Introduction: Cases in Islamic FinanceAuthor(s): Saad Al-HarranSource: Arab Law Quarterly, Vol. 14, No. 3 (1999), pp. 193-202Published by: BRILLStable URL: http://www.jstor.org/stable/3382078 .Accessed: 18/10/2011 20:51

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact support@jstor.org.

BRILL is collaborating with JSTOR to digitize, preserve and extend access to Arab Law Quarterly.

http://www.jstor.org

INTRODUCTION: CASES IN ISLAMIC FINANCE

Saad Al-Harran*

This series of articles results from the proceedings of an international workshop on Partnership (Musharakah) Financing: Concept and Case Studies, which was organised by the Mentor Centre for Business Research Sdn Bhd, Malaysia, 23-24 April 1996. This event was organised to achieve the following objectives:

(1) to intemationalise musharakah financing as the main front of Islamic finance in order to bring about real changes in the economies of the developing countries where Islamic banks operate;

(2) to develop closer links between musharakah financing and the concept of venture capital in order to create a new breed of entrepreneurs and industrialists in Islamic finance who are keen to manage business risk successfully rather than avoiding it;

(3) to create more awareness about the importance of such a mode of financing. This has been translated through the practical approach adopted by the workshop in presenting various case studies from Sudan and Iran where musharakah financing has been successfully implemented;

(4) to bring a new breed of youth to Islamic finance through the proper utilisation of the human assets at the higher learning institutions (such as the International Islamic University Malaysia), in order to promote musharakah financing at the university campus level through Islamic venture capital projects and their role in marketing Islamic products internationally.

This event was indeed unique simply because it succeeded to playing its role in internationalising Islamic finance and, more importantly, musharakah financing. We are of the opinion that this kind of financing, once it is properly implemented by a proposed Islamic consultancy house, to be established (and financed) by some of the Islamic financial institutions, can assist many small businesses to develop and compete with others in the market.

For the last two decades, the practice of the majority of Islamic banks has shown a widespread preference for murabahah (trade financing), and a lesser degree of mudarabah financing. In contrast, musharakah (partnership) financing has

* Editor and Chairman of the International Workshop, Christchurch, New Zealand. International Business Consultant in Islamic Finance and Managing Director of Global Horizon Limited, New Zealand.

Arab Law Quarterly, [1999] 193-202

? 1999 Kluwer Law International. Printed in the Netherlands.

193

194 ARAB LAW QUARTERLY

generally been avoided on the mistaken presumption that it is an economically non-viable (high-risk) instrument. Adopting such a strategy results in no profound benefit being brought to a large number of societies where Islamic banks operate.

Indeed, it has been said by many scholars that if musharakah financing is properly implemented by Islamic financial institutions, which have total assets of US$153 billion all over the world, it will undoubtedly bring about a real socio- economic change in the economies of developing countries, alleviating many social ills which face these nations, such as poverty and unemployment. Therefore, it is the role of Islamic finance to reduce the gap between those that have and the have nots, saving humanity from many diseases.

In the first article Muhammad Taqi Usmani analyses in a comprehensive way musharakah and its application as an Islamic mode of financing. He defines musharakah as sharing, and states that in business it is a joint enterprise in which all the partners share the profit or loss of the joint venture. Since Islam has prohibited interest, these instruments can be used for providing funds of any kind. Therefore, musharakah can play a vital role in an economy based on Islamic norms. He discusses the basic principles of musharakah and the way in which it can be implemented in the context of modern business and trade. His article is considered to be a background for those who are interested in making a joint venture with Islamic banks. He deals with not only musharakah but also mudarabah financing, which is a special kind of partnership, where one partner gives money to another to invest in a commericial enterprise. He also discusses the basic problems which may be faced in implementing musharakah financing in a modern world.

In the second article Badawi B. Osman examines the role of the Sudanese Islamic Bank (SIB) in rural development in Sudan. This bank is unique in terms of its goals and objectives, which are to assist small farmers in the rural area of Sudan by raising their standards of living. (SIB was established in 1983 and I had the opportunity to examine the performance of this bank during my studies at the University of Durham in 1988-1990.)

Badawi Osman has highlighted the problems that face the world today; that is, increases in population growth, at the same time as an acute shortage of food. This requires serious attention by the policy makers in developing countries to examine why such a situation has become uncontrollable. A part of the problem is rapid urbanisation and industrialisation with the agriculture sector consequently being left behind for various reasons. A good example to support this argument is what the South East Asia region is currently experiencing - rapid economic growth in the industrial sector at the expense of agriculture.

Sudan is an agricultural country and the government has set as a policy objective to develop this sector of the economy in which 75 per cent of the population depend. Therefore, financing is one of the key areas on which the government focuses and the efforts of SIB in assisting rural farmers are indeed welcome. Consequently, the management of this bank have decided to target small farmers, rural women, craftsmen, artisans and small entrepreneurs both in the rural and urban centres.

INTRODUCTION 195

The uniqueness of SIB, which makes this bank different from other institutions in the country, is the terms for providing credit to farmers in a comprehensive package of financing, which includes not only finance but also agricultural inputs, extension services, marketing and storage advice, all delivered to the farm gate. This may be due to the establishment of a rural department in the bank with one of its main tasks being to monitor the performance of various agricultural activities. This department has also embarked on a number of innovations to assist farmers, such as productive families. Since this mode of financing is well developed in this bank compared with others, various musharakah models were presented such as agricultural financing (canal irrigation and pump and rain irrigated schemes).

SIB assists farmers through co-irrigation, where the bank provides irrigation pumps and accessories, instals them on the farm and provides permission for the farmers to operate them. The advantage of such a facility is to provide additional financing by the bank (over and above irrigation) to the farmer for such commodities as seeds, fertilisers and pesticides.

The bank also provides agricultural machinery to farmers at rates that are lower than prevailing market rates, as well as providing help with storage and marketing. The farmer is then free to market his share of the produce in a way he likes. Since farmers lose a lot by marketing their crops at harvest time when prices are normally at their lowest, SIB was found to be a good business partner by the farmer who feels that the relationship should continue based on musharakah financing. SIB pays the farmer 50 per cent of the price prevailing at the time of harvest and the crop is then stored under dual control by both the farmer and the bank. SIB pays all transport costs and storage, and when the crop is sold at a time when it can command a higher price, the farmer gets 50 per cent of the net profit for management, and the remaining net profit is divided equally between the bank and the farmer.

SIB has played a vital role in terms of providing finance for poultry production projects involving poor families. The projects are executed in close collaboration with the Sudanese Ministry of Social Welfare, the Ministry of Animal Wealth and the Ministry of Finance and Planning by supplying battery cages of 95 layer capacity with hens at the laying to each family. Management advice provided by the bank through regular visits to these families is also an important factor which makes the programme successful.

Although Badawi has not provided the workshop with any recent data about the various agricultural activities financed by the bank, especially in potato production, it is fair to say that the Sudanese Islamic Bank's experience has proven without doubt that musharakah financing is relevant and is capable of bringing benefits to the rural community in Sudan, especially the women and small farmers. This view has also been expressed by Professor Malcolm Harper of the Cranfield School of Management (UK) in his research on SIB.' He discovered that musharakah

2 "Musharakah partnership financing: an approach to venture capital for microenterprises", Small Enterprise Development, vol. 5, no. 4, December 1994.

196 ARAB LAW QUARTERLY

financing can provide a reasonable return for the investment of both parties (the bank and small farmers) and can lead the way to a self-sustaining banking system.

In the third article Ali Yasseri discusses the Iranian experience in musharakah (partnership) as a model for interest-free financing. He defines musharakah and mudarabah as the favourite modes of financing in the eyes of Islamic scholars, in preference to other financing, such as murabahah (mark up), instalment sales and ijarah (leasing), which are short-term in nature.

He gives a brief historical background to musharakah and describe the rules and regulations under which it operates in the Islamic Republic of Iran. Since the banking system was Islamised after the revolution, he has paid due attention to the practical applications of musharakah and some problems of implementation. Partnership contracts in Iran are divided into two categories, mainly civil and equity. The former is more popular than the latter. The main reason for the relative lack of importance of equity partnership contracts in Iranian banking practices at present is the fact that in Iran all banks are government owned.

He also explains the difference between the civil and equity partnership in terms of their legal nature, function and implementation. The banking rules governing civil partnership contracts and its procedure are discussed in more detail. Since civil partnership contracts need special attention by the bank the first step is to examine the credit credentials of the application and to appraise the economic, financial and profitability prospects of the project proposed for bank financing. This assessment is useful to the bank to ensure that its estimated rate of return (profit) exceeds the minimum expected rate of profit stipulated by the Central Bank of the Islamic Republic of Iran (CBIRI). This cut-off rate is considered to be one of the instruments of monetary policy in an interest-free banking system. CBIRI can change this rate periodically in order to adjust the volume of credit injected into a sector of the economy. An increase in this rate signals credit contraction and vice versa.

Bank credit under partnership contracts is either requested on a short-term basis such as working capital, or is long-term in nature, for the long-term investment needs of the prospective partner. For the former, it involves regular supervision and auditing of the contracts and the need for partners to keep books and to abide by accepted accounting standards. Many businesses do not keep proper accounting records, and hence bank supervision over such ventures becomes difficult. For the latter, credit is provided for long-term investment purposes for projects in the housing, manufacturing and agricultural sectors. In such cases, at the end of the partnership period when profits (or losses) are realised, the bank's partnership share is evaluated and it can sell that share to the partner, on a cash, or on an instalment-sale basis.

An interesting project which was financed in 1994 by the Tehran Municipality was a musharakah bonds certificate to finance the Navab development project in the south-west of the country. The musharakah bonds issued by the municipality have a four-year time-span, with a 20 per cent interim annual rate of profit guaranteed by the largest government owned commercial bank in Iran.

INTRODUCTION 197

Yasseri considers inflation as a serious threat to interest-free banking practices. In an inflationary situation long-term investments are discouraged and short-term trade financing of a highly speculative nature is instead encouraged. For this reason, among others, the instalment sale is the most popular method of financing in Iran and elsewhere.

Yasseri feels that since musharakah financing has become complicated, standardisation of interest free banking procedures, including other forms, necessitates the formation of universal rules, like those governing the operation of foreign trade financing operations. If this proposal is realised greater co- operation among interest-free banks all over the world will be achieved.

The role of musharakah financing in the agricultural bank of Iran is highlighted by Kazem Sadr in the fourth article. The main purpose of the article was to explain why the Agricultural Bank (AB) of Iran has gradually shifted its investment portfolio from low risk contracts to relatively high risk partnership agreements. He has not provided the workshop with the objectives of AB and its role in assisting farmers in Iran. However, according to Sadr, the experience of AB of Iran seems to satisfy the bank's expectation although it continues to use salaf (forward purchase) and instalment sale for short-term financing. However, such short-term financing has recently been changed towards a more balanced approach, that is, profit-loss sharing contracts.

He explains in more detail the nature of musharakah contract and its characteristics. The advantage of such a contract over joaleh (commissioning) and instalment sale as a form of agreement between AB and its customers is that there are no third parties invovled. Injoaleh, in addition to both the Bank and the farmer, the consent of the agent who guarantees to carry out the job specified in the contract is necessary; thus it is signed by three parties. In the case of an instalment sale the commodity in demand is supplied by a separate firm. The bank buys it from the seller for the farmer. If the seller is untrustworthy, the contract becomes vulnerable.

After the Interest Free Banking Law (IFBL) was implemented, special committees were formed both in the Central Bank and others to devise methods for satisfying financial demands in the productive and service sector by contractual agreements. AB has also set up a committee for the same purpose with the objective of making the application of the proposed contracts easier, especially in reducing collateral from farmers and other applicants. Farmers also complained about the 5 per cent tax to the joaleh applicant, to be paid to the tax department at the Finance Ministry. Added to this farmers have to pay another five per cent insurance charge to the Social Security Agency. Thus 10 per cent of the total sum of the fund has to be deducted by banks and charged to users. These charges have raised objections from farmers who are reluctant to deal with joaleh contracts.

Such a scenario has persuaded the AB authority to move towards musharakah

financing activities. In 1992, it exceeded that of the instalment sale, and in 1996, about 48 per cent of the total sum of AB funds were supplied through the musharakah partnership as shown in Table 1 of his article. Finally, the

management of AB have played an important role in the shift towards musharakah

198 ARAB LAW QUARTERLY

finance and this has helped the policy makers in the country to understand agricultural financial problems through this institution.

Although the AB of Iran has achieved reasonable success, learning from other Islamic institutions such us the Sudanese Islamic Bank (SIB) is vitally important, especially as the latter deals with small farmers. Indeed, learning from each other will undoubtedly bring a new era of co-operation between the two countries in the field of agricultural development.

Undoubtedly, the financing of small enterprises has received growing attention during the last decade. Mustafa Gamal-Eldin Abdalla examines partnership (musharakah) as a new option for financing small enterprises in the fifth article. He analyses the problems that faces this sector in Sudan and highlights the main Islamic financing methods adopted. A special assessment is also made asking why musharakah financing is suitable for small enterprises.

Although we are living in an age of small enterprises (or micro-enterprises), venture capital, and entrepreneurship, little attention has been given by the formal financing institutions (not only in Sudan but also elsewhere) to finance them. These institutions were reluctant to extend credit to this vital sub-sector of the economy for various reasons.

They adopted rigid conditions when it came to collateral requirements and failed to reach the grassroots people who have the entrepreneurial ideas but lack access to credit.

One exceptional case is the Sudanese Islamic Bank which in 1992 established a special micro credit window called productive family branches to assist small and micro-enterprises. To what extent has this experience succeeded so far? Does musharakah financing have potential for replication elsewhere?

Abdalla also explains various methods of Islamic finance (such as murabahah, mudarabah and musharakah) after Sudan introduced Islamic Shariah law in 1984. Since mudarabah and musharakah are important instruments he highlights the difference between them; in that when the partner offers his labour/skill only (without any contribution in cash or in kind) this would be mudarabah. Musharakah differs in that the partner gives some contribution in cash or in kind. Another difference is that, in case of loss the loss is shared in musharakah by both partners, while in mudarabah it is wholly borne by the financier.

The question is whether musharakah financing constitutes a suitable new option for small enterprises. Two fundamental problems are discussed, mainly the double burden of failure where a borrower's project fails and the depletion of the lender's capital as a result of inflation. Abdalla is of the opinion that musharakah financing is a solution to these problems. But the real challenge is, what are the supportive measures to be taken to encourage micro-credit institutions to operate efficiently?

To enable micro-enterprise programmes to succeed, some suggestions were put forward by Abdalla which need to be thoroughly examined by the Islamic financial institutions.

Undoubtedly, the success and sustainability of such experience requires a conducive environment at the macro level of the country. This could be translated

INTRODUCTION 199

into waiving some restrictions on taxes and fees in order to create a healthy environment for small entrepreneurs to operate successfully in the economy.

In the sixth article, based on my long experience as an Islamic banker and formerly as Assistant Professor of Islamic Banking and Finance at the International Islamic University in Malaysia, I have suggested an innovative and creative idea to be considered by Islamic financial institutions. My article on the new strategic alliances between Islamic financial institutions, international university students and entrepre- neurs to implement musharakah financing to meet the challenges of the twenty-first century is worthy of being considered by the policy makers of Islamic banks, especially those who wish to internationalise their operations.

I realise the importance of strategic alliances to Islamic finance, due to the fact that the business world is undergoing massive and fundamental change. At the same time as competition is raising the standards for quality, innovation, productivity and customer value, the scope of what a financial institution can do alone is shrinking. Since Islamic finance lacks expertise in project financing and entrepreneurial development which make their practices dominated by short-term murabahah financing, there is an urgent need to train more students in these fields, and this requires a change in the current business curricula at the higher learning institutions, to assist small and medium-sized industry entrepreneurs (SMIEs) in Malaysia and elsewhere in the Muslim world. In the case of Malaysia, SMIEs (especially Muslims) have many problems, such as proper use of financial resources, a shortage of skilled labour, marketing and competition. If these entrepreneurs want to be competitive in the local and international market, they need assistance from new educated partners, and these could be students.

The challenge is how to implement the triangular relationship between Islamic financial institutions, SMIEs and international university students in order to make the programme effective. I argue that a proper screening of students is one of the key factors to ensure successful implementation of the programme, along with a conducive environment in the university without any red tape. Once the selection is made, the international university students will be classified into four groups. These are: (1) those who are interested in musharakah financing venture capital projects at the campus level; (2) to be an agent for marketing Islamic products; (3) to undergo marketing research for SMIEs; and (4) to identify new markets in the country they come from.

These groups need to be closely monitored by the relevant professor(s) to ensure successful implementation in order to bring a new breed of professionals to Islamic finance. The key message I try to convey that while Islamic financial institutions are approaching the twenty-first century, many challenges still face them. The fundamental question is, can these institutions, which have funds at a global level of US$153 billion in 180 Islamic banks, allocate some of their financial resources to establish an Islamic consultancy house (ICH)? One of the main objectives of ICH is to train students and others in project financing in order to produce more entrepreneurs, venture capital industrialists and investment managers who are keen to manage business risk successfully.

200 ARAB LAW QUARTERLY

In the seventh article, Hossein Mahdavi Najmabadi proposes a modified model in musharakah financing, with emphasis on Iran, based on his experience as one of the professionals who was involved in the formation and. implementation of interest-free banking practices in the country. He divided the problems that face current banking into operational and systemic. Operational problems of

implementation can be categorised as: (1) multiplicity of methods of financing; (2) limited practical application of many methods of financing; (3) complexity and

proliferation of rules and regulations; (4) lack of co-ordination among banks; (5) training; (6) hesitation and indifference towards the new banking system; (7) doubt and suspicion with regard to the existence of the element of usury in

banking operations; and (8) banking supervision. Systemic problems of implementation he classifies into (1) prolonging financing

or repayment periods; (2) charging penalties for late payment; (3) impossibility of

having a floating profit rate with regard to the credit facilities extended, to borrowers; (4) impossibility of offering a floating rate of return to bank depositors; (5) the application of the profit rate as an instrument of monetary policy; and

(6) requiring collateral security for granting credit facilities. The model tries to avoid many existing complications and procedural

inconsistencies as well as the systemic and operational problems referred to above. The most important features of the proposed model are: (1) the wide ranging application and simplicity of operation; (2) the profit rate charged by banks for the use of its facilities will be a floating rate and so is the rate of return offered by banks to their depositors; (3) the extension of financing and repayment periods will be

possible; (4) the systemic problem relating to inability of banks to charge penalties for late repayments will be solved; (5) it will give the monetary authorities an effective monetary policy instrument to quickly change the profit rate charged by banks for the use of their credit facilities and consequently to change periodically the rate of return offered to bank deposits; (6) issuance of musharakah bonds within the framework of the proposed model will be feasible, hence the finance of

long-term investment projects will also be possible. It will be interesting to see this proposed model implemented in order to

simplify the current practices of Islamic banking in Iran. If the policy makers at the Central Bank of Iran, and the Ministry of Finance can be convinced about the

feasibility and practicality of the proposed model suggested by Najmabadi (who has had a hand in drafting the various banking rules and regulations that control the operations of banks and other monetary institutions in Iran), the outcome will be widespread use of partnership shares in the form of partnership bonds

throughout the banking system in the country. This will undoubtedly lead to a

greater incentive to Islamic banks to provide long-term investment financing for industrial and agricultural projects.

I made some recommendations to be examined by the policy makers of Islamic financial institutions. The participants were grouped into four and I selected a leader from among them who has a long, practical experience in the field of Islamic

INTRODUCTION 201

banking and finance. Group A was led by Badawi B. Osman, while Group B was led by Haji Sallehuddin Bin Haji Yaacob. Group C was led by Mustafa Gamal- Eldin Abdalla, with Group D was led by Ali Yasseri and Group E by myself.

The recommendations of each group follow:

GROUP A

(1) To establish an international body to set standards for musharakah financing to Islamic banks;

(2) to encourage more learning and exchange of experiences about musharakah financing;

(3) to encourage countries to gear their laws to adopt and encourage musharakah financing;

(4) when applying musharakah a thorough study of the partner needs to be made and a good appraisal of the project, taking into account market conditions and the economy in general;

(5) to establish venture capital institutions to promote growth and entrepre- neurship and small enterprises. Existing venture capital should emphasise long-term financing.

GROUP B

(1) Setting up of an Islamic venture capital company licensed under the Islamic Banking Act so that it is regulated. The market should be all for Muslims and non-Muslims and targeted at small and medium-sized industries;

(2) establishment of a training institution where "implementors" of Islamic financial products could be trained.

GROUP C

(1) Creation of a network among participants for continuous exchange of experiences;

(2) call for forming an international forum for continuous deliberations and exchange of views and experiences;

(3) exchange of visits among Islamic bank staff; (4) exchange of documentation and information through a specialised magazine; (5) introducing musharakah and other Islamic modes of finance in the curricula

of banking training institutes and universities.

202 ARAB LAW QUARTERLY

GROUP D

(1) Control and management of business risk, so that a degree of business risk can be made valuable and flexible according to the needs of the entrepreneur-client;

(2) reliable and competitive banking services should be extended by Islamic banks to both depositors and investors;

(3) marketable Islamic financial products should be devised by groups composed of bankers, religious experts, and financiers;

(4) secondary markets should be established where such products could be traded. Such markets should be connected to one another;

(5) standardisation of musharakah procedures; (6) division and separation between banking and investment operations and

specialisation of investment operations among various fields.

GROUP E

(1) Practical training of Islamic bank personnel; (2) to bring operational officers from the respective Islamic banks (especially

from the Muslim Commercial Bank in Pakistan) in order to teach other professionals from other Islamic banks about their experiences in implementing musharakah financing. Emphasis should also be placed on documentations and procedures;

(3) utilisation of the students for undertaking marketing research to Islamic banks;

(4) need to educate entrepreneurs on the concept of Islamic finance in general, and musharakah financing in particular;

(5) modify the Banking Act in Malaysia to facilitate the implementation of musharakah financing facilities.

From the above recommendations, the important message the workshop wants to convey is, there is a need for Islamic finance to have a paradigm shift in their operations. The challenging factor for their survival in the 21st century will be investment in musharakah long-term financing to give more hope to the young and others who are trying to achieve entrepreneurship, to work hard and get on, to expand and develop their business. Islamic finance needs to bring a new breed of innovative and creative investment managers, entrepreneurs and venture capitalists who are willing to manage business risk successfully rather than avoiding it.

Can the Islamic financial institutions succeed while approaching the 21st century? Time and history will tell.