Operationalization of Mudharaba Contract in Present Day Islamic Banking

To make Mudharaba contract valid and in line with Shariah, the following guidelines between Rabb ul Maal (capital owner) and Mudarib (fund manager) have been laid down by scholars:

  • The amount of capital must be specified from the inception, uncertain amount of capital leads to uncertainty when it comes to profit sharing.
  • The currency of the contract must be clearly specified e.g. US Dollars, Kenya Shillings or Saudi Riyal, or in case the capital is in form of merchandise, then the merchandise must be fully described in terms of quality, quantity, price on the date of contract etc.
  • The capital is not a liability or debt on the Mudarib (fund manager). This means that the Rabbul Maal (capital owner) is not a lender but a business partner to the Mudarib (fund manager). Incase of loss they both bear the loss unless negligence on the part of fund manager is established.
  • It is a permissible for the Mudarib (fund manager) to mix his own private capital with the capital of the Mudharaba (partnership) so long as he adheres to principles of Mudharaba with regards to the agreement with the Rabbul Maals funds (capital owner).
  • The capital of Mudharaba agreement must be delivered to the Mudarib. Regarding this condition, some jurist’s opine that capital owner can hold on to the capital and deliver it gradually, according to the need of the business need.
  • In case two or more Islamic financial institutions are involved in a Mudharaba contract as Mudarib, the distributable profits are distributed among them on pro-rata basis. The share of capital owners profit is provided by each as agreed upon.
  • Stipulation of any restriction on the Mudarib is permitted if the restriction is beneficial and does not cause a compulsion on Mudarib to achieving the profit required and is not counterproductive to the purpose of the Mudharaba agreement.
  • The Mudarib (fund manager) is allowed to hire an assistant.
  • The Mudarib’s management is restricted to what is conducive to the Mudharaba agreement.
    1. The Mudarib can’t lend or donate the Mudharaba capital.
    2. The Mudarib is not permitted to purchase more than the investment capital.
    3. The Mudarib is also not allowed to use the Mudharaba capital for other partnership agreement, with a third party without express authority from the Rabbul Maal (capital owner).
  • It is not permissible to impose a condition that force the Mudarib to bear capital loss except in cases of negligence. It is permissible to take a security from the mudarib to guarantee the payment in case of negligence or infringement of the contract. But, it is not allowable to take the security as a guarantee for profit or capital loss.
  • The proportion of profit sharing must be specified. It is condition that profit sharing ratio have to be stipulated in the contract. Lack of this condition abrogates the contract.
    1. It is permissible that the profit sharing ratio can be stipulated in form of a percentage or lump sum. Note the amount of profit but the percentage at which profit will be shared in case it is realised.
  • Profit in Mudharaba is shared according to pre-agreement between the contracting parties. However, it is a condition that monetary loss is absorbed by the Rabb ul Maal (Fund provider, capital owner) alone.
  • The Mudarib receives his/her share of the profit only after obtaining the permission of the capital owner.
  • Mudarib is entitled to receive his share of profit only after the capital is recovered because the Shari’ah principle states that “profit is protection to capital”.
  • Mudaribs ownership becomes secure after the liquidation of the Mudharaba agreement and the capital owner has recovered his capital.
  • The Mudharaba is terminated if one of the two parties rescinds, given that it is an optional and not a binding contract. However some of the jurists hold the view that Mudharaba is binding and it cannot be rescinded if the Mudarib has commenced work.

Practical Example of Mudharaba In Practice

  1. Customer deposits his money in to an Islamic Bank on Mudharaba contract basis.
  2. The Islamic Bank uses the (deposits) funds in its possession for business investments to generate profit.
  3. The Investments are varied in nature which includes financing instruments, stocks exchange, real estate etc.
  4. The investments generates either positive or negative profits.
  5. Positive profits are shared between Depositor (customer) and the Islamic Bank at a pre-agreed ratio.
  6. Negative profits are absorbed by Depositor (customer) as the decline of the asset created with its investments and the value of the deposits deteriorates. In most jurisdictions however, the Central banking prudential guidelines and consumer protection guidelines do not allow an Islamic bank to share losses with the Customer. To circumvent this, Islamic banks creates two accounts which act as insurance. An Investment Risk Return fund (IRR) and a Profit Equalization Return fund (PER). Incase of loss, the customer is paid from the Investment Risk Return fund to ensure the customer doesn’t lose his deposits. Profit equalisation fund is for profit smoothening process while distributing profits to the investment accounts in a Mudharaba pool.
  7. In cases of Negative profits and it is established that the losses are as a result of negligence, then the Mudarib will loose his/her share of the efforts and guarantee the principal as well.
  8. Mudharaba contract is used in the investment of deposits (savings and fixed deposit accounts) where the customer requires a return on his/her investments in a Shari’ah compliant manner.

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