The Musharaka Contract in Islamic Finance
The second kind of equity participation financial instrument used by Islamic banks is based on a musharaka contract. It establishes a partnership or joint venture for an economic activity between the bank and one or more clients. In this joint venture, all parties may contribute some (not necessarily equal) percentage of all three factors of economic production (capital, labor, and entrepreneurship).
Two or more working partners
In a mudaraba contract, one party is a financier (silent partner), and the other party (working partner) provides labor and entrepreneurship. But in a musharaka contract, all participants are working partners.
For example, say that the hypothetical company Jamaldeen, Inc., wants to establish a joint venture project with World’s Best Islamic Bank. Jamaldeen, Inc., brings $200,000 in capital to the table, and the bank contributes $300,000. Jamaldeen, Inc., has most of the expertise needed to get the project off the ground, but the bank also wants to be involved with managing some aspects of the project.
The agreement states that the two parties share the profit this way: Jamaldeen, Inc., gets 80 percent, and the bank gets 20 percent. (Why the disparity? Jamaldeen, Inc., is contributing more labor and expertise for the project, as well as a decent percentage of the capital.) Similarly, both parties bear any losses according to their capital contributions (40 percent for the company and 60 percent for the bank).
This means that if the project is successful and the end product sells for $800,000, the company gets 80 percent of the $300,000 profit ($240,000), and the bank gets the remaining $60,000. If the project falls flat and sells for only $400,000, the $100,000 loss is divided this way: The company accepts $40,000 in loss, and the bank eats $60,000.
Islamic banks use the musharaka contract to finance trade, provide working capital, and support other large projects. For example, based on the musharaka contract, Bahrain Islamic Bank (BisB) provides letters of credit to its customers that deal in international trade.
On its website, the bank describes the contract as being a limited partnership that supports customers who lack sufficient funds to import what they need. A customer supplies part of the money, the bank supplies the rest, and the bank issues the letters of credit. Then, after the imported items arrive, one of three scenarios applies:
BisB sells its share in the musharaka to the customer on cash payment or deferred basis at an agreed margin
The customer sells its share to BisB on cash payment or deferred basis
Both sell their shares in the market together
Choose between a consecutive and declining balance partnership
Islamic banks divide musharaka products into two categories based on the retention of the partners in the joint venture (how long the partners will stay in the joint venture):
Consecutive partnership (consecutive musharaka): Each partner can keep its share in the partnership until the very end of the joint venture, project, or business. However, the partners are often allowed to withdraw or transfer their shares (unless the initial contract specifically states that all partners shall remain in the partnership until the date of maturity). If one of the partners withdraws from the contract, the whole partnership doesn’t terminate.
Declining balance partnership (diminishing musharaka): One partner is allowed to buy the other partner’s share of equity step by step until the whole equity of the other partner is transferred. It’s called a declining balance partnership because one partner’s equity balance declines gradually.
If the diminishing musharaka setup sounds confusing, think of it this way: A client and a bank are willing to enter a partnership for a project or business. The partnership project or business is divided into a number of equity units, and the partners agree on certain periods of time to remain invested; this agreement appears in the contract.
The client that eventually wants to have full ownership of the project repurchases the equity units step by step over time. (The client can either repurchase a fixed number of units each period or repurchase an increasing number of units per period.) At the end of the contract, the client owns the full project or property.
The profit and loss sharing (PLS) ratio may be revised every time the client repurchases equity units or according to some other agreement between the bank and the client. The bank derives income from this transaction in two ways. First, the bank’s investment comes back in full (assuming the project or business is a success). Second, the bank receives whatever percentage of profit is designated in the partnership agreement.
Islamic banks use consecutive musharaka when they’re investing in a project, joint venture, or business activity. Both parties share the profits or losses of this partnership based on their initial musharaka agreement.