quoted by M. T. Usmani, op. cit, p, 212.

firmly that no partner or shareholder can be absorbed of his liability as

such. So according to modem practice Urf the shareholders of a limited

company cannot withdraw from it and receive back their capital invested

therein. He can, however, sell his share to any person desirous of becoming

a shareholder of that company. In a partnership business a partner can be

permitted to withdraw and receive his capital back after fulfilling his

liabilities as a partner according to terms and conditions settled between the

partners1.

Limited liability

A distinguishing feature of modem Musharakah is the limited liability

of their shareholders. They cannot be held liable for more than the amount

of capital they have invested. This requirement makes it necessary to regard

the Musharakah as an entity separate from the individuality of the

shareholders. This common Urf has given way to safe and stable

Musharakah resulting big commercial organizations and flourishing

business2.

To sum up this section, Musharakqji or joint venture relationship is

established with a contract by the mutual consent of the parties for sharing

of profits and losses in the joint business. The profits are divided in

accordance with a contractually agreed proportion. Since the Shari‘ah

admits the entitlement to profit arising from a partner’s contribution to any

of the business assets. However, the Shari‘ah makes it clear that losses are

to be shared in proportion to the contribution made to capital. This is

because losses constitute erosion in equity and must be charged to the

1 S. A. S. Al Harran, op. cit, p. 812 A. M. Irfani, “Musharakah and its Modem Applications”, Paper presented at the Seminar on

Islamic Financing Techniques, Islamabad, December 1984, pp 23-24.

capital. If a loss has been incurred in one period, it must be offset against

profits in the subsequent periods until the entire loss has been written off

and the capital sum restored to its original level. However, until the total

loss has been written off, any distribution of “profit” will be considered as

an advance to the partners. Accordingly, it would be desirable to build

reserves from profits to offset any losses that may be incurred in the future1.

3.14 Difference between Musharakah and Conventional Banking

One of the clear differences between Islamic banking (on Musharakah

basis) and conventional banking is that Islamic banking transactions are

predominantly based on buying/selling or exchanging contracts whereas

conventional transactions are based on lending contracts.

This clear distinction is based on the foundation of Islamic banking

and financing as stated in the Quran, Verse 2:275.

Ijt lnj ut \| 4 IrttwrTt l»T *ill V U

j £UuJ| <lii J& l jb>Jl L»j| tjJts ^ l i *-

J <. L* Ala f1̂x1) 1 jlc- jAllI

..Trade is like usury but Allah hath permitted trade andforbidden usury. ”

The Quranic foundation has resulted in one of the most important

characteristics of Islamic financing where it is based on asset-backed

financing and it places the importance of underlying assets in the contract.

The conventional banking i.e., financing (mortgaging) approach on the

converse, merely deals in money and monetary papers only.

Musharakah, under Islamic financing promoted the trading and sale of

1 S. A. S. Al-Harran, op. cit, p. 81.

I 50 1

real goods, assets and commodities. Thus enabling Islamic financial

institutions and banks to derive profit from it whereas interest, which is

forbidden in Islam, is obtained through the lending of money by

conventional banks.

Interest finance

Depositors

Depositors provide bank with m oney

The bank pays the depositors the agreed rate o f

interest norm ally 1- 2% and keeps the

rest

Bank offers m oney in the

form o f loans to borrowers who have collateral

The borrow er pays the bank the agreed

rate o f interest norm ally 6-7% and

keeps the rest as profit

Interest B ased Bank

Musharakah Finance

DepositorsTnvpstnrs

Investors share risk and return of business venture

Borrower receives profits

not interest from business

venture

Bank purchases share in business

venture

Bank receives share o f profit

instead o f interest from

venture

Businessventure

Borrowers invest this m oney to generate profit , ,

Businessventure

Fig. 3 : Interest Based Financing compared with Musharakah

Tp/W/W/W/JfI 51 1

Thus it may be concluded that “Musharakah (participating financing),

whereby two parties (the bank and clients) provide working capital for a

joint venture project and either one or both may manage the business.

Profits (or losses) are shared strictly in relation to the respective capital

contributions. Banks can exercise the voting rights corresponding to their

equity shares and their representatives can sit on the firm’s board of

directors. Musharakah, adhering to the principle of profit and loss sharing,

is the purest form of Islamic finance and is usually used to fund long term

investment projects. In some cases, debt equity swaps are a form of

investment partnership or direct investment contract between the bank and a

company.

The main features of Musharakah can be summarized as:

> Two types of Musharakah, permanent and diminishing.

> Sharing of profit or loss according to shares.

> Bank takes part in management as partner.

> Can be liquidated anytime on motions agreement of partners.

> Collateral is required against misuse of funds or negligence.

> Profit and loss sharing is a crucial aspect in partnership.

Below is the general summary of rules pertaining to it:

Rules relating to profit

a) The ratio or the basis for sharing profit should be decided at the

beginning of a partnership.

b) Profit should be allocated in percentages of net earnings (after

deducting the operating costs and expenses) and not in a sum of

money or a percentage of the capital or investment by the

partners.

c) It is not necessary that agreement for sharing profit should be

proportionate to capital contribution.

d) A sleeping partner cannot share the profit more than the

percentage of his capital. If a partner did not stipulate that he

would be sleeping partner, he is entitled to get an additional

profit share over his percentage of contribution to the capital

even if he did not work1.

e) The partners may, at a later stage, agree to change the profit-

sharing ratio, and on the date of distribution, a partner may

surrender a part of his profit to another partner.

f) One partner can cap his share of profit to a certain amount of

money, giving the profit over and above that cap to the other

partner(s).

g) The final allocation of profit is not allowed to be based on

expected profit. However it is permissible to distribute a

provisional profit, subject to final settlement after actual or

constructive liquidation.

h) If the subject matter of Shari‘ah is a leased asset, the rental

amount distributed to the partners should be on account, subject

to settlement and reimbursement according to the final position .

1 AA OIFI, 2004-5a, Standard on Musharakah, clause 3/1/5/3; also see, for the basis of Shariah rulings in respect of profit/loss sharing, pp 221-222.

2 Ibid., clause 3/1/5/13.

i) It is permissible for partners to decide not to distribute a portion

of profit for the purpose of creation of various reserves1.

j) Different profit-sharing formulas can be agreed for different

periods or the magnitude of the realized profits, provided such a

formula does not lead to the likelihood of a partner being

preluded from participation in profit2.

k) Profit distribution/allocation should be made on the basis of

actual or constructive liquidation (valuation of assets) of the

venture. Receivable must be valued at the cash values, i.e., after

deduction for an allowance for doubtful debts. For receivables,

it is not permitted to take into account the concept of time value

of money or the notion of discount of the debt amount as

consideration for earlier payment .

Rules relating to loss

a) All partners will have to share the loss in proportion to their

investment.

b) However, it is valid according to the Shari‘ah Standards

(AAOIFI) that one partner can take responsibility for bearing

the loss, at the time of loss, without any prior conditions4.

Musharakah could be in assets or in working capital. At the end of

the production/operation year/season, the cost of production/operation is

deducted from revenue and a certain percentage is earmarked for

1 Ibid. clause 3/1/5/15.2 Idem.3 AA OIFI, 2004-5a, Standard on Musharakah, clause 3/1/5/10.4 Ibid., clause 3/1/5/4.

t 54 I

management fees. The net profit is then divided among partners pro rata

their percentage share capital.If the project is wholly managed by the client,

the management fee goes to him in addition to his profit share. If the bank

is involved in management, part of the fees is paid to the bank. The degree

of bank involvement in projects (partnerships) management depends on the

scale of the venture and the amount of money involved. Management fees

usually range between 10 to 30 percent depending on the clients bargaining

power and on the nature of the project (i.e., in activities that require special

skills, the share of the client is higher)1.

Usually banks ask for collateral against “negligence or misuse” of

funds. Collateral is in the form of a post dated cheque issued by the client

for an amount equal to the bank’s share. Moreover, he is required to sign a

legal undertaking not to dispose of the acquired assets/goods until the

transaction is liquidated. Banks argue that they should protect themselves

(their depositors) against losses, their argue should be borne by the client

alone. A partnership agreement becomes effective when the involved

partners, the bank and the client (s) sign a Musharakah contract.

Musharakah can be concluded with non-Muslims and also interest-

based banks to carry out operations acceptable in the Shari‘ah. In this

respect, arrangement has to be made to obtain all necessary assurances and

guarantees that the rules and principles of Shari‘ah will be observed during

the operation of the partnership2. It excludes all those businesses which are

not lawful in Islam, i.e., trade in Swine flesh or liquor, etc and unlawful

activities like pornography and gambling. For example, if a syndicate of

banks comprising Islamic as well as conventional banks is financing any

1 Abdalla, op. cit, p. 2622 AA OIFI, 2004-5a, Clauses 3/1/1/2, 3/1/1/3, p.201.

I 55 I

huge project or corporate firm, the Islamic bank’s portfolio must comprise

valid contracts like Ijarah to ensure its Shari ‘ah compliance. In this respect,

a distribution has to be made between the goods and activities which are

absolutely prohibited for all and the goods and activities which are

prohibited for Muslims alone. Interest for example, is prohibited for

Muslims alone. A non-Muslim citizen of an Islamic state can be permitted

to trade in the objects of latter category but partnerships in any such trade

will be declared void if any of the parties is a Muslim1.

From the above discussion, it is evident that Musharakah is deeply

involved in financing underlying assets, which promotes the creation of real

trade, real goods, production and services, as opposed to the increase in

money supply under conventional loans for which the supply may or may

not enhance the creation of real assets or at worst fuels inflation.

3.15 Historical background and Early Development

This form of partnership has been known since mankind has existed

on earth. This is because Musharakah is based on cooperation and man has

always needed help from his fellow jnen. This partnership has developed

and expanded according to man’s requirements in business and trade . This

partnership was also known to the Greeks, in the 6th century BC.At that

time they developed the system of marine loans in which a distinction was

made between the capacity of the company and the partners .

' Ayub, op. cit, p. 313.2 Abdul Aziz al-Khayyat, “The Companies in the Shariah Islamic Law and Conventional Law”

(in Arabic), 2nd ed., (Lebenon Al Risala Establishment for Printing, 1983), p. 25, quoted by Ahmad Al Suwaidi, Finance o f International Trade in the G ulf Brill, 1994, p.77.

3 Idem

! 5 6 1

Udovitch is also of the view that the origin of Musharakah goes back

to ancient times and to the Near East, at least since the times of

Babylonians1.

3.16 Financing during the Prophet’s 'fa j All) Era:

Al-Sharikah in business transaction was widely practiced in the pre-

Islamic period as well. Evidence of it has appeared in a poem by Al-

Nabighah al-Jadi.

And we share with Quraish in their piety and in their several ground

o f retentions to respect with the sharing exclusive o f other properties

The Arabs used to write down their agreement of partnership in

business transaction in the form of written documents to avoid any

disagreement. This text expressed the agreed terms of their partnership.

Such partnership took the form of business transactions and joint-stock

company (Sharikat al-Musahamah). In the latter the capital would be

provided or incurred in accordance with the capital would be provided or

incurred in accordance with the conditions agreed. Such partnership was

normally undertaken by traders from Makkah to the Yemen and Al-Sham

(Syria)3. In this case, the partner was called al-jar .Al jar is a partner in a

partnership involving immovable property or trade4. In Musharakah, the

capital can be provided by one or more partners, whether in the form of

immovable property or cash. All profits are divided among the shareholders

1 A. Udovitch, Partnership and Profit in Medieval Islam, Princeton University Press, 1970, p. 156

2 See. Al-Sarakhsi, al-Mabsut XI„Cairo,H 1324-1331, p. 151; Ibn Manzur, Lisan al-Arab, XIII, Beirut,n.d.,p. 293; E.W Lane, Arabic-English Lexicon, Vol. II, Cambridge, p. 154.

3 Jawad Ali, Al-Mufassal f i Tarikh al-Arab Qabl al-Islam, Baghdad, vol. VII, 1950-59 ,p. 406.4 Mohib al-Din, Abu al-Fayad al-Fayed al-Sayyid Muhammad Murtada al-Zubaidi, Tajal-Arus

min jawher al £>amtts,al-Kutubal-Ilmiyah-Lebanon, III, p. 111.

in accordance with their agreement and losses are shouldered by them1

because he has no marital share in the partnership.

Study of various reports shows that such partnerships were widely

practiced in the pre-Islamic period. It was reported that Nawfal ibn al -

Harith ibn Abd al-Mutallib became the partner of al-‘Abbas ibn Abd al -

Muttalib in an unlimited mercantile partnership.2. Saib ibn Aidh became a

partner of the prophet fk-j ’<dl\ before his prophet hood3 in trade in

the Yemen4. Al-Saib ibn al-Harith ibn Sabirah was also a partner of the

Prophet 4in J** in pre-Islamic times in Makkah. It was reported

that the merchants of the Yemen used to go to Hira and the merchants of al-

Hira used to go to Makkah and Madinah and that they all engaged in such a

partnership in the pre-Islamic era5. According to some reports, al-Abbas

ibn Midras al-Sulami was the partner of Harb ibn Ummayah6 and al-Abbas

was a partner of Abd Allah ibn al-Mutallib (the father of the prophet

fk-j *&) in pre-Islamic times.

Islam endorsed this type of practices and its theory was based on the

verse of Quran which says:

1 Ibn Hazm, Kitab al-Muhalla,Ed., Ahmed Muhammad Shakir, Cairo,1926-1928, VIII, p. 124, see Chapter VIII, pp 148-53.

2 Jawad Ali, op. cit, p. 407.3 Ibn Abd al-Barr, Kitab al-lsti ‘ab f i Marifat al-Ashad on the margin o f Ibn Hajar al-Asqalani’s

kitab al-Isabah f i Tamiyaz al-Sahbah,II,Hyderabad, 1918, p. 101.4 Ibn Hajar al-Asqalani, Kitab al-Isabah f i Tamyiz al-Sahabah, II, Cairo. 1910, p. 8 (3057). The

Prophet praised his sincerity and easiness to deal with in their partnership. See Ibn Hishan, Al- Sirah al-Nabawiyyah, Ed.by.Taha Abdul RaufI Sa'd ,1 ,Beirut,1975, p. 254.

5 Jawad Ali, op. cit, pp 407-08.6 Ibn Abd al-Barr, op. cit, pp. 123-24.

t 58 3

*UoL*cJj ( j l j AaLuj ^ i t t ^J| cjjuoj <■ Cw\ la iSl (J\ji

j C l* J L -o J | \ j± ~ C 'j I j^ T (J -w u ^ ifir

j U S"|j j Ajj j<«3 >»U tVtl < L o| ^ 3 j L«

... Truly many are the partners (in business) Al-Khultah who wrong

each other: not so do those who believe and work does o f righteousness,

and how few are they”? (38:24).

The Al-kultah in this verse refers to associates in a partnership1, who

have the right co-ownership. These associates or partners amalgamate their

properties, especially the partnership of livestock (Al-Mashiyyah). The

division of assets, in such cases, should be effected by giving an equal share

of profit in accordance with the capital and their works in partnership2. This

practice is supported by a tradition from the Prophet ^ (J**:

And there was share between two partners (khalikayn), in a co-ownership,

and whenever they withdraw or recess from partnership their properties are

to be divided equally (in accordance with their respective participation) .>

The Prophet’s legitimization of the practice of Al-Sharikah is to be

found in many Ahadith (Traditions):

a) The Prophet fk-j is reported have said, in relation to pre­

emption “whoever has a share in a piece of land or houses (riba), he is

not permitted to sell it until his partner or co-owner (Sharikuh) gives

1 Al-Tabari, Jami al-Bayan and Tawil Ay Al-Quran,Beirut’, Dar o/-Kutub o/-Ilmiyah, 1999). XXIII, p. 145; Al-Sayyid Sabiq, Fiqh al-Sunnah,Dai El Fikr, Beirut,III,1996, pp 354-55.

2 Cf. Al-Shafi, Kitab al-Umm, VIII, pp. 138-39; Cf. Ibn Al-Athir, Kitab al-Nihayah f i Gharib al- Hadith walAthar, II,Ed.by Tahir Ahmad Al Zawi and Mahmud Ahmad al Tanahi,Cairo, 1963. p 63.

3 Al-Shafi, op. cit, VIII, Beirut, 1983,p. 138,; Al-Qurtabi, Al-Jamili Akham al-Quran, XV, Cairo, 1935-1950,p. 179.

I 59 1

his permission. If the partner wants it he can take (buy) it and if he

wishes he can leave it, i.e., he can allow it to be sold to others”1.

b) The Prophet is reported to have said “the Partners or

co-owner is the one with the right of pre-emption (al-saft) in

anything”2.

c) The Prophet 'fiUj JL* is reported to have decreed, for partners,

the right of pre-emption in the case of property which has not been

divided up .3

d) The Prophet All) jLa is reported to have said “And the partner

or co-owner has superior or more right of pre-emption than the owner

of an adjoining property... 4

The above four traditions apply to a partner who is in joint

or collective ownership or tenancy. These accounts indicate that the

Quran and the prophet approved of the concept of mercantile

partnership of Al-Sharikah or Al-Shirkah and sanctioned it and its

practice. .

The Companions (sahaba) continued to practice the contract of Al-

Sharikah business transactions. As a further elaboration or extension of this

contract, they engaged in Shirakah between two parties on credit, when one

of them had no capital and the profits were divided in accordance with the

agreement between them, and may loss was to be deducted form the capital.

Moreover if one the parties authorized either of them to buy or sell, the

1 Al-Sanani, al-Musannaf,op.cit.,VIII,p 82.2 Ibid.,p.88.3 Malik Ibn Anas, Al-Muwatta,Book 35,Hadith 35.1.I4 Malik Ibn Anas, Al-Muwatta: The Version o f Muhammad Ibn al-Hassan al-Shaybani, Ed.

Abdul Wahab Abdul Latif, Beirut, 1979, p305.

profits would be divided equally between them. Therefore, one of them

could not consume the profits which had bee entrusted by this partner. This

was practiced and made a legal precedent by Uthman ibn Affan1 (R.A.).

Ali ibn Abi Talib (R.A.) ruled that the proportional division of profits

could be arranged or divided in accordance with what the parties has

agreed2. He added that all losses should be charged on the capital3. Abd

Allah ibn Abbas (R.A) was of the opinion that the shareholders in a

partnership were allowed to dissociate themselves from their contract

provided both agreed. They were permitted to withdraw their respective

shares or capitals in cash. Possibly, the latter’s ruling was to avoid any

disagreement and confusion. He also allowed the withdrawal of shares by

partners, either in the form of some of them in cash in unspecified currency

and some of them in specified currency concurrently4. He also allowed the

beneficiaries, in the case of inheritance, to withdraw partnership and take

their shares form the debts5.

There is no indication that the contract of al-Khultah was ever

commented on by the Companions. This may indicate that they followed

such a practice without any further ruling. The Successors also recognized

the legality of Al-Sharikah. Ata ibn Abi Rabi and Taus continued to

recognize the legality of a partnership of Al-Khultah6. They considered that

Al-Khultah did not imply anything other than Al-Shurakah, where the

1 Ibid., pp. 283-84.2 Al-Sarakshi, Al-Mabsut,opcit, XI, p. 176; Ibn Hazm, Kitab al-Muhalla, opcit, VIII, p. 126.3 Al-Sanani, Al-Musannaf,opcit, VIII, p. 82.4 Idem.5 Ibid, p. 289.6 Abdullah, Alwi Haji Hassan, opcit., Al-Qurtabi, Al-Jamili Commercial Law, pp. 148-49.

associates or partners amalgamate their properties1. In this case, the division

of assets and profits should be effected by giving an equal share to the

workers in the partnership in accordance with the agreement. Muhammad

ibn Sirin and Qatadah, however, ruled that if the goods were un weighable

or immeasurable, either of the partners could take his own profits without

them being weighed or measured, and Muhammad ibn Sirin allowed either

of them to dissolve the contract and take his own share, before any• * 2 settlement by weighing or measuring .

According to Udovitch the Islamic legal doctrines overseeing the

practice of Musharakah and the treatment of partnership in Islamic legal

treaties remained the same during Islam’s first millennium, stretching to the

role of the ottoman emperors. Accordingly, the institution of partnership

was divided between property or proprietary partnership, and contractual or

commercial partnership. The former was exclusively concerned with joint

ownership of property, while the later focused on joint exploration of

capital and joint participation in profits and losses, a practice similar to our

modem day concept of partnership. The main difference between the two is

that while joint ownership is a pre-requisite of property partnership, it is

consequence of the formation of commercial partnership. Of course, within

or similar to, each category, other forms and variations existed which were

practiced on limited scale”3, for example, in the case of property

partnership, variations included “voluntary” and “compulsory”

partnerships. The former is brought about as a result of an act of the

participants themselves, either through the joint purchase of some specific

1 Al- Qurtiabi, op. cit., p. 179.2 Idem.3 Ali Yasseri, “The Experience of the Islamic Republic of Iran in Musharakah Financing”, Arab

Law Quarterly, vol. 14, 1994 Brill, p. 232.

article, or through the joint acceptance of a gift or bequest. Compulsory

propriety partnership is brought about by some cause other than the act of

the participants, as for example through inheritance1.

Commercial partnership also included limited and unlimited

investment partnerships. The term “limited” however, does not refer to the

extent of each of its members obligations and liabilities incurred in the

course of the conduct of the business. The liability in all partnerships is in

fact unlimited and accordingly in all Islamic partnership, the partners are

liable in proportion to their share of the partnerships indebtness, regardless

of what this amounts to or by how much it exceeds the value of his own

share of the company’s assets2. The limited investment partnership was

limited with regard to the scope and investment aspects of the contract, i.e.,

only that part of a partner’s capital that he wished to invest would become

part of the common fund, whereas in unlimited or universal investment

partnerships all partner’s eligible properly is incorporated in to the common

fund3.

Variations also existed in the manner of dividing profits or losses and>

also in the nature of capital contributed by partners, ranging from

borrowings (credit), to gold, silver and copper coins, labour, commodities,

etc4.

According to Udovitch, this partnership has similar features to those

of the medieval European family compagnia. But according to Heffening

Sharikat al-Mufawaadah (Societea quaestus) appears to have originated fro

1 Idem.2 A. Udovitch, op. cit., ,p 154.3 Ali Yasseri, op. cit., p. 232.4 Journal o f Islamic Banking and Finance, Vol. II, Oct-Dec 1994.

Roman Byzantine law. This form of partnership was already commonly

practiced among the Arab before the advent of Islam. It is also known that

hence partnership forms were so developed that they became independent

institutions and the jurists formed detailed rules and them. There is

consensus of opinion among the jurists of all schools of thought (including

Hanafi, Maliki, Shafi, Hanbali and Jafari) that Musharakah is a said an

legitimate contract in Islam. Thus institution of Musharakah did not only

develop for instrument of finance. Although this concept of finance, which

was henceforth Islamic for centuries but it only came into prominence

during the last century.

Musharakah and Mudarabah as methods of transactions were

extensively practiced by Jewish merchants looking under Muslim

suzerainty throughout the medieval Muslim world, these two forms of

financing were, inter alia, quite prevalent in the area of trade and finance.

In the contemporary period, this principle was first mentioned by

Quraishi but formally discussed by Ahmad (1947). According to Ahmad,

Islamic financing may take the form of Musharakah where shares may be

floated by ordinary joint stock companies in accordance with this principle.

An elaborate theoretical foundation of the profit and loss sharing

system and detailed framework of financial intermediation based on it along

with a formal model of financing was, however, presented by Siddiqui

(1967, 1983). Siddiqui in fact formalized and extended the works of

Quraishi (1955), Mawdudi and in particular, that of Uzair (1954)1.

However, Musharakah ‘as a principle’ was just mention Quraishi but

Tariquallah Khan “ An Analysis of Risk Sharing in Islamic Finance with special Reference to Pakistan”, IRTI,Jeddah,1996, p.18.

formally discussed by Ahmad (1947). According to Ahmad, “shares may be

floated by ordinary joint stock companies an accordance with the

Musharakah principle”. Among other Muslim economists Chapra (1985)

assigns an important role to the Musharakah principle. He, however, does

not present any model of a typical financial intermediation system as

Siddiqui or Uzair did. However, his emphasis is on institutional

arrangement which characterize the Islamic financing institutions more as

investment institutions rather than typical financial intermediaries. Ahmad

and several other scholars in line with this approach. The natural outcome

of such arrangements is expected to provide a much more fertile ground for

Musharakah1.

In 1981, the Council of Islamic Ideology, Pakistan, prepared an

important document on the elimination of interest in the economy of

Pakistan; where the central recommendation was to rely utmost on the PLS

methods and thus started introducing Islamic modes of financing. After a

decade long experience, in 1992, the Federal Shariat Court made a

historical judgment on the elimination of interest and concluded that the

best modes of Islamic (financial) system as alternate to the present system,

are Mudabarah and Musharakah2.

The laws on interest free banking operations passed by Iran’s Islamic

Consultative Assembly (Parliament) in September 1983 determined the

basis of partnership contracts in banking operations in Iran. Article of this

law states: “Banking may in order to extend the necessary credit facilities

with a view to expanding activities in the various sectors of production

1 Ibid, p.19.2 Idem

commerce and services, parts of the capital for the required resources of

these sectors, through Musharakah”1.

3.17 History of Evolution of the Diminishing Musharakah/Musharakah Mutanaqisah

The Diminishing Musharakah (DM) or Musharakah Mutanaqisah is a

new financing technique. While discussing the implications of the

traditional Musharakah-Mudarabah (M-M) principles m the long run

economic perspective, Homoud (1974) confronted the following problem.

Since an Islamic bank is a non-biological entity, its life span can be very

long compared to human beings. Given this reality, if Islamic banks used

the non-terminating M-M contracts (in the ongoing enterprises) at a larger

scale in a period say 100 years, they would be controlling a

disproportionate amount of the economic resources. This may neither be

manageable nor equitable. Thus he proposed the concept of Musharakah

Yantahi bi al Tamlik {Musharakah, which ends in transferring ownership to

one-party entrepreneur).

According to the concept, an Islamic bank and an entrepreneur may

develop a joint project which could later lead to sole ownership of the

entrepreneur. In the proposed contract, profits and losses are shared

according to the Musharakah principle. A certain proportion of the

entrepreneurs share in profits is kept in a screw account. As soon as the

value of this account becomes equivalent to the value of the financier’s

ownership in the joint enterprise, the payment for this ownership is made

and the entrepreneur becomes the sole owner. This proposal was

subsequently discussed and approved as a permissible mode of financing by

1 FSC (Federal Shariat Court) Pakistan, 1995, p. 172.

the first International Conference on Islamic Banking, held in Dubai, during

23-25 Jamadal-Thani 1399 (1979)1.

The idea of developing an Islamic version of the conventional

concepts of preferred stocks, particularly “redeemable capital” must have

occurred to the professionals working in the Islamic banks. However, when

the issue of designing appropriate modes for financing Awqaf properties

was considered in the Islamic Development Bank, a task force appointed

for this purpose recommended the DM as a sole appropriate mode. The

consideration was based on the peculiar legal position of ownership of the

waqf properties, i.e., a financer cannot keep permanent ownership in a waqf

property which is essentially a separate legal entity. The IDB task force thus

suggested that the waqf as a legal entity with participation of its properties

and an Islamic Bank as a financer can develop a profit sharing joint

enterprise. Thus within a given period of time, the waqf ownership will be

completely returned .

Since then diminishing Musharakah has proved to be an efficient tool

of financing :

> Real estates

> Agricultural projects

> Automobile financing

> And other financial projects of local and international standards

Sudanese Islamic Bank, Al-Barakah Bank, London, Jordan

' Boualemer Bendjilali, Tariquallah Khan,“Economics of Diminishing Musharakah, Research Paper No, 31, IRTI, Jeddah.

2 See IDB (Islamic Development Bank) 1987.

The practice was so commonly prevalent among the Arabs and other

Muslims that perhaps under their influence, the Christians of the areas in

Europe where Muslims went also conducted it and introduced it for inside

Europe2.

Islamic Bank were the first to use Diminishing Musharakah/

Musharakah Mutanaqisah in the Banks1.

1 Idem2 See Postan, M. and Rich, E.E. (Eds). The Cambridge Economic History o f Europe. Cambridge

University Press, Cambridge, 1952.