In our previous articles we looked at deposit taking instruments and classified them into two categories; Profit and Loss Sharing (PLS) such as Mudaraba and Musharaka and Debt based modes of deposit taking.
We will today commence with Mudaraba, the first instrument under the Profit and Loss Sharing (PLS) category.
Mudharaba is a profit-and-loss sharing contract in which one party who is known as Rabb al mal or financier who provides all the capital needed for financing the venture and the other party known as Mudharib or agent who provides labour and effort.
In this contract the proportionate share in profit is predetermined by mutual consent between the two parties but in case of loss, only Rabb al-mal or financier bears the capital loss, and Mudharib bears the loss by getting nothing in return for his time, effort and labour.
Historical Background of Mudharaba.
The term Mudharaba was derived from verse of the Quran and refers to walking and traveling on the earth, as it is activity that Mudharib performs in order to seek profitable opportunities.
It is an ideal principle for Muslims to conduct joint venture business as mentioned in various narrations from the Prophet Muhammad ﷺ who also used to practice this contract.
Mudharaba is one of financial modes that was prevalent throughout middle ages. It was a pre-Islamic custom used to finance the caravan trade in Arabia. It was later approved in Islam as legal means of financing.
The Prophet ﷺ used practiced Mudharaba in his business engagement with Khadijah (R.A).
The Prophet’ﷺs companions such as Umar and Uthman, The second and the third rightly guided caliphs also used to invest orphan’s money which is under their protection in trade business between Medina and Iraq on Mudharaba basis.
Mudharaba is also known as Qiradh or Muqarada. In Europe, Mudharaba was known as Commenda and was practiced by Venice merchants since 11th century.
Hanafi School jurisprudents divided Mudharaba contract into two; restricted and unrestricted Mudharaba.
Mudharaba al muqayyada (Restricted Mudharaba)
Restricted Mudharaba have some conditions such as time, place and type of business transaction.
The Mudharib does not have absolute freedom to manage project as he wills, but has to conduct it within the framework of the terms and conditions of the agreement.
Profit is shared according to the pre-agreed ratio but in case of loss, capital loss is borne by the financier or Rabb al-mal.
However, if the loss is caused by Mudharib’s negligence or violation of the terms of the contract, then the Mudharib must take responsibility for the loss.
Unrestricted Mudharaba or Mudharaba Al Muthlaqa
The characteristic of unrestricted Mudharaba derives from the Arab clause “ I’mal fihi bi raika” or “act with it as you deem fit” In Unrestricted Mudharaba, Mudharib is free to conduct project as he deems fit. There are no restricted framework that Mudharib have to act on.
Profit and loss sharing is the same as the above.
Application of Mudharaba in Islamic finance
During the early stages of Islamic Banking, Mudharaba was the first contract which came into use.
Islamic banks or other Islamic financial institutions can use two tired Mudharaba structure as backbone of their operation.
The Islamic institution receive deposits as agent or Mudharib of its customer. The Bank which in this case is the Mudarib and the customer who is the Rab Al Maal then share profit from the investments made by the bank on pre-agreed ratio.
The bank on the other hand provide financing to its customers through the same arrangement where the bank acts as the Rab Al Maal while the customer is the mudarib.
By using Mudharaba thus the Islamic Financial Institutions kick out interest from the system and instead .
Islamic banks use Mudharaba as core structure of investment deposit. Investment deposit is similar to saving and time deposit of conventional bank that they have to pay some return to depositor.
However with the help of Mudharaba, Islamic banks do not pay the return in form of fixed interest rate but in form of proportion of profit share. Prevalent types of investment deposits are as follow:
- General investment deposit which has no special requirement. Profit is calculated and shared at the end of accounting maturity say three months, six months or one year.
- Special investment deposit which is similar to general investment deposit, but adding some special conditions such as which require the bank to invest in particular project or sector.
- Limited period investment deposit which is mutually determined by the depositor and the Islamic bank.
- Unlimited period investment deposit where the period is not specified. Deposits are automatically renewable unless a notice of three months is given to terminate the contract.