Mudaraba

Mudaraba is one of the basic Islamic financial instruments. It is a trust contract, based on the principle of risk sharing between the parties.

Mudaraba is a contract between a capital owner (also known as rabb al-mal) and a managing person (mudarib). The profits generated by such a company are divided between two entities in proportions agreed at the time of signing the contract. However, the financial loss is borne only by the principal. Possible losses of the manager are limited to the lack of remuneration for services rendered. With the exception of the breach of contract or lack thereof, mudarib does not bear any financial responsibility if the project is not successful. Although, rabb al-mal may set his terms in the course of mutual contract terms, he has no right to interfere in the manager's business decisions. Responsibility of rabb al-mal is limited to the amount of capital invested in the project, while the expenses of the manager can not exceed the amount entrusted to him. Mudarib also can not be included in the cost of his private expenses if they do not have a direct relationship with the operating activities.

The mudaraba contract may be terminated at any time by either party by reason of a reason. This condition may lead to difficulties in running a business. In practice, the parties often specify in the contract the manner of its early termination, which does not affect the continuation of the undertaking. The distribution of profits takes place only when all liabilities are repaid and the capital of the financing entity has been restored.

The problem of moral hazard

Mudaraba, which is a trust contract (uqud al-amana), can lead to the phenomenon of moral hazard, thanks to the information advantage on the manager's side. Therefore, mudarib is obliged to act in good faith and diligently perform its duties. Otherwise, he commits a grave sin and is subject to infamy in the Muslim community.

Mudaraba in modern Islamic banking

Using the mudaraba institution, the principles of operation of three parties are defined, in which the first is a bank acting as an intermediary between the borrower and the lender. The other side is an investor who can be both the founder of the bank and the owner of the deposit. The borrower is the third party. The investor makes profits thanks to the actions taken by the commercial bank, and they result from the revenues achieved by the borrower. Therefore, there is a relationship between the liabilities of the bank and the deposits agreed in accordance with the mudaraba. The distribution of profits resulting from complex deposits affects the structure of liabilities. liabilitiesthey do not require adjustments for losses incurred by the investor and do not affect the amount of capital held. The mudaraba, which defines the relationship between the bank and the borrower, works in a similar way. The bank is not required to maintain increased provisions related to the risk of trading activities. In the same situation there is a correspondence between assets and liabilities, limiting the risk of financial crises.

Examples of Mudaraba

• Venture Capital: In this type of Mudaraba, a capital provider (the rabb-ul-mall) lends funds to an entrepreneur (the mudarib) to finance a business venture. The entrepreneur is responsible for the management of the business and is entitled to a part of the profits, according to a predetermined ratio. The capital provider bears the risk of loss for any potential losses.
• Deposits: In this type of Mudaraba, a customer deposits a certain amount of money with a bank or other financial institution (the rabb-ul-mall). The bank then invests the money in a variety of investments (the mudarib), in return for a share of the profits. The bank bears the risk of losses, while the customer is entitled to a part of the profits according to a predetermined ratio.
• Commodity Trading: In this type of Mudaraba, a commodity trader (the rabb-ul-mall) entrusts a trader (the mudarib) with the task of trading in a particular commodity. The trader is responsible for the trading decisions and is entitled to a share of the profits according to a predetermined ratio. The commodity trader bears the risk of losses in the event of any potential losses.

Advantages of Mudaraba

Mudaraba is one of the basic Islamic financial instruments and it has many advantages. These advantages include:

• Clear risk sharing: Mudaraba is based on the principle of risk sharing between the two parties involved. It is a contract that clearly defines the roles of the two parties, the investor and the entrepreneur, and their respective responsibilities.
• Flexibility: The contract can be easily adapted to various business activities. The contract can be tailored to fit a particular situation or business activity.
• Low costs: The contract does not require the parties to pay any fees or commissions. This makes it an attractive option for small and medium-sized businesses.
• Low risk: The contract is based on the principle of risk sharing, which means that the parties involved bear only a limited risk.
• Transparency: The terms of the contract are transparent and clear, ensuring that all parties are aware of their rights and obligations.
• No speculation: The contract does not permit speculation, which helps to reduce the risk of losses.

Limitations of Mudaraba

Mudaraba is one of the basic Islamic financial instruments, based on the principle of risk sharing between the parties. However, this contract has certain limitations that must be considered:

• It requires high levels of trust and mutual understanding between the two parties.
• It is not suitable for large-scale investments, as the capital provided by the investor is not sufficient to cover the needs of the business.
• The risks of the business are solely borne by the investor, leaving the capital provider with no financial protection.
• The profits generated by the business are not guaranteed, and are only distributed after the business has been liquidated.
• The capital provider is not responsible for any losses incurred by the business, and has no legal recourse against the investor in case of a loss.
• The mudaraba contract is not suitable for long-term investments, as the terms of the contract are not flexible and can not be amended.

Other approaches related to Mudaraba

Mudaraba is one of the basic Islamic financial instruments. It is a trust contract, based on the principle of risk sharing between the parties. Other approaches related to Mudaraba include:

• Murabaha - where the bank purchases a commodity from a supplier and sells it to the customer at a markup.
• Ijara - is a leasing contract where the bank leases an asset to the customer and collects periodic lease payments.
• Musharaka - is a form of partnership between the bank and the customer, where the profits and losses are shared according to a predetermined ratio.
• Takaful - is an insurance contract that is used to protect against the risks of life, health, and property.

In summary, Mudaraba is an important Islamic financial instrument that provides a basis for other financial approaches. These approaches include Murabaha, Ijara, Musharaka, and Takaful.

Mudaraba — recommended articles

Ijarah — Tri party agreement — Musharaka — Credit Facility — Working interests — Staged payments — Noncovered security — Nominee shareholder — Cross margining

References

• Bacha, O. I. (1997). Adapting mudarabah financing to contemporary realities: a proposed financing structure.