An introduction to Musharaka and Istishna products of Islamic financing/banking.

Islamic financing/banking: The underlying principles defining Islamic financial transactions are that the purpose of financing should not involve an activity prohibited by Sharia (Islamic law) and that the financing must not involve riba (the giving or receiving of interest) and should avoid gharar (uncertainty, risk, and speculation). For example, gambling is against Sharia and thus any financing agreement/arrangement to finance a casino is against Sharia. Riba includes interest charged on lending money whereas gharar includes excessive uncertainty regarding essential elements of a contract, such as price in a contract of sale. The ownership and trading of a physical good or service is a critical element in structuring Islamic financial products. Principles of Islamic financing/banking: Islamic financing is based on the themes of community banking, ethical banking and socially responsible investing. It is based on the following principles Freedom from Riba: By prohibiting riba, Islam seeks to foster an environment based on fairness and justice. Riba is also believed to be exploitative and unproductive because it is considered to represent sure gain to the lender without any possibility of loss as well as a reward in return for no work. Risk-and-Return Sharing: Sharia prohibits Muslims from earning income by charging interest but permits income generation through the sharing of risks and rewards between the parties to a transaction. This profit sharing mechanism is believed to encourage people to become partners and work together rather than to enter into a creditordebtor relationship. Sharia-Approved Activities. Islamic banks may engage in or finance only activities that do not violate the rules of Sharia and are permitted by Islam. Sanctity of Contract: Islam views contractual obligations and the related full disclosure of information as a sacred duty. Full disclosure is intended to reduce financial speculation (gharar), by providing as much information as possible for investors to make accurate assessments about the risks and rewards of an investment. The conditions that are necessary for a contract to be valid include a competent understanding of the underlying asset(s) and the profit-sharing ratio, as well as the presence of a willing buyer and seller. Contracts must also not offend Islamic religious and moral principles; if they do, they will be deemed illegal and unenforceable. Avoidance of Gharar. Sharia prohibits financial transactions that involve gharar, which is often translated as deception, excessive risk, or excessive uncertainty.

Islamic banks/financial institutions are supervised by a Sharia Supervisory Board (SSB). The main product types of Islamic finance are Mudaraba: A Mudaraba is a profit sharing partnership agreement in which the investor (the Rabul-mal) provides the necessary finance, while the recipient of the funds(the Mudarib or the manager) provides the professional, managerial and technical know-how towards carrying out the venture, trade or service with an aim of earning profit. Murabaha: Murabaha is a contract wherein the Islamic bank, upon request by the customer, purchases the asset from a third party supplier/vendor and resells it to the customer either against immediate payment or on a deferred payment basis i.e. Cost plus finance Musharaka: This is a type of partnership between the Bank and the customer whereby each party contributes to the capital of the partnership in equal or varying proportions either to establish a new venture or share in an existing one. Within Musharaka there are different types of products based on the tenor and requirements for financing like Permanent Musharaka (Equity Participation) Diminishing Musharaka (Long-term) Temporary Musharaka (Working Capital Financing) Istishna: Istishna is a sale agreement between the Bank as Al-sani (the seller) and the customer as Al-mustasni (the ultimate purchaser) whereby the Bank based on the order from the customer undertakes to have manufactured or otherwise acquire the subject matter (Al-masnoo) of the contract according to the specifications stipulated by the customer and sells it to the customer for an agreed upon price and method of settlement whether that may be in advance, by instalments or deferred to a specific future date

Parallel Istishna: This refers to the second sales contract entered into by the Bank with a subcontractor to fulfil its contractual obligations in the first contract (Istishna) to the customer

Bai AlSalam:

Bai Al Salam (also known as Salam) is a contract whereby the Bank (Al-muslam) makes a lump sum payment to a seller (Al-muslam Ileihi) for a specifically defined commodity (Al-muslam Fihi) which will be delivered in the future.

Parallel Salam: This is a second Salam contract entered into by the Bank with the buyer for the sale of the specifically defined commodity which is to be delivered to the buyer on a specified future date for an agreed selling price. The buyer must be a third party and not related to the original seller.

Ijara:

Ijara is an operating lease that allows ownership of the right to use an asset in return for consideration and the contract does not end with the transfer of the ownership of the asset For our current purpose/project, lets look at the products Musharaka and Istishna in some more detail.

Musharaka (Joint Venture/Partnership)

Musharaka is an agreement between two or more persons to carry out a particular business with the view of sharing profits by joint investment. Based on the above definitions, the ideas of partnership are: first, 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. Therefore, the partnership can be used in the case of large users of funds to establish investment for short term or long term basis. Thus, a partnership needs to be defined as a contract between two or more persons in carrying out a particular business with a view of not only sharing the profit but also loss and liability.

Variants of Musharaka contracts

1. 2. 3. 4.

Musharaka Inan (equivalent to joint stock) Musharaka mufawada (flexible partnership) Musharaka amal (based on work done jointly) Musharaka al-wujooh (reputation based on credit partnership)

Inan partnership

It is a contract between two or more persons. Each of the parties contributes a portion of the overall fund and participates in work. Both parties share in profit or loss as agreed between them, but equality is not required either in the contribution to the fund or in work or in sharing of profit.

Mufawada partnership

It is a contract between two or more persons. Each of the two parties contribute a portion of the overall fund and participates in work. Both parties equally divide profit or loss. It is a condition of this type of partnership that contributed funds, work, mutual responsibility and liability for debts equally shared by the parties.

Amal partnership

It is a contract between two persons who agree to accept work jointly and to share the profit from such work. For example, two persons of the same profession or craft may agree to work together and to divide the profit arising from such work on an agreed basis.

Al-wujooh partnership

It is a contract between two or more persons who have good reputation and prestige and who are expert in trading. Parties to the contract purchases goods on credit from firms, depending for that on their reputation and sell the goods for cash. They share profit or loss according to the guarantee to suppliers provided by each partner. This type of partnership does not require capital since it is backed by guarantee. Hence, it is called receivables partnership. Areas of Financing Some of the business areas in which Musharaka could be used are as under:1. 2. 3. 4. 5. Project Finance Issuance of Sukuk (Islamic Bond) Import Letter of Credit Working Capital Asset Management

Recognition of the Islamic banks share in profits or losses

1. Profits or loss on Musharaka transactions which commence and culminate during the same financial period are recognized at the time of (constructive) liquidation; 2. The Islamic banks share of profits on Musharaka 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 Musharaka capital; 3. The treatment mentioned in the above point shall apply to a Diminishing Musharaka after taking into consideration the decline in the Islamic ban ks share in Musharaka capital and its profits or loss; 4. Share of profits is recognized as a receivable due from the partner if he does not pay the Islamic banks due share of profits after liquidation or settlement of account is made;

5. Loss incurred due to negligence or misconduct of the partner is recognized as a receivable due from the partner. Typical business flow for a Musharaka contract can be The customer approaches the Bank with the request for financing The Bank enters into a Musharaka agreement with the customer Specific role of the two parties in the management of the venture Profit from the venture is distributed between the Bank and the customer

The major risks involved in the Musharaka arrangement can be Banks have a lower degree of control over the management Lack of commitment and mismanagement of funds by the Musharaka Risk of default due to poor credit standings, lack of experience or lack of commitment

Istishnaa (Progressive Asset Finance)

An Istishna'a contract refers to an agreement to sell to or buy from a customer, a non-existent asset which is to be manufactured or built according to the ultimate buyer's specifications and is to be delivered on a specified future date at a predetermined selling price. It is a sale transaction where commodity is transacted before it comes into existence. For example, the buyer (customer) approaches the Islamic Bank (maker) to assist him/her in construction of workshed/building. In Istishna contract, the customer is called Mustasnia and the Islamic Bank is called Sania and the thing to manufacture viz., work-shed/building is called Masnooa. The payment in the Istishna contract could be immediate or deferred basis. The calculation of profit in Istishna contract is dependent on what Bank actually pays in Parallel Istishna plus its profit margin.

Conditions for Istishna The subject of Istishna is always a thing which needs manufacturing Manufacturer uses his/her own material Quality and quantity should be agreed in absolute term Purchase price should be fixed with mutual consent Price of Istishna/Parallel Istishna can be spot or in instalments The instalments may be tied up with different stages of project The Istishna contract can be cancelled unilaterally before the commencement of Istishna contract After starting the work, the Istishna contract cannot be cancelled unilaterally it has to be done mutually

Parallel Istishna After the customer has requested the Islamic Bank for construction of workshed/building, the Islamic Bank can engage the services of sub-contractor to complete the task of the customer. In the second contract viz., Parallel Istishna, the Islamic Bank assumes the role of Mustasnia and the sub-contractor takes the role of Sania. However, both Istishna contract entered into between the customer and the Islamic Bank and the second contract viz., Parallel Istishna which is entered into between the Islamic Bank and the sub-contractor are independent of each other.

Conditions for Parallel Istishna

There must be two different and independent contracts, these two contracts cannot be tied up with each other and the performance of one should not be contingent (binding) on the other. Parallel Istishna is allowed with only third party.

Areas of applications The contracts in the nature of BOT (Build, Operate, Transfer), can be categorised as Istishna transactions. Istishna contract is applied in high technology areas viz., aircraft, ship and locomotive building industries. Istishna contract can also be applied in the area of infrastructure building activity viz., construction of hospitals, building, schools, universities, etc.

Following are the steps involved in Istishna contract: Customer approaches the Islamic Bank with a request to manufacture an asset. Bank, after obtaining necessary documents and satisfying conditions enters Istishna contract with the customer (buyer). Bank in turn enters into a Parallel Istishna contract with sub-contractor to manufacture the same asset as per the Istishna contract. Sub-contractor delivers the asset to the Islamic Bank on due date. The Islamic Bank delivers the asset to the customer, as per the terms and conditions of Istishna contract.

Business Processes for Istishna & Parallel Istishna contract 1. Customer approaches the Islamic Bank to manufacture a thing. 2. Bank and customer enter into a Istishna contract to manufacture either on immediate / progressive or deferred payment basis. 3. Islamic Bank enters into a Parallel Istishna contract with sub-contractor to manufacture the machinery as per Istishna specification. The terms of payment could be immediate or progressive or on a deferred basis. 4. Sub-contractor delivers the asset on the specified date to the Islamic Bank. 5. Islamic Bank, in turn, delivers the asset to the customer. The major risks involved in the Istishna arrangement can be Customer has no recourse to nor any contractual relationship with the actual contractor, hence the Bank is prone to failure Bank has no or little control over the selection process of the contractor Banks have no control over the manufacturing process Risk of default due to poor credit standing or lack of commitment