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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[edit]

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[edit]

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.