In the contemporary world there is always a dilemma for the entrepreneur who has a promising idea for a new venture. How is he to raise the capital necessary to launch the venture? Borrowing the money is probably out of question. If the normal interest rate is 6% but the venture has a 10% chance of failing within a year, the lender will probably charge interest at a rate of 16%. High interest, plus amortization, will impose heavy fixed costs on the venture from the outset and this will increase the danger of failure, and in turn the interest rate. Moreover, if the venture’s prospects can not be predicted with reasonable confidence, it will be very difficult even to calculate an appropriate interest rate. The alternative must be for the entrepreneur to admit a partner to the business who is entitled to receive a portion of profits from the venture, if any, in exchange for contributing the necessary capital to it. The partner’s compensation is determined automatically by the fortunes of the business. There is no need to compute an interest rate and there are no fixed costs of debt, the partner will receive his profits only if and as earned.
However, Islam aims at establishing a social order where all individuals are united by bonds of brotherhood and affection like members of one single family. This brotherhood is universal and not parochial. It is not bound by any geographical boundaries and encompasses the whole of mankind and not anyone family group, tribe or race.
The purpose of this chapter is to thoroughly examine the framework for musharakah (equity participation) and other financial instruments of the Islamic banks. The chapter is divided into eight sections. The first will define musharakah and give its historical background while in the second the different types of musharakah will be identified. The third will deal with the conditions of present day musharakah and the fourth analyses equity financing and its channels of investment in an Islamic society. The fifth will identify the steps to be taken to transfer to an equity financing system and the sixth is concerned with the role of equity financing in mobilizing funds and stabilization of the system. The seventh section describes other financial instruments of Islamic banks. Additional subsections are included which examine ijara (leasing), murabaha (cost plus financing), qard al-hasanah (beneficence loans), bai muajjal (deferred payment sale), bai salam (purchase with deferred delivery) and tadamun (solidarity). Finally some conclusions are drawn.
The concept of brotherhood and equal treatment of all individuals in society and before the law is not meaningful unless accompanied by economic justice such that everyone gets his due for his contribution to society or to the social product and that there is no exploitation of one individual by another. The Prophet aptly warned: “Beware of injustice for injustice will be equivalent to darkness on the Day of judgement” . This warning against injustice and exploitation is designed to protect the rights of all individuals in a society (whether consumers or producers and distributors, and whether employers or employees) and to promote general welfare, the ultimate goal of Islam.
Of special significance here is the relationship between the employer and the employee which Islam places in a proper setting and specifies norms for the mutual treatment of both so as to establish justice between them. An employee is entitled to a “just” wage for his contribution to output and it is unlawful for the employer to exploit his employee.
4.1. Definition of Musharakah & Its Historical Background
Musharakah or shirkah can be defined as a form of partnership where two or more persons combine either their capital or labour together, to share the profits, enjoying similar rights and liabilities.
From the very inception of human society, the methods to meet day to day needs have been changing with the change of social, economic, scientific, cultural and political circumstances, especially habits, fashions and the standard of living. These methods regulate the commercial activities and vary from place to place and time to time. The Arab society at the time of the rise of Islam had very simple financing methods and forms of business peculiar to that society.
The advent of the Holy Prophet saw the practice of musharakah already prevailing over the commercial activities in Arabia. He not only ratified it, but also himself did business on the basis of musharakah.1
After Hijra, the muhajireen and the ansar were declared by the Prophet to be brothers. Subsequently they joined as partners, in the form of musharakah, muzara and musaqat, in their trade and commerce. The nature of the transaction, in the different forms, is identical. The different nomenclature in arabic refers to diverse activities such as muzara in agriculture, musaqat in gardening and musharakah in trade. The musharakah of capital and labour is called mudarabah. These four forms were so developed that they became independent institutions and the jurists formed detailed rules about them. There is a consensus of opinion among the jurists of all schools- of thought (including Hanfia, Maleki, Shafei, Hanbali and Shia) that musharakah is a valid and legitimate contract in Islam. The jurists, however. differ over its form. conditions and other details.
4.2. Types of Musharakah
Originally musharakah or shirkah (Partnership) was of two types. namely,
(a) Shirkah al-milk (non-contractual partnership)
(b) Shirkah al-uqood (contractual partnership)
Shirkah al-milk (non-contractual) implies co-ownership and comes into existence when two or more persons happen to get joint-ownership of some asset without having entered into a formal partnership agreement; for example, two persons receiving an inheritance or a gift of land or property which mayor may not be divisible. The partners have to share the gift. or inherited property or its income, in accordance with their share in it until they decide to divide it. If the property is divisible and the partners still decide to stick together, the shirkah al-milk is termed ikhtiyariyyah (voluntary). However, if it is indivisible and they are constrained to stay together, the shirkah al-milk is characterised as jabriyyah (involuntary).
Shirkah al-uqood (contractual partnership) can, however, be considered a proper partnership because the parties concerned have willingly entered into a contractual agreement for joint investment and the sharing of profits and risks. The agreement need not necessarily be formal and written, it could be informal and oral. Just as in mudarabah, the profits can be shared in any equitably agreed proportion. Losses must, however, be shared in proportion to the capital contribution.
Shirkah al-uqood has been divided in the fiqh books into four kinds: al-mufawadah (full authority and obligation); al-inan (restricted authority and obligation); al-abdan (labour, skill and management); and al-wujuh (goodwill, credit-worthiness and contracts).
In the case of mufawadah the partners are adults, equal in their capital contribution, their ability to undertake responsibility and their share of profits and losses. They have full authority to act on behalf of the others and are jointly and severally responsible for the liabilities of their partnership business, provided that such liabilities have been incurred in the ordinary course of business. Thus each partner can act as an agent (wakil) for the partnership business and stand as surety or guarantor (kafil) for the other partners.
Inan on the other hand implies that all partners need not be adults or have an equal share in the capital. They are not equally responsible for the management of the business. Accordingly their share in profits may be unequal, but this must be clearly specified in the partnership contract Their share in losses would of course be in accordance with their capital contributions. Thus in shirkah al-inan the partners act as agents but not as sureties for their colleagues.
Shirkah al-abdan is where the partt1ers contribute their skills and efforts to the management of the business without contributing to the capital.
In shirkah al-wujuh the partners use their goodwill, their credit-worthiness and their contacts for promoting their business without contributing to the capital.2 Both these forms for partt1ership, where the partners do not contribute any capital, would remain confined essentially to small-scale businesses only.
These are of course models. In practice, however, the partt1ers may contribute not only finance but also labour, management and skills, and credit and goodwill, although not necessarily equally.
4.3. Types of Modern Musharakah and its Conditions
The modern business concerns being run on the basis of musharakah (as defined above) are as under:
1. Partnership: It is regulated by-
(a) Partnership rules framed by the government,
(b) Business practices prevailing in the business community.
2. Limited company. This type of musharakah is strictly controlled by the statutory rules framed by the government Its commercial activities are, however, influenced by the business practices (urf).
3. Co-operative societies. This musharakah is also governed by statutory rules. Its commercial activities are influenced by the practices prevailing in the business community.
The above modern musharakah principally resembles shirkah al-inan. The details are, however, considerably different due to change of urf and other factors including modem commercial techniques, economic conditions and legal requirements. Let us discuss briefly the conditions of musharakah, which are those of shirkah al-inan. Other types of musharakah mentioned by jurists are nearly obsolete nowadays.
Capital to be invested by the partners may be unequal. For the majority of the jurists the capital should be in the shape of currency and not in the shape of goods. The condition for capital to be in the form of currency only was imposed when it was difficult to refer to the goods in terms of currency. This was true in the days of barter systems when the jurists framed the rules, but now goods are generally referred or accounted for in terms of currency. This condition should, therefore, be waived. In limited companies and co-operative societies the capital is invested in the form of equal units of currency called shares and the intended partners buy as many shares as they wish. This practice has universally been accepted as urf and is therefore according to Islamic principles.
Musharakah is run and managed by the will and equal rights of participation of all the partners. Different aspects of musharakah business are as follows :
1. Every partner is an agent for the other, as all the partners benefit from the musharakah business. When a contract of musharakah is made the condition of agency is automatically presumed to be in existence in the contract. The actual possession of a partner over a property of the musharakah business is considered as possession of other partners in as much as if a partner purchases half portion of a specific good for himself and half portion thereof for the musharakah. When he takes possession of that specific good, this possession will be considered as possession of all the partners. If, however, a partner purchases some goods for himself only, it is exclusively for him and not for the musharakah business.
2. Every partner enjoys equal rights in all respects in the absence of any condition to the contrary.
3. Any condition regarding participation in and administration of the musharakah and variation in the share of profit on this ground is valid. The contract of musharakah is not invalid on grounds of a condition of non-participation in the musharakah business, but on the ground that a share in the profit exists.
4. Every partner has a right to participate actively in the affairs of musharakah if he wishes.
In all modern forms of musharakah, the partners have equal rights as mentioned above. In the limited companies and cooperative societies the shareholders delegate their powers (rights in respect of administration etc.) to some among them to be called directors or given any other appropriate title. In a partnership concern the partners, by a mutual agreement, distribute among themselves their responsibilities, duties and jobs, As mentioned above these practices are valid being urf of business community.
4.3.2. Distribution of Profit
The basis for entitlement to the profits of a musharakah are capital, active participation in the musharakah business and responsibility. Profits are to be distributed among the partners in business on the basis of proportions settled by them in advance. The share of every party in profit must be determined as a proportion or percentage. No fixed amount can be settled for any party.3
Limited companies and co-operative societies distribute their profit according to the capital of share-holders. If any share-holder participates actively in these modem musharakah he is paid for it and such payments are regarded as the expenditure of musharakah. This is modem urf and there is nothing un-Islamic in this urf.
4.3.3. Liability of Loss
All the jurist are, unanimously, of the view that the loss shall be borne by the partners according to their capitals. In all forms of musharakah (i.e.limited companies, co-operative societies and partnership) the loss is borne on the basis of capital invested.
There can be little doubt. after the citations above, of the unanimity of the principle. The jurists have categorically laid down that a party which has no capital invested in an enterprise, does not have to share its loss. From the explanation of the jurists, it is clear that it is not possible, after investment of capital, to avoid the risk of loss in the enterprise. This is a direct consequence of the prohibition of interest in Islam and is of fundamental importance for our analysis. The jurists point out that this is because of the fact that loss means destruction of a part of the capital and hence, as it occurs, is a liability of the owner of capital alone.
However, according to modem commercial practices the loss does not cut down the respective capitals of the partners or share-holders, but remains as it is in the accounts books of the musharakah in order to be adjusted against the future profits. It is pertinent to note that while adjusting the loss against future profits the accounting procedure automatically works in a manner so as to bear on the capitals subsequently.
4.3.4. Withdrawal of Members
In the early days of Islam the musharakah were generally formed on a short term basis, mostly of a joint venture type. It was, therefore, quite easy for a partner to withdraw from a musharakah. The withdrawal did not create many problems such as the taxation of capital expenditure, the continuous nature of business activities and goodwill. This is why the old jurists did not feel any need to impose restrictions on the withdrawal of a partner, but in the present complicated commercial practices, legal requirements and public control entangle a musharakah for a considerable period so deeply and firmly that no partner or shareholder can be absolved of his liability as such. So according to a modem urf the shareholder of a limited company cannot withdraw from it and receive back his capital invested therein. He can, however, sell his share to any person desirous of becoming a shareholder of that company. In a partnership business a partner can be permitted to withdraw and receive his capital back after fulfilling his liabilities as a partner according to terms and conditions settled between the partners.
4.35. Limited Liability
A distinguishing feature of modern musharakah (except the partnership) is the limited liability of their shareholders. They Cannot be held liable for more than the amount of capital they have invested. This requirement makes it necessary to regard the musharakah as an entity separate from the individuality of the shareholders. This common urf has given way to safe and stable musharakah resulting in big commercial organizations and flourishing business. 4
To sum up this section, the shirkah al-lnan, which implies unequal shares and is recognised by all schools, may tend to be the most popular. In this case, the profits are divided in accordance with a contractually agreed proportion, since the shariah admits an entitlement to profit arising from a partner’s contribution to any of the business assets. However, the shariah makes it clear that losses are to be shared in proportion to the contribution made to capital. This is because losses, constitute an erosion in equity and must be charged to the capital. If a loss has been incurred in one period, it must be offset against profits in the subsequent periods until the entire loss has been written off and the capital sum restored to its original level. However, until the total loss has been written off, any distribution of “profit” will be considered as an advance to the partners. Accordingly, it would be desirable to build reserves from profits to offset any losses that may be incurred in the future.
The real world situation may be a combination of mudarabah and musharakah where all partners contribute to the capital but not to the entrepreneurship and management. It this case profits need not be shared in accordance with capital contributions. They may be shared in any proportion agreed to by the partners, depending on their contribution to the success and profitability of the business.
4.4. Equity Financing
Equity financing in an Islamic economy may have to be for either an indefinite period, as it is in the case of the stock of the joint stock companies or shares in partnerships, or a definite (short, medium or long) period as it is in the case of borrowed capital (loans, advances, bonds and debentures). Since borrowed capital would also be on the basis of profit-and-loss sharing and could not be interest-based, it would be in the nature of temporary equity financing and would mature on the expiry of the specified period. Such financing would hence not carry the same connotation as it does in the capitalist economies. It would, like equity capital but unlike qard al-hasanah, not enjoy any lien on the assets of the firm.
The inability to secure a lien on the assets of the business financed, possible in the case of interest-based lending, would make the financiers more careful in evaluating the prospects of the business and cautious in providing finance. Moreover, it would be difficult to find medium or long term financing in an Islamic economy without sharing the ownership and control of the business. Expansion of the business would hence be closely related to the distribution of ownership and control. Similarly it would not be possible for anyone to earn an income on savings without being willing to share in the risks of business. Thus ownership, fruits and risks of business would become more widely distributed in an Islamic economy than is possible under capitalism.
There are three types of borrowers who are looking for funds to satisfy their financing needs. These are (i) private sector investors looking for funds to finance their expanding business; (ii) private sector borrowers seeking funds to finance tl1eir consumption needs; and (iii) governments seeking funds to finance their budgetary deficits. Can the needs of all three categories of borrowers be satisfied within the framework of equity financing? It is only the subject of private sector equity finance which is discussed in this section. Whether or not, and to what extent, equity financing can be used to meet the needs of consumers and government are issues which were discussed in Chapter Two of this book.
4.4:1. Channels of Equity in an Islamic Society
Islamic banking is equity-oriented and the Islamic instruments of financing would ideally be based on profit and loss sharing. This would bring a fundamental change in the role of Islamic banks and would convert them from creditors to partners.5
The channels that equity investment may take in an Islamic society are the same as elsewhere, namely, sole proprietorship, partnership (including both mudarabah and musharakah) and joint stock companies. Cooperation can also play an important role in an Islamic economy because of its harmony with the value system of Islam and the valuable contribution it can make to the realisation of its goals.
(i) Sole Proprietorship
Generally speaking, the entrepreneur depends essentially in this case on his own finance and management He may be able to supplement his financial resources by supplier’s credits which played an important role in Muslim society in the past and tends to be a major source of short-term capital.
If the sole proprietor needs substantial extra resources on a temporary basis for a specific consignment or profitable opportunities, he may raise the necessary finance from individuals or firms or financial institutions on a profit-and-loss sharing basis, in which case his sole proprietorship will merge into the mudarabah form of organisation. If his need for funds is of a permanent nature, he may consider the entry into his business of other partners and take advantage of the mudarabah or musharakah forms of partnership, depending on whether he needs merely finance or managerial ability as well to complement his own business talent.
What this implies is that an enterprising businessman in an Islamic society need not be constrained in his ambitions by his own finance. He can still expand his business by securing funds on a profit-and-loss-sharing basis. This should actually be better for him as well as the financier in term of justice; the entrepreneur does not have to pay a predetermined rate of return irrespective of the outcome of his business and the financier does not get a low return even when the business is paying high dividends. Since the ultimate outcome of business is uncertain, one or other of the two parties, entrepreneur or financier, suffers from injustice is an interest-based arrangement and Islam wishes to eliminate injustice.
To sum up the sole proprietorship form of business organisation, along with mudarabah financing, needs to be encouraged as it will help achieve the goals of Islam. It provides self-employment, and enables the entrepreneur to stay in his own town or village, thus helping reduce concentration of population in a few large urban centres.
It is the relationship which exists between two or more persons carrying on a business in common with a view to profit.
The definition provides us with three requirements for a partnership in that there must be a business, that it must be trading (carrying on), and that it must have the capability of making a profit.
Where, at the beginning of a business, one partner provides, say £5,000 in, cash and the other provides the professional skill and expertise to make the venture work it will be a matter for them to decide how the rewards of the business are to be shared out.6 In the absence of any agreement no interest will be paid on capital, profits will be divided equally and, in the event of a dissolution, the second partner will be required to bear an equal share of any loss of capital, although he will not be entitled to share in the increase in value of capital unless it has been turned into partnership property.
The distinctive features of the partnership is the right of each of the partners to participate in running the firm and it is this right which gives rise to a number of obligations which partners have towards each other. If it is accepted that each partner participates then it is obviously important that there is a sound relationship between them.
Partnership in an Islamic society may take one of two juristic forms, mudarabah or musharakah. The Islamic jurists have proposed other forms of partnership to provide credit and finance for Agricultural, manufacturing and trading purposes. These are:
(1) Consecutive Partnership
This instrument of financing is a real innovation on the part of the Islamic banks. The formula is used as a basis for the distribution of profits among depositors, who, in Islamic banks, hold a middle place between shareholders of equity on the one hand and depositors and or lenders on the other. Consecutive partnership formula, practised by all Islamic banks, considers depositors of one financial year as partners in the proceeds of that financial year, regardless of matching between the periods of projects in which their funds were used. Indeed, even some proceeds pending from previous years, for which accruals or provisions were made, are included in the proceeds of the year in question. On the other hand, some yields corresponding to the said financial year are excluded, if they are not yet due, and left to a future year.
Such an accounting system was necessary to reconcile the depositors’ need to withdraw funds, regardless of the liquidation of investment in which their funds are used, with the continuity of the bank’s investments which constantly flow in a mixed basket, and the need to make regular accounts every financial year, as an accounting unit for this basket.
(2) Agricultural Partnerships
Privately owned agricultural land could be exploited in one of the three ways: (a) directly by the owner, (b) indirectly by renting it (ijara), (c) through agricultural partnership.
The two main frameworks in traditional Islamic law for agricultural enterprise are (a) muzara’ a (share cropping) and musaqat (water partnership or tree-sharing). Both these techniques typically afford a partnership between capital and labour.
Muzara’ a (sharecropping or crop partnership) is a contract whereby the landlord puts his agricultural land at the farmer’s disposal to farm and the farmer undertakes to give the owner an amount of the agricultural products. This framework is, of course, based on the generally accepted view that there should be a partnership between capital and labour.
A contract is termed musaqat (water partnership or tree-sharing) when one person strikes a deal with another person calling for the latter to trim and water those fruit trees whose fruits are either one’s own, or are at his disposal, in exchange for an amount of the fruits, as agreed upon. If a contract of musaqat or treesharing related to fruitless trees, like willows and sycophants, it is not valid. However, it would be valid in such trees as henna whose leaves are used or in those trees whose flowers are used. 7
(iii) A combination of sole proprietorship and partnership
In practice, business organisations would reflect a combination of sole proprietorship and mudarabah or a combination of musharakah and mudarabah. Not all savers can, or are interested in participating in the management of a business and may be just looking for opportunities to invest their surplus funds for short, medium or long-term periods. They could in this case make financing available to on-going businesses and share in the profits and losses in accordance with agreed ratios.
(iv) Joint stock companies
These constitute along with financial institutions the most convenient form of investment available to a majority of savers, who have neither their own businesses to invest in nor the ability to evaluate running business or become sleeping partners. Corporate shares would be more attractive to them because of, the relative ease with which they can acquire them when they wish to invest, or to sell them when they need the liquidity. In the light of Islamic teachings it will however be necessary to reform joint stock companies to safeguard the interests of share holders and consumers, and also to reform stock exchanges to ensure that share prices reflect more or less the underlying economic conditions and do not fluctuate erratically in response to speculative forces.
In addition to the above forms of business organisation, which are all profit-oriented, “cooperation”, which is service- oriented, could make a rich contribution to the realisation of the goals of an Islamic economy. With the emphasis of Islam on brotherhood, “cooperation” in its various forms to solve the mutual problems of producers, businesses, consumers, savers, and investors should receive considerable emphasis in a Muslim society.
Cooperative societies could render a number of valuable services to members, including temporary financial accommodation when necessary through a mutual fund, the economies of bulk purchases and sales, maintenance facilities, advisory services, assistance or training for solving management and technical problems, and mutual insurance. Cooperation is a mutually beneficial relationship for all concerned, and everyone’s participation is completely voluntary.8
Informal cooperation between craftsmen and businesses is quite widespread in Muslim history. In all these forms of informal cooperation, businesses rendered services to each other without receiving any profit, commission or remuneration. These different forms reflected not only Islamic brotherhood and mutual trust but also fulfilled the common needs of businessmen on a mutually cooperative basis.
Historical experience has shown that during the jahiliyah (pre-Islarnic) period, trade (over many territories) stretched over long distances and all financial resources were mobilised on the basis of either interest or mudarabah and musharakah. Islam, however, abolished the interest basis and organised the entire production and trade on the basis of mudarabah and musharakah. With the abolition of interest, economic activity in the Muslim world did not suffer any decline. In fact there was increased prosperity.
A combination of several economic and political factors, including the ability to mobilise adequate financial resources, were responsible for this prosperity. All these factors together provided a great boost to trade which flourished from Morocco and Spain in the west, to India and China in the east, Central Asia in the north, and Africa in the south. Therefore, the economic prosperity in the Muslim world had made possible a development of industrial skill which brought the artistic value of the products to an unequalled height.
Mudarabah and musharakah were the basic methods, by which financial resources were mobilised and combined with entrepreneurial and managerial skills for purposes of expanding long-distance trade and supporting crafts and manufacture. They fulfilled the needs of commerce and industry and enabled them to thrive to the optimum level given the prevailing technological environment.
4.5. Steps to be Taken to Transform to an Equity Financing System
It was mentioned earlier that to abolish interest implies that all businesses in Muslim countries, including industry and agriculture, currently operating on the basis of a mix of equity and interest-based loans, would have to become primarily equity-based.
This requires that all financial needs of a permanent nature, whether for fixed or working capital, should normally be expected to come out of equity capital in an Islamic economy. This broader equity-capital base may be supported to the extent necessary by medium-and long-term mudarabah advances. Short-term loan financing, even though in a profit-and-loss sharing framework, may be resorted to only for bridge-financing or temporary shortage of liquidity resulting from seasonal peaks in business for which purpose it may not be desirable or feasible to have a permanent increase in equity.
A number of steps would need to be taken to bring about the transformation to an equity-based financing system in the gradual Islamisation of the economy of Muslim countries.
Firstly, projects should be selected for funding through partnerships primarily on the basis of their expected profitability rather than the creditworthiness or solvency of the borrower.9 This factor, together with the predominance of equity markets and the absence of debt markets, has led Muslim scholars to conclude that, potentially, in an.lslamic system, there would be : (a) a greater number and variety of investment projects that would be seeking financing; (b) a more cautious, selective, and perhaps more efficient project selection by the savers and investors; and (c) a greater involvement by the public in investment and entrepreneurial activities, particularly as private equity markets develop.
Secondly, to enable firms to increase their equity it may be necessary to “regularise” the existing stock of “black” money (arising from tax evasion), the major outlet for which currently is mainly capital outflows or conspicuous consumption. This move should help draw a substantial volume of such funds into the fold of investment Without this move it may be difficult to increase equity because there may not be a sufficient volume of “white” money in the economy for this purpose. In the next chapter we will be discussing this issue in the context of the middle east stock markets.
Thirdly, tax laws should be revised to treat interest payments in the same way as dividends and profits are now being treated, and taxes should be levied on gross profits before interest payments. In fact, it would be desirable to impose a higher rate of tax on the interest portion of the gross income than that applied to profits to accelerate the transformation to an ‘equity-based financing structure.
Fourthly, the tax structure of Muslim countries should be streamlined to ensure that it does not discourage investment and channel even legally earned profits into “black” money. While Islam does allow the levying of taxes to a reasonable extent to meet all necessary and desirable state expenditures, it does not permit an unjust tax structure which penalises honesty and creates the un-Islamic tendency of evading taxes.
Finally, the formation of appropriate financial institutions and investment banks should be encourged to make venture capital available to businesses and industries and thus enable them to undertake necessary investments. In the process they would also provide investment opportunities to savers who are either unable to find lucrative opportunities, for direct investment, or are unable to locate partners or mudaribs for profitable investment of their savings.
4.6. The Role of Equity Financing in Mobilising Funds and Stabilization of the System
Given Islam’s emphasis on equity financing, there should re a greater urge to save for investment in one’s own business. If there are profitable opportunities for investment which cannot re exploited by reliance merely on internal cash flows, access could be had for premises, equipment and supplies through leasing, murabaha or bai muajjal, and supplier’s credits. Businesses desiring further expansion could also mobilise resources on the basis of profit, mudarabah or musharakah. Market forces will take care of those who act in a self-defeating manner. Nevertheless, a state-regulated proper auditing system can be instituted to safeguard the interest of investors.
Joint stock companies should also play an important role in an Islamic economy. Their shares would re available to investors who are not active or do not wish to make their funds available to sole proprietors or partnerships. Corporate equities constitute a substantial proportion of total capital formation in capitalist societies.
In an Islamic economy, it is always possible for an individual investor to diversify and reduce his risk by making fM1ancial institutions and investment trusts a vehicle for his investment because such institutions diversify their own risk by properly regulating their exposure to different sectors of the economy as do individuals and firms. It must be clearly understood that the return on equity in an Islamic economy will not re equal to just “profit” but will rather re the sum of what constitutes “interest plus profit” in the capitalist economy and is called “return on capital”. It will include the reward for saving and risk-taking, on the one hand, and entrepreneurship, management and innovation, on the other.
Hence the Islamic system should be able to ensure justice between the entrepreneur and the financier. No one would be assured of a predetermined rate of return. One must participate in the risk and share in the outcome of business. This may not necessarily change the total outcome. It would no doubt change the distribution of the total outcome in accordance with the Islamic norm of socio-economic justice. It would also eliminate the erratic and irrational fluctuation between the shares of the savers or financiers and the entrepreneurs. Hence situations where the savers suffer (if interest is low and profit is high) or the entrepreneurs suffer (if interest is high and profit is low or negative) would be eliminated and justice established between the two. The impact of this should be healthy on both savers and entrepreneurs.
When it comes to the question of stability, it must be realized that the stability of any economic system may be evaluated either empirically or analytically. Empirically, the simulation of an econometric model of a given economy has been successfully tried to evaluate stability. The results of such investigations, however, lack the generality of analytical results. 10 Furthermore, this approach cannot be employed in the present case since a full-fledged Islamic economic system does not as yet exist.
Analytical methods of examining stability have also been developed by economists and have provided important general results. Such methods have not yet been applied to study an Islamic economy and have in any case their own limitations. More importantly, stability is quite responsive to government action and regulations, hence a definitive analysis requires the specification of several institutional details.
All things considered, there appears to be room for offering some remarks on the stability of an equity-based Islamic economy. The profit in the equity-based system will be dependent on the profit-sharing ratio and the ultimate outcome of the business. The share of the entrepreneur or financier cannot fluctuate violently from month to month. Moreover the distribution of the total return on capital (profit plus interest) between the entrepreneur and the financier would be determined more equitably by economic considerations and not by speculative financial market forces. In case of dividends it can however, be reduced in bad times and, in extreme situations, even passed. So the burden of finance by shares is less. There is no doubt that in good times an increased dividend would be expected, but it is precisely in such times that the burden of higher dividend can be borne. This factor should tend to have the effect of substantially reducing business failures, and in turn dampening, rather than accentuating, economic instability. Minsky argues that when each firm finances its own cash flow and plans to invest its own retained profits, there is no problem of effective demand, the financial system is robust and investment has great inertia. When firms can raise outside finance direct from rentiers or through the banks, they are liable to instability. Schemes of investment are planned that are viable only if the overall rate of investment continues to rise. A fragile debt structure is built up. When the acceleration in the rate of investment tapers off, some businesses find current receipts less than current obligations, and a financial collapse occurs.11 During a boom, equity holders experience capital gains and increase the ratio of expenditure to income; when the boom breaks, thriftiness increases. Thus, long-run average growth may occur in cycles.
Interest rate volatility has defeated all efforts to restore stability to exchange rates. In a fixed parity system it is impossible to keep the exchange rates pegged because of the movement of “hot” money to take advantage of interest rate differentials. The effort to keep the exchange rate pegged leads to a significant loss of central bank reserves and impairs confidence in the strength of the currency. In a floating exchange rate system, where the rate tries to find its own equilibrium level and fluctuate excessively from day to day in response to international interest rate movements bearing no relationship to underlying economic conditions, it becomes difficult to predict exchange rates. This renders long-term planning almost impossible. A country facing a recession is unable to keep its interest rates low because such a policy leads to an outflow of funds, depreciates the exchange rate of its currency, and raises the cost of living. 12 To prevent an even deeper plunge in the value of its currency, the recession-ridden country is forced to maintain interest rates at a higher level than dictated by the need for recovery. This, in turn, slows down the recovery and undermines confidence in the government.
The elimination of interest and its replacement by profit-loss-sharing would not only change the level of uncertainty but also redistribute the consequences of uncertainty over all parties to a business. It would moreover, by removing the daily destabilising influence of fluctuating interest rates, bring about a commitment of funds for a longer period and also introduce a discipline in investment decisions. In such an environment the strength or weakness of a currency would tend to depend on the underlying strength of the economy, particularly the rate of inflation, and exchange rates. Accompanied by the Islamic emphasis on internal stability in the value of money, exchange rates should prove to be more stable because all other factors influencing exchange rates, such as cyclical developments, structural imbalances and differences in growth rates, are of a long-run nature and influence expectations about long-term trends in exchange rates.
Moreover, in the Islamic system, there will also be a greater interdependence and a closer relationship between investment and deposit yields because banks can primarily accept investment deposits on the basis of profit-sharing and can provide funds to the-enterprises on the same basis. Due to the fact that the return to liabilities will be a direct function of the return to asset portfolios and also because assets are created in response to investment opportunities in the real sector, the return to financing is removed from the cost side and relegated to the profit side, thereby allowing the rate of return to financing to be determined by productivity in the real sector. It will be the real sector that determines the rate of return to the financial sector in the Islamic financial system rather than the other way around. For these reasons, Islamic banking tends to reduce the vulnerability of the capital importing country to fluctuations in the level of capital inflows and to a sharp slowdown of new investment due to uncertainty among investors.
In the Islamic system, no such instability exists when a bank, rather than issuing fixed liabilities, issues shares to its depositors. In this case assets acquired by the banks are transparent to investors, they are no more or less than the deposits supporting them. If there is a decline in the value of the bank’s assets then it will not be to the advantage of depositors to withdraw their money because their share would consequently decline. Also the welfare of a depositor does not depend on the actions of other depositors because each gets a share in the bank’s value which is independent of whether some withdraw their shares while others do not. In fact there is a greater incentive to remain in the bank when it suffers a decline in the value of its assets because otherwise it will mean acceptance of a loss on initial deposit. whereas retaining shares in the bank will give hope” for a revaluation of the bank’s assets in the future.13 Perhaps the greatest advantage of such a system is that it not only resolves the bank’s problem of panic among its clients but it also does not require the provision of deposit insurance and other government interventions surrounding banking institutions.
4.7. Other Financial Instruments of Islamic Financing
The Islamic banks are engaged in developing various instruments of financing which not only conform to the Islamic tenets of equity and fairness but will also stand the test of day to day business, corporate needs of the modern world and the sophisticated tools of scientific analysis. The Islamic banks have identified and developed a relatively broad range of business and banking contracts. These include:
4.7.1. Ijara (Leasing) Definition and its Advantages
Ijara means a lease contract as well as a hire contract. In the context of Islamic banking it is a lease contract under which the bank of financial institution leases equipment or a building to one of its clients against a fixed charge.
The primary advantage of ijara over the conventional forms of borrowing to finance equipment is that the ownership of the asset remains with the lessor. The financing is largely unrelated to the size of assets and the capital base of the lessee and depends principally on the ability of his cash flow to service payments of lease rentals.
Ijara is probably the most suitable means to raise investment funds especially for industries where rapid technological innovation is either underway or desired and for top class firms which are quickly expanding their business or small and medium enterprises and firms which have normally insufficient assets and capital base to meet normal collateral requirements of most other forms of long term financing. The basic security under the ijara arrangement is the “ownership of the equipment”. The title of ownership to the equipment remains with the leasing company and in case of serious default the equipment is repossessed.
18.104.22.168-. The Modern Concept of Ijara
Leasing is the modem technique that can be compared with the Islamic technique of ijara. Leasing is based on the same fundamental concept of ijara according to which one does not have to own an asset in order to enjoy the benefits of it. It is now being applied on a large scale to business activity. There are obvious examples of businesses which have benefited from their investment in fixed assets over the years. Some businesses have made substantial capital profits from the sale of assets or have been able to improve the look of their balance sheets by the revaluation of assets. In the main, the profitability of a business lies in the use to which the resources are put It is the use, not necessarily the ownership, which matters. Once a business decision for example the investment appraisal, has been made on some new venture, the choice of purchasing or leasing is partly a matter of arithmetic, partly a question of the availability of capital.
A comparsion between leasing and other similar forms of transactions, such as rental, will give a clearer picture. “Rent” as is shown by the rent a car business, is a contract according to which the objects are leased to individuals or a number of users for a much shorter period than their actual usefullife.14
In contract law, the “rental contract” specifies the lease and usage for an indefinite period. A typical example is IBM’s computer sales system. This system was initiated by the company which has an over-whelming world market share to promote sales in an attempt to outstrip its competitors, in the belief that it could control the progress of technological innovation of computers. While the users of the equipment leased on a rental system are major enterprises and their usage is continuous, the rented equipment is usually used in a transient manner, whether the case is “rental” or “rent” the lessor is charged with the responsibility for maintenance. Especially, in the case of “rental” the lessor is also charged with the responsibility for coping with the products obsolescence, so that it may be termed a service-oriented business.
22.214.171.124. Economic Role of ljara
Lease financing because of its special features can supplement the existing conventional forms of financing and further accelerate investment in the private sector.
There is a large requirement of balancing and modernization of the existing industry. As a supplementary source of term credit, lease financing through balancing and modernization of the existing industry, will improve capacity utilization, quality, production cost, profitability, internal generation of cash for future investment and international competitive capability to increase exports.
Lease financing is most suited to the programmes of balancing, modernization and replacement. It would involve a small dosage of investment which would carry relatively smaller investment risk but would result in a quick value added production. It would increase capacity utilization and thus contribute to the growth of the economy.
4.7.2. Murabaha (Cost Plus Financing)
Murabaha is generally defined as the sale of a commodity for the price at which the vendor has purchased it, with the addition of a stated profit known to both the vendor and the purchaser. It is a cost-plus-profit contract Islamic financial institutions aim to make use of murabaha in circumstances where they will purchase raw materials, goods or equipment etc. and sell them to a client at cost, plus a negotiated profit margin to be paid normally by installments. With murabaha, Islamic financial institutions are no longer to share profits or losses, but instead assume the capacity of a classic financial intermediary.
The legality of murabaha is not questioned by any of the schools of law. There are of course differences in the details. However, the use of murabaha as a credit vehicle by the Islamic financial institutions has been regarded with apprehension by some Muslim economists, for example M. Siddiqi, who contended that the simple fact that murabaha enables a buyer to finance his purchase with deferred payments, as against accepting a mark-up on the market prices of the commodity, means that the financier, in this case the Islamic bank, earns a predetermined profit Without bearing any risk.15
This form of contract is widely used for import finance. So the bank sells a commodity to the client for a predetermined amount or rate of profit over and above the total costs. Usually, goods or commodities are provided to the order of the client according to definite specification, but, following the rules of the Shariah Supervisory Board (SSB) (which is established in each bank under the bank’s articles of association in order to make sure that each bank’s transactions confirm to Islamic shariah), the client is not obliged to accept the goods or commodities, even if they are provided according to the given specification.
4.7.3. Beneficence Loans (Qard al-Hasanah)
Qard al-hasanah means an interest-free loan, which is the only loan permitted by shariah principles. Funds are advanced without any profit or charge for humanitarian and welfare purposes. Repayments are made over a period agreed by both parties. A levy of a modest service charge on such a loan is permissible provided it is based on the actual cost of administering the loan.
One may wonder how lending could be a business proposition once interest is “abolished. It seems that the Islamic financial institutions are advised to make use of qard al-hasanah in the following circumstances:
(a) In the case of musharakah between the institution and the client, it often happens that not all of the institution’s shares in the project can be earmarked for the right to participate in profits; otherwise no substantial share would be left to the other partner, namely the client. Therefore the institution’s participation is split into two parts: one constitutes a share in the partnership capital and the other a share in the working capital provided through qard al-hasanah.
(b) A qard al-hasanah can also be provided to a client of the institution who has cash-flow problems, either in order to protect the institution’s investment, or, when the cliQ1t is reliable, to boost the institution’s image and reputation at no great risk.
(c) A third use of qard al-hasanah may occur when a client who has with the financial institution a blocked savings account which generates no interest, encounters an urgent need for short-term finance, making recourse to the mudarabah concept useless. The necessary funds can be provided to him by the institution through qard al-hasanah. There are probably other circumstances where qard al-hasanah has its value for the lender; these circumstances will gradually develop with the day to day business of the Islamic financial institutions.
4.7.4. Deferred Payment Sale (Bai Muajjal)
This transaction allows the sale of a product on the basis of deferred payment in installments or in a lump-surn payment. The price of the product is agreed to between the buyer and the seller at the time of the sale and cannot include any charges for deferring payments.
4.7.5. Purchase with Deferred Delivery (Bai Salam)
In this transaction the buyer pays the seller the full negotiated price of a specific product which the seller promises to deliver at a specified future date. This transaction is limited to products whose quality and quantity can be fully specified at the time the contract is made.
4.7.6. Tadamun or Takaful (Solidarity)
Takaful literally means “mutual guarantee”. In the context it is the Islamic answer to the modem concept of insurance, which is one of the most important subjects among scholars. This type of contract represents Islamic insurance based on a collective sharing of risk by a group of individuals whose payments are akin to premiums invested by the Islamic banking institution in a mudarabah for the benefit of the group. After a certain period, the group may expect to stop making further payments while remaining insured. The purpose of this solidarity mudarabah may be life assurance and it may also be risk insurance covering a property. If the assured person dies before the end of his covered time, or an insured risk on the property materializes, then payment is made out of the account of the insured person; if there is not enough money in that account, the outstanding balance is covered by the money of the other participants inside the same pool. This is what is meant here by solidarity; the participants in a solidarity mudarabah share the consequences of a mishap. In other words, the participants in a given solidarity mudarabah have the right to share the surplus profits generated by such a mudarabah but at the same time they are liable for contributing to amounts in addition to the premiums they have already disbursed, if their initial premiums paid in during a particular year are not sufficient to meet all the losses and risks incurred during that year.
In this chapter and the preceding one, we have argued that mudarabah and musharakah are the basic methods by which financial resources are mobilised and combined with entrepreneurial and managerial skills for purposes of expanding long-distance trade and supporting crafts and manufacture. They fulfill the needs of commerce and industry and enable them .to thrive to the optimum level given the prevailing resource environment. These financial instruments along with others mentioned in this chapter constitute an important feature of both trade and industry and provide a framework for investment in a modern Islamic economy.
To sum up, an Islamic banking system is essentially an equity-based system in which depositors are treated as if they were shareholders of the bank. Consequently, depositors are not guaranteed the nominal value, or a predetermined rate of return, on their deposits. If the bank makes profits then the shareholder (depositor) would be entitled to receive a certain proportion of these profits. On the other hand, if the bank incurs losses the depositor is expected to share in these as well, and receive a negative rate of return. Thus, from the depositor’s perspective an Islamic commercial bank is in many respects similar to a mutual fund or investment trust Furthermore, to remain consistent with religious strictures, the bank cannot charge interest in its lending operations, but has to use special modes of investment and financing that are also based on the concept of profit and loss sharing system.
No doubt unit trusts and investment trusts are different The value of shares in an investment trust is determined in the stock market directly. In the case of a unit trust (e.g. the United States mutual fund) the value is based on a weighted basket of the underlying shares which are traded in the market.
With Islamic deposits, it is not the market value which matters, there is none as they are not traded. Nor is it the underlying value of the assets which the bank has invested in unless there are deposits. What is important is the profitability of the investment Values of shares do not always reflect profitability. Profit/earnings ratios can vary widely, and the market accepts this. Similarity with unit trusts relates to the uncertainty regarding both returns and the value of Islamic deposits. In practice however value seldom varies, which is not the case with unit trusts where it is determined by the market. In general Islamic deposits are less risky than unit trust holdings. Income oriented unit trusts are most easily compared to the Islamic deposits and not those which are growth oriented. In this regard there is much confusion in the Islamic literature on finance. always reflect profitability. Profit/earnings ratios can vary widely, and the market accepts this.
Similarity with unit trusts relates to the uncertainty regarding both returns and the value of Islamic deposits. In practice however value seldom varies, which is not the case with unit trusts where it is determined by the market. In general Islamic deposits are less risky than unit trust holdings. Income oriented unit trusts are most easily compared to the Islamic deposits and not those which are growth oriented. In this regard there is much confusion in the Islamic literature on finance.
Some Non-Islamic businesses have ventured into Project Financing using a similar model however the Non-Islamic sources of funds often will not forego their funding models and as a result, are not cohesive to the mudarabah principles.
1 A. M., Musharakah and its Modern Applicalions, Paper presented at the Seminar on Islamic Financing Techniques, Islamabad, December 1984, p.2.
2 Chapra, M. U., Towards a Just Monetary system, The Islamic Foundation, Leicester, 1985. p.251.
3 Siddiqi, M. N., Partnership and Projit-Sharing in Islamic Law, The Islamic Foundation,Leicester, 1985, p.22-23.
- Irfani, op.cit pp.23-24.
5 Qureshi, D. M., The Role of Shariah Based Financial Instruments in a Muslim Country, Paper presented at the Seminar on Developing a System of Islamic Financial Instruments, Malaysia, May 1986, p.12. 83
6 Smith, P., Essential Business Law of the Family Business, Sweet & Maxwell, London, 1979, pp.l0-28. n.
7 Amin, So Ho, Islamic Banking and Finance, Vahid Publications,lran, 1986, Wo34-35.
8 Hessen, R. ‘The Modern Corporation and Private Property: A Reappraisal’, Journal of Law and Economics, Vol. XXXVI, June 1983, p.287.
9 Iqbal. z. and A. Mirakhor. Stabilization and Growth in an Open Islamic Economy. Paper presented at the International Seminar on Islamic Economics. Islamabad. August 1987. p.5.
10 Zarqa, M. A., ‘Stability in an Interest-Free Islamic Economy: A Note’: Pakistan Journal of Applied Economics, Vol.II, No.2, Wmter 1983, Pakistan, p.182.
11 Minsky, H. ‘Summary of Minsky’s Argument’ by Joan Robinson in “What are the Questions’,? , Journal of Economic Literature, Vol.XV, No.4. December 1977, p.3331.
12 Chapra, op.cit. pp.120-121.
13 Khan, W. M., Towards an Interest-Free Islamic Economic System, The Islamic Foundation, Leicester & International Association for Islamic Economics, Islamabad, 1985, p.84.
14 Ghifari, N. M & Muzaffar, M.,ljara and ils Modern Applicalions, Paper presented at the Seminar on Islamic Financing Techniques, Islamabad, December 1984, p.11-12.
15 Saleh, N. A., Unlawful Gain and Legitimate Profit in Islamic Law, Cambridge. London, 1986, pp.94-95.