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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 Shari’a (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 Shari’a and thus any financing agreement/arrangement to finance a casino is against Shari’a. 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: Shari’a 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 creditor–debtor relationship. Shari’a-Approved Activities. Islamic banks may engage in or finance only activities that do not violate the rules of Shari’a 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. Shari’a prohibits financial transactions that involve gharar, which is often translated as “deception,” “excessive risk,” or “excessive uncertainty.

trade or service with an aim of earning profit.Islamic banks/financial institutions are supervised by a Shari’a 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. Murabaha: Murabaha is a contract wherein the Islamic bank. 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 . 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. upon request by the customer. 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. while the recipient of the funds(the Mudarib or the manager) provides the professional. managerial and technical know-how towards carrying out the venture.e. 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.

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. let’s look at the products Musharaka and Istishna in some more detail. 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.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.

to contribute capital to an enterprise or a venture. work. Variants of Musharaka contracts 1. Mufawada partnership It is a contract between two or more persons. mutual responsibility and liability for debts equally shared by the parties. Each of the parties contributes a portion of the overall fund and participates in work. 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. 4. . whether existing or new. either on a temporary or permanent basis. Thus. It is a condition of this type of partnership that contributed funds. 2. but equality is not required either in the contribution to the fund or in work or in sharing of profit. the partnership can be used in the case of large users of funds to establish investment for short term or long term basis. or to owner of a real estate or moveable asset. Based on the above definitions. Each of the two parties contribute a portion of the overall fund and participates in work. 3. the ideas of partnership are: first.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. Therefore. Both parties equally divide profit or loss. 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. Both parties share in profit or loss as agreed between them.

Project Finance Issuance of Sukuk (Islamic Bond) Import Letter of Credit Working Capital Asset Management Recognition of the Islamic bank’s share in profits or losses 1. Hence. depending for that on their reputation and sell the goods for cash. 3.Amal partnership It is a contract between two persons who agree to accept work jointly and to share the profit from such work. Al-wujooh partnership It is a contract between two or more persons who have good reputation and prestige and who are expert in trading. 4. The Islamic bank’s 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. The treatment mentioned in the above point shall apply to a Diminishing Musharaka after taking into consideration the decline in the Islamic ban k’s share in Musharaka capital and its profits or loss. 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. 2. They share profit or loss according to the guarantee to suppliers provided by each partner. 4. Areas of Financing Some of the business areas in which Musharaka could be used are as under:1. 5. 3. . For example. it is called “receivables partnership”. 2. Profits or loss on Musharaka transactions which commence and culminate during the same financial period are recognized at the time of (constructive) liquidation. Share of profits is recognized as a receivable due from the partner if he does not pay the Islamic bank’s due share of profits after liquidation or settlement of account is made. This type of partnership does not require capital since it is backed by guarantee. Parties to the contract purchases goods on credit from firms.

5. 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 . Loss incurred due to negligence or misconduct of the partner is recognized as a receivable due from the partner.

In Istishna contract. 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. In the second contract viz. It is a sale transaction where commodity is transacted before it comes into existence. However. 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 payment in the Istishna contract could be immediate or deferred basis. the Islamic Bank assumes the role of “Mustasnia” and the sub-contractor takes the role of “Sania”. The calculation of profit in Istishna contract is dependent on what Bank actually pays in Parallel Istishna plus its profit margin. both Istishna contract entered into between the customer and the Islamic Bank and the second contract viz. the customer is called “Mustasnia” and the Islamic Bank is called “Sania” and the thing to manufacture viz..Istishna’a (Progressive Asset Finance) An Istishna'a contract refers to an agreement to sell to or buy from a customer. Parallel Istishna. Conditions for Parallel Istishna . the buyer (customer) approaches the Islamic Bank (maker) to assist him/her in construction of workshed/building. work-shed/building is called “Masnooa”.. Parallel Istishna – which is entered into between the Islamic Bank and the sub-contractor are independent of each other. 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. the Islamic Bank can engage the services of sub-contractor to complete the task of the customer. For example.

universities. Sub-contractor delivers the asset to the Islamic Bank on due date.  There must be two different and independent contracts. 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. Bank. as per the terms and conditions of Istishna contract. 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 . The terms of payment could be immediate or progressive or on a deferred basis. 2. aircraft. Parallel Istishna is allowed with only third party. Areas of applications    The contracts in the nature of BOT (Build. can be categorised as Istishna transactions. Transfer). schools. Istishna contract can also be applied in the area of infrastructure building activity viz. in turn. Operate. ship and locomotive building industries. Islamic Bank enters into a Parallel Istishna contract with sub-contractor to manufacture the machinery as per Istishna specification. delivers the asset to the customer. etc. Business Processes for Istishna & Parallel Istishna contract 1. Bank and customer enter into a Istishna contract to manufacture either on immediate / progressive or deferred payment basis. Islamic Bank. Istishna contract is applied in high technology areas viz. The major risks involved in the Istishna arrangement can be     Customer has no recourse to nor any contractual relationship with the actual contractor.. 3. construction of hospitals. building. Customer approaches the Islamic Bank to manufacture a thing.. Sub-contractor delivers the asset on the specified date to the Islamic Bank. 5. 4. The Islamic Bank delivers the asset to the customer. Following are the steps involved in Istishna contract:     Customer approaches the Islamic Bank with a request to manufacture an asset. these two contracts cannot be tied up with each other and the performance of one should not be contingent (binding) on the other.