Musharakah

Musharakah (also spelled musharaka, from the Arabic shirkah, "sharing") is a partnership in Islamic finance in which two or more parties contribute capital to a business or project and share in its results. Profits are divided according to a ratio agreed in advance, which need not match each partner's share of the capital, while losses are borne strictly in proportion to the capital each partner contributed.

Musharakah is often described, together with mudarabah, as the ideal form of Islamic financing, because the financier shares the real risk and reward of the venture instead of earning a fixed return, which would be riba.

Classical Islamic law, set out in fiqh al-mu'amalat, distinguishes two broad categories:

• Shirkat al-milk (partnership of ownership), where two or more people jointly own an asset, for example through inheritance or a joint purchase, without necessarily running a business together.
• Shirkat al-'aqd (contractual partnership), where the partners agree to carry on a business together. The jurists further divided this by what each partner brings, such as money, labor or creditworthiness, and by how much authority each partner holds.

Modern Islamic finance mainly uses the contractual form with cash contributions. Standards issued by AAOIFI set out the conditions for using it in financial institutions.

• Each partner's capital contribution must be specified, normally in cash or in assets valued in cash.
• Profit is shared as a proportion of actual profit. A partner may not be promised a fixed sum or a fixed return on capital.
• Loss is shared in proportion to capital contributions. A partner cannot be guaranteed against loss by another partner, although third-party guarantees and promises are discussed in the literature.
• Every partner has the right to take part in management, but partners can agree that one or more of them will act as "sleeping" partners. A sleeping partner's profit share should not exceed its capital share.

A bank contributes 600,000 and an entrepreneur contributes 400,000 to a 1,000,000 venture, with profits shared 50:50 because the entrepreneur also manages the business. If the venture earns a profit of 120,000, each receives 60,000. If the venture instead loses 100,000, the loss is divided 60:40 according to capital, so the bank bears 60,000 and the entrepreneur 40,000.

Islamic banks use musharakah for project finance, real estate development, working capital lines and joint ventures, and as the basis for some sukuk, in which investors hold shares in a partnership's assets. A widely used variant is the diminishing partnership, musharakah mutanaqisah, in which the customer gradually buys out the bank's share. It is commonly combined with an ijarah lease and is used for home and asset financing.

Musharakah also has a counterpart in Jewish law, where the heter iska converts what would otherwise be an interest-bearing loan into a partnership with shared profit and loss.

Although musharakah is held up as a model, it makes up a small share of most Islamic banks' financing compared with sale-based contracts such as murabaha. The reasons include the difficulty of monitoring the partner's business, the risk that profits are under-reported, higher capital charges that supervisors apply to equity-type exposures, and depositors' preference for predictable returns. Prudential guidance from the IFSB treats such exposures as equity investment risk. A purchase undertaking that obliges one partner to buy out the other at the original face value has also been criticized, especially in sukuk structures, because it can turn a partnership into something close to a loan, and a bank's Sharia supervisory board is expected to ensure that loss-sharing is genuine.

In mudarabah, one party supplies all the capital and the other supplies only management, and financial loss falls entirely on the capital provider. In musharakah, every partner supplies capital and losses are shared according to contributions. Both contracts share profits by an agreed ratio, and both exclude any guaranteed fixed return to the financier.