Professional Documents
Culture Documents
Case Study
January 2011
1000310
Table of Contents
4.0 Answer 3 26
i. Estimated profit amount for both partners 26
ii. Estimated annual rate of return to TBL 26
iii. Actual profit amount for both partners, and actual annual rate of 27
return to TBL
iv. Justification for TBL to provide the Musharakah Project 27
Financing
5.0 References 29
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Solid Base Bukhara Limited (SBBL), a public-listed company which main activity is
property development is seeking Islamic financing to finance the development of its
new mixed development project in Tashkent, Uzbekistan. The development plan
comprised of various types of house that include link-houses, semi-detached houses,
high-rise apartments and commercial complex.
For this Musharakah venture, SBBL will contribute only in tangible assets i.e. the
land to be developed which was valued by a renowned property-valuer at USD100
million. After lengthy discussions about the project viability, financial position and
risks involved, TBL and SBBL has agreed that the Profit Sharing Ratio (PSR) of the
venture be fixed at 60:40 i.e. 60% to SBBL and 40% to TBL.
Buyers for the unit of houses and commercial complex will be seeking bank’s
financing, average financing margin given is between 80% and 90% of total purchase
price. The developer will be submitting redemption claims from end financing banks
based on progress of project construction until completion. Therefore amount of
Musharakah capital financing required is only up to 30% of TPV.
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TBL has recently appointed you as a Senior Corporate Financing Officer after
completing the CIFP at INCEIF.
Required:
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2.0 Answer 1
Generally, a possible general model is to assess the basic credit factors of a potential
company or client, in this case SBBL which is based on 5Cs of Credit Assessment
I. Character
Character is arguably the most important and crucial factor to assess before deciding
to provide financing. Character gets to the issue of people and normally done by
asking questions such as “Are the owner and management of the company honourable
people when it comes to meeting their obligations?” Without SBBL scoring high
How do banks assess character? After all, it is an intangible criterion. It is partly fact-
based and partly “guts feeling”. The fact-based assessment involves a review of credit
reports on the company, and in the case of smaller companies, the personal credit
report of the owner as well. Besides that, the bank’s previous experience with the
reputation of the company in the industry, and possibly the other banks’ experiences
with the customer. The soft side of character assessment will be determined by how
SBBL deal with TBL during the application process and their resultant “gut feeling”.
judgment.
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II. Capital
When it comes to capital, the bank is essentially looking for the owner of the
company to have sufficient equity in the company. Capital is important to the bank, in
this case TBL for two reasons. First, having sufficient equity in SBBL provides a
cushion to withstand a blip in the company’s ability to generate cash flow. For
example, if the company were to become unprofitable for any reason, it would begin
to burn through cash to fund operations. The bank should never be interested in
lending money to fund a SBBL’s losses, so I want to be sure that there is enough
equity in the company to weather a storm and to rehabilitate itself. Without sufficient
capital, the company could run out of cash and be forced to file for bankruptcy
protection.
When I assess capital, I need to look at the sufficiency of financial commitment of the
business and should also include any subordinated financing to the business and third
the situation and the owner’s financial profile. Commonly, banks will look at the
owner’s investment in the company relative to their total net worth, and they will
compare the amount of the loan to the amount of equity in the company – the
company’s Debt to Equity Ratio. This is a measure of the company’s total liabilities
to shareholder’s equity. I should like to see Debt to Equity Ratios no higher than 2 to
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III. Capacity
TBL needs to be certain that SBBL’s business generates enough cash flow to repay
the loan that it is requesting. In order to determine this I will be looking at the
company’s historical and projected cash flow and compare that to the company’s
projected debt service requirements. There are a variety of credit analysis metrics that
can be used to evaluate this, but a commonly used methodology is the “Debt Service
Coverage Ratio”.
Typically the bank will look at the company’s historical ability to service the debt.
This means I should compare the company’s past 3 years free cash flow to projected
debt service, as well as the past twelve months to the extent SBBL is well into its
fiscal year.
Usually projected cash flow figures are higher than historical figures due to expected
growth at the company. However I can view the projected cash flows with scepticism
as they will generally entail some level of execution risk. To the extent that the
historical cash flow is insufficient and I must rely on SBBL’s projections, I shall
check whether future cash flow projections are defended with information that would
entrepreneur to pay back his or her financing to meet future obligations from earnings.
In this factor, source of income is essential to gauge the lender’s ability to repay the
financing. Cash flow of SBBL needs to be analyzed in order to ensure the company
meets its obligation of paying debt. Furthermore, identify the source of income of the
client to repay its payment for example by looking at account statement. Apart from
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IV. Conditions
I am going to assess the conditions surrounding the company and its industry to
determine the key risks facing SBBL, and also, whether or not these risks are
strong, the bank wants to be sure of the future viability of the company. TBL should
not provide a loan to SBBL if it looks like the viability of the company is threatened
This factor deals with any external influences that can affect the ability of the owner
of the company’s ability to honour their obligations to the banks. This is to ensure the
conditions surrounding the business do not pose any significant unmitigated risks.
To summarize this, the common method here is to assess the competitive landscape of
the company, the nature of customer relationships, supply risk and industry issues.
V. Collateral
In most cases, the bank wants the financing amount to be exceeded by the amount of
think that the bank will finance a dollar for every asset that their company owns. This
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repay the financing at some point in the future, the bank, in this case TBL, wants to be
sure that it will be able to recover its facility by liquidating the collateral and thus
This minimizes TBL’s risk by ensuring there is an item of value to recover the
investment from, in the event the customer defaults on the financing. Moreover,
collateral is intended to provide banks with more comfort and security. However,
collateral cannot be the basis for the initial comfort as collateral is the reinforcement
of the foundation on which a bank bases its credit approval and not the foundation
itself.
scenario, these asset classes can be collected or sold to generate funds to repay the
financing or loan. Other asset classes such as goodwill and prepaid amounts shall not
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3.0 Answer 2
i.
In this Musharakah project financing, the rules of any valid Islamic contract which
comprise of the three pillars known as subject matter (al-Aqad), contracting parties
(al-Aqidan) and statement of contract (Sighah) also form the pre-requisite of the
financing contract. For example, the parties should be capable of entering into a
contract; the contract must take place with free consent of the parties without any
duress; fraud or misrepresentation; and etc. But there are certain criteria which are
Distribution of Profits
The proportion of profit to be distributed among the partners must be determined and
agreed upon at the time of the contract. Otherwise the contract is not valid under
Shariah.
Apart from that, as additional information, there are also some differences in opinion
According to Imam Malik and Imam Shafi’i, it is necessary that each partner’s share
in the profit is exactly equal to the proportion of initial investment into the
partnership. According to Imam Ahmad, the ratio of profit distribution may vary,
without restriction, from the ratio of investment. According to Imam Abu Hanifah, the
ratio of profit distribution may vary however, for silent partners (non-active partners,
who only contribute capital), as in the case here for TBL, it cannot be any higher than
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Distribution of Loss
All the Muslim jurists are unanimous that each partner’s share in loss must be exactly
equal to the ratio of initial investment. Anything to the contrary will render the
contract invalid.
Nature of capital refers to in what form the capital is contributed. There are some
According to Imam Malik and some Hanbali jurists, the nature of capital is not a
by partners are allowed. The share in partnership will be determined based on the
market value of the commodity contributed. According to Imam Abu Hanifah and
This is because they believe it poses problems if the partnership needs to be liquidated
For the purposes of modern business, the view of Imam Malik has been widely
accepted.
Management of Musharakah
The norm is for each partner to take part in the management of the partnership, with
each partner acting as an agent of the partnership and any work done by one partner
deemed to be authorized by all partners. However, if the partners wish they can
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Note on the fact that Musharakah differs from Mudharabah in terms of involvement
where in Mudharabah the Rabbul-Mal remains as only the capital provider and
should not be involved with the management side of the venture, while the Mudharib
will not contribute at all in terms of financial or asset capital, but will contribute in
In this case, since SBBL is an existing developer, thus have more expertise in
managing property development business, and also is the one who approached the
bank for the Musharakah, SBBL will be involved with building, managing, and then
selling the properties to interested parties. This is also why although SBBL has
contributed less capital, it has bigger share in PSR which is 60% compared to TBL’s
40%, due to its management role. In this case, TBL is considered a sleeping partner
(for the purpose of classification) as explained earlier, although TBL in its role as
financier will be required to actively monitor the progress of the development project
to ensure any potential risk can be mitigated, especially in today’s complex challenges
in banking practice.
Termination of Musharakah
It is agreed upon by the jurists that a partnership (by one the following reasons) is
terminated if:
ii. One of the partners dies (where the heirs get the choice to continue the
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If the remaining partners want to continue the business under any of the above
scenarios, it is achievable with mutual agreement. Thus in this case, the remaining
For the consideration of this case, if SBBL decides to terminate the partnership, or
becomes bankrupt, or deemed legally unfit by the law under whatever reasons to
continue business, then TBL as the financier may have to find another developer
willing to take-over the role of SBBL as a partner in this Musharakah, and vice versa.
Another question raised is whether the partners can agree, at the time of contracting,
that the partnership will not be terminated unless all partners agree to the termination,
in this case both SBBL and TBL agree to have such a clause. Though the earlier Fiqh
books are silent on the issue, there is nothing in the Shariah that would prohibit such
an arrangement. This clause can help protect both parties from unforeseen unfortunate
circumstances and also major inefficiencies that may cost a huge amount of money,
due from waning desire of either TBL or SBBL to continue and complete such
venture.
ii.
Both partners, SBBL and TBL have their duties and responsibilities to fulfil the
essential requirement of Musharakah. Every partner has responsibility and right in the
other in all matters of the business, and as for sleeping partner, its share of profit
should not exceed the ratio of its investment in the partnership business.
equal. The contributed capital can be either in the form of cash or assets with a
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million;
II. While both partners may undertake the management of the business, if a
III. It has been agreed that SBBL will undertake the management side of the
until the sales of the units and submitting redemption claims from end
financing banks.
60:40 for SBBL and TBL respectively has been agreed upon; and
VI. Any losses shall be distributed between the partners according to the capital
contribution ratio. In this case the capital contribution ratio is 100:150 or 2:3
to SBBL and TBL respectively. However, if the loss is due to the negligence
of the managing partner or management team, in this case SBBL, then such
losses shall be borne by the respective partner or the management team i.e.
SBBL.
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iii.
Solid Base
Tamwil Bank
Bukhara Limited
Limited (TBL)
(SBBL)
Musharakah Venture:
Mixed Development Project in Tashkent
Estimated Cost: USD300 million
40% 60%
USD80 million USD120 million
PROFIT
Estimated Profit: USD200 million
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iv.
I. MUSHARAKAH
Let us now examine some risks viewed as peculiar to Musharakah financing and the
Risk of Loss
Of course in business there is always the risk of loss, but here the risk is somewhat
likely to pass on losses of the business to the financier bank or institution, in this case,
TBL, especially when the capital contribution portion of the bank is much higher than
Thus, this loss will be passed on to depositors also. The depositors, being constantly
exposed to the risk of loss, will not want to deposit their money in the banks and
Banks like TBL in order to mitigate this type of risk, will study the feasibility of the
proposed business for which funds are needed, before financing on the basis of
Musharakah. TBL study the potentials of the business in a more thorough manner and
if they apprehend that the business is not profitable, they can refuse to advance a
financing. In the case of Musharakah, TBL will have to carry out this study with more
Moreover, TBL can have a diversified portfolio of Musharakah and not restrict itself
expected to suffer loss, and the possibility of loss to the whole portfolio is merely a
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theoretical possibility which is not seen as a possibility that can discourage the public
Dishonesty
of Musharakah financing is that the dishonest clients may exploit the instrument of
Musharakah by not paying any return to the financiers. They can always show that
the business did not earn any profit. Indeed, they can claim that it has suffered a loss
in which case not only the profit but also the principle amount will be jeopardized. It
is, no doubt, a valid risk, especially in societies where corruption is the order of the
day. Undoubtedly, the risk of dishonesty is more severe for Islamic banks and
financial institutions like TBL, working in isolation from the main stream of
conventional banks. In some countries, Islamic banks have not much support from
their respective governments and central Banks. However, the solution to mitigate this
If all the banks in a country are run on pure Islamic pattern with a careful support
from the Central Bank and the government, the problem of dishonesty is not hard to
whereby the accounts of all the clients are fully maintained and properly controlled. It
is already discussed that the profits may be calculated to the basis of gross margins
only. It will reduce the possibility of disputes and misappropriation. However if any
to punitive steps, and may be deprived of availing any facility from any bank in the
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These steps will serve as strong deterrent against concealing the actual profit or
committing any other act of dishonesty. Otherwise, also the clients of the banks
cannot afford to show artificial losses constantly, because it will be against their own
interest in many respects. It is true that even after taking all such precautions, there
will remain a possibility of some cases where dishonest clients may succeed in their
evil designs, but the punitive steps and the general atmosphere of the business will
Credit structure/product risk is the risk related to the financing given by the banker.
Poor structuring of the Musharakah financing will cause inherent risk to the
implementation of the credit. To mitigate this risk, TBL would have to really
understand the true financial capability of SBBL and allow as much help especially
financially to ensure the project development from phase to phase will not be affected.
On the other hand, most Islamic banks also are still lacking in their policies and
Musharakah financing.
equity participation may expose the Islamic banking institutions to various types of
risks, such as counterparty credit risk, equity investment risk, liquidity risk and
reputational risk. These risks require proper, adequate and sound risk management
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Apart from the two above, the following are the recommended steps to be taken in
mitigating the risks of Musharakah in general. These risk management activities and
processes require active oversight by the Board and senior management of TBL.
regularly review and update the Musharakah policies, processes and limits to
take into accounts the risk appetite of TBL and changes that take place in the
Musharakah contracts and the risks associated with such exposures. The
Islamic banks including TBL are expected to develop a strong risk management
process to clearly identify, measure, monitor and control the risks associated with
financing of property development project. The risk management process shall take
into account different types of risk profiles arising from property development and
property investment activities undertaken by TBL. The list of functions that are
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Equity Risk
TBL shall assess all material risk relating to having equity position in companies
(i) Sound measurement and valuation framework on the equity position held by
TBL;
risk taking against predetermined internal limits and risk tolerance levels;
(iv) A rigorous stress testing framework that enable periodical assessment on the
invested entities and its implication to the equity position of TBL; and
project non-completion).
To avoid excessive sectoral exposure risk, TBL shall institute appropriate and
effective control to continuously assess and conduct stress testing as to whether the
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business strategies and within the tolerance level defined by the internal policies as
In conducting the stress testing exercise, TBL shall take into account plausible
scenarios on real estate or property sector and continuously assess any potential
TBL shall take appropriate measures to mitigate all risks associated with the
techniques; and
the properties.
Legal risk
TBL are expected to clearly define and properly document the contractual
relationship, rights and obligations of the respective parties involved in the real estate
business. The documentation shall be consistent with the requirements of the Shariah.
Islamic banks shall execute all legal documentation in the correct flow or sequence to
effectively reflect the underlying Shariah transactions. Any attempt to simplify the
processes or sequence due to practical grounds should not compromise or affect the
sanctity of the Shariah contract. Islamic banks shall ensure that the appointed legal
firms, in-house legal personnel and operations staff have the necessary knowledge,
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skills and experience in executing Shariah contracts and transactions involved in the
Market risk
It is defined as the risk of changes in the demand and price of a product as a result of
changes in the factors which are beyond the control of the customer. For example, the
movement of commodity prices, foreign exchange and stock prices in the stock
it involves a huge volume of amount, and always turns to be the first industry to be
affected when there is a recession. Therefore, TBL should monitor client’s cash flow
TBL must also identify external factors affecting real estate and to ensure proper
valuation methodology, risk mitigation method and income recognition process. The
joint-venture may not generate projected return or even worse making losses in which
Depending on TBL’s business models and nature of risks to which it is exposed, TBL
is expected to:
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Project/Time Management
is an inability to complete the project within the time frame originally specified. This
regulatory policies. TBL may mitigate this risk by having the shareholders pumping
v.
Extracted from the Musharakah project financing table provided, and also additional
information, the basic features, terms and conditions of the facility are as follows:
i. The Shariah principles applied is Musharakah, and thus the general rules of
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partners. In this regard, the partners may agree to vary or revise the
partners.
the bank i.e. TBL & on the basis of annual audited accounts
requirements.
expectations.
6. SBBL to furnish all information which the bank (TBL) may require,
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capital from the Total Gross Development Cost will be covered by the
9. Any of the partners acting as agents of each other shall be liable for
10. Any partner acting on his own or as agent who has caused the loss of
11. Any loss of capital in the course of the venture shall be recognized as
to capital contribution.
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14. In the case of an actual liquidation, the assets shall be sold at market
partnership; and
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4.0 Answer 3
SBBL TBL
؞Thus, the estimated profit amount for SBBL and TBL are USD120 million and
TBL
Annually = 17.78%
؞The annual rate of return for TBL from its capital investment in this project
venture is 17.78%.
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iii. Actual profit amount for both partners, and actual annual rate of return for
TBL
= USD175 million
SBBL TBL
؞Actual profit amount for SBBL and TBL are USD105 million and USD70
million respectively, and actual annual rate of return for TBL is 15.56%.
iv.
financing if we look at the annual rate of return of 15.56%. This level of annual rate
of return can be considered satisfactory from the viewpoint of most average investors.
The risk in Musharakah financing is a justified concern among banks. This is because
banks are heavily dependent upon the integrity of the partners involved. However, in
this case, as SBBL has been a customer for the bank since 2005 and is also a
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and the established nature of parent company of SBBL somehow in some ways gave
(Musharakah).
The nature of Musharakah contract will also allow TBL to be actively involved in
Mudharabah. This will ensure that the bank’s interest is well taken care of from time
to time, and also will facilitate the bank in monitoring the progress of SBBL’s work
done.
partner i.e. SBBL is in the form of land with a market value of USD100 million. This
means that if, God forbid, the project turns out to be a failure, the project venture still
has assets worth at least USD100 million (current market value, and may appreciate in
value due its nature as land asset) and therefore TBL will be compensated with around
USD60 million, amount derived based on the capital contribution ratio of 100:150
mentioned earlier. This means a worst case scenario is for the bank to incur a loss of
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5.0 References
http://cief.wordpress.com/2006/03/12/musharakah/
_. 2011. 5 C's of Credit (5 C's of Banking). WikiCFO. Accessed: March 14, 2011.
http://www.wikicfo.com/wiki/5%20Cs%20of%20Credit.ashx
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