Islamic Economic

BBA ISLAMIC FINANCEEIB 10203 (ISLAMIC ECONOMIC AND FINANCE 1)

TITLE:The current issue in Islamic banking that will affect

development

GROUP:IF22

PREPARED BY:HATTA BIN KHARTANI (62289113658)

AMIRUL AMRI BINTI ALWE (62289113943)MOHD AZHARI BIN WAHAB (62289313030)NUR IZZATY BINTI SALIM (62288113786)

ANNUR ASSHIELA BINTI MOHD ANUAR (62289113796)

PREPARED FOR:SIR AHMAD MONIR BIN ABDULLAH

Table of ContentsAbstract..........................................................................................................................................3

Introduction....................................................................................................................................4

The Concept of Musharakah Mutanaqisah....................................................................................5

Data Analysis.................................................................................................................................7

Musyarakah Mutanaqisah issue in Islamic Finance......................................................................9

(MMP) FOR HOME FINANCING USING AL-IJARAH.................................................................13

AS THE INCOME GENERATING ENGINE.................................................................................13

Conclusion...................................................................................................................................14

Reference....................................................................................................................................16

Abstract

The dual-banking system in Malaysia is expected to place Islamic finance at a

disadvantage because of its over-dependency on fixed rate asset financing such as bai

bithaman ajil and murabahah. Currently, the Islamic finance system is being faced with

a number of paradoxes and it is consistently being criticized for the overuse of contracts

which has been declared to be Islamically permissible. This study focuses on “The

current issue in Islamic Finance thath will affect development. Subsequently, this study

proposes Musharakah Mutanaqisah (MM) as an alternative issue can be affect

development. However, the requirement of large funds from each participant in an MM

contract and the complicated procedure to determine the rental rate could hinder

bankers or business entities from implementing MM contracts.

Introduction

Musharakah (Partnership): The Arabic word musharakah is a derivative from the

root word sharaka, which literally means sharing, and mixing shares of two or more

parties to make them interchangeable. Technically, Hanafi scholars define musharakah

as’ a contract between partners on both capital and profit”. The Malikis define it as

permission to transact where each of the partners permits the other to transact where

each of the partners permits the other to transact with the same property (Al-Dardir,Al-

Sharh Al-Kabir, 3/348). Shafi’I scholars define partnership as “a confirmation of the

rights of two or more people over a common property” (Al-Sharbini, Mughni Al-Muhtaj,

3/221). According to Hanbali scholars, it is the amalgamation of rights or the freedom to

use (Ibn Qudamah, Al-Mughni, 5/3). See ISRA Islamic Financial System: Principles and

Operations for further details.

The Concept of Musharakah Mutanaqisah

Figure 1

Basically, the Musharakah Mutanaqisah (MM) arrangement involves three steps:

i) The first step is to create a joint ownership in the property under partnership

agreement (shirkah al-milk), wherein the client will pay 10% down payment

from the total amount of asset that is considered the initial share and the

financer will provide the balance (90%).

ii) The second part of this arrangement is that the financier leases his share in

the asset under Ijarah contract to his client and charges rent from him.

Basically, the Annual Percentage Rate (APR) is determined by the rental rate

by dividing the annual rent with the original price of the asset. APR formula is

stated as shown below:

APR= (Monthly rental× 12 months ) /Asset price × 100 %

The annual rental rate is determined from similar asset in the particular

location. In this paper, RM 1000 is the monthly rental payment to be used in

MM calculation. Each rental payment is jointly shared between the customer

Sharikat al-Aqad between the bank and the customer, e.g. at 90:10The objective of the partnership is to acquire and own an asset

Musharakah

The Customer rents the bank's undivided share andfor completed house: pays the rental payment.For house under constructions: pays ijarah mausufah fi dhimmah

IjarahTh customer will continue to buy the units representing the bank's share gradually until the house is fully owned by him

Sale

and the bank according to the respective shareholding, at that point in time,

and it will keep changing as the customer redeems the financier’s share. The

customer’s share ratio will therefore, increase after each rental payment until

eventually fully owned.

iii) The third step in the abovementioned arrangement is when the client wishes

to redeem the share of the financier by adding extra monthly payments at a

specified time. The monthly redemption payment can be determined in the

Mathematical Derivation equation as below:

A =x [P − (1 + x )n C0 ]

(1 + x )n − 1

A= Monthly redemption amount

x = Rental rate (rental charge divided by asset price)

P= Asset Price

n = Redemption period

Other equations can also be used for computing total monthly payments which

are similar to the normal annuity formula excluding the interest rate and replacing it with

the rental rate. The formula is stated as below:

M =x (1 + x )n B0

(1 + x )n−1

M = Total monthly payment

x = Rental rate

B0 = Financer’s contribution into the partnership

n = redemption period

Data Analysis

This part shows the calculation for both instruments, the Bai Bithaman Ajil and the

Musharakah Mutanaqisah, and the annuity formula will be used for each periodic

payment for both instruments. The results will be presented according to the

comparative purpose:

i) Annual Profit Rate (APR) could be charged by financer to their client;

ii) Periodic payments should be paid by client to the financer;

iii) Total payments should be paid by client to the financer at the end of the

financing (for BBA) or leasing (for MM) period.

Measurement factors for both instruments are determined based on the same example

and stated as shown below:

Type of asset = A house

Asset price = RM 150,000

Client’s down payment = RM 15,000(10% from asset price)

Duration of financing = 15 years

i) Additional information for BBA:

Annual Profit Rate = 14%

ii) Additional information for MM:

Rental payment = RM 1,000

APR or Rate of Return (IRR) = 0.67%

Bai Bithaman Ajil Calculation

a) Annual Instalments

=

i(1+i)nPV(1+ i)n−1

=

0 .14 (1 + 0 .14 )15 (RM 150 ,000 − RM 15 ,000 )(1 + 0 .14 )15 − 1

= RM 21,979.21

b) Monthly Instalments

=

Annual Instalment12 months

=

RM 21 ,979. 2112 months

= RM 1,831.60

c) Total Payment

= Down Payments + (Monthly Instalment x 15 years)

= RM 15,000 + (RM 1,831.60 x 12 months x15 years)

= RM 344,688.15

Musharakah Mutanaqisah Calculation

a) Monthly Rental

= RM 1,000

b) Monthly Redemption

=

0 .0067 (RM 150 ,000 − (1 + 0 . 0067 )180 RM 15 ,000)(1 + 0 .0067 )180 − 1

= RM 288.25

Musyarakah Mutanaqisah issue in Islamic Finance

In Islamic banking system which using Musyarakah Mutanaqisah product in

housing finance and asset ownership. Musyarakah Mutanaqisah product is product that

is best in Islamic banking system because it together in giving profit to second party.

However, there are also a few issue and problem which occurred in this product that

was applied by this Islamic banking system.

Bank still impose fine fee on customer when they commit tabulation back their

payment when fail to do follow original payment schedule that done. Customer will ask

bank to do tabulation back on monthly payment that they need to explain according to

their ability. Therefore, payment period will be longer and this forced to make internal

change contract agreement that they don ago. Therefore, issue that has arisen now,

bank will impose fee on tabulation back payment and payment of fines because do not

meet contract agreement carried out earlier. Apart from that too, customer having to pay

back payment charge in manage agreement document that is new for tabulation back.

This meaningful, customer forced to bear again between new agreement contract

provision payment bank and customer because do new payment tabulation that

customer need to obey to financing done.

Issue this obviously show them do not practice partnership principle properly

because in lose any liability partnership or profit must be borne by both sides who did

partnership. Apart from that too, any cost imposed in doing partnership is need to be

borne by all members share together because they agreed in doing partnership whether

profit or loss and all capital contribution carried out it with. In banking system carried

out, any cost in implementing this partnership have been incurred by customer only

while bank only bearing cost capital only. This obviously shows inequality in suffering

problem in the partnership. Bank also imposing fines on customer because failure

explain instalment payment as scheduled.

Hence, should follow partnership principle, in suffering aspect carried out is

needs by party second cooperation who did partnering. This can reduce burden

customer to keep administrative cost that need to be explained alone. Although in

ending is owned by customer only on asset, however partnership course of doing must

be together pay cost imposed and can reduce partner burden. This is due to in ending,

bank also will obtain profit from partnership because installment payment explained is

exceed payment issued by the bank when issuing partnership capital.

Apart from that too, second issue arise is on takaful guarantee payment on

house. This guarantee should be borne by both sides because property ownership is

joint ownership and it is liability with. In this partnership, they are responsible bear with

protection expenditure on their property and not just burden to one joint member only.

This is because, protection on property imposed is giving benefit to both sides that

shares that beside guarantee safety on property. What done by bank nowadays

according to mutanaqisah partnership concept is, bank only provide takaful service or

suggest takaful company to clients ensure property. On the other hand, bank not

together bear pledged against property. They can perform partnership on property

guarantee although in this contract, in this contract ending property will be owned by

one art only. However, partnership course of doing, those who share had to look after

with property security from happen any flaw or destruction that probability happen

during partnership still done. Therefore, bank also need with pay guarantee cost and in

the ending when property become property only one party, bank may impose a little

service fee (al-ujr) to customer because yard heart together bear guarantee.

Next issue is determination of rental price. First, is studies which mainly focused

on the rate of return of bank deposits and factors influence its volatility. As an example

for this kind of study is Chong and Liu (2008) which has attempted to show the

relationship between Islamic bank deposit rate with conventional fixed deposit rate in

Malaysia. Using time series data ranges between April 1995 April 2004, Chong Liu

(2008) was able to provide evidence that rate of return in Islamic bank deposit is highly

pegged to interest rate in Islamic bank fixed deposit.

Second is those studies which are directly discuss the amount of bank deposits

and its determinants. One study is done by Haron and Azmi (2008). The study uses

macroeconomic variables as explanatory variables as explanatory variables to predict

the behavior of bank deposits in Malaysia and revealed that growth in the economy and

an increase in money supply. Composite index and consumer price index, continue to

increase Islamic bank deposits. Furthermore, Haron and Azmi (2008) also empirically

proven that any increase and Islamic bank deposits will decrease and vice-versa.

Another study conducted to investigate the behavior of Islamic bank deposits is

by Kasim et al. (2009). Using monthly data covering the period from January 1999-

2006, this study the impact of monetary policy shock on Islamic bank’s balance sheet in

Malaysia. The study convincingly provides evidence that the impacts of policy shocks

are more destabilizing on the Islamic bank balance sheet item are more sensitive to

interest rate changes compared to their conventional counterparts.

Haron and Ahmad (2000), moreover, examines the effects of conventional

interest rates and rate of profits on funds deposited with Islamic banking system in

Malaysia. The negative relationship emerged between the interest rate of conventional

banks and the total deposits in Islamic banks provides evidence for the existence of the

utility maximization theory among the Muslim customers. Meanwhile, Kasri and Kasim

(2009) provide similar conclusion for similar study done for Indonesia. It supports Haron

and Ahmad (2000); Haron and Azmi (2008) and Kasim et al. (2009) by concluding that

higher Islamic deposit is significantly correlated with higher rate of return and lower

interest rate.

Third, is a group of studies which combine the discussion between rate of return

on bank deposits and the volume of the deposits. Bacha (2004) seminal work discusses

causality relationships between conventional bank interest rate with Islamic banking rate

of return as well as between conventional fixed-deposit and Islamic bank deposit. Using

time series data spread from January 1994-2003, the study shows that the changes in

conventional banks interest rates and total deposits Granger cause changes in Islamic

banks rate of return and total deposits repectively.

Zainol and Kasim (2010) examines the determinants of rate of return and total

deposits in Islamic banking. Utilizing 10 years monthly data spread from January 1997-

2008, they found that Islamic bank’s rate of return and conventional bank’s interest rate

are cointegrated and have a long-run equilibrium. Furthermore, the study also indicates

the profit motive among Islamic bank’s depositors due to the significant impact of the

mudharabah deposit rate with the total deposit and negatively significantly related with

the changes in conventional fixed-deposit rate.

In the case pf inflation, study the relationship between inflation. Tax rate increase

and consumption behavior in US using data spread from 1071-1984 and conclude that

inflation has a substantial impact in consumption. However, this effect is more on

services, particularly financial services. Rather than on nondurable goods. During the

time of high inflation, people reduce their very costly and insignificant expenditures for

their real consumption. One of the best choice is by reducing cost of services charged

by financial institutions. Huybens and Smith (1999) provides evidence which indicate a

significant and economically important, negative relationship between inflation and

banking sector development.

(MMP) FOR HOME FINANCING USING AL-IJARAHAS THE INCOME GENERATING ENGINE

Figure 2

If money is tight, the bank can direct the customer to increase the true rental

value while keeping the added premium constant. The opposite is true when interest

rates decline. This rental adjustment technique, although not thoroughly transparent

from the Shariah viewpoint, requires more research in order to gain acceptance.

There is one last point, though. To apply MMP in banking, one must identify who

owns the asset? The bank or the customer? How does the asset appears in the bank’s

balance sheet? Theoretically, both should hold legal claim on the house. But what type

of business entity the MMP should adopt? Will the Banking and Financial Institution Act

1989 (BAFIA) recognizes the partnership as a business entity? Finally, it is the

partnership ant nit the bank alone the purchases the asset. The pricing of rental and

Customer Share Capital$10,000

10%

Bank Share Capital$90,000

90%

MUSYARAKAH MUTANAQISAHPARTNERSHIP (MMP)

The MMP invest the $100,000Capital in the Al-ijarah-rental business

HOUSEMonthly Ijarah

Payment$800

Actual rental Value$500

Share purchase

ReducesBank’s

shareholding

IncreaseCustomer’s

shareholding

Customer – 10%Profit - $50

Bank – 90%Profit - $450

Customer sharePurchase $300

changes in premium payments for share buy-back requires meticulous care so that

periodic adjustment to market movement in property and rental prices reflects “win-win”

deal.

The law states, “Wealth must not circulate only among the rich ones among you”

(Sura 59:7). Economic justice therefore implies that wealth creation must not be

monopolized by the few rich. In this way, the establishment of unit trusts serves to

promote welfare, as it opens new opportunities for the average man to participate in the

capital market. On this matter, Islamic banks deserve praise, but more is better. Doing

so does not necessarily mean providing them access to the capital market via ASBI

scheme alone. It also means providing direct finance to small and medium-scale

industry. Unlike conventional banks, Islamic banks have extra flexibility to inject funds

into the SMIs since it can invest in equities via mudarabah, musyarakah, salam and

istisna financing.

Musyarakah instruments run on profit- sharing principle (PLS). This means SMIs

are not required to place collaterals over the capital injection. For example, under the

musyarakah framework, banks provide equity funds into the project and take an active

role in the management of the project as well; which means they no longer act as debt

collectors.

Experience in Pakistan has shown that an equity approach in banking does not

work too well. Banks are not ready to manage equity-based projects simply because

they not familiar with the project financing. The high exposure to market risk chased

deposits away and deprived banks of funds. There is no apparent mechanism the bank

can use to deter the business partner from abusing the contract. This explains why

Islamic banks around the world have opted to use al-bai-bithman ajil contracts in their

business.

Conclusion

By using musyarakah mutanaqisah partnership financing concept with more

raising further concept quality according to Islamic law track, so much more developed

usage on mutanaqisah concept because it is concept that is effective in housing

finance. Therefore, if any change on responsibility from bank or customer must refer to

original contract that carried out and change carried out is well founded and still giving

profit to both sides. Therefore, when making internal change contract, price should be

explained in early contract carried out by getting agreement of two party split to prevent

occurrence of usury of gharar in contract change. Apart from that too, Musyarakah

Mutanaqisah can give confidence and belief on customer in using Islamic banking

system that is transparent and true. Although this product said will reduce bank profit

compared to financing product the rest, however this product will attract many more

customers and additionally can keep profit that is prolonged to bank. With effectiveness

on mutanaqisah contract this, this will give development that is developed in property

ownership apart from can build further country economy because with the existence of

mutanaqisah concept, it will encourage public to own property and will reduce poverty

rate in country because they afford to own their own asset. With according to Islamic

law track set, this product will be more thrive and able to give service that is best in

Islamic banking system beside gives profit that deeper this Islamic banking because can

attract even more customer to use this Islamic banking system.

Reference

http://www.kantakji.com/media/8275/n309.pdf

http://www.ukm.my/fep/perkem/pdf/perkemVIII/PKEM2013_2B2.pdf

Saiful Azhar Rosly. 2005. Page 141 Musyarakah Mutanaqisah Home Financing:

Critical Issues on Islamic Banking and Financial Markets.

Saiful Azhar Rosly. 2005. Page 253 Islamic Banking and Economic Development:

Critical Issues on Islamic Banking and Financial Markets.