Recently I got a query from a reader in Macedonia on the Musharaka Financing model. A few questions which I feel are worth exploring to see if anyone have the viable answer. I have put up my responses in Islamic Banking 101.
In my humble opinion, Musharaka Financing has its own place in the Islamic Banking world, but not necessarily suitable for the likes of traditional Islamic Banks. Banks, as financial intermediary, is essentially set up to do “banking business” and the scope of banking revolves around debt financing, where the risk faced by the Bank is predominantly Credit Risks. The Shareholders, and to the large extent the Customers, dictates the type of risks that they are will to undertake when choosing a Bank. The main intention of banking with a financial institution is to protect the value of their deposits, without taking excessive risks, and with the expectations of reasonable returns derived from low risks investments.
RISKS UNDER MUSHARAKA CONTRACTS
Because of the above, the most suitable structures where Credit Risks is assessed are contracts such as Tawarruq (Commodity Murabahah), Murabahah, Istisna’a, Ijarah Thumma Al Bai (AITAB), Musawamah, Musharakah Mutanaqisah and Qard. The nature of these contracts are creation of an obligation between one party and the other, and because the above are based on sale or lease on an underlying asset, the risks are purely Credit Risks, and Interest Rate Risks.
However, Musharaka and Mudharaba financing risks should be based on consideration of Valuation Risks, Equity Risks and to some extend, Market Risks (I also include Ijarah and Murabaha Purchase Order into this category).
In essence, a Musyaraka refers to “equity partnership”, arriving from the word “Shirkah” or in Malaysia we commonly know it by the word “Syarikat”. It means, a group of investors pool their money (as capital), and jointly enters into a business venture as partners, be it finance or expertise for the business for the purpose of making a profit. A leader or manager may be appointed to run the business. All the partners agree on a profit-sharing ratio for profit they intend to share, and this is negotiated up-front based on what they contribute (money, skills or otherwise determined). However, this also means that the partners agree that any losses will be shared amongst the partners but limited to their capital contributions.
USE OF MUSHARAKA IN ISLAMIC BANKS
As I mentioned, not many Banks are set-up to handle “equity-based” financing, as the risks are above and beyond the threshold a normal Bank is willing to take. The risky nature of the endeavour, and potential diminished Equity, does not bode well with many Banks.
While it is difficult to offer these products directly from Banks, there are already initiatives by Bank Negara Malaysia to develop the product via a stand-alone platform, where Bank’s involvements are kept at a minimum and the platform acts as a direct link between the Customer (as Investors with Equity Funds) and Businesses (as Entrepreneurs seeking Equity) as partners.
This platform is the Investment Account Platform (IAP) which was launched in 2015 and Shariah-Compliant. So far, the ventures listed in the IAP uses either the Musharaka Restricted Investment or Mudharaba Restricted InvesTment Accounts (RA).
MUSHARAKA AS AN EQUITY-BASED STRUCTURE
Further, the application of “equity-based” structures are limited in the banking world, as it must be able to manage “Investment Accounts” for the purpose of equity financing. Many Banks do offer this via Restricted Investment Accounts (RA) set-up, commonly known as Profit Sharing Investment Account (PSIA). This is a direct “equity financing” arrangement where the Investors (usually the parent financial institution, and the Islamic Bank itself) will provide a sum-equity to match-fund a particular project or financing requirement of the customer (entrepreneur). The Islamic Bank, in this case, also acts as a manager where it earns a “manager fee”. The risks and rewards of the Musharaka, is enjoyed together by the Investors under the PSIA arrangement. However, this structure is not offered to Retail customers, as the structure is designed to retain the “investment” throughout the financing tenure (no early redemption of the investment).
In short, there are already structures based on Mudharaba or Musharaka Financing that we can look at in the Malaysian market, although at this moment, many parties involved are threading with caution. It remains to be seen how successful these will be, but slowly the market would be able to understand the requirements for such products. Besides, these products and structures have been operating as Venture Capitalists (VC), Partnerships and Crowd Funding. It is a matter of operationalising it in the banking space, either in the existing Islamic Banks (which is highly regulated) or consider a totally new financial institution that is able to take higher “equity” risks, which promotes innovation and re-think the way we look at financing.
For an extended read on Musharaka Financing, please click on this link for Islamic Banking 101 on the topic.
Note: Musharaka Financing is different from the often-seen financing Musharaka Mutanaqisah for mortgages.