Partnership Based Financing Models in Islamic Finance

The main goal of Islamic finance is rising a client to the level of a partner to financial institutions in order to break the paradigm that clients have to be subordinated to financial institutions and that banks always gain and never lose. Experts have developed two groups of financing models in Islamic finance. The first group of these models is based on a partnership approach, while the other is based on trade/leasing.

The cleanest models proposed in Islamic finance are those based on partnership. Within partnership financing, the most used models are Musharakah – active partnership and Mudharabah – passive partnership. Musharakah is the formation of a joint business venture in which all partners share the profit in accordance with the agreed percentages, and share the loss in accordance with the invested funds. Mudharabah is similar to Musharakah, in the fact that it is a passive partnership where the investor (Rabbu-l-mal) invests funds in a specific project led by a specific company or person (Mudharib). The profit is shared according to the agreement, and any loss is borne by Rabbu-l-mal, while the Mudharib’s loss is in the effort invested and the wasted time. Musharakah is an ideal alternative to interest-based financing as it has very positive long-term effects on the production and distribution of wealth in the economy.

It is important to note that every Islamic bank operates within the framework of certain legislation and that it is very often limited to implement certain models, and in practice, it is often used the combination of financial models such as a combination of diminishing Musharakah and Ijarah (leasing) and others. Although it is often cited as the purest model of Islamic finance, Musharakah is rarely used in practice because the risks that this type of business carries are not adapted to banks as financial intermediaries, nor to depositors who, according to the conventional model, are the most protected category in the banking system because they expect gains on their stakes and that the funds they have deposited are safe from any losses. Islamic banks rarely resort to the use of classical Musharakah because of the risks that this business model carries and because of the fact that it has a responsibility towards its shareholders, depositors, and employees.

It is very important to understand that the existence of an Islamic bank is not necessary for the application of the partnership financing model within Islamic finance. This process can be carried out through the implementation of models that are already used in developed economies for financing start-up companies. Start-up is a category that is very rarely financed by banks due to the lack of financial indicators, considering that the company is just beginning, and even when they decide to finance a start-up, banks require very high collateral or a high-quality co-borrower as security for the credit. The main goal is that entrepreneurs may obtain the capital they require to establish a company. An alternative to bank loans are models that are very well known in the United States of America that led to the success of financial giants such as Microsoft, Apple, Amazon, Google and others. These models are Venture capital and Equity crowdfunding. The main purpose is financing start-up companies, where basic capital is provided by investors called “angel investors” because of their role, which is the financing of high-risk start-up ventures. Investors receive shares in the ownership of these companies in return for the capital they provided.

In some regions in Europe, these models are not welcomed since business owners are not willing to give shares to investors, and they often go with bank loans giving their own properties as collateral. These issues may be solved using the model of Diminishing Musharakah where the investor would gradually withdraw from the share of the firm in which the initial capital was invested.

Partnership-based financing models foundations should be promoted and it is significant to understand that Islamic banks are not necessarily needed for their application, but with the will of capital owners and good ideas and projects, it is possible to obtain initial funds for start-ups and high-quality investments with positive results.

HZ