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An introduction to Musharaka for term financing

Sultan Choudhury intro to islamic finance

Sultan Choudhury is chairman of Offa

 

Islamic Finance uses several structures in providing alternative financing products. For most conventional products, there is an Islamic finance alternative. Term financing is no exception.

In conventional finance, term finance or term loans are a credit facility that allows borrowers to borrow a lump sum for a set period with an agreed schedule for repayment with interest. In some transactions, the term loan commitment is structured to allow the borrower to draw the full amount of the term loan facility in multiple borrowings at different times. Once repaid, an amount borrowed under a term loan cannot subsequently be re-borrowed unlike a revolving credit facility.

Term financing is used for several reasons such as boosting cash flows, managing uncertainty, adding extra working capital, covering overheads and other non-asset-based transactions in support of exports, projects and contract requirements. Term financing is also used for asset acquisitions such as business premises, industrial factories, warehouses, commercial properties and equipment; as well as working capital requirements for a business.

Conventional term financing products are interest-bearing loans, and therefore are not Shariah compliant. Islamic banks offer revolving credits through Shariah compliant structures. However, any term finance will not be offered to the following non-compliant businesses:

–          Interest

–          Gambling

–          Gaming

–          Manufacturing or trading of non-halal products

–          Conventional insurance

–          Entertainment activities not permitted by Shariah

–          Stockbroking or share trading in securities not permitted by Shariah

One such product used in offering term financing is Musharaka, which is joint enterprise. There are two types of Musharaka that are offered in Islamic term financing, namely temporary and diminishing. Both types of Musharaka are based on the model rules of Musharaka, however in a temporary Musharaka, the term financing is typically used for a business venture and ceases to exist once the business venture is completed, without the customer purchasing any equity of the financier in the duration of the Musharaka. This temporary Musharaka is often used for working capital financing where the customer requires greater liquidity.

The second variant of Musharaka often used in term financing is the diminishing Musharaka. This Musharaka involves the customer purchasing the equity of the financier gradually throughout the Musharaka term. This type of Musharaka is often used in term financing where an asset acquisition is the goal of the customer.

Musharaka is based on the concept of profit and loss sharing which is participative in nature because each partner is taking a risk by participating in the venture and also profiting from the partnership. Each party to a Musharaka may contribute capital in the form of either ‘cash’ or ‘cash in kind’. Thereafter, all partners are entitled to a ratio of the profits that accrue to the Musharaka and all partners are liable for any losses arising therefrom.

The losses of any one partner are always limited to their capital contribution. One of the features that makes Musharaka unique is that no partner in the Musharaka may give a guarantee in relation to the capital contributed by another partner. However, a Musharaka partnership gives each partner a right to partake in its management. However, it is not a requirement that each partner takes part in the management, the management can be delegated to one partner.

This Musharaka involves the customer purchasing the equity of the financier gradually throughout the Musharaka term. This type of Musharaka is often used in term financing where an asset acquisition is the goal of the customer”

For example, where diminishing Musharaka is used for a property purchase the financier and the customer are partners in the initial ownership of the property (for instance in the ratio 70% ownership by the financier and 30% ownership by the customer).  The customer pays rent for the part of the property that they do not own (i.e. the financier’s portion) using a lease like structure (called an Ijara).

The two parties (financier and customer) can agree that every payment period (typically monthly) the customer will purchase some of the financier’s share in addition to the rent, until such time (the term of the finance) that the customer owns the property outright.  Typically, this structure is used for Islamic Home Purchase Plans in the UK where the customer is the occupier.   Of course, the two parties may agree to keep the proportions of ownership the same through the term as is often typical with Islamic Buy To Let Home finance in the UK.

Islamic Finance is not just an alternative mode of financing, rather it provides a completely different and interesting system to make the economy function efficiently and sustainably. Moreover, Islamic Finance offers an ethical framework of financing for ethical companies.

 

Read an introduction to Islamic finance instruments here.

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