INTRODUCTION TO MUDARABA

Mudaraba is the first of the two equity-based contracts that are popular in modern Islamic finance and involve some sort of partnership. Mudaraba is a form of trust financing, while Musharaka is a joint-venture partnership (dealt with in Chapter 6). Islamic banks have successfully transformed these partnership contracts into financial instruments. In Mudaraba, one party provides the entire capital while the other provides time and effort in the business venture. The capital provider is called the Rab al Maal while the entrepreneur who manages and runs the business using their time, expertise, management and entrepreneurship skills is called the Mudarib. The Rab al Maal does not interfere in the day-to-day running of the business, but may specify some conditions related to management of the business. Rab al Maal trust their capital with the Mudarib, hence the name of ‘trust financing’. Mudaraba can also be called a passive partnership, since one party is involved actively while the other is not. Rab al Maal is not involved in the actual management of the business activity and as such is called the sleeping partner, while the Mudarib is the managing partner.

The capital injected into the venture by the Rab al Maal is called Ras al Maal. Rab al Maal has the right to information and to monitor activities. They are like the limited partner in a limited liability company or an investor in a mutual fund company. The two parties mutually agree to a profit-sharing ratio at the onset of the contract which is based on the actual profit made by the business excluding the original capital invested. The monetary loss though is borne entirely by the financier, the Rab al Maal; the Mudarib would lose their time and effort in managing the business and would not be earning any profit, unless the losses were due to misconduct, negligence or violation of conditions by the Mudarib. In Mudaraba, the Rab al Maal's liability is limited to their capital contribution only. The Mudaraba contract can be terminated by either party unilaterally, after providing a reasonable period of notice, or it can be mutually terminated at any time.

USE OF MUDARABA FOR FINANCIAL INTERMEDIATION OF ISLAMIC BANKS

The major application of Mudaraba as an instrument is in the way Islamic banks perform their financial intermediation role, as discussed in Chapter 3. Mudaraba is used on both the asset and the liability side of an Islamic bank. Islamic banks, the same as conventional banks, are set up as corporations with initial capital sourced from shareholders. Financial intermediation, that is the matching of surplus units with deficit units, is the core business of banking. Islamic banks source funds from depositors on a Mudaraba basis and then supply the funds to borrowers or entrepreneurs using the Mudaraba instrument again. This system of Mudaraba is called two-tier Mudaraba, and Islamic banks use two-tier Mudaraba to replace conventional interest-based financial intermediation with the profit and loss-sharing mechanism of financial intermediation. Two-tier Mudaraba includes three parties: the depositors or investors, the borrowers or entrepreneurs and the Islamic bank which serves as the intermediary between the other two parties.

On the liability or deposit side of the Islamic bank's balance sheet, which constitutes tier one of the Mudaraba, the bank receives funds from the depositors into current, savings and investment accounts. The depositors are the Rab al Maal, the capital provider or financier and the bank is the Mudarib, the capital user. Current and savings accounts are demand deposits and can be withdrawn anytime. Current accounts are placed with the bank for safekeeping and do not earn any profit. Savings accounts are placed for safekeeping as well as a small profit. Meanwhile clients place their funds in investment accounts expecting a return. Investment accounts are based on the Mudaraba contract and can be either of restricted type (specific investment accounts) or unrestricted type (general investment accounts). The restrictions are related to how the Islamic bank can use the funds in these accounts. More details of these restrictions will be covered in the types of Mudaraba later in this chapter.

On the asset or financing side of the Islamic bank's balance sheet, which is tier two of the Mudaraba, the bank's role is reversed. The bank now acts as the Rab al Maal and provides capital to borrowers or business ventures, who are the capital users. Islamic banks have funds available from their own share capital, as well as funds in the current, savings and investment accounts to use as the funds for financing. According to central bank regulations, only a prescribed portion of the funds in current accounts can be used by the banks for financing and that too at the bank's own risk, since these funds can be withdrawn on demand and are placed with the bank based on safekeeping only. In case of restricted investment accounts, as per the client preference they mutually agree with the bank to apply the funds in these accounts only to certain types of businesses, during certain periods and at certain locations. For savings accounts and unrestricted investment accounts depositors place no such restrictions and their funds can be co-mingled with the bank's own funds, its share capital and can be applied to any venture that is Halal, Shariah compliant and deemed appropriate by the bank. Islamic banks also provide financing to certain entrepreneurs according to the restricted Mudaraba, limiting the choice to specific activities, duration and location and retaining the right to monitor the activities of the project. These restrictions though do not interfere in the operations and day-to-day management of the project, which is the responsibility of the entrepreneur.

In conventional banking all deposits, current, savings and term accounts are capital guaranteed but this is not allowed by Shariah in Islamic banking. Only current accounts held as Amanah or safekeeping are without risk for the depositors. To compensate for the lack of absolute capital guarantee, Islamic banks take other measures to reduce depositors' risk and ensure a competitive profit. Shariah scholars recommend that Islamic banks mix their own capital with depositors' funds to improve the efficiency in project selection. On the asset side of the bank's business, the Islamic bank itself is the Rab al Maal and is exposed to the loss of its entire capital when it finances borrowers or entrepreneurs. The measures taken by Islamic banks to protect their capital outlay, as well as indirectly to protect depositors' funds and ensure a reasonable profit for themselves and their depositors, include maintaining adequate capital, investing in a diversified portfolio of projects, selecting each project with a thorough study of its feasibility and profitability, asking for collateral or third-party guarantees, as and when possible within Shariah boundaries. In Mudaraba, Rab al Maal cannot demand a guarantee from the Mudarib for the repayment of the capital or for a fixed profit. The entrepreneur's liability is limited to their time and effort only, unless the loss has been caused by negligence or mismanagement of the entrepreneur, which will require the entrepreneur to compensate the financier. On the other hand, if the entrepreneur deliberately fails to make repayments to the bank, the bank can initiate legal proceedings and recover its dues from the collateral or guarantees, but it cannot ask the Mudarib to guarantee against business risk. The Rab al Maal's liability towards the project is limited just to the funds invested by them.

PROFIT CALCULATION IN MUDARABA

In contemporary Islamic banking, the bank's gross profit comes from its sales, investing and financing transactions related to the common Islamic banking products, acting as seller, lessor, partner, etc. All fee-based income is added to the profit, and all expenses – including overheads and Zakat (Islamic tax) – are deducted to arrive at the gross operating profit or loss of the bank. The Islamic banks share their gross operating profit with the savings and restricted and unrestricted investment account holders as per the pre-agreed profit-sharing ratio of each category of product and the deposit holders' proportional contribution of deposits. The bank receives the residue of the profit and distributes dividends to their shareholders or retains the profit in the business.

On the deposit side, the Islamic bank as Mudarib receives the funds from depositors against an anticipatory return, which is not guaranteed. The bank can aggregate the funds of various depositors to apply them to various financing and investment projects from which the bank earns a profit, which can also be aggregated together. In case of loss in any financing project of the bank it bears the loss as Rab al Maal, and if this leads to total loss for the bank, the depositors will also lose a proportional part of their deposits or the entire amount as they also are the Rab al Maal to the bank on the liability side of the balance sheet of the Islamic bank. The Mudarib, which is the bank on the liability side, and the entrepreneur or borrower on the asset side only lose their time and effort. The only exception to this is when the Mudarib is charged with misconduct, negligence or violation of conditions agreed in the Mudaraba contract. To be Shariah compliant, shared profit cannot be a fixed amount or a fixed percentage of the capital contribution, but needs to be a percentage of the profit earned.

PROVISIONS AND RESERVES RELATED TO MUDARABA

Since Islamic banks operate on profit and loss sharing, unlike interest-bearing conventional banks, the return to account holders is not fixed. As such, Islamic bank account holders bear higher risk. To reduce this risk and provide more stability to the return of the account holders, most modern Islamic banks include certain provisions and reserves within their operations. The international Islamic finance regulators AAOIFI and IFSB have both allowed such reserves and provisions. Moreover, in most countries the central bank or other regulatory body usually encourages the reserve fund as a mechanism that allows Islamic banks to stabilize their profit and loss and better compete in the global finance industry.

Common provisions set aside by Islamic banks are for doubtful accounts, a permanent decline in the value of investments like real estate, long-term investment, etc. and any contingent liabilities. The provisions are not fixed, but based on best judgment and management's decision on how conservative the provisions should be. The provisions need to be disclosed to all stakeholders including the auditor, the shareholders, the regulators and the investors.

Islamic banks allocate a percentage of their profit to a reserve fund before sharing it with depositors and distributing to shareholders. The purpose of this fund is aimed at smoothing the profit distributed to account holders between high-profit and low or no-profit years. Strict accounting rules need to be followed in allocating profit to the reserve funds, as this affects both the bank, its account holders and finally the shareholders. The approval of the account holders, mainly the investment account holders, who are the Rab al Maal, is required for the reserve allocation. Islamic banks and other Islamic financial institutions usually maintain two kinds of reserves.

• Profit equalization reserve. The allocation for this reserve from the Mudaraba profit is made before allocating any amount to the Mudarib. This reserve aims to maintain the level of return for investment account holders.
• Investment risk reserve. The allocation for this reserve from the Mudaraba profit is done after the share of the Mudarib has been allocated and it aims to protect investment account holders from future losses.

MUDARABA AS A LIMITED RECOURSE DEBT FINANCE

According to Kettel (2011), the Rab al Maal of the Mudaraba contract provides the entire capital and as such the Mudarib is indebted to the Rab al Maal who has first claim to the cashflows of the business till their original capital is recovered. After this the profit-sharing mechanism takes place. This debt is limited recourse, since it applies only to the cashflows of the project and not to other assets of the entrepreneur in case the cashflows are insufficient. On the downside, the claim is like a debt investment and the investor has priority till its investment is paid off. Rab al Maal has a claim to the profit of the project only, but not to the Mudarib's personal assets to recover their investment. Once this breakeven point is reached, on the upside, the investor no longer has any priority and it becomes like an equity investment rather than a limited recourse debt; the profits of the business are shared with the entrepreneur in the pre-agreed ratio. Usually the calculation and distribution of Mudaraba profit is done at regular periods. If both Rab al Maal and Mudarib agree to it, then part of the profit from the venture is used to repay the initial capital of the Rab al Maal and the remainder of the profit is shared between the two parties in the pre-agreed ratio.

TYPES OF MUDARABA

The most important classification of the Mudaraba is based on the mandate of limitations provided by the Rab al Maal to the Mudarib. According to this classification, there are two types of Mudaraba.

• Mudaraba al Muqayyadah. This is also called the restricted Mudaraba. In this case the capital provider, the Rab al Maal, provides certain parameters or restrictions within which they would prefer the Mudarib to invest their funds. These restrictions are usually about the type of investment, the place or location of the investment, and the time of the business venture. Besides these restrictions provided at the beginning of the contract, the Rab al Maal does not interfere in the everyday operations of the business, which is completely the responsibility of the Mudarib. In case of an Islamic bank, the restricted Mudaraba is applied for restricted or specific investment accounts where the depositors specify the projects in which they prefer their funds to be invested.
• Mudaraba al Mutlaqah. This is also called the unrestricted Mudaraba, where there are no restrictions imposed on the Mudarib. The Mudarib has complete authority and freedom to choose any type of project, provided it is Halal, Shariah compliant and legal. The location and time of the venture are also up to the Mudarib to choose. The unrestricted Mudaraba is applied to unrestricted or general investment accounts, where the bank co-mingles the funds of many depositors and invests according to the bank's own judgement and criteria.

Besides these main two classes of Mudaraba, from the operational viewpoint the following types of Mudaraba transactions are being used in modern Islamic banks:

• Bilateral or simple Mudaraba. In this case there are only two parties, one is the capital provider or Rab al Maal while the other is the entrepreneur or Mudarib.
• Multilateral Mudaraba. In this case there are several capital providers, whose funds are collectively provided to one Mudarib or entrepreneur.
• Two-tier Mudaraba or re-Mudaraba. In this case there are three parties involved in two Mudaraba contracts, as discussed in the ‘financial intermediation’ section above. There is Rab al Mal and Mudarib in the first Mudaraba. The Mudarib of the first contract becomes the Rab al Maal in the second Mudaraba and provides capital to a second Mudarib.

SHARIAH CONDITIONS RELATED TO MUDARABA

Mudaraba is one of the earliest and purest Islamic finance instruments that provides an alternative to interest-based finance. The Prophet served as a Mudarib, with his wife Khadija as Rab al Maal, when he conducted trading on her behalf. Some of the Shariah rules identified by the scholar Muhammad Taqi Usmani in 1999 and discussed in Kettel (2011) are given below.

• Capital. The total amount of capital must be known to both parties and needs to be returned to the Rab al Maal on settlement of the Mudaraba. Capital is calculated in the normal currency of the land. Capital could include tangible or intangible assets, but their value in the normal currency of the land must be calculated and stipulated in the contract. Rab al Maal gives the capital to the Mudarib on trust as investment, not as debt.
• Profit sharing. Shariah treats the shared profit as protection of the capital and this allows the investor to recover capital first from the profit and only then is the profit shared with the Mudarib. An exception to this is only allowed if the Rab al Maal permits it. Profit sharing is based on a pre-agreed ratio or percentage, but is never a lump sum. If the Mudaraba contract includes more than one Rab al Maal, then profits are distributed amongst them in the proportion of their capital investment, after deducting the Mudarib's portion.
• Financial loss. The capital provider is completely responsible for any financial loss, the capital user or entrepreneur does not own any capital and so loses none. The entrepreneur is liable to lose their time and effort and would not be getting any profit in case of loss.
• Restrictions. The Rab al Maal can invest their funds in a restrictive manner that can limit the Mudarib to use the funds in specific types of projects, in specific locations and within specific time periods to ensure efficient use of their funds. These restrictions should not prevent the Mudarib from executing their business activities and earning a profit. The Rab al Maal, which can either be the depositors or the Islamic bank, does not get involved or interfere in the management of the business invested in. The Mudarib is not permitted to lend or donate the Mudaraba capital or to enter into partnership with other Rab al Maal without the permission of the original Rab al Maal.
• Security or guarantee. The Rab al Maal cannot ask for any security or guarantee from the Mudarib against repayment of capital or for a fixed profit amount. However, a security or guarantee can be taken by the Rab al Maal from the Mudarib against losses that may occur due to negligence or mismanagement of the Mudarib.
• Termination. A Mudaraba contract can be terminated anytime by mutual consent or the contractual relationship can be cancelled by any one party by giving a reasonable notice period to the other party. At termination, the non-cash assets are liquidated, though most Islamic scholars recommend the method of calculating the worth by the net asset value method and agree that the Mudarib can buy the Mudaraba units from the Rab al Maal instead of liquidating the project if they prefer.

CHALLENGES AND PROBLEMS RELATED TO MUDARABA

Mudaraba is one of the purest forms of profit and loss-sharing Islamic finance products. In today's modern financial sector it is a high-risk method of financing. The Rab al Maal needs to put complete trust in the honesty, ability and performance of the Mudarib with their investment and in earning a reasonable profit from the venture. Islamic banks use the Mudaraba contract on both sides of their balance sheet in the two-tier Mudaraba. On the liability or supply side they collect funds from the depositors via the Mudaraba contract acting as the Mudarib and on the demand or asset side they provide funding to entrepreneurs or users of funds as the Rab al Maal. Islamic banks find the Mudaraba contract quite difficult to apply and unpopular on the demand side, since in current socio-cultural and business environments the fund provider is required to place absolute trust in the fund user, and this is often not realistic. Sufficient legal protection is also often not available for the Rab al Maal. Due to its profit and loss-sharing characteristics on both the demand and the supply side of the Islamic bank, Mudaraba finance is neither pure debt nor pure equity. Entrepreneurs or borrowers prefer to consider it as equity, while the banks prefer to consider it as debt. Mudaraba can still be used by taking measures to reduce the risk as far as possible. These measures involve financing only those borrowers who are highly reliable (like governments or corporations with transparency of financial information), by closely monitoring the business activities of the borrower and by taking collateral and guarantees against any negligence or mismanagement of the borrower.

PRACTICAL APPLICATIONS OF MUDARABA

The most common application of the Mudaraba contract is in the financial intermediation process of Islamic banks, mainly in their relationship with the investment account holders, for both general and specific investment accounts. The Mudaraba structure also works well in the financing of venture capital, project financing, formation of unit trusts as well as real estate investment trusts.

COMPARISON OF MUDARABA WITH INTEREST-BASED CONVENTIONAL BANKING

As can be seen from Figure 5.1, in the case of interest-based conventional banking depositors place their funds with the conventional banks on the basis of fixed or market-based variable interest rates for both savings accounts and term deposits, while current accounts are deposits without any interest payments. The bank then lends the funds, or the part of it allowed by regulations, to borrowers again at fixed or market-based interest rates. This interest rate paid by the borrower to the bank is not in any way linked to the profit earned by the borrower's business venture. Similarly, the interest paid by the bank to the depositors is not related to the bank's profit. Let us assume that the average interest paid by the bank to the depositors is 2%, and that the average interest received by the bank from the borrowers is 6%. The interest margin earned by the bank is 4% (6%−2%). The business venture may earn a profit of, for example, 2% or 6% or 16%, or may even have a loss. Irrespective of the borrower's business profit, they are required to pay the bank the fixed 6% interest. As such the loan has no connection to the real venture in which the funds were applied. The bank earns its due even when the profit of the borrower is less or none. But it does not earn more than the prescribed interest when the venture earns much more, as in the case of 16% profit.

In contrast, in the case of the Islamic bank, the depositors place their funds with the bank based on a pre-agreed profit-sharing ratio and they also share in the risk in case the bank loses money, where the depositors are the Rab al Maal and the bank is the Mudarib. Islamic banks then use the funds to finance entrepreneurs or borrowers, and this time the bank is the Rab al Maal and the entrepreneur is the Mudarib and there is a pre-agreed profit-sharing ratio as part of the contract. Let us assume this ratio is 50:50. If this business venture now earns a profit of, for example, 2% or 6% or 16%, or even has a loss, what will the entrepreneur have to pay the bank? No matter what amount of profit the business earns, it shares 50% with the bank so the bank will be paid 1% or 3% or 8%, respectively and in the situation where the business makes a loss the bank will not earn anything. So, we can see that what the bank earns is directly linked to the real economic activity and results of the business. The bank may earn less or nothing in some scenarios compared with a conventional bank, but it also has the opportunity to earn much more when the business venture is very successful. On the other hand, the bank shares its profit – after deducting all operational expenses – with the depositors as per the pre-agreed profit-sharing ratios. These ratios can be different for different types of depositors. The depositors' income varies with the variation in the bank's actual profit and is indirectly linked to the real economy too.

ACCOUNTING ISSUES RELATED TO MUDARABA

Accounting standards set by the Islamic regulatory bodies require the banks to recognize the assets and liabilities of the bank, value the assets, clearly identify income and expense, as well as profit or loss, and provide standard disclosure to the relevant stakeholders. At the end of each financial year the Islamic banks take account of the below:

1. The initial book value of capital is calculated.
2. Repayment of capital deducted from the Mudaraba financing is made.
3. Any loss of capital, happening before the Mudarib starts work and not attributed to mismanagement or negligence of the Mudarib, is deducted.
4. The Mudaraba capital may be cash or in kind, either tangible or intangible assets, is valued at fair market price and any difference with the book value is recognized as a profit or loss for the bank.
5. The loss of Mudaraba capital is borne by the Rab al Maal and may lead to the contract being terminated.
6. At liquidation or termination of the Mudaraba contract, accounts are fully settled between the Rab al Maal and the Mudarib.

KEY TERMS AND CONCEPTS

• Bilateral Mudaraba
• Investment risk reserve
• Mudaraba
• Mudaraba al Muqayyadah
• Mudaraba al Mutlaqah
• Multilateral Mudaraba
• Profit equalization reserve
• Two-tier Mudaraba

CHAPTER SUMMARY

Mudaraba is one of the two main equity-based Islamic banking products. It is also called trust financing since one party, the Rab al Maal, pays the entire capital and trusts the other party, the Mudarib, to use the funds to generate profit. The two parties share the profit according to a pre-agreed ratio. While any financial loss is borne by the Rab al Maal, the Mudarib loses their time and effort and gets no profit. Mudaraba is the main instrument used to design Islamic financial intermediation. Depositors as Rab al Maal provide funds to the bank, as Mudarib, on the liability side. Meanwhile the bank, as Rab al Maal, provides the collected funds to borrowers or investors, as Mudarib, on the asset side. This is called the two-tier Mudaraba, where the bank as intermediary connects the surplus units with the deficit units. To compete with the conventional banks' guaranteed interest payments, Islamic banks build reserve funds to stabilize profit payments between high and low years.

When the Rab al Maal provides funds with restrictions related to type, place and time of investment it is called Mudaraba al Muqayyadah and without such restrictions it is called Mudaraba al Mutlaqah. Based on the operations, Mudaraba are also classified as bilateral, multilateral or two-tier. Specific Shariah conditions related to Mudaraba require both parties to be aware of the capital amount, which can be cash or tangible or intangible assets, but valued in local currency; profits from the Mudaraba project would first pay the Rab al Maal's capital and then be shared between the two parties as agreed, with loss according to each party's contribution of capital or effort. Shariah also allows the Rab al Maal to provide funds with general restrictions, but not interfere in the day-to-day management or require security. Termination can be mutually agreed at any time or if a unilaterally decided reasonable notice period has to be given.

Mudaraba is a pure form of Islamic finance. Islamic banks mainly use it for the liability side of their balance sheet but due to its risky nature, especially for the Rab al Maal, on the asset side it is less frequently used. In modern Islamic banking, a Mudaraba contract is applied in investment accounts, venture capital and project financing, as well as in real estate investment trusts.

END OF CHAPTER QUESTIONS AND ACTIVITIES