Introduction Virtually unknown three decades ago, Islamic financing is now practiced around the world.

Since its official launch in the 1970s, Islamic financial institutions have witnessed rapid international growth in both Muslim and Non-Muslim countries (Dudley 2001). Although the concept of Islamic finance has existed for centuries, it only came into prominence during the last century (De Jonge 1996, p.3). The first successful application of Islamic finance was undertaken in 1963 by Egypts Mit Ghamr Savings Banks, which earned its income from profit-sharing investments rather than from interest (Lewis & Algaoud 2001, p.5). By the 1970s, the push for Islamic finance had gained momentum. In 1973 the conference of foreign ministers of Muslim countries decided to establish the Islamic Development Bank with the aim of fostering the economic development and social progress of Muslim countries in accordance with the principles of Shariah (Saeed 1996, p.13). This marked the first major step taken by Muslim governments in promoting Islamic finance. Shariah law (Islamic law based on the teachings of the Koran) prohibits the followers of Islam from conducting any business involving Riba (interest). This means that Muslims cannot receive or pay interest, and they are, therefore, unable to conduct business with conventional financial institutions (Jaffe 2002). The creation of Islamic financial institutions came about as a method for servicing this niche market. In order to compete with conventional modes of financing (interest-based financial instruments), Islamic financial institutions developed products that would fulfill the Shariah obligation and provide the same value as conventional bank products (Malaysian Business 2001). The main Islamic financial products include profit-and-loss sharing (Mudaraba and Musharaka), cost plus mark-up, and leasing. The focus of this article is to analyze the profit-andloss sharing instrument of Musharaka and the way it is implemented. The article begins by briefly describing the profit-and-loss sharing system, followed by a detailed analysis of Musharaka. The article then looks at the application of Musharaka as a home financing instrument, and concludes by analyzing the current issues affecting Musharaka, and the criticism leveled against it Profit-And-Loss Sharing System

Although Islam excludes interest earnings from financial activities, it does not necessarily mean that the financier cannot earn a profit. In order to do so, the financier has to ensure that gains made on the original amount are directly related to the risk undertaken on the investment (Siddiqui 1987). If there is no risk involved, the gains made represent interest rather than profit. In order to understand how the Islamic system differentiates between profit and interest, one has to look at the differences in the economic ideology. In a capitalist system, capital and entrepreneurs are treated as two separate factors of production. The return on capital is interest, whereas the entrepreneur, who risks losing money, earns a profit. While interest is a fixed return for providing capital, profit can only be earned after distributing the fixed return to land, labor and capital (in the form of rent, wage and interest). Thus, the capitalist system seems to favor those who lend capital to entrepreneurs by providing them a secure return, entrepreneurs bear the risks of incurring losses and still making interest payments on borrowed capital. In comparison, Islamic economic system does not consider providers of capital and entrepreneurship as separate factors of production. It believes that every person who contributes capital in the form of money to a business venture assumes the risk of loss and therefore is entitled to a proportional share in the actual profit (Siddiqui 1994, p.99). The system is protective of the entrepreneur, who in a capitalist economy would have to make fixed interest repayments even when the venture is losing money. (Usmani, M.I. 2002, p.13). Capital has an intrinsic element of entrepreneurship, so far as the risk of the business is concerned and, therefore, instead of a fixed return as interest, it derives profit. The greater is the profit earned by a business, the higher the return on capital will be. With no fixed interest repayments, profit in an Islamic economic system would be higher than in the capitalist economy. The system ensures that profits generated by commercial activities in the society are distributed equally amongst those who have contributed capital to the enterprise. Another difference between the two economic systems lies in the way money is used. In economic terms money has no intrinsic value; it is only a medium of exchange, therefore, earning interest on a medium of exchange without bearing any risks does not sit well in the Islamic system (Rahman 1994, p.14). Islamic financing is, therefore, an asset-backed financing. When a financier contributes money on the basis of the profit-and-loss sharing instruments, it is bound to be converted into assets having intrinsic value (Usmani, M.T. 1998, p.19). The profit-and-loss sharing system has its roots in the ancient form of financing practiced by Arabs since long before the advent of Islam. After the introduction of Islam, this system was permitted to continue and was legitimatized as a finance instrument. For this historical reason, scholars consider profit-and-loss sharing financial instruments to be the most authentic and most promising form of Islamic contracts (Ariff, 1982). Mudaraba (finance trusteeship) and Musharaka (equity partnership) are two such financial instruments based on the profit-and-loss sharing system, where instead of lending money to an entrepreneur at a fixed rate of return, the financier shares in the ventures profits and losses (The Economist 2001). Musharaka

The literal meaning of the word Musharaka is sharing. Under Islamic law, Musharaka refers to a joint partnership where two or more persons combine either their capital or labor, forming a business in which all partners share the profit according to a specific ratio, while the loss is shared according to the ratio of the contribution (Usmani, M.I. 2002, p.87). It is based on a mutual contract, and, therefore, it needs to have the following features to enable it to be valid:

Parties should be capable of entering into a contract (that is, they should be of legal age). The contract must take place with the free consent of the parties (without any duress).

In Musharaka, every partner has a right to take part in the management, and to work for it (Gafoor 1996). However, the partners may agree upon a condition where the management is carried out by one of them, and no other partner works for the Musharaka. In such a case the "sleeping" (silent) partner shall be entitled to the profit only to the extent of his investment, and the ratio of profit allocated to him should not exceed the relative size of his investment in the business. However, if all the partners agree to work for the joint venture, each one of them shall be treated as the agent of the other in all matters of business, and work done by any of them in the normal course of business shall be deemed as being authorized by all partners (Usmani, M.I. 2002, p.92). Musharaka can take the form of an unlimited, unrestricted, and equal partnership in which the partners enjoy complete equality in the areas of capital, management, and right of disposition. Each partner is both the agent and guarantor of the other. Another more limited investment partnership is also available. This type of partnership occurs when two or more parties contribute to a capital fund, either with money, contributions in kind, or labor. Each partner is only the agent and not the guarantor of his partner. For both forms, the partners share profits in an agreed upon manner and bear losses in proportion to the size of their capital contributions (Lewis & Algaoud 2001, p. 43). Interest predetermines a fixed rate of return on a loan advanced by the financier irrespective of the profit earned or loss suffered by the debtor, while Musharaka does not envisage a fixed rate of return. Rather, the return in Musharaka is based on the actual profit earned by the joint venture. The presence of risk in Musharaka makes it acceptable as an Islamic financing instrument. The financier in an interest-bearing loan cannot suffer loss, while the financier in Musharaka can suffer loss if the joint venture fails to produce fruits (Usmani, M.T. 1998, p. 27). Musharaka In Home Financing When used in home financing, Musharaka is applied as a diminishing partnership. In home financing, the customer forms a partnership with the financial institution for the purchase of a property (Saeed 2001). The financial institution rents out their part of the property to the client and receives compensation in the form of rent, which is based on a mutually agreed fair market value. Any amount paid above the rental value increases the share of the customer in the property and reduces the share of the financial institution.

The application of diminishing Musharaka in home financing can be illustrated with the help of the following example, which the LaRiba bank in the U.S. follows: Let us assume that a potential buyer is interested in purchasing a home worth $150,000. The buyer approaches an Islamic financial institution for the purchase of the property and puts 20 per cent of the price ($30,000) as down payment (the down payment required differs between financial institutions. In some cases it is as low as 5 percent ). The financial institution pays for the other 80 per cent of the price ($120,000). This agreement results in 20 per cent of the home ownership belonging to the client and the remaining 80 percent to the financial institution. The next step for both parties would be to determine the fair rental value for the property. One way to determine the rental value is for both the client and financial institution to survey the market to obtain estimates for similar properties in the same neighborhood and negotiate an agreement. This fair rental value will remain constant over the life of the agreement. For this example, we will assume $1,000 per month as the rental value. A rental value of $1,000 means that the client will pay $800 as rent for the 80 per cent share the financial institution holds. The two parties then agree on the period of financing. In this example we will assume that the financing period is 15 years (180 months). Based on the rental value and the financing period, the financial institution then determines the fixed monthly payments the client would have to make to own the house. Table 1 Example of payment schedule for a home-loan under Musharaka. Extra Payment Total Fixed Month Rent $ $ Payments $ Opening 1 800 347 1147 2 798 349 1147 .. .. 176 37 1110 1147 177 30 1117 1147 178 22 1125 1147 179 15 1132 1147 180 7 1065 1072

Bank's Ownership $ 120,000 119,653 119,304 4,439 3,322 2,197 1,065 0

In this example the client starts by paying $1147, which includes the required 80% of the $1,000, and extra payment of $347. By doing so the client reduces the share of the financial institution by $347, and increases their own share by the same amount. The next months rental payment of the client would be reduced to $798, and again the payment made above the rent amount will result in an increase in the clients ownership of the property. This continues on till

the client buys back all the shares of the home that the financial institution holds at the end of the agreed financing period. This example does not take into account fees and charges that the financial institution may charge such as insurance and taxes. In the event of non-payment of rent from the client, the financial institution has to take into consideration the reason for the non-payment. If the client has a valid excuse for non-payment, the financial institution has to show leniency so that the client does not feel over-burdened, and the client should give more time to make the payment. In theory, if the financial institution charges any extra amount as compensation for the late payment, the amount would be considered as interest and therefore is not permitted in Islam. If there is no genuine reason for the late payment, the financial institution can ask the client to make a payment to a charity as penalty (Usmani, M.T. 1998, p.172). This prohibition of charging late fees makes it even more important for Islamic financial institutions to carefully evaluate each application before entering into an agreement.