Musharaka deals pose risks

In the last few weeks we have been examining various risks in the Islamic financing structures and their aversion, management and mitigation from within the respective structure.

We have so far discussed in detail a variety of risks found in Ijara (leasing) and Istithna (forward sale of an asset) and their management/mitigation by utilising the characteristics of the structure itself, without needing to rely on external collaterals and securities, which are often demanded by the conventional banks from their clients to protect their interest-based lending.

The subject of risk management is of high substance and the financial institutions around the world spend huge sums of money on research and development (R&D) to come up with latest tools and softwares to safeguard them from risks such as credit/default risk, capital impairment risk, liquidity risk, market risk, operation risk, interest rate/rate of return risk, etc.

What the Islamic scholars and practitioners have just started to discover are the ways of managing these risks embedded within the Islamic structures revealed to mankind over 14 centuries ago.

Furthermore, whilst the conventional risk management is centred around protecting the interests of the lender alone, the Islamic structures emphasise fairplay by providing adequate shield to both the parties.

However, since we are on the subject of discussing the risk mitigation for the Islamic Financial Institutions (IFIs), we will move on to look at how an IFI protects itself from various risks in a Musharaka transaction.

Readers would recall that a Musharaka is a partnership between an IFI and its customer whereby each of them contributes a specific amount of capital (be it in cash or kind) in a manner that gives each of them a right to deal in the assets of the partnership on condition that

the profit will be distributed according to what has been agreed in the partnership contract, irrespective of the equity contribution ratio, but the losses (if any) would be borne by them strictly as per the equity ratio.

Sharia considers a Musharaka to be an independent juristic personality, similar to any legal entity, irrespective of whether it is in shape of a registered company or merely on document.

Musharaka does not own the assets of its partners, except what has been specifically declared by them in the Musharaka contract to be their respective equity in the Musharaka.

Similarly, Musharaka does not bear the individual liabilities of its partners but only the liabilities of the Musharaka created during the course of Musharaka operation.

IFIs usually enter into redeemable Musharaka (Sharia term "Musharaka Mutanaqisa") with their clients which allows them to gradually sell their equity to the clients over an agreed period of time and manner. This structure suits the clients too who would not welcome and accept an IFI to be a permanent partner with them in their business.

Let us examine the risks an IFI is exposed to while entering into a Musharaka Mutanaqisa transaction and the 'by-default' mitigation from within the Musharaka structure.

The Musharaka structure is exposed to high capital impairment.

How does an IFI protect itself from such risk?

Once an IFI enters into Musharaka with a client, it is bound to respect and obey the principles of Fiqh (Islamic jurisprudence) relating to Musharaka which are clear as to the responsibilities of each partner in running the affairs of the Musharaka, including bearing the losses, if any.

Sharia permits an IFI to appoint the customer as the managing partner of the Musharaka with a well defined and clear managerial mandate.

Having accepted the mandate, the managing partner (customer) would be liable to strictly abide by the assigned responsibilities for running the Musharaka affairs in a prudent manner and with an aim to generate Halal profit for the Musharaka.

However, any loss caused to the Musharaka due to managing partner's negligence will protect the IFI in a manner that the IFI's equity will be transformed into a debt on the managing partner and it will no more be carrying the risks of being part owner in the Musharaka business.

- The writer is vice-president and head, Sharia Structuring, Documentation and Product Development, Dubai Islamic Bank.