A financial institution participating in musharakah contracts (whether permanent musharakah or diminishing musharakah) is typically exposed to four different types of risk (mukhatarah), namely: operational risk (al-mukhatarah al-tashgheeliyah), credit risk (mukhatarat al-i’etiman), market risk (mukhatarat al-souq), and liquidity risk (mukhatarat al-seyoolah).

Operational risk: in permanent musharakah arrangements, this risk exposure arises from all uncontrollable external events or inadequate activities or failures that cause losses to the institution. A financial institution engaged in musharakah contracts has to participate in financial results, positive and negative alike (profits and losses). It is a shari’a condition that the loss-sharing ratio must be equal to the capital ratio, while it is up to the contracting parties to agree on their desired ratio of profit sharing (i.e., it can differ from the capital ratio). Hence, for a capital ratio of 2:3, a profit-sharing ratio of 1:4 would expose the financial institution to an unfavorable spread of profits and losses. In the context of diminishing musharakah, the financial institution is said to have sold equities to the partners by payment of installments. In the event that the partner is unable to buy the equities for the preset price, the financial institution will end up being exposed to operational risks. In this type of musharakah, operational risks trigger other types of risk.

Credit risk: operational risks arising in both types of musharakah (permanent and diminishing) would eventually result in credit risk. In permanent musharakah, the financial institution is entitled to a specific share in the business profits and in case the business defaulted, it would no longer be able to produce the expected cash flows. This situation gives rise to credit risk exposure. In turn, credit risk may expose the institution to another type of risk- that is, liquidity risk. In diminishing musharakah, the inability of the partner to buy the equities for the preset price (i.e., operational risk) would constitute a default on the expected payments from the partner, and would expose the financial institutional to credit risk. Credit risk in a diminishing musharakah would negatively affect the financial institution’s cash flow, and as a result another type of risk would be ushered in (liquidity risk).

Liquidity risk: in both permanent and diminishing musharakah settings, as cash expectations get negatively impacted by exposure to credit risk, the institution would not be able to cater to investments and activities with necessary cash. Hence, it would be exposed to liquidity risk whose severity depends on the proportion of cash shortage.

Market risk: major losses in permanent musharakah may hinder continuation of the institution’s business activities, and may, as a result, have a negative effect on the market value of the last payment (this payment may have a market price lower than the price initially expected). In diminishing musharakah, the price of the equity is predetermined and market risk would arise from situations where the actual market price is lower than the fixed price.