Concepts in Islamic Economics and Finance

Musharakah is a type of Shirkat-ul-Amwal which literally means sharing. In the context of business, it refers to a joint enterprise in which partners (or parties) to the enterprise share the profit and loss of the enterprise. Musharakah has far reaching implications for Islamic banking and finance in the modern context and provides an excellent alternative to the interest-based economy.

In a Musharakah, the party investing the capital shares equally in both the profit and loss, which is different from an interest-based system where the upside is limited while the downside is very nearly non-existent.

The Basic Rules of Musharakah

Since Musharakah is, in essence, a contract, all conditions and rules of a contract must be met. Apart from those, there are some basic rules that apply specifically to Musharakah.

Distribution of Profits

1. The proportion of profit to be distributed among the partners must be determined and agreed upon at the time of the contract. Otherwise the contract is not valid under Shari’ah.
2. According to Imam Malik and Imam Shafe’i, it is necessary that each partner’s share in the profit is exactly equal to the proportion of initial investment into the partnership.
3. According to Imam Ahmed, the ratio of profit distribution may vary, without restriction, from the ratio of investment.
4. According to Imam Abu Hanifah, the ratio of profit distribution may vary, however, for silent partners (non-active partners, who only contribute capital), it cannot be any higher than the ratio of investment.

Distribution of Loss

All the Muslim jurists are unanimous that each partner’s share in loss must be exactly equal to the ratio of initial investment. Anything to the contrary will render the contract invalid.

The Nature of Capital

There are the following opinions on this:

1. According to Imam Malik and some Hanbali jurists, the nature of capital is not a restriction in a Musharakah arrangement. Therefore, in-kind (non-cash) contributions by partners are allowed. The share in partnership will be determined based on the market value of the commodity contributed.
2. According to Imam Abu Hanifah and Imam Ahmed, no in-kind contributions are allowed in a Musharakah arrangement. This is because they believe it poses problems if the partnership needs to be liquidated or redistributed.
3. Imam Shafe’i makes a distinction between replaceable commodities and irreplaceable commodities (like cattle). The view is rather complex, and not important for our purposes.

For the purposes of modern business, the view of Imam Malik has been widely accepted.

Management of Musharakah

The norm is for each partner to take part in the management of the partnership, with each partner acting as an agent of the partnership and any work done by one partner deemed to be authorized by all partners. However, if the partners wish they can contract under alternate arrangements for the management of the partnership.

Termination of Musharakah

It is agreed upon by the jurists that a partnership is terminated if:

1. One of the partners terminates the partnership;
2. One of the partners dies (where the heirs get the choice to continue the partnership or liquidate it to draw their share from the partnership);
3. One of the partners becomes insane.

If the remaining partners want to continue the business under any of the above scenarios, it is achievable with mutual agreement. The remaining partners would have to purchase the share of the out-going partner.

Another question raised is whether the partners can agree, at the time of contracting, that the partnership will not be terminated unless all partners agree to the termination. Though the earlier fiqh books are silent on the issue, there is nothing in the Shari’ah that would prohibit such an arrangement.

Source: Usmani, Chapter 1.

Following is a comprehensive understanding of interest, from an email message posted by Mark Robbani of the Institute of Islamic Finance, on the IBF-NET YahooGroup. 

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Regarding the meaning of the word ‘interest’: It would be better to define the context of its use first, before discussing its meaning. Putting aside the true linguistic origins of the word, since ‘interest’ is currently an English word, then for our purposes - we should really use the English meaning of it only in financial & economic contexts. Thus:  

[from: http://en.wikipedia.org/wiki/Interest]

In finance, interest has three general definitions.

Interest is a surcharge on the repayment of debt (borrowed money).

Interest is the return derived from an investment.

Interest is the right to one’s claim in a corporation, such as that of an owner or creditor.

In economics, interest is the return to capital achieved over time or as the result of an event. In population dynamics the rate of population growth (the interest rate) is sometimes referred to as the Malthusian parameter. This article covers the “financial” use of the term.

[from: www.investorwords.com/2531/interest.html]

Definition 1

The fee charged by a lender to a borrower for the use of borrowed money, usually expressed as an annual percentage of the principal; the rate is dependent upon the time value of money, the credit risk of the borrower, and the inflation rate. Here, interest per year divided by principal amount, expressed as a percentage. also called interest rate.

Definition 2

The return earned on an investment.

Definition 3

Partial or total ownership in an asset.

[from: http://en.wikipedia.org/wiki/Interest]

In common use the term “interest” is seen as rent paid for the use of money. As with any rental, the market price (or rate) is subject to change to reflect market conditions. The fraction by which the balances grow is called the interest rate. The original balance is called the principal. Interest rates are very closely watched indicators of a financial market, and have a dramatic effect on finance and economics.

The fact that lenders demand interest for loans can be attributed to the following reasons:

Time value of money or time preference

(TVM: Having money now is more valuable than having it at some future time because interest is earned)

(TP: Interest is the value borrowers place on having money now)

Opportunity cost

(OC: The cost in terms of options no longer available once one particular option is chosen)

We should narrow down the use of the generic term ‘interest’ to the more specific ‘interest rate’ and also accept the practical application of ‘interest rates’ as the Central banks of the English speaking and western European countries apply it. Thus:

[from: http://en.wikipedia.org/wiki/Interest_rate]

An interest rate is the price a borrower pays for the use of money he does not own, and the return a lender receives for deferring his consumption, by lending to the borrower. Interest rates are normally expressed as a percentage over the period of one year. Interest rates are also a vital tool of monetary policy and are used to control variables like investment, inflation, and unemployment.

For instance:[from: http://www.bankofengland.co.uk/monetarypolicy/how.htm]

[from: ]The Bank of England sets an interest rate at which it lends to financial institutions. This interest rate then affects the whole range of interest rates set by commercial banks, building societies and other institutions for their own savers and borrowers. It also tends to affect the price of financial assets, such as bonds and shares, and the exchange rate, which affect consumer and business demand in a variety of ways. Lowering or raising interest rates affects spending in the economy.

Thus, the meaning & definition of interest appropriate for our purposes is the one ‘in common use’ - which happens to be a “surcharge on the repayment of debt (borrowed money)”, “rent paid for the use of money”, “The fee charged by a lender to a borrower for the use of borrowed money”, etc. All of these definitions are actually for the more relevant and specific term, ‘interest rate’ - and are similar to my own definition, which is a monetary charge applied for the use of money).

Here, the surcharge, rent or fee is actually money, which is exchanged for more money (i.e with a contractual difference in the corresponding/counter values). Since any contractual difference in the value of 2 or more items of the same type, quality and value when they are exchanged (irrespective of the time-period involved or the type, magnitude or form of the difference) is Riba, it therefore follows that the surcharge, rent or fee (in this context) is also riba [as any such surcharge, rent or fee (i.e monetary charge) is an 'increase' or an 'excess' in a like-for-like (money-for-money exchange) - thus haraam].

Regarding the variations in the application and meaning of the word ‘interest’ in different countries & languages: This is really more to do with sociology rather then the financial sciences. This is really more to do with sociology rather then the financial sciences.

For instance:

Although in the German language “…jurists categorise rent as being interest (while rent is not riba, and in Dutch interest is event called rent) and accountants sometimes go as far as talking about interest on equity (which will finally confuse everybody to mix up profit with interest)…” - when the German and Dutch (and most other) central banks set the base interest rate, they set it as their monetary charge for lending to financial institutions, and not as the base property/asset rental amount, or equity dividend, etc. This alone should make clear the true meaning of interest (and the context of its use) for our purposes. All other meanings are culturally subjective and thus not suitable for our universal & legalistic use.

Although in the German language - when the German and Dutch (and most other) central banks set the base interest rate, they set it as their for lending to financial institutions, and not as the base property/asset rental amount, or equity dividend, etc. This alone should make clear the true meaning of interest (and the context of its use) for our purposes. All other meanings are culturally subjective and thus not suitable for our use.

In conclusion:

My own personal opinion still remains that ‘interest’ (the form in common English and use) and more specifically, ‘interest rates’ riba (as defined by the authentic sources), but riba (again, as defined by the authentic sources) is not restricted to ‘interest’.

Ar-Rahn, or mortgage or collateral, is defined in the Islamic jurisprudence as “possessions offered as security for a debt so that the debt will be taken from it in case the debtor failed to pay back the due money.”

Ar-Rahn is a permissible contract in Shari’ah. It is known from the Sunnah that when the Prophet of Allah, Muhammad (SAW), passed away, his shield was with a Jewish man in Medina as a collateral.

The conditions of Ar-Rahn

1. The indebted party cannot be coerced into putting up a collateral;
2. An orphan’s property cannot be put up as a collateral by the trustee, unless under exceptional circumstances;
3. The property held as collateral must be liquid;
4. The property held as collateral must be distinct from other properties;
5. The ownership does not change, therefore the owner is responsible for the cost of upkeeping the property even when it is pledged as a collateral. Likewise, the owner continues to enjoy any secondary benefits to the property;
6. There is disagreement among the scholars on whether the property pledged as a collateral can be used. Many of the scholars say that the property cannot be used by either the debtor or the borrower, while many argue that the owner (the borrower in this case) can continue to use the property;
7. If the property held as collateral is lost or damaged while in possession of the trustee, without any negligence on his part, there is no guarantee by the trustee;
8. The ownership of the property cannot be transferred until the debt is settled or the debtor allows for such a transaction;
9. If the borrower cannot pay back at the expiry of the term, the judge will order the property pledged as collateral to be sold in the open market, even if it is the residence of the borrower.

Sources: Abdelhaleem, 14-15 and Kharofa, 154-161.

The Arabic word sharekah means partnership or company and denotes mixing of two shares in a way as to make them indistinguishable.

In Islamic jurisprudence, there are several definitions of partnership

Hanafi scholars define partnership as “a contract between partners on both capital and profit.”

Shafe’i scholars define partnership as “a contract giving the right in something to two or more people, making it common.”

Hanbali scholars define partnership as “the coming together of two or more people in disposal or acting.”

Two main kinds of partnerships

Partnerships are primarily of two kinds: partnerships of ownership and partnerships of contracts.

Partnerships of Ownership (Amlaak)

A partnership of ownership means that two or more people share the ownership of a single property, either by their own choice (i.e., by agreeing to buy the property) or without their own choice (i.e., inherting the property, for example). Each of the parties is a partner and none of the parties can dispose of the object on his or her own, without the permission of all other partners.

Partnership of Contracts (Uqood)

A partnership of contacts is between two or more people to have partnership in capital and profit. Such partnerships are subdvided into four kinds:

1. Amwal - financial company, where two partners contribute finances to start the company. This type further includes Al-’Inan or unequal share partnership and Al-Mufawadah or equal share partnership;
2. Wojuh - eminence, where a partner only contributes his or her eminence to the partnership (e.g., Al-Azhar University giving accreditation to an institute in Canada is a partnership where Al-Azhar is exhanging its eminence for a consideration);
3. Sana’i - workmanship, where the partners contribute labour to the partnership;
4. Mudarabah - capital-labour partnership, where one partner contributes labour and the other partner contributes capital.

It is the Mudarabah partnership that has become the focus of Islamic economics and finance in the modern era. We will generally not go into more details on all the various kinds of partnerships.

Source: Kharofa, 166-171.