Define Mudarabah Types, Principle, Risk for Islamic Banks

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Mudarabah Partnership

The Mudarabah contract is a form of partnership between one who contributes efforts in the form of managerial skills (Mudarib) and the other who contributes capital (Rabb-ul-maal). Profit from the outcome of the venture is shared between the capital provider and manager. Profit will be shared according to mutually agreed profit sharing ratio. However, losses are borne solely by the capital provider. Provided such loss is not due to the negligence or violation of Mudarib’s specified conditions.

Differentiate between Mudarabah and Musharakah Partnerships:

Mudarabah is the contribution which comes from the investor (Rabbul-Maal). In Mudarabah, the investor (Rabbul-Maal) is not permitted to manage the business. The Mudarib will only manage the business. The Mudarib can also invest in the capital of Mudarabah.

Musharakah is the contribution comes from all partners in form of cash, commodities, services or liability in the case of reputation partnership. The work, as a general rule, is to be done jointly by all partners. Any or some partners may be sleeping.

Types of Mudarabah

  • Al Mudarabah Al Muqayyadah (Restricted Mudarabah)
  • Al Mudarabah Al Mutlaqah (Unrestricted Mudarabah)

Al Mudarabah Al Muqayyadah (Restricted Mudarabah):

Rabb-ul-Maal may specify a particular business or a particular place for the mudarib. In which case, he shall invest the money in that particular business or place.

Al Mudarabah Al Mutlaqah (Unrestricted Mudarabah):

Rabb-ul-maal gives full freedom to Mudarib to undertake whatever business he deems fit. However, he is not authorized to:

  • Keep another Mudarib or a partner
  • Mix his own investment in that particular Mudarabah without the consent of Rabb-ul Maal

Profit & Loss Principles:

It is essential for the validity of Mudarabah contract that the parties must agree, right at the beginning, on a definite proportion of the actual profit to which each one of them is entitled. They can share the profit at any ratio they agree upon. However in case the parties have entered into Mudarabah without mentioning the exact proportions of the profit, it will be presumed that they will share the profit in equal ratios. Some incentives may be given to the Mudarib.

Apart from the agreed proportion of the profit, the Mudarib cannot claim any periodical salary or a fee or remuneration for the work done by him for the Mudarabah Partnership. The Mudarib & Rabb-ul-Maal cannot allocate a lump sum amount of profit for any party nor can they determine the share of any party at a specific rate tied up with the capital.

If the business has incurred loss in some transactions and has gained profit in some others, the profit shall be used to offset the loss at the first instance, and then the remainder, if any, shall be distributed between the parties according to the agreed ratio.

The Mudarib shares profit of the Mudarabah as per agreed rate with the investor but his expenses like meals, clothing and medical are not borne by Mudarabah. However, if he is traveling on business and is overstaying the night, then the above expenses shall be covered from capital.

Termination of Mudarabah Partnership:

The contract of Mudarabah Partnership can be terminated at any time by either of the two parties after giving a notice to the other party. If all assets are in form of cash and some profit has been earned on the principle amount, it shall be distributed between the parties according to the agreed ratio.

If the assets of the Mudarabah are in other form the Mudarib shall be given an opportunity liquidate them and the actual profit may be determined.

Mudarabah in Islamic Banks:

It as a mode of finance used by Islamic Banks for the following purpose:

  • Relationship with depositors.
    • The depositors provide moneys to bank as Rabb-ul-Mal to be invested by bank as Mudarib on the basis of profit and loss sharing on pre agreed specific ratio
  • Islamic bank can also use this mode through providing capital in a business and sharing in the profit with pre-agreed ratio.
    • Large Enterprise financing
    • Project Finance
    • Business ventures
    • Private equity
  • Depositors and Islamic bank relationship
    • Mudaraba is used by Islamic Banks for taking deposit from depositors
    • The depositors provide moneys to bank as Rabb-ul-Mal to be invested by bank as Mudarib on the basis of profit and loss sharing on pre agreed specific ratio

Risks for Islamic Banks:

Mudarabah is among the preferable modes of financing which is also heavily recommended by scholars and Ulema, but certain difficulties are there in application of this mode. Some are given below:

  • Mudaraba is considered to be very high risk financing activity.
  • Collateral can be asked but could not be used in case of real loss.
  • Bank’s existing competencies in project evaluation and related techniques are limited.
  • Dual book keeping trends in market.
  • No legal mechanism for treatment with Mudarabah.

Conclusion:

Risks in Islamic financial instruments are complex and change and evolve during the transaction. It is important to know the underlying features of the contracts and risks arising in Mudarabah Financing. Risk management would require knowledge of Islamic contracts and also the appropriate skills to mitigate risks arising in them.

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