Islamic Finance: A marriage of convenience

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 entrepreneur.
• 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 effort.

• 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 are:

1. There are many investors and scores of entrepreneurs, as against one-to-one interaction in old times.

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 investors.

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 requirements.