I) Growth of Islamic Finance
Islamic finance has become increasingly significant since the mid-1970s and has made its presence felt, both in the eastern and western worlds. The growth in national and personal wealth in the Middle East over the past 25 years has coincided with a resurgence in the influence of Islamic beliefs in various parts of the world. This has created a strong demand for a financial system which enables Muslims to make use of their wealth in a manner consistent with their beliefs.

Market dynamism has been felt in both the traditional Islamic finance centres and a number of other markets.

Sukuk – the Islamic finance world’s equivalent of a traditional bond – has taken the Islamic finance industry by storm over the recent years, with most of the origination in Malaysia and the Gulf Co-operation Council countries.

Although Sri Lanka is yet to witness any sukuk issuances, there is a growing interest in these instruments to tap the liquidity of the Muslim community in Sri Lanka. Presently, Islamic institutions and community have limited investment vehicles that are in accordance with Islamic principles. This together with the tight liquidity in the conventional finance market has fuelled interest in Islamic Finance. However, in order
to support the growth of this alternative instrument, regulatory, accounting, legal and tax issues need to be resolved.

In Malaysia’s case, the Islamic finance market has grown from strength to strength and is one of the fastest-growing capital pools, rapidly being drawn into the mainstream financial system. The Malaysian Sukuk market, in particular, has successfully evolved out of its infancy. The viability of Islamic finance is no longer an issue; the success of
the domestic Islamic bond market – within a relatively short period – is a firm testament to investors’ widespread acceptance of Islamic financing principles in that country.

II) Principles of Islamic Finance
The cornerstone of Islamic finance is that funding is not provided for monetary returns.
Rather, Islamic finance is based on contracts of exchange. Under such contracts, assets or services will be exchanged for money, or for other assets. These give rise to sale and purchase contracts or leasing contracts.

Among the fundamental components of Islamic finance is the Shariah board. Shariah simply refers to Islamic law and Shariah boards are councils that are made up of Islamic scholars who ensure that all the activities of a company are in accordance with Shariah. Although Shariah interpretations may vary from one board to another, the
differences are very minimal. The challenges can be mitigated by creating an apex Shariah council so that there is uniform practice in the industry. In Malaysia, Islamic securities are based on principles and concepts that are approved by the Securities Commission of Malaysia’s Shariah Advisory Council.

III) Types of Islamic Contracts
The foregoing are structures that have been observed in the Malaysian context. RAM Ratings Lanka notes that these are not prescriptive structures as each market will have its own preference with regard to the underlying Islamic structure; over time, these can and do change.

1) Murabahah
A contract referring to the sale and purchase transaction for the financing of an asset, whereby the cost and profit margin (mark-up) are made known and agreed upon by all parties involved. The settlement for the purchase can either be on a deferred lump-sum
basis or via instalments; this is specified in the agreement.

Murabahah is the most popular and most common mode of Islamic financing. It is also known as mark-up or cost-plus financing. The word Murabahah is derived from the Arabic word Ribh, which means profit. Murabahah is a contract of sale in which a commodity is sold for profit. In this case, the seller is obliged to tell the buyer his cost
price and the profit he is making.

There are a number of requirements for this transaction to be a real transaction, in order to meet the Islamic standards of a legal sale. The entire Murabahah transaction must be completed in 2 stages. In the first stage, the client requests the bank to undertake a Murabahah transaction and promises to buy the commodity specified by
him, if the bank acquires the same commodity. Of course, the promise is not legally binding. As the client may renege on his promise, the bank risks the loss of the amount it has spent. In the second stage, the client purchases the item acquired by the bank on a deferred-payments basis, and agrees to a payment schedule. Another important
requirement for a Murabahah sale is that the 2 sale contracts, one through which the bank acquires the commodity and the other through which it sells the same to the client, should be separate and real transactions.

2) Bai Bithaman Ajil
A contract that refers to the sale and purchase transaction for the financing of an asset on a deferred basis. The buyer may be allowed to pay by installments within a preagreed period, or in a lump sum. The sale price includes a profit margin. Although this principle had been popular in the past, it is now not as widely used for Islamic securities
in Malaysia given the lack of acceptance by Islamic jurists in other parts of the world.

In the next article, we will be discussing other types of Islamic contracts, namely Istisna, Ijarah, Mudharabah and Musharakah.

As mentioned before, these structures are not meant to be prescriptive, and there can be variations over time.

3) Istisna
Istisna is a purchase contract for an asset, whereby the buyer places an order with the seller to purchase the asset to be constructed or delivered on a certain date in the future, according to the specifications in the contract.

The settlement of the purchase price by the buyer is concluded according to the agreement between the 2 parties. Both parties decide on the sale and purchase prices, and settlement can be delayed and arranged based on a schedule of work completed.

4) Ijarah
Ijarah is a contrac for the sale of benefits and services between the owner of the assets (lessor) and the user of those same assets (lessee), at an agreed price. Under Islamic financing practices, the Ijarah concept is where the issuer sells the Ijarah assets
(normally plant, equipment, machinery or transportation vehicles) to the financier via an asset-purchase agreement. The financier, having obtained ownership of the assets, will then lease them back to the issuer via an Ijarah contract. The title to the assets will remain with the financier throughout the tenure of the Ijarah contract. Upon payment of the final instalment, the lessor and the lessee may agree to transfer the title from the lessor to the lessee; otherwise the title will remain with the lessor. Al Ijarah Thumma Al Bai is a contract that begins with an Ijarah contract for the purpose of renting out a
lessor’s asset to a lessee. Upon expiry of the lease period, the lessee purchases the asset at an agreed price from the lessor, by executing a purchase (bai’) contract.

5) Mudharabah
The term refers to a form of business contract where a party contributes capital while the other one provides expertise and effort. Their proportionate shares of the profits are determined by mutual agreement. On the other hand, the loss – if any – is borne only
by the owner of the capital; as such, the entrepreneur would get nothing for his labour.

The financier is known as rabb-ul-maal while the entrepreneur is mudharib.
As a financing technique adopted by Islamic banks, Mudharabah is a contract where all the capital is provided by the Islamic bank while the business is managed by the other party. The profit is shared according to pre-agreed ratios; any loss – unless caused by negligence or violation of the terms of the contract by the mudharib – is borne by the
Islamic bank. The bank passes on this loss to its depositors.

In theory vis-à-vis Islamic banking, Mudharabah has been suggested as a technique that will provide the basis for the Islamic reorganisation of the commercial-banking sector. In practice, however, Mudharabah has not made much progress on the asset side of the balance sheet. Nonetheless, on the liability side, Islamic banks accept funds
based on Mudharabah in investment accounts.

Although Mudharabah is translated into English as profit- and loss-sharing, there is actually no loss-sharing in a Mudharabah contract. Profit- and loss-sharing is a more accurate description of the Musharakah contract. The Mudharabah contract may be
better represented by the expression “profit-sharing” as it is an Islamic contract where one party supplies the money while the other provides management in order to undertake a specific trade. The party supplying the capital is called the owner of the capital. The other party is referred to as a worker or agent who actually runs the business. In Islamic jurisprudence, different duties and responsibilities have been
assigned to each of these 2 parties.

As a matter of principle, the owner of the capital does not have the right to interfere in the management of the business enterprise, which is the sole responsibility of the agent. However, the capital owner has every right to specify conditions that would ensure better management of his money. That is why Mudharabah is sometimes referred to as a sleeping partnership.

An important characteristic of Mudharabah is the arrangement of profit-sharing. The profits in a Mudharabah agreement may be shared according to any pre-agreed ratio between the parties. However, any loss is completely borne by the owner of the capital. In the case of a loss, the capital owner will bear the monetary loss while the agent will
lose the reward for his efforts.

Islamic banks practice Mudharabah in both individual and joint forms. In the case of an individual Mudharabah, an Islamic bank provides financing to a commercial venture run by a person or a company, on a profit-sharing basis. On the other hand, joint Mudharabah may be between the investors and the bank on a continuous basis. The
investors who keep their money in a special fund and share the profits, have the flexibility to withdraw from the Mudharabah funds. Many Islamic investment funds operate on the basis of a joint Mudharabah.

6) Musharakah
A partnership arrangement between 2 parties or more, to finance a business venture where all parties contribute capital, either in the form of cash or in kind, for the purpose of financing the business venture. Any profit derived from the venture is distributed according to a pre-agreed profit-sharing ratio, but a loss is shared on the basis of equity

Musharakah is another popular financing technique used by Islamic banks. It can roughly be translated as “partnership”. In this case, 2 or more financiers provide funding for a project. All the partners are entitled to a share in the profits resulting from the project, in a ratio that is mutually agreed upon. However, any loss must be shared
according to their proportion of capital contribution. All the partners have the right to participate in the management of the project; they also have the right to waive their right of participation in favour of any specific partner or person.

There are 2 main forms of Musharakah: permanent and diminishing. These are briefly
explained below:
– Permanent Musharakah – In this form of Musharakah, an Islamic bank participates in the equity of a project and receives a share of the profits on a pro rata basis. Since the period of the contract is not specified, it can continue as long as the parties concerned wish so. This technique is suitable for the financing of projects with longer life spans, where funds are committed over a long period; the gestation
period may also be lengthy.

– Diminishing Musharakah – This allows equity participation and sharing of profits on a pro rata basis. It also provides a method by which the bank’s equity in the project keeps on reducing; ultimately, ownership of the asset transfers to the participants. This form of Musharakah provides for a payment over and above the bank’s share in
the profits i.e. the bank gets a dividend on its equity and at the same time, the bank also gets a payment from the entrepreneur who purchases some of its equity. Thus, the equity held by the bank is progressively reduced. After a certain time, the equity held by the bank will become zero and it will cease to be a partner.

The Musharakah form of financing is increasingly being used by Islamic banks to finance domestic trade and imports as well as to issue letters of credit. It may also be applied in agriculture and industry.

source : ramlk

Financing Through Musharaka: Principles And Application



Virtually unknown three decades ago, Islamic financing is now practiced around the world. Since its official launch in the 1970’s, Islamic financial institutions have witnessed rapid international growth in both Muslim and Non-Muslim countries (Dudley 2001).

Although the concept of Islamic finance has existed for centuries, it only came into prominence during the last century (De Jonge 1996, p.3). The first successful application of Islamic finance was undertaken in 1963 by Egypt’s Mit Ghamr Savings Banks, which earned its income from profit-sharing investments rather than from interest (Lewis & Algaoud 2001, p.5). By the 1970’s, the push for Islamic finance had gained momentum. In 1973 the conference of foreign ministers of Muslim countries decided to establish the Islamic Development Bank with the aim of fostering  the economic development and social progress of Muslim countries in accordance with the principles of Shari’ah (Saeed 1996, p.13). This marked the first major step taken by Muslim governments in promoting Islamic finance.

Shari’ah law (Islamic law based on the teachings of the Koran) prohibits the followers of Islam from conducting any business involving Riba (interest). This means that Muslims cannot receive or pay interest, and they are, therefore, unable to conduct business with conventional financial institutions (Jaffe 2002). The creation of Islamic financial institutions came about as a method for servicing this niche market.

In order to compete with conventional modes of financing (interest-based financial instruments), Islamic financial institutions developed products that would fulfill  the Shari’ah obligation and provide the same value as conventional bank products (Malaysian Business 2001). The main Islamic financial products include profit-and-loss sharing (Mudaraba and Musharaka), cost plus mark-up, and leasing. The focus of this article is to analyze the profit-and-loss sharing instrument of Musharaka and the way it is implemented. The article begins by briefly describing the profit-and-loss sharing system, followed by a detailed analysis of Musharaka. The article then looks at the application of Musharaka as a home financing instrument, and concludes by analyzing the current issues affecting Musharaka, and the criticism leveled against it


 Profit and Loss  sharing system


Although Islam excludes interest earnings from financial activities, it does not necessarily mean that the financier cannot earn a profit. In order to do so, the financier has to ensure that gains made on the original amount are directly related to the risk undertaken on the investment (Siddiqui 1987). If there is no risk involved, the gains made represent interest rather than profit.

In order to understand how the Islamic system differentiates between profit and interest, one has to look at the differences in the economic ideology. In a capitalist system, capital and entrepreneurs are treated as two separate factors of production. The return on capital is interest, whereas the entrepreneur, who risks losing money, earns a profit. While interest is a fixed return for providing capital, profit can only be earned after distributing the fixed return to land, labor and capital (in the form of rent, wage and interest). Thus, the capitalist system seems to favor those who lend capital to entrepreneurs by providing them a secure return, entrepreneurs bear the risks of incurring losses and still making interest payments on borrowed capital.

In comparison, Islamic economic system does not consider providers of capital and entrepreneurship as separate factors of production. It believes that every person who contributes capital in the form of money to a business venture assumes the risk of loss and therefore is entitled to a proportional share in the actual profit (Siddiqui 1994, p.99). The system is protective of the entrepreneur, who in a capitalist economy would have to make fixed interest repayments even when the venture is losing money.  (Usmani, M.I. 2002, p.13). Capital has an intrinsic element of entrepreneurship, so far as the risk of the business is concerned and,  therefore, instead of a fixed return as interest, it derives profit. The greater is the profit earned by a  business,  the higher the return on capital will be. With no fixed interest repayments, profit in an Islamic economic system would be higher than in the capitalist economy. The system ensures that profits generated by commercial activities in the society are distributed equally amongst those who have contributed capital to the enterprise.

Another difference between the two economic systems lies in the way money is used. In economic terms money has no intrinsic value; it is only a medium of exchange, therefore, earning interest on a medium of exchange without bearing any risks does not sit well in the Islamic system (Rahman 1994, p.14). Islamic financing is, therefore, an asset-backed financing. When a financier contributes money on the basis of the profit-and-loss sharing instruments, it is bound to be converted into assets having intrinsic value (Usmani, M.T. 1998, p.19).

The profit-and-loss sharing system has its roots in the ancient form of financing practiced by Arabs since long before the advent of Islam. After the introduction of Islam, this system was permitted to continue and was legitimatized as a finance instrument. For this historical reason, scholars consider profit-and-loss sharing financial instruments to be the most authentic and most promising form of Islamic contracts (Ariff, 1982). Mudaraba (finance trusteeship) and Musharaka (equity partnership) are two such financial instruments based on the profit-and-loss sharing system, where instead of lending money to an entrepreneur at a fixed rate of return, the financier shares in the venture’s profits and losses (The Economist 2001).




The literal meaning of the word Musharaka is sharing. Under Islamic law, Musharaka refers to a joint partnership where two or more persons combine either their capital or labor, forming a  business in which all partners share the profit according to a specific ratio, while the loss is shared according to the ratio of the contribution (Usmani, M.I. 2002, p.87). It is based on a mutual contract, and, therefore, it needs to have the following features to enable it to be valid:

  • Parties should be capable of entering into a contract (that is, they should be of  legal age).
  • The contract must take place with the free consent of the parties (without any duress).

In Musharaka, every partner has a right to take part in the management, and to work for it (Gafoor 1996). 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 Musharaka. In such a case the “sleeping” (silent) partner shall be entitled to the profit only to the extent of his investment, and the ratio of profit allocated to him should not exceed the relative size of his investment in the business.

However, if all the partners agree to work for the joint venture, each one 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 (Usmani, M.I. 2002, p.92).

Musharaka 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 other. Another more limited investment partnership is also available. This type of partnership occurs when two or more parties contribute to a capital fund, either with money, contributions in kind, or labor. Each partner is only the agent and not the guarantor of his partner. For both forms, the partners share profits in an agreed  upon manner and bear losses in proportion to the size of their capital contributions (Lewis & Algaoud 2001, p. 43).

‘Interest’ predetermines a fixed rate of return on a loan advanced by the financier irrespective of the profit earned or loss suffered by the debtor, while Musharaka does not envisage a fixed rate of return. Rather, the return in Musharaka is based on the actual profit earned by the joint venture. The presence of risk in Musharaka makes it acceptable as an Islamic financing instrument. The financier in an interest-bearing loan cannot suffer loss, while the financier in Musharaka can suffer loss if the joint venture fails to produce fruits (Usmani, M.T. 1998, p. 27).

Musharak in home financing


When used in home financing, Musharaka is applied as a diminishing partnership. In home financing, the customer forms a partnership with the financial institution for the purchase of a property (Saeed 2001). The financial institution rents out their part of the property to the client and receives compensation in the form of rent, which is based on a mutually agreed fair market value. Any amount paid above the rental value increases the share of the customer in the property and reduces the share of the financial institution.

The application of diminishing Musharaka in home financing can be illustrated with the help of the following example, which the LaRiba bank in the U.S. follows:

Let us assume that a potential buyer is interested in purchasing a home worth $150,000. The buyer approaches an Islamic financial institution for the purchase of the property and puts 20 per cent of the price ($30,000) as down payment (the down payment required differs between financial institutions. In some cases it is as low as 5 percent ). The financial institution pays for the other 80 per cent of the price ($120,000). This agreement results in 20 per cent of the home ownership belonging to the client and the remaining 80 percent to the financial institution.

The next step for both parties would be to determine the fair rental value for the property. One way to determine the rental value is for both the client and financial institution to survey the market to obtain estimates for similar properties in the same neighborhood and negotiate an agreement. This fair rental value will remain constant over the life of the agreement. For this example, we will assume $1,000 per month as the rental value.

A rental value of $1,000 means that the client will pay $800 as rent for the 80 per cent share the financial institution holds. The two parties then agree on the period of financing. In this example we will assume that the financing period is 15 years (180 months). Based on the rental value and the financing period, the financial institution then determines the fixed monthly payments the client would have to make to own the house. 

Table 1

Example of payment schedule for a home-loan under Musharaka.

Month Rent $ Extra Payment $ Total Fixed Payments $ Bank’s Ownership $









































In this example the client starts by paying $1147, which includes the required 80% of the $1,000, and extra payment of $347. By doing so the client reduces the share of the financial institution by $347, and increases their own share by the same amount. The next month’s rental payment of the client would be reduced to $798, and again the payment made above the rent amount will result in an increase in the client’s ownership of the property. This continues on till the client buys back all the shares of the home that the financial institution holds at the end of the agreed financing period.

This example does not take into account fees and charges that the financial institution may charge such as insurance and taxes.

In the event of non-payment of rent from the client, the financial institution has to take into consideration the reason for the non-payment. If the client has a valid excuse for non-payment, the financial institution has to show leniency so that the client does not feel over-burdened, and the client should give more time to make the payment. In theory, if the financial institution charges any extra amount as compensation for the late payment, the amount would be considered as interest and therefore is not permitted in Islam. If there is no genuine reason for the late payment, the financial institution can ask the client to make a payment to a charity as penalty (Usmani, M.T. 1998, p.172). This prohibition of charging late fees makes it even more important for Islamic financial institutions to carefully evaluate each application before entering into an agreement.


Criticism of Musharaka



Musharaka is sometimes criticized as being an old instrument that cannot be applied in the modern world. However, this criticism is unjustified. Islam has not prescribed a specific form or procedure for Musharaka. Rather it has set some broad principles which can accommodate numerous forms and procedures (Usmani, M.T. 1998, p.29). A new form or procedure in Musharaka that would make it suitable for modern financial needs cannot be rejected merely because it has no precedent in the past. In fact, every new form can be acceptable as long as it conforms to the principles laid down by Shari’ah. Therefore, it is not necessary that Musharaka be implemented only in its traditional form (Usmani, M.T. 1998, p.30).

Another criticism leveled against Musharaka is based upon the issue of profits being guaranteed by some financial institutions. Even though Musharaka is considered to be the most authentic form of Islamic financing, the risk associated with sharing losses means that it is not as popular as the other modes. To make the product more appealing to the customer, some financial institutions have started guaranteeing profits in Musharaka. By doing so, these institutions are contravening the basic law of Islamic finance that requires linking rewards to risks (Warde 2000, p.5). If profits are guaranteed, the risk factor is eliminated, making the profit resemble interest. Although these actions may help Islamic banks grow in the short-run, the long-term costs (harm to reputation and authenticity) will outweigh the benefits. Such moves also provide ammunition to the critics of the system, who are already questioning whether the system is nothing more than an interest-based system operating under the guise of profit (The Economist 1994).




Although not as popular as other Islamic financial instruments, Musharaka is still considered to be one of the most authentic forms of Shari’ah approved financing. Recognising the problem that some financing instruments used by Islamic financial institution closely resemble interest-bearing instruments, Muslim scholars have voiced their opinion that more profit-and-loss sharing instruments should be developed and used. In recent times there have also been calls for Muslim countries to follow the lead of Iran and Pakistan, where their governments have enforced the Islamic financial system as the only available finance option. The push for such actions to be taken means that Musharaka’s use as an Islamic financial instrument will continue to rise in the future. Also, by relying on Musharaka for financing projects, Islamic financial institutions can erode any fears that Islamic financial institutions are essentially providing interest-bearing products under the guise of profit and mark-up has hurt their reputation. This is important for the survival and future growth of Islamic finance.




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