ISLAMIC BANKING AND FINANCE:MUSHARAKA

Literally speaking, Musharaka means partnership or a system of sharing. It is one of the several financing options available under Islamic Banking.
There are two types of Musharaka-Direct and Diminishing.

DIRECT MUSHARAKA: Under this option of financing, the Bank and the Customer form a partnership in which the Bank provides part of the capital to the customer and the customer manages the project apart from providing part of the capital. The proportion of capital provision by the two parties is mutually decided upon in advance. It is the customer that runs the business enterprise.
The notable feature of this partnership is that the liability of the partners is unlimited. When the business suffers a loss, it is distributed between the Banker and the Customer in the agreed proportion, whereas in case of profit, it is shared between the two in proportion to the capital contributed by them. The contract may also provide for the customer to be exempt from running the show or the business, in which case the share of the Bank in the profit would be proportionately higher.

The Musharaka contract is based upon real capital and specific limits and not on the basis of debt. Partners to the contract should know the extent of their participation in the capital and their share in the profits and losses at the time of making the contract. Uncertainty in the terms of the contract would vitiate the contract. Normally, these contracts are pursued by the partners till the final objectives of the venture are achieved. However it is permitted for either of the partners to exit the partnership with the consent of the other.

DIMINISHING MUSHARAKA: In this form of contract, the Banker agrees to part finance the project and also agrees to exit the partnership voluntarily upon repayment of his share of the capital by the other partner, the customer. This repayment must be made within the specified period. The customer agrees to bring in his share of the capital and act as a trustee for the entire capital.
Like in the case of the Direct Musharaka, the loss from the business venture is distributed among the partners in the agreed ratio, whereas profits are shared between them in proportion to their capital contribution.
As per agreement, the Bank agrees to sell its share of its capital to the customer over an agreed period of time, and the customer buys out the Bank share in the partnership so that eventually the customer becomes the master of the whole enterprise.
This type of financing is a very convinient form of financing where customers can rely upon the Bank not only for capital but also managerial expertise. And in the course of time, the customer becomes the sole owner of the business enterprise. For the Banker, this arrangeement ensures a regular, and steady income. Further, losses are shared according to respective share in the capital, thereby reducing the burden of losses.
There is a third kind of Musharaka financing that is akin to Venture Financing which will be the subject of another article.

Author’s Note: Readers may please note that the above article is meant to be a introduction to one of the forms of financing available under the Islamic System, and not an exhaustive study of the same.