Managing Default in Musharakah Mutanaqisah By Edib Smolo, Associate Researcher, ISRA BANK 90% 10% CUSTOMER Musharakah Venture SELLER/ OWNER 5 4 2 payment title 3 1 As can be seen above, MM creates a complex set of relationships, rights and obligations between the partners. Thus the risk profiles would be different from some other financing arrangements. According to the BNM report, financial institutions are exposed to both market risk and credit risk. The former is associated with the joint ownership of the underlying property, while the latter is related to the ability of the customer to buy and of the financial institution to sell its share. Therefore, for successful implementation by financial institutions, this mechanism requires prudent and efficient risk management based on reliable and adequate data. Practical Example of MM Default In the event of default, the termination of MM can be done in two ways as briefly stated by BNM Financial Stability and Payment Systems Report 2007: (i) without wa’ad (purchase undertaking); & (ii) with wa’ad. In the first case, the underlying asset will be sold in the market and the proceeds will be shared between the partners according to the latest ownership share ratio (after all the outstanding costs and payments, such as outstanding rents and legal fees, are covered). In the second case, the customer is required to buy the remaining shares of the bank. Wa’ad in default creates a legal obligation on the customer to buy all outstanding shares of the bank and to pay outstanding rental and other fees. Through this process, a debt is created, and this debt is to be paid by the customer. 1. Customer selects house and applies for the financing 2. Bank. once application is approved, enters into a Musharakah arrangement with customer 3. Customer leases Bank’s share in the house 4. Customer makes an additional monthly payment, along with the rent, to buy the Bank’s stake in the property. 5. The parnership will be terminated with the custome owning 100% of the house; the title will be transferred to him/ her. M usharakah mutanaqisah, or diminishing partnership, is a relatively new technique that is not found in classical literature. It has been formulated by contemporary Muslim scholars to facilitate investments among Muslims. Although the mechanism of musharakah mutanaqisah (MM) was approved by the First International Conference on Islamic Banking, held in Dubai in 1979, it has not been widely implemented in the Islamic financial industry. Currently, MM is implemented in Malaysia and UK, where the necessary amendments to the prevailing laws have been made. Banks in Middle East make relatively less use of MM and its variants. Bank Negara Malaysia (BNM), in its Financial Stability and Payment Systems Report 2007, defined MM as “a form of partnership in which one partner promises to gradually acquire the equity share of the other partner until the share of ownership is completely transferred to the first partner.” The Mechanism of MM The MM model can be easily implemented for various financing purposes. However, it is most commonly used for home financing. Basic steps involved in the MM structure for home financing are illustrated in Figure 1 below. SECTOR REPORT • banking BULLETIN 5