34. WHAT IS MUSYARAKAH.?

Article 33C(ii) is the last section on debt financing. At first the Writer thought of writing on other financing related matters such as legal documentation, risk ...etc on debt financing (including other financing products such as Ijarah, Salam etc.,)  however due a number of requests, the Writer agreed to write about Musharakah first.

In earlier Article 16A-16D, the Writer had explained about Diminishing Musharakah Financing (DMF) and this product is repeated under this Section 34 but with more details or with an updated version to meet requirement under the new BNM Islamic Financial Service Act (FSA) 2013 that replaced the old Islamic Banking Act 1983.

Before we start, let us define what is Musharakah or Musharakah financing?

Musharakah is a partnership agreement entered by at least two (2) parties or best to be described as partners, for a particular business venture (must be "halal" venture). In banking perspective, the business partners shall comprise the Bank (acting as a Financier) and the Customer (supposed to be the expertise in the venture or in reality, the person who needs the funding). The Writer really hope that one day, Islamic banks will readily to offer Musyarakah financing to replace or perhaps, to complement the venture capital companies that have been active in this area (especially in the Western countries), to certain extend. Capital charge issue is the main reason why Musyarakah financing is not yet readily accepted by banks but there are other ways of structuring Musyarakah, which we will discuss later.

We shall touch on Shariah requirements for Musyarakah under Article 34(B) but our focus later shall be on the Writer's proposed structure (particularly on Musyarakah Muntanaqisah or Diminishing Musyarakah) which is contrary to the current practices offer by Islamic banks in Malaysia and it's possible features.

Brief common features for Musharakah Financing?


a) Both partners shall together raise the joint venture working capital and they need to decide on the working capital contribution ratio prior commencement of business;

b) Both shall manage the business but they have option to allow the other partner to run or lead the venture instead. If they decide to do this, roles and responsibilities of each partner shall be defined in the shareholders' agreement;

c) Profit sharing ratio (PRS) to determine the allocation of profits from the business, need to be decided by the partners, prior signing the joint-venture agreement;

d) Losses this business venture shall be based on actual capital contributed by each partner and NOT based on the agreed profit sharing ratio.

e) The venture can either be an incorporated joint venture (setting-up a new company - for Malaysia this requires BNM approval and there will be a lot of regulatory requirements) or the simplest way is to set-up a loose joint-venture where the venture can be entered via a joint-venture agreement (couple with other agreements, if it need be) between the partners. Since the Bank is the financier, it can have control over the flow of funds (they can do this via a designated current account to control the inflow and outflow of funds).

What is most important in this venture is that the Bank as financier should not treat Musyarakah akin to debt financing especially in situation when there is a cost overrun (or in case of a loss situation) but to act as responsible partner especially under loose JV structure, by injecting new funds (of course, not in situation where good money to cover a hopeless venture) and renegotiate on the terms of the profit sharing distribution i.e. to resolve, it would be best for the customer to agree for profits reduction in lieu of the new capital injected (if they are unable to contribute more capital) or by other ways, subject to Shariah's consent on the revised structure.

To protect both parties, the joint venture agreement should be prepared to cover all possible eventualities especially since Musyarakah is something that have not been tested in court between the Bank as Financier and the Customer.

If the joint venture is set-up using a new entity, the cost overrun issue would be easier to handle i.e. the Bank as Financier can issue new shares and if the other partner (Customer) cannot subscribe to the new shares, it's current shareholdings will be diluted.

So before entering a  Musyarakah Financing arrangement, the Bank and the Customer need to study deeply on the type of JV they need to set-up i.e. either an incorporated JV (this will take sometime) or just enter a loose JV.

How to differentiate Musharakah from debt financing?

Musyarakah is akin to a "Venture Capital " financing where risk is borne by both parties. This is contrary to the one sided debt financing structure where profits are charged by the Bank (irrespective the customer is making a profit or a loss) and the terms of the debt financing is generally structured to minimize risk to the fullest benefits of the Bank. Infact, to lower the risk further, the Bank will requests for collateral as added security.

In Musyarakah Financing or specifically for Mudharabah type (where only bank provides the capital), collateral can be only be requested to cover possible negligence of the Customer in running the business.

Under debt financing, the Customer is required to pay the principal and profit portion due to the Bank on due dates and if the Customer defaults, the Bank will recall the facility (stop the customer from utilizing the facility) and sue the Customer to recover total amount owing to the Bank, and if need be, the collateral is auctioned when the Bank cannot recover the full amount owing to the Bank. Under Musyarakah financing both the Bank and the customer will jointly bear the losses according to their capital contribution and NOT based on agreed profit sharing ratio.

Under this topic, the Writer shall illustrate a number of possible Musharakah structures that can be considered by the practitioners, particularly the Bankers.

However before we discuss further,  it is necessary to highlight why Banks are reluctant to provide Musharakah financing. Put aside the risk aspects, the main reason for Banks not interested to venture into this type of financing is mainly because of the Bank Regulatory capital charge. What is it? It's simply the amount of capital that the Banks are required to hold against their assets. Generally, though the concepts have been evolving with various Basel Accords, regulatory capital for various debt financing instruments is 8% on the Bank's risk-weighted assets.

Surprisingly enough, there are actually lots of different answers. Many believe that it should cover a bank's potential losses in a portfolio with some cushion. There are opinions that say that this is wrong. Why? In reality, no banks will ever gets the luxury of seeing  whether over the long run,  the capital is enough to cover actual losses. The real world doesn't work like that.

Bank runs (people will start withdrawing their deposits on ground that the bank will go bankrupt etc..) start when people become concerned that if a bank had to liquidate its portfolio, there wouldn't be enough money to pay the deposit place by the customer in the Bank. So no matter what style of accounting method a bank uses, at some basic level, investors react to the perceived value of the assets, not eventual value. This is a key distinction.

Depositors reacting that way are the biggest threat, because if they pull deposits, then banks have to sell assets even though they hope to hold until maturity. If the bank isn't relying on the short term funding, the run is less likely, as they have more ability to weather the storm.

So regulatory capital or capital adequacy or just plain capital, actually needs to address the worst of eventual loss i.e. potential "mark to market loss issue". Since mark to market loss risk is almost always worse than eventual loss risk, that has to be the key focus. The way a bank funds itself is also important, the less it has "demand" deposits, the more control they have over the asset side of the balance sheet (no forced selling), so the liability side has to play a role in capital determination.

Therefore, not to be concerned over capital charge issue, the best sources of funds for a Musyarakah financing is a SPECIFIC OR RESTRICTED FUNDS where a the Bank uses money from depositor or a group of depositors whom are willing to fund partially (Bank still has impact on capital charge as per IFSB's Risk Weight of 400% under the Simple Risk Weight Method or between 90-270% under the Slotting Risk Weight Method) OR provide 100% funding to back the joint venture project i.e. able to absorb 100% of the losses, where the Risk Weight is supposed to be Zero % i.e. nil. For the this later structure, the Bank should be agreeable to earn less as no specific or restricted depositor would like to take-up risk if his return does not commensurate with the risks that he is willing to take-up. As a rule of thumb, return of above 15.0% per annum, would be considered a reasonable good return to a restricted depositor. Of course, there are those who are talking about a return of more than 20% per annum. Most importantly, both partners (under joint effort of the Bank and the Customer) are able to come out with a viable proposition to a potential restricted depositor.


To write this article, the Writer too need to undertake research and continued support by readers, who have been contributing opinions and related articles on Musyarakah. The Writer's own practical experience in dealing with Musyarakah Financing was a few years ago when he structured one (1) Musharakah financing using restricted funds and had involved in providing free consultancy services to a Credit & Leasing company that offers Musyarakah Contract Financing mainly for government contracts. The Writer will share both experiences with the readers of this blog.


Last but not least, there is an interesting article about debt and equity financing that the Writer would like readers of this blog to read. The Writer proposed the first article that you should read is an article on Bank of International Settlements leading to the issue of Basel Accord and indirectly to the issuance of the Islamic Financial Service Board (IFSB) standard. Please visit this link http://zahidsay.blogspot.com




ONLY ALLAH IS MOST KNOWING
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