Forward Planning Islamic finance

					Islamic Finance: A marriage of convenience
Dubai |By Sohail Zubairi | 30-12-2002
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In simple terms, Mudaraba is a form of financing where an investor and an entrepreneur join hands.
As per a formal agreement drawn between them, the investor provides funds whereas the
entrepreneur utilises his skills in order to earn profit for their venture.

Mudaraba is considered the original mode of Islamic financing along with Musharika whereas the other
modes such as Murabaha, Ijara, Sallam, Istisna, etc. are modes of trade which have been modified for
use as financing vehicles. Following are the parameters of Mudaraba:

• It is for an agreed period of time.

• Investor does not interfere in the operation of Mudaraba which is solely carried out by the
• At the end of the agreed tenure, profit is determined and distributed between the parties according
to the pre-agreed ratio.

• Capital is returned to the investor upon completion of Mudaraba but prior to distribution of profit.

• In case of a loss, the investor bears it fully, however, he is not liable beyond the capital contributed
by him.

• Though eligible to share profits, entrepreneur is not liable to share the financial loss.
• In the loss situation, the entrepreneur does not have a right to claim compensation for his time and

• If the loss is occurred due to entrepreneur's negligence, he is liable to return the entire amount of
capital to the investor.

• Negligence will be considered to have occurred if the entrepreneur is found to have acted outside
the scope of agreement entered into by him with the investor.

The investor or provider of the capital is called Rabb Al Mall and the entrepreneur Mudareb. In case of
an Islamic bank, the depositors are Rabb Al Mall whereas the bank is Mudareb. When it comes for the
bank to invest the funds, it in turn becomes Rabb Al Mall and the borrowers Mudareb.

Mudaraba is a marriage of convenience and achieves benefits for both parties, i.e. the investor and
the entrepreneur. Investor may not have the time or the expertise to efficiently utilise the capital
and earn profits whereas the entrepreneur may have skills but lack the capital.

The residents of the holy city of Makkah had commonly practised Mudaraba financing, even before the
advent of Islam, due to their location at the crossroads of ancient trade caravans. Credible Mudarebs
carried goods and/or money for investors and had to be accountable to them. Upon return of the
caravan, the profit and loss account was prepared, enabling the Mudareb to claim his share of profit
and return the capital, alongwith the profit, to the investor - be it in cash or kind.

However, in the Islamic era, the Mudaraba was fine tuned to eliminate some elements such as making
Mudareb liable to bear the trading loss at times or for the theft and robbery in transit, beside
payment of interest if the capital remained undeployed in the trip due to some reason, etc.

In Makkah's small population, almost every investor knew every Mudareb and the credibility was the
key factor to conduct Muda-raba transactions. Dishonest Mudarebs were barred from continuing with
the activity.

However, in today's world, the credibility gap has been successfully filled by the Islamic banks who
have assumed the dual role of Mudareb on one hand as well as the investor on the other. As an
intermediary, the Islamic banks are ideally positioned to build formidable risk capital contributed by
small to medium to large investors (depositors) whereas on the other hand they are privy to the
lucrative investment opp-ortunities where this risk capital could be profitability deployed.

I would like to elaborate this point further. However, please note that in the form of an Islamic bank,
there are six important modifications to the basic concept of Mudaraba as explained earlier. These
1. There are many investors and scores of entrepreneurs, as against one-to-one interaction in old

2. The bank is an intermediary who enjoys investors' confidence in receiving their funds; a new
concept which was previously non-existent.

3. The projects put forward by the entrepreneurs are financed by the intermediary, rather than the

4. Investors and entrepreneurs do not have a direct relationship and have no responsibility or
obligation towards each other.

5. Whilst the ratio of sharing the profit is pre-agreed between intermediary and entrepreneur, no
such agreement takes place between investor and intermediary.

6. There is no specified period or limit to the number of projects and it is an ongoing process.

It is interesting to note that in this investor-intermediary-entrepreneur triangle, the investor
continues to remain an inactive partner, as was originally perceived. He provides capital and then
shares the profit or absorbs losses, if not caused by intermediary's negligence.

As discussed earlier, the intermediary plays a vital dual role of an entrepreneur and an investor. As
such, it becomes his primary responsibility to hire experienced staff in order to thoroughly examine
the business propositions submitted by the entrepreneurs and prudently invest the trusted funds. He
is also responsible to keep proper books of accounts and conducts periodical audit in order to
maintain high credibility. It becomes all the more important since the investor does not know which
project is being financed through his capital. Similarly, the entrepreneur does not know whose funds
are financing his project.

When it comes to profit sharing, it is the net profit from all the avenues that is distributed by the
intermediary to the investors, after having netted out his operating expenses and retention of his
share of profit. However, the entrepreneurs share the pre-agreed ratio of profit with the
intermediary out of the income generated by their projects.

It is interesting to note that in the above scenario, the financiers - both the investors and the
intermediary - operate purely on the basis of Mudaraba while the entrepreneur is free to choose any
mode of financing such as Mura-baha, Ijara, Sallam, Istisna, etc. suitable to his business

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