MUSILM UNIVERSITY OF MOROGORO
DIPLOMA IN ISLAMIC BANK
AND FINANCE
OPERATIONS OF ISLAMIC
COMMERCIAL BANKS (DIB 115)
FINANCING PRODUCTS AND SERVICES OF
ISLAMIC BANKS (EQUITY-BASED)
COMPILED AND PRESENTED BY: Mr. JAMAL I. JUMA
Trustee Partnership (Mudaraba) Facility


Trustee partnership based on mudaraba is a mode
of financing through which the bank provides
capital finance for a specific venture indicated by
the customer.
The bank, called rabb-al-mal is the owner of the
capital and the customer-entrepreneur, called
mudarib, is responsible for the management of the
business and provides professional, managerial and
technical expertise for initiating and operating the
business enterprise or project.
Trustee Partnership (Mudaraba)
Facility…





Profit is shared according to a pre-agreed ratio.
Losses if any, are entirely absorbed by the capital
provider – the bank.
Mudaraba may be of two types – restricted or
unrestricted.
In a restricted mudaraba (mudaraba al-muqayyada)
the bank or the financier may specify a particular
business in which investments may be undertaken.
In unrestricted (mudaraba al-mutlaqa) the mudarib
may invest the capital provided in any business he
deems fit.
A simple mudaraba financing structure
1.
2.
3.
4.
5.
Bank and Client discuss business
plan; Bank provides funds to client
towards capital investment;
Client sets up the business and
manages its operations;
Business generates positive or
negative profits;
Profits if positive, are shared
between Client and Bank as per a
pre-agreed ratio;
Profits if negative, are absorbed
by Bank; effectively bringing down
the value of the asset created with
its investments
Joint Venture (Musharaka) Facility




A joint venture based on musharaka involves a
partnership in which both the bank and its customerclient contribute to entrepreneurship and capital.
It is an agreement whereby the customer and the
bank agree to combine financial resources to
undertake any type of business venture, and agree
to manage the same according to the terms of the
agreement.
Profits are shared between the bank and the
customer in the pre-agreed ratio.
Losses are shared strictly in proportion to their
respective capital contributions.
A simple musharaka financing structure
1.
2.
3.
4.
Client and Bank discuss business plan
and jointly contribute to capital of the
venture;
Client and Bank jointly set up the
business venture and manage its
operations, sharing the responsibilities
as per pre-agreed terms; Business
generates positive or negative profits;
Profits if positive, are shared as per a
pre-agreed ratio;
Profits if negative, are shared in
proportion to capital contributions;
effectively bringing down the asset
value while keeping their respective
shares in it unchanged.
Diminishing Musharakah (DM)








A form of Musharakah where the financier and the
client participate in a joint commercial enterprise or
property.
This enterprise is converted into undivided ownership of
both the financier and the client.
Over certain period the equity of financier, divided
into equal value units, is purchased by the client.
And ultimately the client becomes the sole owner of the
enterprise.
Uses of DM
Agric. Machinery and implements financing
Storage facility construction/sheds
Transport vehicles, etc.
Declining Musharaka…
A declining musharaka is a recent innovation;
Its popularity originates from the fact that
classical musharaka aims to involve bank as a
permanent partner in the venture.
 This may not be a desirable idea for a
financial intermediary.
 A financial intermediary likes liquidity in its
investments or at least a finite maturity of its
investments.

Declining Musharaka…
In a declining musharaka, the bank's share in
the equity is diminished each year through
partial return of capital.
 The bank receives periodic profits based on its
reduced equity share that remains invested
during the period.
 The share of the client in the capital steadily
increases over time, ultimately resulting in
complete ownership of the venture.

A simple declining musharaka financing structure
1.
2.
3.
4.
Client and Bank discuss business plan and
jointly contribute to capital of the venture;
Client and Bank jointly set up the business
venture and manage its operations, sharing the
responsibilities as per pre-agreed terms;
Business generates positive or negative profits;
Profits if positive, are shared between Client
and Bank as per a pre-agreed ratio; the profit
share of Client flows into Bank too, towards
partial redemption of the latter’s capital
contribution;
Profits if negative, are shared between Client
and Bank in proportion to their respective
capital contributions; effectively bringing down
the asset value while keeping their respective
shares in it unchanged.
Procedural details of DM






Client requests the bank for DM
Appraisal is accorded
Approval is conveyed.
bank releases its share to become partner in the
asset. And contract of Musharakah is executed.
[buying &selling not stipulated]
This asset becomes undivided ownership of both the
bank and the client [Musha] None of the parties can
withdraw its equity till DM is terminated
General rules of partnership apply
Procedural details of DM…
At the same time, uni-lateral promise from
client is obtained to purchase the units of
bank’s equity.
 The price of one unit of bank’s equity is valued
 Ijarah Agreement is signed
 In case of Ijarah the rent is realized while in
case of business or services profit and losses
are shared
 Expenses connected to asset are borne by the
partners proportionately

Procedural details of DM…
Equity of bank is periodically purchased by the
client
 Bank’s share in the asset decreases while that
of client increases – so happens to the rent or
profit
 Ultimately the client becomes the sole owner of
the asset [Bank’s share reduces to zero]

Example – Financing Purchase of Tractor


A client wants to purchase a tractor by sharing
of equity of TSHS 4,000,000/= against price
of TSHS 40,000,000/=. The bank shares rest
of the price of tractor ie. TSHS 36,000,000/=.
How his request can be accommodated by a
bank?
Bank agrees to finance the purchase of
tractor through DM.
Example – Financing Purchase of Tractor…






10% of the cost (TSHS 4,000,000/= ) is paid by the
client and 90% of the cost (TSHS 36,000,000/=) is
paid by the bank. [Musharakah Contract is signed]
The rental of tractor is fixed according to certain
reference price [Ijarah for future date is signed]
The client promises (unilateral promise) to the bank to
purchase banks equity divided in to equal value units
Say, rent is fixed @ 15% p.a.
The DM terminates after 3 years
Installments can vary [Seasonal, quarterly, monthly]
Example – Financing Purchase of Tractor…
After acquisition, the client uses tractor and
pays rent to bank for using bank’s share in the
property
 At the same time, purchases unit(s) of equity
after expiry of each rental period
 The equity of bank diminishes to zero on
expiry of three years, the rent as well, client
becomes sole owner

Example – Financing Purchase of Tractor…
1
Share in
capital
Share in
capital
2
Partner
Bank
3. Accruing Rentals
Pays price of the
units of bank’s
equity
4
Sell its
share in
equity
Example – Financing Purchase of Tractor…








Total value of Asset: 40,000,000/=
Share of client
4,000,000/=
Share of Bank
36,000,000/=
No. of units
36
Value of one unit
1,000,000/=
Rent per year
36,000,000×15%=5,400,000/=
Rent per month
5,400,000÷12=450,000/=
Rent per unit per month 450,000÷36 = 12,500/=
Example – Financing Purchase of Tractor…
End of
Month
Rent
Value unit
purchased
Total
payment
(TSHS)
Remaining
units
Remaining
balance
(TSHS)
0
0
0
0
36
36,000,000/=
1
12,500 x 36
= 450,000
1,000,000
1,450,000
35
35,000,000/=
2
12,500 x 35
= 437,500
1,000,000
1,437,500
34
34,000,000/=
3
12,500 x 34
= 425,000
1,000,000
1,425,000
33
33,000,000/=
35
12,500x 2
= 25,000
1,000,000
1,025,000
1
1,000,000/=
36
12,500x 1
= 12,500
1,000,000
1,012,500
0
0
Total
16,200,000 36,000,000 52,200,000
Issues in Product Management






Risk and Return
Liquidation
Combination of Mudaraba-Musharaka
Forward Commitment
Pricing of Redemption
Areas of Application
Risk and Return




Mudaraba and musharaka are equity-based
products that involve sharing of returns and risks.
Returns may accrue in the form of periodic profits
and change in the value of the assets.
An important feature of mudaraba is a pre-agreed
ratio in which profits are to be distributed between
the financier-bank and the entrepreneur-client.
It rules out any allocation of profits in absolute
terms other than as per the agreed ratio. The same
holds good for musharaka as well.
Risk and Return…



Losses in a mudaraba are completely absorbed by
the financier-bank; The client-entrepreneur is liable
to bear losses, if such losses are the outcome of his
managerial negligence or misconduct.
In musharaka however, both the bank and the client
share in the losses in the ratio of their investment in
the project.
Mudaraba also provides for limited liability for the
financier in line with the modern equity contract; The
liability of the bank is limited to its investment in the
project.
Risk and Return…



This is quite rational and fair, since the bank does
not participate in the managerial decision-making
and cannot be held responsible for the risks created
by the entrepreneur-client.
Musharaka on the other hand, involves unlimited
liability of the partners, as both the bank and its
client are decision-makers in the business.
Therefore, if the liabilities of the business exceed it’s
assets and the business goes into liquidation, all the
exceeding liabilities shall be borne pro rata by the
partners.
Risk and Return…
The value of assets created under mudaraba,
the client-entrepreneur can neither benefit nor
lose because of such change; Such gains or
losses accrue solely to the financier-bank.
 In musharaka, however, such gains or losses in
the value of assets financed by the joint pool
of funds rightly accrue to both the bankfinancier and client-entrepreneur.

Liquidation




A feature of the classical mudaraba and musharaka
is that either of the parties to the agreement have an
option to terminate the agreement or withdraw from
the venture any time they deem fit.
Liquidity of investments is thus ensured for the
partners.
On the date of termination, profits are determined as
the excess of the liquidated value of all assets over
investment.
Once profit is so determined, is distributed between
the parties according to the agreed ratio.
Liquidation…



It is problematic for projects that require a certain
minimum time period before coming to fruition and
projects that are “going concerns”.
In such cases withdrawal of a partner from the
project may have material consequences for the
project.
However, at the same time, the partners need to be
provided with liquidity of their investments in the
project.
Liquidation…
Therefore, modern day scholars have devised
the concept of “constructive liquidation” which
may be practiced with the mutual consent of all
parties.
 The concept implies that the Net Asset Value
of the venture may be calculated at periodic
intervals by subtracting all liabilities from the
asset value.
 An investor or partner would now be allowed
to liquidate its investment at this value.

Combination of Mudaraba-Musharaka




Often a mudaraba may be combined with musharaka.
In such a facility the client-entrepreneur contributes to
the capital of the venture, as does the bank-financier.
Like any other mudaraba the client-entrepreneur is
solely responsible for the management of the business
and the bank is purely a sleeping partner.
The ratio of profit share for a pure financier (who does
not participate in the management and operations of
the business) is equal to or cannot exceed the ratio of its
contribution to capital of the venture.
Forward Commitment
A major issue in design of products based on
declining musharaka is related to the forward
nature of some activities that are part of the
mechanism.
 A financier would prefer a forward
“commitment” and certainty about the price at
which it could sale its share of investment, this
may not be permissible in the framework of
Islamic finance.

Forward Commitment




The common view is that Shariah does not permit
forward purchase or sale involving commitment
from both parties, but allows a unilateral promise.
As such, the client may make unilateral promise(s)
to purchase or redeem the bank’s share on specific
dates in future.
The promise should be independent of the
partnership contract.
Such promise(s) may also be binding on the
promisor.
Pricing of Redemption
Another related issue is the pricing or valuation
of financier shares/units.
 The general view is that the redemption should
be undertaken at the prevailing market price
of the property.
 The partner cannot purchase the assets of
partnership at face value.
 The purchase must be at market value or price
agreed upon at the time of sale.

Pricing of Redemption

The price of units (shares) of the financier
cannot be fixed in the promise to purchase,
because if the price is fixed before hand at
the time of entering into musharakah, it will
practically mean that the client has ensured the
principal invested by the financier with or
without profit, which is strictly prohibited in the
case of musharakah.
Pricing of Redemption



The best option is the financier to agrees to sell the
units on the basis of valuation of the business at the
time of the purchase/sale of each unit.
If the value of the business has increased, the price
will be higher and if it has decreased the price will
be less.
Such valuation may be carried out in accordance
with the recognized principles through the experts,
whose identity may be agreed upon between the
parties when the promise is signed.
Areas of Application
1. Project Finance:
 If the financier wants to finance the whole project,
the form of mudarabah can come into operation.
 If investment comes from both sides, the form of
musharakah can be adopted.
 If the management is the sole responsibility of one
party, while the investment comes from both, a
combination of musharakah and mudarabah can be
brought into play according to the rules already
discussed.
Areas of Application
1. Project Finance…
 Mudaraba facility is observed to be a useful mode for
financing projects, such as, real estate and housing
development, construction of public roads, ports,
markets, buildings, corporate plants, warehouses, and
other infrastructural concerns.
 Musharaka is suitable all the above projects; In fact, it
is suitable for financing any kind of business venture,
manufacturing, trading, and others where the bank is
willing to act as partner in the venture
 Since financial institutions do not normally want to
remain permanent partner of a specific project, they
can sell their share to other partners of the project at
an agreed price.
Areas of Application
2. Housing Finance:
 A survey of diminishing musharaka financing at
various Islamic banks reveals that it is used primarily
in the area of housing finance.
 The proposed arrangement is composed of the
following transactions:
 To create joint ownership in the property (Shirkatal-Milk).
 Giving the share of the financier to the client on
rent.
Areas of Application
2. Housing Finance…



Promise from the client to purchase the units of
share of the financier.
Actual purchase of the units at different stages.
Adjustment of the rental according to the
remaining share of the financier in the
property.
Areas of Application
3. Microfinance:
It is also observed to be potentially quite
promising in the field of microfinance or
financing of small and medium enterprises.
4. Letter of Credit:
 A useful application of musharaka financing is
the Islamic letter of credit.
 In this case, the ownership of the imported
goods shall remain with the financier to the
extent of the ratio of his investment.

Example: Musharaka-Based Letter of
Credit at Al-Amanah Philippines