Reference no: EM132671205

Mudarabah as a Mode of Finance

Mudarabah is a sort of joint venture partnership. Both parties participate in the profit that is going to be generated by the financed activity. The parties are free to agree on the ratio of profit distribution (70% - 30% or 50% - 50% or any other). However, unless they agree at the initiation of the contract, the latter is, from Shari'ah point of view is void. Furthermore, it is a Shari'ah requirement in mudarabah that all of the capital has to be paid at the signing of the contract. It is not allowed to pay it later or on installments basis. Rub-ul-mal can impose any (reasonable) instructions and conditions on the agent, if they are acceptable to the latter they become part of that contract. Once operation starts, the financier has no right to interfere in the day to day business. If agent fails to follow the instructions and satisfy the conditions, then he is liable for loss of capital. The mudarib don't guarantee capital nor profit to the financier. This is the source of moral hazard and adverse selection in mudarabah.

Profits are any amount in excess of capital. It is therefore, imperative to liquidate the Mudarabah before declaring any profit. In recent years, many Shari'ah scholars have accepted what in called constructive liquidation constructive liquidation. Simply means that accounting procedures are applied to decide the profit and loss status of the operation. This liquidation process can be done periodically using accounting procedures and based on the outcome profit (loss) can be declared every quarter or year.

The agent in Mudarabah is entitled to nothing but his share of profits. If he (or the financier) receives any income before liquidation, it is always subject to adjustment when financial results are declared. Both parties are required to avoid any conditions in the contract that can fade away the particular nature of the mudarabah being a "company in profit". For example, if one requested that he gets the first $ 500.00 of profits and the rest is for his partner then the contract is void. This is because it is quite possible that the whole profit will only be $ 500.00. Before the advent of Islam, Mudarabah was the most common mode of finance in Makkah. The Makkan were the foremost traders in their area of the world in the 7th century, bringing goods from India and Yemen and selling to the Roman Empire. To finance this international commercial project, the majority of the merchants of Makkah presented themselves to the rest of the community as Mudaribs (agents), collecting monies from men, women and etc. who become financiers.

Contemporary scholars were able to develop the Mudarabah contract to suit modern needs. In Pakistan, for example, a special Mudarabah law has been introduced which allows the floating of negotiable Mudarabah Certificates. An attempt to introduce a similar scheme was tried in Jordan, and many Islamic banks are trying to go into special Mudarabah finance with major clients, where the problem of moral hazards is less severe.

However, mudarabah can be considered as a high-risk mode of finance. It is so risky that it is almost "Unthinkable" to any banker. This is because the bank advances capital to client relying completely on his integrity, ability and good management. The bank is not only risking the expected return but also capital itself. This high degree of moral hazard and adverse selection is present in the classical form of Mudarabah. Recently, however, many Islamic banks were able to develop a new, albeit Shari'ah based, forms of Mudarabah with significantly reduced degree of risks. For example, mudarabah is used only with public limited Companies, where a reasonable degree of transparency is possible i.e. audited accounts, and quarterly reported performance. Securities and guarantees are introduced in the contract, but not against profit or payment of capital. Rather, only against loss due to negligence or mismanagement and delayed repayment of capital and profit after end of mudarabah. And last but not least, those economic activities where the bank can easily see what the money is being used for can be financed on Mudarabah basis. For example, a car dealer who buys autos from manufacturer and then sells on installments will be suitable for such mode of finance.

Source: An Introduction to Islamic Banking, Shaykh Dr Mohamed Ali Elgari. Republished with permission.

Based on the article 'Mudarabah as a Mode of Finance' above: -

a. Discuss how mudarabah can be different from musyarakah contract?

b. In the case of risk to the business, analyse how the risk may affect financial institution in providing mudarabah financing and how financial institution handle the risk?