MIBF 6013 Islamic Financial System Presentation, INSANIAH University College, Alor, Kedah, Malaysia

1. P
Islamic Financial System
MIFB - 6013
Application of Musharakah and Mudarabah
as financial instruments in Islamic Finance
and Banking practice
A term paper presented
by
Mohamed ibrahim ismail
[Matric No: A1111477M04]
15th Oct 2011

2. Outline
 Introduction
 Legality of Musharakah and Mudarabah
 Definition of Musharakah
Application of Musharakah
 Definition of Mudarabah
Application of Mudarabah
Conclusion
Page  2

3. Introduction
As many contemporary Muslim scholars and Islamic
economists are advocating for the implementation of equity-
based modes of financing, the most important contracts in
this regard are Musharakah and Mudarabah.
These two modes of financing are based the concept of profit
and loss sharing.
hey are true Islamic products, whereby all Muslim scholars ,
classical and contemporary are unanimous in its validity and
permissibility..
Page  3

4. INTRODUCTION
 Theoretically, much has been discussed about these two
concepts such the terms ,conditions and tenets
 The following sections will discuss the modern application of
these concepts in the as financial instruments in Islamic
finance and banking practice
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5. Legality of the two products
Legality of Musharakah
“
Page  5

6. Cont…..
Allah SWT says:
“Verily, many partners oppress one another, except those who
believe and do righteous good deeds and they are few” Sad: 24
Page  6

7. Cont….
The prophets SAW said : “Allah Says: “I am the third
partner of any two partners as long as neither of them
betrays the other. But if one of them betrays the other I
get out of them“”. Abu Daud Hadith No.3383
Page  7

8. Legality of Mudarabah
1
“ ”
Ibn Munzir said in his book “Al-Ijma”,
“They [Muslim Ulama] unanimously agreed upon each other that
Qirad(Mudarabah) in Dinars and Dirhams (Cash) is permissible”
Page  8 1.Ibn Mundir (1999) A,l-Ijma, Maktabah Alfurqan, Ras Khaima, p.140

9. Definition of Musharakah
Draft of Shariah parameter reference 4:Musharakah Contract, a paper
published by Bank Negara in 2010 defined Musharakah as follows:
“Technically, Musharakah is a contract between the partners to
contribute capital to an enterprise or a venture, whether
existing or new, or to owner of a real estate or moveable
asset, either on a temporary or permanent basis. Profits
generated by that venture or real estate or asset are shared
in accordance with the terms of the Musharakah agreement,
while losses are shared in proportion to each partner’s share
of capital.”
Page  9

10. How is Musharakah applied in modern finance and
Banking Practice?
Musharakah as equity-based financial instrument is used in
many areas and is applicable to a wide spectrum of business
activities, it can be used in trade financing, such as import or
export, project financing, syndicated asset financing, stock
markets and issuance of sukuk or certificates
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11. Musharakah in trade financing: Import
 Musharakah can be applied in trade finance without complexities,
since the chances of fraud, negligence and other problems are
relatively lower in international trade than in other Musharakah-
based projects.
 A bank may enter into a Musharakah arrangement with a client
who intends to import;
 the bank may also appoint him as agent for acquisition and
disposal of the goods after the same are imported;
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12. Cont……
 an L/C(letter of credit) could be opened in the bank’s or the
client’s name
 The net profit out of this limited purpose Musharakah will be
shared between the bank and the client in an agreed ratio.
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13. Musharakah in trade financing: export
 In the case of export finance under L/C, the goods will be
acquired and made ready for shipment on a Musharakah
basis.
 The client will prepare the export documents strictly in
accordance with the terms of the L/C and undertake to
indemnify the bank for any loss in case of his failure to
honour his commitment.
Page  13

14. Cont………..
 Export proceeds will be distributed according to the agreed
ratio.
 If there is no L/C involved, the merchandise will be made
ready for export under joint ownership of the bank and the
client.
Page  14

15. Cont….
 The following could be the procedure for export financing on the
basis of Musharakah:
 the exporter receives an order from abroad to export a specific
commodity or goods at a known price.
 He estimates its expected profit. If he needs financing for
manufacturing or procurement of the goods, the bank can provide
financing on the basis of Musharakah.
.
Page  15

16. Cont…
 Profit would be shared on a pre-agreed percentage.
 The bank can secure itself from any negligence on the part of the
exporter. However, being a partner of the business, the bank will
be liable to bear any loss which may be caused due to any reason
other than the negligence of the exporter.
 However, in order to undertake such an operation, banks need to
understand the nature of the exporter’s business and other
requirements
Page  16

17. Project Financing
In the case of project financing, the traditional method of
Musharakah can be easily adopted whereby investment comes
from both sides
 The following may be the flow of transactions in the case of
Musharakah for running business:
1. A running Musharakah Account for the client will be opened in
the books of the financing bank.
 2. The client’s proceeds from the sale of finished of goods will be
credited in the Running Musharakah Account.
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18. Cont….
 3. The client’s cash flows generated from investment activities (for
example, sales proceeds from the disposal of fixed assets) and cash
flows from long-term financing activities (for example, long-term
finance availed for the project) cannot be credited in the Running
Musharakah Account.
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19. Cont…
 5. At the end of each quarter or month, as the case may be, the
profit earned by the client in the Musharakah will be paid to the
bank.
 6. The profit-sharing will be based on the computed operating
profit for the same period for which the running Musharakah limit
was awarded.
Page  19

20. Syndicated asset financing
 A group of banks joint efforts to partially finance a big enterprise or
a large project.
The enterprise contributes its part of the investment to the project
such building a new factory for a car manufacturing company or
another giant company.
A group of Islamic banks which joined hands finance the remaining
part.
Page  20

21. Cont…
The enterprise runs the project on behave of the banks. The banks
and the enterprise share the profit according to the agreed ratio in
the Musharakah contract and losses are borne in terms of each
investors capital contribution
Page  21

22. Musharakah in stocks
 Business companies issue shares based Musharakah concept. The
investors buy these shares and become shareholders in the
company. Like the ordinary partners the are entitled to profits
generated by the company generated based on the Musharakah
agreements.
Musharakah as a basis of securitization
Musharakah can easily be adopted as a basis for
securitization, especially in the case of big projects where
huge amounts are required.
Page  22

23. Cont…
 Every subscriber can be given a certificate representing his
proportionate ownership in the assets of the joint business, and
after the project is started by acquiring substantial non-liquid
assets, these Musharakah certificates can be treated as negotiable
instruments and can be bought and sold in the secondary market
Page  23

24. Diminishing Musharakah ( )
 In a Diminishing Musharakah contract, a party, after participation
in ownership of any business or project, can liquidate his
investment from the asset or the ongoing business.
DM contracts contain a sale provision, according to which, one
partner makes a promise to sell his part of ownership to the other
party periodically.
Page  24

25. Cont…..
DM is used in house financing, auto financing, plant and machinery
financing, factory or building financing and all other fixed asset
financing.
House financing
Trade financing
Page  25

26. Mudarabah
According to Islamic Financial System by ISRA Mudarabah is
defined a partnership in profit whereby one party (rabbul mal)
provides capital and the other party (mudarib) provides labour.2
Page  26 2
ISRA (2011) Islamic financial System, ISRA, Kuala Lumpur p. 249

27. Application of Mudarabah
 Mudarabah is used in the following a source of fund
Saving Deposit Account
- Bank accepts deposits on wadiah yad damanah and utilize it in its
financing activities
Current Deposit Account
General Investment Account
Special Investment Account
Page  27

28. Cont…..
 Mudarabah as a financing instrument can be used in the following:
Project financing
Trade financing: import/export
Mudarabah as applied in takaful
Mudarabah sukuk
-facilitated by SPV or SPM
Page  28

29. Cont…
 Inter-bank Funds Market
A bank in short of funds enters into a mudarabah contract with a bank with
surplus funds. This creates an investee-investor relationship.
Government/Public Sector Financing
The government issues certificates of Mudarabah when it is short in funds,
purchases assets or utilities and leases the asset to the public
corporations.
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30. Concluding remarks
 Musharakah and mudarabah can be applied in a spectrum of areas
and the Muslim scholars are unanimous in on their permissibility,
however the practitioners in the Islamic banking industry overstate
the risks associated with undertaking projects based on PLS
concepts.
 To avoid any future financial crisis, the Islamic banking industry
should be more on the equity side in terms of financing modes
while at the same time trying their level best to mitigate any
possible risks that may arise in adopting equity-based financial
instruments
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31. THANK YOU
THE END
B
I
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Application of Musharakah and Mudarabah