4. Partnership (musharakah and mudarabah) Various forms of partnership can be direct financing methods. In Islamic banking and finance, the arrangement is commonly known as “profit and loss sharing”. The Shariah has developed two forms of profit and loss sharing arrangement i.e. mudarabah and musharakah.

Mudarabah is an arrangement whereby an investor or group of investors entrusts capital to an entrepreneur, who puts this into production or trade, and then returns to the investors a pre-specified share of the resulting profits, along with their principal. The remaining share accrues to the entrepreneur as a reward for his time and effort. If the business fails, the capital loss is borne entirely by the investors, the entrepreneur’s loss being his expended labour⁷.

Mudarabah is a viable basis for Islamic banking whereby Islamic banks plays a role of is a financial intermediary. The arrangement can be made adopting two-tier mudarabah agreement. The first tier of the mudarabah agreement is between the bank and the depositors, who agree to put their money in the bank’s investment account and to share profit with it. In this case, the depositors are the capital providers (rabb al-mal) and the bank function as a manager of the funds. The second tier of the mudarabah agreement is between the bank and the entrepreneur who seek financing from the bank; who agree that the profits accruing from the business will be shared between them and the bank in an agreed proportion, but the loss shall be borne by the financier only. In this instant, bank functions as the provider of the capital and the entrepreneur works as a manger. In cases where there is more than one financier of the same project (one project jointly financed by several banks), profits are to be shared in a mutually agreed proportion previously determined, but loss is to be shared in the proportion in which the different financiers have invested the capital.

Under musharakah, the entrepreneur adds some of his own capital to that supplied by the investors (rabb al-mal), exposing himself of the capital loss. The difference between the two techniques lies in the entrepreneur’s own financial commitment. In the context of Islamic financing, the arrangement can be done where that the Islamic investment company (or bank) and the client agrees to participate in a joint venture project to be completed within an agreed period of time. Both parties contribute to the capital of the operation and agree to divide the net profit in an agreed proportion. In the event of loss, all parties bear loss in proportion to their share of financing.

The newly developed model of Islamic financing based musharakah is Musharakah Mutanaqisah or diminishing partnership by which the investors’ share in a musharakah is progressively retired or liquidated⁸. The arrangement is made in such a way that the investor, in his payment of periodic profit distributions to the bank, pays not only the bank’s profit share but also a predetermined portion of his own profits which go towards reducing the bank’s capital share. The additional funds are normally held in a special account, which will be used either to purchase the bank’s share in a lump sum at the end of musharakah period, or they are applied progressively to reduce the bank’s capital share and thereby also reducing the ban’s claim on profits. The bank’s share is thereby reimbursed over time by the investor.

6. Islamic forwards (salam and istisna’)

Salam (advance sale) and istisna’ (manufacturing sale) can also be used as a method of financing in Islamic banking. Salam is a sale in which advance payment is made to the seller for deferred supply of goods. It is a sale and purchase transaction whereby the payment is made in cash at the point of contract but the delivery of the asset purchased will be deferred to a pre-determined date⁹. Istisna’, on the other hand is a contract of manufacture where a manufacture undertakes to manufacture goods for a buyer. The parties of the contract will decide on the price and the payment can be made either in lump sum or according to the schedule of the work completed¹⁰. The distinction between istisna’ and salam is on the nature of the goods being bought and sold. In istisna’, the purpose of a buyer is to obtain the manufactured goods, whereas in salam a buyer seeks to buy a future goods which are assured to exist. Thus, in istisna’, it requires a unique manufacturing process to produce the goods, whilst in salam, the items are not manufactured or constructed, but rather it is produced naturally such as vegetables etc.

Like many other modes of sale, this mode too, was prevalent even before the advent of Prophet. As a matter of principle, the sale of a commodity which is not in the possession of a seller is not permitted. But the practice of salam and istisna’ has been legalized as an exception on the ground of necessity. These forward purchases of described goods, whether for full advance payment or progressive payments, are important device for Islamic financing. Salam, for example, can be used by the modern banks and financial institutions, especially to finance the agricultural sector. The bank can transact with farmers who are expected to have the commodity in plenty during harvest time from their crops or crops of others, which they can buy and deliver in case their crops fail. As a general rule, the price of salam can be fixed at a lower rate as compare to the price of those commodities when delivered on the spot. As such, the difference between the two prices is considered a valid profit for the banks or financial institutions. Since the delivery of the goods in salam is in the future, it is also allowed for the banks and financial institution to request the seller to furnish a security, which may be in the form of a guarantee or in the form of mortgage, to cover the risk of non delivery. In the case of default, the guarantor may be asked to deliver the same commodity; and if there is a mortgage, the buyer or the financier may sell the mortgaged property and the sale proceeds can be used either to realize the required commodity by purchasing it from the market, or to recover the price advanced by him.

On the other hand, in Islamic banking practice, istisna’ is frequently employed to finance manufacture or construction projects. For example, if a client seeks financing for the construction of a house, the financier may undertake to construct the house on the basis of istisna’. Since it is not necessary that price to be paid in advance, nor it is necessary to be paid at the time of delivery, the parties may agree in the manner and time for payment. As such, the payment may be in installment, according to the convenient of the customer. Another arrangement is called back to back istisna’ or parallel istisna’. In this arrangement, the bank will enter into the contract of istisna’ with the customer, and later contracted the second istisna’ contract with the manufacturing party. This structure is normally used by the Islamic bank to finance purchases of major manufactured goods such as ships or planes. Under the first istisna’ the bank as a seller accepts a long term schedule of payments from its customer, while under the second istisna’ he bank as buyer pays the manufacturer over a shorter period with progress payments¹¹.