Musharakah Mutanaqisah Home Financing: Shari ah Issues, Financial Implications and Accounting Considerations. INCEIF, Kuala Lumpur, Malaysia.

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1 Musharakah Mutanaqisah Home Financing: Shari ah Issues, Financial Implications and Accounting Considerations Alam Asadov, Zaheer Anwer, Shinaj V. Shamsudheen 1 & Zulkarnain Muhamad Sori (PhD) 2 INCEIF, Kuala Lumpur, Malaysia Abstract It is well reported that the bubbles in global real estate market are a result of unequal risk burden in conventional mortgage financing and speculative nature of the market. The problem could be fixed by introducing Musharakah Mutanaqisah (MM) mode of Islamic financing, where bank and customer enter into a contract of joint property ownership. Throughout the financing period, the customer will increase his ownership through gradual acquisition of bank s share. The aim of this paper is to examine pertinent issues in the MM financing and subsequently, recommend possible solutions to improve the practices. The result of analysis indicated that exist significant gap between theory and practices of MM home financing. Among important issues analysed are: i) the use of interest based benchmark for profit calculation, ii) application of historical cost value during the tenure of share transfer, and iii) accounting implications. Furthermore, MM home financing become more effective by using Rental Index for profit calculation along with periodical assessment of fair value of assets in the financing record. It is important to note that MM financing should reflect a true partnership contract through sharing of risk and reward between both parties. Keywords: Musharakah Mutanaqisah, Islamic banking, Shari ah compliance, home financing. 1 Asadov, A. and Anwer, Z. are PhD candidates and Shamsudheen, S. V. is a Master student at INCEIF. The corresponding author is Asadov, A. and he could be contacted at alam.asadov@gmail.com. 2 M. Sori, Z. is an academic staff at INCEIF.

2 INTRODUCTION Islamic finance has shown tremendous growth, where its assets surpassing USD 2.1 Trillion by the end of 2014 and expected to reach USD 2.4 Trillion by end of 2015 that give it cumulative growth rate of 17.3% for last five years. With forecasted growth rate of 12.5% per annum, the industry s asset size is expected to exceed USD 4 Trillion by 2020 (MIFC, 2014). Since the emergence of Islamic Finance in 1970s, many new products complying with Islamic religious principles (Shari ah) came into existences. Even though many of those products look similar to conventional financing products in form, the underlying principles on which they were established are completely different. Musharakah Mutanaqisah (or Diminishing Partnership) agreement is one such innovative product that was introduced in 1990s, became popular in 2000s and still getting wider acceptance and application in the field. Indeed, the introduction of Musharakah Mutanaqisah financing mode could be good alternative for replacement of controversial Islamic financing line al Bai Bithaman Ajil and Bay al Inah (Mydin-Meera & Abdul-Razak, 2009). Embedded profit and loss sharing features of Musharakah and gradual transfer of the ownership by period instalments that cover both profit share and payment of Islamic bank s share make this product less risky and convenient for both the bank and the customer. Smolo & Hassan (2011) believe that this mode of finance may stand better when compared with both conventional and other compliant modes as it can play safeguarding role against inflation. Nevertheless, Islamic banks must be careful not to cross Shari ah compliance borders while trying to make practical and risk reducing adjustments to some of the product features. There seems to be consensus among authors on point that the price of shares as well as rent should be determined in accordance with market forces (Mydin-Meera & Abdul-Razak, 2009; Smolo & Hassan, 2011) The aim of this paper is to discuss and debate some important Shari ah and financial considerations of Musharakah Mutanaqisah home financing and to link them with accounting perspectives. The structure of the paper is as follows. The next section discusses basic features of Musharakah Mutanaqisah from both Shari ah and financial perspectives followed by a deliberation on contemporary issues with the product s applications in Islamic home financing. Then for the next three sections we will discuss our proposed MM home financing product along with some accounting considerations and suggested adjustments in accounting for Shari ah compliance concerns. Some practical solutions and accounting recommendations are suggested as remedy for above-mentioned discrepancies. Finally, analysis of relevant cost and benefits of proposed MM home financing model will be discussed. Conclusion part will summarize the findings and give some suggestions for further research. OVERVIEW OF MUSHARAKAH MUTANAQISAH The inaugural proposal of Musharakah Mutanaqisah (MM) mode of financing, where Islamic bank and their customer jointly owned a property or a project with subsequent transfer of ownership to the customer was laid down during the First International Conference on Islamic Banking held in Dubai in 1979 (Bendjalali & Khan, 1995). However, formal acceptance of the concept was only announced by Resolution No. 136 of OIC s International Fiqh Academy at its 15 th Session held in Muscat, Oman in As a result, the financing product was widely acceptespecially in area of home financing. 1

3 The Musharakah Mutanaqisah (MM) agreement is a Shari ah compliant financing product, which used concepts of Musharakah (partnership), al-bay (sale) and possibly Ijarah (rent) depending on the subject of partnership. In general, the partnership steps are as follows: It begins with two parties (i.e. the bank and the customer) purchasing certain asset (for instance, house) as partners. After the purchase, one of the parties (usually the customer) starts renting or utilizing the asset. In return, the customer shares profit with (or pays monthly rent to) its partner (i.e. the bank) according to the agreed ratio. However if there is any loss, it would be shared in proportion to the partner s share in the asset, which is in line with principles of Musharakah. Besides sharing profit or loss from (or renting) the asset the customer starts to gradually acquire partner s share in the asset by making additional payment over the bank s profit share (the rental payment) in every period (e.g. every month). At every subsequent payment profit (rental) part of the instalment decreases since the bank s share decreases in the shared asset. The partnership ends when the customer makes last payment to the bank that covers both its profit (rental) and amount equal to remaining share of the bank in the asset. Even though the concept seems straight forward, there are many nuanced Shari ah principles and country specific requirements of this agreement that could make it very complicated. Figure 1: Working of Musharakah Mutanaqisah principle Islamic Bank Jointly owned of the property Customer Periodic installments (including both profit and payment for bank's shares) Gradual transfer of ownership from the bank to the customer (the customer becomes sole owner with transfer of the last share) 2

4 To Summarize we can say that following are major steps of MM agreement 3 (See Figure 1 for illustration): 1. The customer and the bank make partnership to raise the capital to buy the property. 2. The customer and the bank become the owner of the property based on the ratio of payment in purchasing the property. 3. The bank starts sharing profit or loss with the customer (or leases its share to the customer in return for monthly rentals) for a predetermined period. 4. The customer gradually buys out the bank s share in the partnership throughout this period. 5. Finally, the bank s share ceases to exist and the customer gets the full ownership of the property. Shari ah principles governing contracts in Musharakah Mutanaqisah From Shari ah perspective, Musharakah Mutanaqisah agreement is not considered as a single contract, but seen as combination of several contracts; Musharakah being the central one. One could consider it as enhanced version of Musharakah contract as well. If we take the first position and consider it as combination, then there is a need to spell out Shari ah position in such as case. According to majority view it is permissible to combine more than one contract in a package given that there is no condition imposed by one on the other(s) and each contract must be permissible in Shari ah independently (Lahsasna (2012), pp. 109). Though most of the Islamic jurists agreed upon the permissibility of MM, there are some scholars who hold different opinions. The majority believes that it is permissible and Shari ah compliant. Evidence for each subcontract used in MM agreement such as Musharakah (partnership), Ijarah (lease) or Bay (sale) could be found from primary or secondary sources of Islamic jurisprudence (Fiqh). The following Qur an verse provides support on Musharakah, where it describes on co-operation in good deeds among Muslims and avoids injustice by saying: O you who have believed cooperate in righteousness and piety, but do not cooperate in sin and aggression. And fear Allah; indeed, Allah is severe in penalty (Al- Ma idah, 5:2). Shari ah scholars generally agreed on the validity of a sale contract which is combined with lease contract. Also, there is no clear text in the Shari ah that prohibits MM. Considering the public interests and benefits of MM in the investment; it should be permitted in the Shari ah (Smolo, 2007). Some scholars however, disagreed to the validity of MM contract. To them, it should be declared invalid as it contains some elements of doubts. They claim that it is 3 List is borrowed from Osmani & Abdullah (2010) 3

5 similar to interest as the primary purpose of MM is to give loan to the customers and to derive extra money from the amount of loan (Al-Kawamelah, 2008). This view of some scholars seems to be misleading. The MM agreement is a joint ownership plus sale and lease contract, and both the bank and the customer share the profit and loss of the business together. Therefore, the claim that MM is similar to interest based loan is unfounded in theory. Moreover, the International Fiqh Academy of OIC (2004) in its 15th session made resolution that MM is a valid contract in the Shari ah. Besides, the Shari ah Advisory Council of Bank Negara Malaysia in its 56th meeting decided that MM is a recognized contract in the Shari ah and the current practice of the contract is permissible (Bank Negara Malaysia, 2007). Therefore, it is safe to conclude that MM is a permitted contract in Shari ah. However, scholars suggest some principles and guidelines that are needed to be observed strictly, so that this contract does not exceed the boundary of the Shari ah and is not assimilated with the interest based contracts. (Al-Kawamelah, 2008; International Fiqh Academy, 2004) The principles are as follows: 1. The goods must be present. So, the property which is not present at the moment or pledged is not allowed to use as collateral in a transaction. 2. The proportion of the profit must be specified and the profit will be in proportion not by amount of money. 3. Both the bank and the customer must share the profit and loss of the property. 4. The Shari ah advisory board must have the right to monitor the contract. 5. The contract of partnership and the contract of sale should be done separately, and not collectively. 6. A binding promise can be taken from one partner to purchase the share of the other partner gradually. Additionally, there are some Shariah concerns on the issues like simultaneous use of Musharakah and Ijarah contracts in one agreement and the bank s treatment of the customer s share as a pledge against his obligations towards the bank. The Shari ah Advisory Committee of the Malaysian SEC, in its 56 meeting on 6 February 2006 came up with following resolution: i. The collective usage of Musharakah and Ijarah contracts is permissible as long as both contracts are concluded separately and clearly. ii. Only the customer s share could be pledged to the Islamic financial institution since beneficial ownership is recognized by the Shari ah 4. 4 Lahsasna, A. (2015). Shari ah issues and resolutions in contemporary Islamic banking and finance. 4

6 Applications of the Musharakah Mutanaqisah in home financing Since Musharakah Mutanaqisah is an enhanced version of Musharakah contract it could be applied in almost all cases where Musharakah is applicable and also in some additional cases where pure form of Musharakah may not be applicable. One such cases where the pure Musharakah is hard to apply but MM concept is widely used is home financing. For example, a customer wanting to purchase a house using MM financing as follow, Let say 10% of the price is paid by the customer and remaining 90% by the bank. In this context, the bank owns 90% of the house while the customer owns 10%. After jointly purchased the property, the customer uses the house for his residential requirement and pays rent to the bank for using its share of the property. At the same time the share of the bank is further divided in ninety equal units, each unit representing 1% ownership of the house. The customer promises to the bank that he will purchase one unit every month. Accordingly, after the first month of the purchase, the customer acquires one unit of the bank s share by paying 1/100th of the price of the house. It reduces the share of the bank from 90% to 89%. Hence, the rent payable to the bank is also reduced to that extent. At the end of the second term, he purchases another unit that increases his share in property to 12% and reducing the share of the bank to 88% and consequentially reducing the rent to that proportion. This process goes on in the same fashion for 90 months, the customer purchases the whole share of the bank reducing the share of the bank to zero and increasing his own share up to 100%. This arrangement allows the bank to claim rent according to its proportion of ownership in the property at the same time allows periodical return of a part of the principle through the purchases of the units by the customer from the bank s share. The proposed arrangement is composed of the following transactions (Usmani, 2008): 1. Formation of joint ownership in the property (Shirkat-ul-Milk). 2. Giving the share of the bank to the customer on rent (Ijarah). 3. Promise from the customer to purchase the units of share of the bank (Wa d). 4. Actual purchase of the units at different stages (Bay). 5. Adjustment of the rental according to the remaining share of the bank in the property (Musharakah terms). Usmani (2008) states that Musharakah Mutanaqisah may be used for home financing with following conditions, (a) The agreement of joint purchase, leasing and selling different units of the share of the bank should not be tied-up together in one single contract. However, the joint purchase and the contract of lease may be joined in one document whereby the bank agrees to lease his share, after joint purchase, to the customer. This is allowed because Ijarah can be affected for a future date. At the same time the customer may sign one-sided promise to purchase different units of the share of the bank periodically and the bank may undertake that when the customer will purchase a unit of his share, the rent of the remaining units will be reduced accordingly. 5

7 (b) At the time of the purchase of each unit, sale must be affected by the exchange of offer and acceptance at that particular date. (c) It will be preferable that the purchase of different units by the customer is affected based on the market value of the house as prevalent on the date of purchase of that unit, but it is also permissible that a particular price is agreed in the promise of purchase signed by the customer. CONTEMPORARY ISSUES AND CHALLENGES IN APPLICATION Even though Musharakah Mutanaqisah contract looks completely consistent with the Shari ah, when it comes to the practice, Islamic Banks prefer the version that resembles conventional home financing. Many issues make theory and practice of MM partnership markedly different, which sometimes raises the question of Shari ah compliance of many MM products as practiced by Islamic Banking industry today According to Osmani and Abdullah (2010), some minimum Shari ah guidelines and principles must be strictly followed in MM partnership to be in line with principles of Fiqh Muamalat. It is more so important because we do not want it to be mere replication of the conventional loan. On its 15 th Session OIC s International Fiqh Academy, some basic principles for Musharakah Mutanaqisah contract were laid down as follows 5 : i. None of the parties have the right to acquire other s share at the cost price. So the price paid should be either the market price or the price agreed at time of the sale. ii. No partner should be forced to bear entire cost of the insurance or other general expenses. Such expenses should be born according to share of each partner in the property. iii. Profit should be distributed according to pre-agreed ratio while loss should be shared according to the proportion of each partner s share in the ownership. iv. Contracts underlying MM partnership could be combined in one package but should not be binding to each other. This means that Musharakah and Bay contracts should be separated from each other. v. Finally, there should not be any stipulation preventing either party from withdrawing his contribution from the partnership. However, there seems to be broad range of Shari ah compliance and legal issues related to Musharakah Mutanaqisah based products offered by Islamic banks at the moment. If some of those concerns are general to the most of Islamic Banking products, some are more specific to MM based contracts. In the subsequent section, some of such concerns will be discussed from practical application of Musharakah Mutanaqisah in Islamic finance. 5 Resolution No. 136 of OIC s International Fiqh Academy (2004) 6

8 Impermissibility of two agreements in one As has been mentioned earlier MM agreement is considered as a bundle of contract rather than being separate contract on its own. In case of MM home financing there are three contracts of Musharakah (partnership), Ijarah (lease) and Bay (sale). Scholars opinion on this matter is such that given the Shari ah prohibition of the combination of two agreements in one transaction that are made conditional upon each other, it is still permissible for the contracting parties to combine the two contracts of Musharakah and Ijarah into one document as long as both were concluded separately and do not overlap (Usmani, 2002; Boon Ka, 2009). However, when it comes to Bay (sale) contract, the majority of scholars agree that it cannot be combined with other contracts or especially make conditional to other contracts in any form. In general, if all these transactions have been combined by making each of them a condition to the other, then this is not allowed in the Shari ah, because it is a well settled rule in the Islamic legal system that one transaction cannot be made a pre-conditioned for another. However, the proposed scheme suggests that instead of making two transactions conditional to each other, there should be one sided promise from the client, firstly, to take the share of the bank on lease and pay the agreed rent, and secondly, to purchase different units of the bank s share in the house at different stages. This leads us to the next issue, which is, the enforceability of such a promise. Arguments about use of the Promise (Wa d) in MM agreement Excessive use of promise (wa d) by Islamic banks is one of major debatable issues in contemporary Islamic Finance (Wisham, et al., 2011). There is no consensus among Islamic jurists about fulfilling such promise being obligatory or recommended. Thus depending on each opinion legal consequences will differ. If we accept wa d to be obligatory then bank can impose a fine to customer if he fails to fulfil his promise. On the contrary, if the fulfilment of wa d is considered as not compulsory but just moral obligation, this means it would be up to the customer either to fulfil or cease his promise. In such case, the bank cannot impose any financial punishment in case of customer not fulfilling his promise. Majority Shari ah scholars and international organizations take promise to be legally imposable in Islamic finance transactions. For instance, the OIC International Fiqh Academy in one of its resolutions gave fatwa for promise to be legally binding. Therefore, compensation equivalent to the lost incurred must be paid by customer to the bank in case of failure to fulfil promise from his side. However, exception is given to this ruling if the customer has some valid reason for non-fulfilment of his promise (Resolution no of Islamic Fiqh Academy, 1988). Instrument of wa d is usually in MM based home financing entrenched in two forms. First, the customer undertakes to pay the monthly payment until the end of MM. Second, the customer irrevocably undertakes to purchase the bank s share (even in the event of default). By virtue of this promise, the customer shall be obliged to acquire the bank s ownership 7

9 share in the property at the buyout amount when there are changes in circumstances resulting in illegality, even if it is not caused by the customer (Boon Ka, 2009). Stipulation and enforcement of such wa d goes against guiding principles of Musharakah, the main concept used under MM agreements. Under Musharakah, any lose should be shared by all partners unless it was causes by clear negligence of one partner. Controversy over issues of the ownership risk In Musharakah Mutanaqisah contracts, the ownership risk is totally born by the customer even if the bank is also considered as a partner in theory. It is understandable that if there is any damage on the property due to customer s negligence, he should be liable for the damage. However, if the cause of the damage is a natural calamity or an action of unrelated third party, then both the bank and the customer shall share the loss according to share of each parties in the property. On the other hand, default by the developer is another major risk and huge lose in case of property under construction. According to Boon Ka (2009), in the events of default by the developer as abandoned property or winding up of developer that is not fault of the customer, the customer is still obligated to buy the bank s share in the asset. He argues that this practice is similar to what is practiced under conventional loan, where customers will keep paying to the bank until the receipt of proceeds for the damage from the insurance coverage. Even worse, there may be no Takaful available to cover such risks. On the other hand, question arises about party to be responsible for the cost of Takaful, in case Takaful has to be purchased for the property against any possible damage. From analogy to the above argument, it looks like both partners should share Takaful cost in line with their share in the property. Unfortunately, banks oblige the customer to pay for all such costs in practice. In an Ijarah relationship, the owner (lessor) has to bear the cost of basic and structural maintenance while the occupying party (customer/lessee) shall bear the routine and operational maintenance of the property. Nonetheless, since the customer s ultimate objective of engaging in the transactions is to own an asset, and not merely to rent it for a certain period of time, it has been arguably accepted that the customer should bear all the costs, particularly when the customer is acknowledged as the sole legal owner in the document of title. Scrutiny of a sample MM co-ownership agreement (a clause on payment of taxes and outgoings) indicates that the customer shall pay 100 per cent of the amount of all taxes due in relation to or associated with the property, notwithstanding the customer being the partial owner of the property until the end of the coownership (Boon Ka, 2009). Furthermore, in Musharakah contract one of the partners could not be held responsible for the damage cause to the partnership property because of the natural calamities or third party action. It is especially true if it is not due to the customer s negligence or fault. Al-Zuhayli (2003) defined it as partnership property in the possession of one partner is considered a trust, since the partner is not holding the partnership property to collect a price or to guarantee some other payment as in pawning, he is not responsible for the perishing of what 8

10 is kept in his possession. Pushing all such costs and risks of ownership as sole responsibility of the customer runs against to the concept of risk sharing under Musharakah agreement. Use of interest benchmarks for profit calculation The use of interest based benchmarks such as LIBOR, interbank offer rate or bank s Base Rate as benchmark for rental payments are widespread including in the MM contracts. Indeed, this practice has been rejected by scholars, where Mydin-Meera and Abdul-Razak (2009) recommended the use of actual rental rates instead of interest based benchmarks for MM home financing. Usmani (2002) states that in case of Ijarah, the rental payment should be determined for the whole period of lease contract. However, he also admits that fixing different amounts of rental throughout various phases of the lease period is also allowed and those rentals should be agreed upon signing of Ijarah agreement. Finally, he concludes that any ambiguity left about amount of the lease for subsequent phase of the lease period will make Ijarah contract void. Consistently, Al-Zuhayli (2003) pointed out that a sale without naming the price is defective and invalid. Similar to a sale contract, in rent, goods or its usufruct cannot be sold without specifying the price. Conversely, fixing rental rate in the beginning may not be practical and could put either the bank or the customer in uncomfortable situation if rate changes. Therefore, some scholars recommend fixing rental rate to some identifiable rental index for that specific location. Usually, housing rental is different for various locations and it could increase as time passes. Mydin-Meera and Abdul-Razak (2009) posited that such rental increase may cause difficulty for the customer. However, for most part of rental rate is lower than corresponding interest based benchmarks which are used as alternative. Contemporary MM agreements link rental rate to some know interest rate index such as the London Inter-bank Offered Rate (LIBOR) in the UK and the Bank s Base Rate in Malaysia. Even though, scholars do not see linking rental or profit rates to some market interest rates as haram in it, they allow it only as temporary solution because of it resembling practice in conventional finance. It was argued that until some Islamic index is established some interest based indices could be used as benchmark (Yacuby & Usmani, 1998). Consistent with al-zuhayli (2003) and Usamani (2002), Mydin-Meera and Abdul-Razak (2009) rejected this practice due to the difficulty to estimate future interest ratesand the use of interest based benchmarks would cause uncertainty (gharar) in the rental price. Another point that makes this practice even more doubtful as it give right to fix consequent rental entirely to the option of lessor without even considering of the lessee approval. Usmani (2004) asserts that lessor is not allowed to change the rental without the approval of the lessee and furthermore any contract stipulating such condition would be void in Shari ah. A major drawback of interest rate benchmarks is the fact that they only represent conditions in the financial market. They fail to account for the real world economic conditions and as a result, such indices are not a good proxy of rental rates. Thus, rental indices for that particular location should be used or developed for approximation of the rental payment by the customer. The bank s insistence on the use of interest-based index to estimate real value of 9

11 the rental is tantamount to insisting on Riba. That in return would increase Shari ah noncompliance risk of the bank and the product. Periodical revaluation of the property during MM home financing agreement The value of property could change during the contract period due to various market factors, and thus, the partnership should determine the value of each partner s share. Usmani (2004)pointed out that the value of property in MM contract should be recalculated every time one partner wants to acquire part of another s share. This would be fairer for both parties and oppression (zulm) could be avoided to towards any of them. Furthermore, Usmani (2002) and International Fiqh Academy (2004) consider revaluation or setting some fixed price in the initial promise by the customer as plausible alternatives. However, the periodic revaluation to be as more preferred option especially if one is going to argue in favor of fixing rental payments to a specified rental index. This way the MM home financing agreement will not be very unattractive to the banks because rental in general being lower than prevailing interest rates, the bank could gain from appreciation in the value of the property. This way both the bank and the customer would be bearing the risk of ownership together, which would make the agreement fair to all parties. However as Mydin-Meera and Abdul-Razak (2009) point out there are some issues involved in application of this concept in MM agreement, especially in home financing. They suggested that: Firstly, MM partnership involves gradual acquisition of bank s share by customer. Hence, at the end of the MM contract, the customer would have bought out the entire property and any change in price at that time would fully belong to the customer. However, this argument would not fairly reflect the substance of the transaction. In its resolution concerning MM agreement, the International Fiqh Academy pointed out that price at which one partner acquires other s share could not be historical cost and market value should be considered 6. Thus revaluation of the property few times during the share transfer seems to be more in line with Shari ah. Then they state that valuation is only possible at time of sale, where ownership is fully transferred to the buyers. Thus, valuation will not be appropriate within MM agreement period since the full transfer have not taken place due to the gradual transfer of ownership throughout the duration of the MM contract. In this context, the main flaw in this argument is confusion about ownership transfer. By not recognizing the purchase of bank s shares as transfer of (at least partial) ownership could totally jeopardize the concept of MM agreement. Question of how could the customer benefit from his newly acquired shares as reduction in rental proportion to be paid if he could not be considered as owner of those shares puts many thing under suspicion. Such arguments would make a laymen suspect of whether any real partnership being involved in MM contract or it just being used as legal trick to go around issue of Riba of conventional loan based home financing. 6 Resolution No. 136 of OIC s International Fiqh Academy (2004) 10

12 Finally, Mydin-Meera and Abdul-Razak (2009) pointed out that if we allow for period revaluation of the property, then it should be open for either appreciation or depreciation in value. Knowing bank s attitude towards risk, it is most unlikely for the banks to agree with such arrangement. It is suggested that revaluation of assets value to their fair value should take place at certain periods to be agreed by both parties depending on the length of the agreement and the nature of the real estate market. Security pledge It is a common practice for conventional and Islamic banks to require their customer to pledge some amount of money in their effort to reduce the financing risk as much as possible. One of such instruments is the use of security pledge by the customer against the facility provided by the bank. In such pledge, the customer is required to deposit certain amount of money for safekeeping in the bank and this amount could only be withdrawn upon final settlement of the facility. According to majority opinion no security pledge (via legal charge) can be arranged in MM transactions since it cannot have a guarantee attached to the financing (contribution of) principal according to the Shari ah 7. But, the use of such pledge in MM based contracts by some banks seems to be in clear violation of the underlying Musharakah principles. Challenges of offering the truly Shari ah compliant MM products Mydin-Meera and Abdul-Razak (2009) believed that the flexibility of MM contracts such as its amortization schedule makes the product gain popularity over the BBA contract. However, they anticipated some problems could arise when banks simplify and adjust its features that make MM s similar to conventional finance product. Mydin-Meera and Abdul-Razak (2009) argued that banks cost of funds being tied to the interest rates due to its convenience and similarity with conventional practice. Indeed, the interest rates are higher as compared to rental rates and finally cumbersomeness and additional costs related to tracking rentals in absence of any national or regional rental indices. In essence, a true Islamic financing should be free of interest rates even in use in benchmarking. Rental and profit payments in such a system should be determined exclusively by the real economic activities. No doubt there need to be a lot of work done to make the use of real economic factors as robust and possible as use of financial market tools such as the market interest rate. Another interesting observation that could be drawn from the practice of MM products is their primary application in home financing. Musharakah Mutanaqisah is such a universal product which could be applied in many type of financing that could be arranged as partnership. However, Islamic banks prefer to apply it in home financing because of its embedded convenience and low level of risk. After replacing the rental rate with interest 7 See Boon Ka (2009) for more details. 11

13 benchmark, ignoring revaluation option for the property and totally transferring ownership risk to the customer, it becomes mere Islamic replicate of the conventional loan-based house financing. Since such replication is difficult in other types of partnerships such as business or trade financing, they become less attractive alternative for the Risk averse Islamic banks. Only limited number of banks offer MM financing in other areas than house financing. PROPOSED MM HOME FINANCING AND ITS FINANCIAL IMPLICATIONS 8 In this section, the financial implications of proposed version of Musharakah Mutanaqisah home financing agreements will be discussed. The main assumptions of the proposed model are the use of rental index for calculation of rental profit, periodic revaluation of the property during share transfer and the use of either market or latest valued price in case of early termination depending on time and circumstances of the termination. Some minor assumptions of sharing ownership risk and expenses are also included in the model. However, for sake of simplicity we will not consider those issues in this section. General comparison of proposed MM home financing and the one practiced by most of Islamic banks (IBs) is given in Table 1 below. Table 1. Comparison of practiced and proposed versions MM home financing agreements Comparable characteristics of MM home financing Calculation of rental rate for the bank s share of the property Price at which the bank s shares are transferred to the customer Price at which the bank s shares are transferred to the customer in case of early termination Ownership risk assumed or relevant costs paid by the bank MM home financing practiced by IBs Use of interest benchmarks such as LIBOR, KLIBOR, or Bank s base rate. Equal to the value of the original cost paid by the bank for joint acquisition of the property Value of remaining principle and any early termination fee if applicable Almost all of the risks are transferred to and all cost (such as takaful) are paid by the customer. Proposed MM home financing Use of Rental Index or other housing indices for given location and characteristics of the house Equal to the value of the property that is estimated at latest periodic revaluation (i.e. at latest estimate of property s fair value) At value of latest estimated fair value or current market price if revaluation is due Bank shares both risks and cost of ownership according to its share in the property. 8 For this section we borrowed some examples from Mydin-Meera and Abdul-Razak (2009) to illustrate some variations in rental rate and value of the property. 12

14 Proposition of tying rental rates to a rental index Mydin-Meera and Abdul-Razak (2009) pointed out that rental index should be used instead of fixed rate, where this approach could minimise theliquidity risk. Indeed, MM contract can be more flexible and in line with real economy if we allow for periodical review of rent payment. The review should not be done in short period of time like quarterly, semi-annually or annual basis, but, a longer period like 3-5years would be more realistic and practical. Such flexibility would decrease the mismatch issue and would be fairer for both parties. Let us look at the scenario that follows. Let us consider a case where the customer wants to buy an apartment for price of $100, 000. As down payment the customer pays 10 percent of the price, i.e. $10, 000, the bank pays the 90 percent remainder, $90, 000. The customer is planning to buy back the bank s share let us say in 15 years (i.e. 180 months). If we also assume that rental payment to be $ 500 / month for the first 3 years, and increased by $50 for next 3 years to be $550 and continues in same fashion until it would be $700 for last 3 years. For sake of simplicity and easy understanding we will assume not change in value of the property in this section (or just assume using historical price for share transfer). So our all of the assumptions are summarized in Table 2 below: Table 2. Assumptions of the model with only variable rental rate Original price and share of the partners Rental Periods Rent in Dollars Rent as % of Original Price Price of house 100, Months % Beginning share of the customer Beginning share of the bank 10, Months % Months % 90, Months % Months % To calculate total monthly payment and part of redemption (principle payment) in it we would use formula for calculation of instalment with diminishing balance used by Mydin- Meera and Abdul-Razak (2005). It is general formula for calculation of annuity details of which is show in Appendix A. The schedule of payment due by the customer and each partner s shares in the property for each period is given in Table B1 of the Appendix B. Only difference from calculation of ordinary annuity as can be seen from the table is that we have to recalculate amount of instalment every time rental rate is changes. The amount of instalments has increase from $ for the first 3-year period to $ the next and subsequently to $803.17, $ and $ for following subsequent 3-year periods as amount of rental was increasing by $50 (or 0.05% of the original value of the property) in each 3-year period. If customer pays installments in scheduled manner the value of his share in the property would increase from $10,000 (10%) in the beginning period to $100,000 (100%) at the last period. That would make him sole owner by making the last installment at 180 th month. 13

15 In general we can conclude that with assumption of only variable rental rate and fixed value for the property calculation is relatively straight forward. It is not very complicated to calculate instalments and rental payments under such assumptions. If rental rate is increasing (which is the general case) it could be beneficial for the bank to adopt such model of MM home financing. Only nuance is that rental rates are generally lower than interest rates as it was documented by Mydin-Meera and Abdul-Razak (2009, p. 134) in case of Malaysia. Therefore, it may not be attractive for banks to consider this version of MM agreements. Therefore, we propose periodic revaluation of the property for calculation of the value of the bank s share during transfer of the ownership. Since prices of real estate tend to increase over passage of time such consideration will increase attractiveness of the model for the bank, while still making it fair for both parties. In following section we will consider detailed analysis of such enhanced feature of the proposed model. Proposition of considering variation in value of property The MM house financing based on a partnership between the customer and the bank is ownership of property, while at the same time the customer rents the property. Throughout the partnership period, the customer gradually acquires bank s share in the property ending up with full ownership at maturity of the contract. In previous section, we have shown how adjustments in installments could accommodate change in the rental rate. However, some scholars also propose considering change in the value of the property when transferring the bank s share to the customer. The argument goes like this:- If the partners in Musharakah jointly own the property and any profit or loss from it is also shared, any appreciation or depreciation in the value of the property should also be shared by them. However, as Mydin-Meera and Abdul-Razak (2009) point out, there are some issues involved in application of this concept in MM partnership, especially in house financing. We have discussed their argument in a section above related to revaluation of the property. While rental can be determined upfront, it is difficult to approximate the future value of the property. Therefore, we think that revaluation should take place at certain periods agree by both parties. As in our rental example, let us assume that parties agreed to revaluation the property every 3 years. If observed values are as given in table below, we can consider entire 15 years contract as a series of five MM contracts. Table 3. Hypothesized rental rate and value of the property for tenure of the agreement Period Rental Price at the Months In Dollars As % of Price Beginning of Period % 100, % 120, % 140, % 160, % 180,

16 Using those new prices for every period we can recalculate new monthly installments and calculate share (or its value) of each partner in the property. There results of calculation are shown in Table B2 in Appendix B. If we pay attention to the given table especially in highlighted rows value of bank s share suddenly increases as value of the property increases. As justification for such rise in value of the property the new installment scheduler is substantially higher in previous model with only varying rental rate. New installments requirements for first, second, third, fourth and last 3-year periods will be $759.47, $887.38, $1,019.99, $1, and $1, respectively. However, the value of customer s share is also increasing because of increase in total property not just bank s share. Nevertheless, we should not forget that bank is not guaranteed to gain from revaluation of the property since value of the property could decrease as well. As a result the value of bank s share may decrease drastically as well. In next section we will consider both increase and decrease in value and their respective financial implications. Example of value appreciation and depreciation in MM agreement As already mentioned, if periodic valuation of the asset is agreed upon then it should involve both appreciation and depreciation in value. Here we can consider an example for calculation of periodic payments under following example. Let us consider as in previous case that the customer wants to buy a house for price of $100, 000. As down payment the customer pays 10 percent of the price, i.e. $10, 000, the bank pays the 90 percent remainder, i.e. $90, 000. The customer is planning to buy back the bank s share in 15 years. Let us assume the rental is agreed upon to be $ 500 per month for the first 3 years. Let us now assume that revaluations are agreed to be done every year and value of the house was observed to be equal to values shown in Table 4 below for the course of the first three years: Table 4. Rental rate and value of the property for the first 36 months (3 years) Period Rental Months In Dollars As % of Price Price at the Beginning of the Period 1-12: % 100, : % 120, : % 80, Using those new prices for every period we can recalculate new monthly installments and calculate share (or its value) of each partner in the property as shown in Table B3 in Appendix B. If we pay attention to the highlighted rows and column in above table, following can be noticed: The value of both the bank s and the customer s shares suddenly increases as value of the property increases and similarly they suddenly decrease as value of the property degrees. This tells us that bank is not guaranteed to gain from revaluation of the property since the value could decrease as could be seen for year 3. 15

17 Also, notice the amount of monthly installment required for smooth transfer of ownership also changed with change in the value of property. Even though the rental portion is decreasing gradually reflecting decrease in bank s share (irrespective of property s value), the redemption (payment of principle) part is jumping up and down with change in value of the property. Thus we could consider rental profit to be more stable which capital gain from the appreciation of the value of property is not much stable or guaranteed. However, as we can see in later sections this model suggests that higher use of such home financing methods could also serve to stabilize second proportion of the profit for the bank as well. Considerations in cases for early termination Now we can elaborate about financial calculations in case of early termination because of either default or decision to settle in advance. In the case of early settlement (for instance, if the customer wants to settle at the end of 8 th year of a 15-year MM contract) there are two possibilities. In the first case, if the customer is not planning to sell the house, he would just have to pay outstanding balance in total forth redemption and there would be no need for revaluation of property since it had already been done in agreed periods before. However, in the second case, there would be a need for revaluation of the property if the customer intends to sell the house. Proceeds from the sale will first be used to offset all of outstanding amount due to the bank. Whatever is left shall be shared between the customer and the bank according to current share of each partner in the property. Similarly, if customer defaults, the sale of the property will take place and the customer and the bank will share amount left after all outstanding balance, cost of liquidation and legal expenses are taken care of. Let us apply this to our last example in previous section. We assume that the customer lost his job and defaulted after making 108 monthly installments in full. At that point, the bank s and the customer s equity ratios in the house will be 45.05% and 54.95% respectively (calculated by dividing the bank s and the customer s share value by previous revalued price of the property equal to $140,000 (See Row 108 in Table B2 in Appendix B)). Let us also assume that the new market price of the house was $160,000 at that point. Therefore, the bank s and the customer s portions in the price would be $72, and $87, respectively. As it was mentioned above, all liquidation costs should be taken care of before any division. As was mentioned earlier, in case of default, there would be a deduction for any arrears such as rental due from customer before the customer s portion is returned. Calculation of unpaid rental sum should be based on the each partner s share. For instance, if it takes 4 months to sell the house and the customer stays in the house during those months he has to pay for rental amount due of the bank s share. If the rental were considered as $650/month, which equals $2600 for four months, the bank s share would be$ (i.e. $2600 x ). Therefore, $ must be subtracted from the customer s share and the rest should be returned to him as his rightful share in the partnership. 16

18 ACCOUNTING OF CONTEMPORARY MM HOME FINANCING At present, International Financial Reporting Standards (IFRS) are followed by most the countries where Islamic Financial institutions exist. However, as it does not possess any standards to specifically deal with Islamic finance transactions, the practitioners have to move towards standards developed by Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI). The primary difference between both the standards is owing to AAOIFI s view on two important pillars of IFRS namely time value of money and substance over form (Hassan, 2012). AAOIFI states that the former concept can be used only for trade products and not for loan products (Ibrahim & Hameed, 2007). Their stance on later is also ambiguous evidently due to the difference of opinion in Shafi i school with other schools that prefers form over substance in comparison to the apparent consensus of the other three schools on preference of substance over form. The Malaysian Accounting Standards Board (MASB) is following the International Accounting Standards but since they do not offer any guidance regarding Islamic Finance transactions, AAOIFI standards are being used for this purpose. Malaysia is among the countries that have a very high rate of adoption of AAOIFI standards used to record all the Islamic banking transactions (Hasan, 2011). Recognition of Share of Islamic Bank When the bank enters the agreement and makes capital available to the partnership, the same is recorded as Musharakah financing as an asset in Balance Sheet. In case the capital is in the form of trading or non-monetary assets, the initial step is to calculate fair value of such asset. If the fair value is different from carrying value, any surplus/deficit is recorded as gain/loss in Income Statement. The amounts of any preliminary expenses (like feasibility study, legal documentation charges) are not included in the value of asset. Measurement of Share of Islamic Bank In case of Musharakah Mutanaqisah, the share of Islamic bank is measured at the end of each financial period. This measurement is made after deducting the historical cost of the asset transferred to the partner. This transfer is by way of a sale of asset on fair value to the partner and Musharakah Financing is accordingly settled. If there arises any difference in the fair value of the asset from the historical cost at the time of sale, the gain/loss will be recorded in Islamic Bank s Income Statement. At the time of termination of MM, the complete transfer of assets is made in the shape of sale of asset in entirety. If the case is otherwise, i.e., the partner is unable to buy the asset in due time, MM is terminated and a liquidation is initiated. The amount thus recovered is credited to bank s asset account Musharakah Financing. If there is a difference in the book value and recovered amount, the same shall be recorded as a gain/loss in Income statement. As MM continues normally for more than a year, the resulting effect of partial or full settlement of MM is recorded in financial statements of the bank. The asset is credited by the amount and any gain/loss is recorded in Income Statement. Disclosure Requirements FAS 4 of AAOIFI requires Islamic Bank a disclosure of provision for loss of capital in Musharakah financing transactions. This disclosure is to be given in the notes. The IFRS requires this provision to be included in Balance Sheet, which is considered a better practice and followed by majority of banks. 17