Islamic Finance: Mudaraba concept in the modern world

The following adaptations allow an Islamic bank to practice a Mudaraba role today, while respecting Sharia:

a) Today, there are many investors and scores of entrepreneurs, compared to the one-to-one equation prevailing in olden days;

b) The bank acts as an intermediary, enjoying investors' confidence and receiving their funds a concept which did not exist before;

c) The intermediary acts as a Mudareb (agent) with a large number of Rab Al Mals (investors);

d) The projects/commercial transactions proposed by the entrepreneurs are financed by the intermediary rather by than the investors directly;

e) Investors and entrepreneurs do not have a direct relationship and therefore have no obligation towards one another;

f) While investors deal with the bank purely on a Mudaraba basis, the bank is free to invest funds via any financing or investment option, such as Murabaha, Musharaka, Mudaraba, Istisna, Salam, Ijara, Sukuk, etc;

g) There is no specified period or limit to the number of projects, and it is an on-going investment process for the intermediary.

Readers will notice how, in the triangular association between the investor, intermediary and entrepreneur, the investor remains a passive participant, as in the old days.

Investors are not permitted to interfere in the Mudaraba's transactions, and wait to share the profit or loss (that is, if the loss is not caused by the negligence of the Mudareb).

The Islamic bank has come to play the roles of a Mudareb and a Rab Al Mal at the same time.

There are two questions we can now examine: how a customer's funds are channelled through an Islamic bank, and how a loss is handled.

When an investor hands over funds (i.e., makes a deposit) to the Islamic bank, the bank enters into a Mudaraba agreement with him.

The agreement appoints the bank as trustee (or agent) for the investor for his funds. This trustee arrangement allows the bank to place the funds into a common pool.

The common pool may or may not include some of the bank's own funds, such as paid up capital, reserves and provisions and retained earnings. Both practices are acceptable under Sharia, albeit with a different treatment to the two types of funds.

While the bank bears responsibility for the risk for the placement of its own funds through the common pool, the depositors carry the risks on their investment, as owners of the funds.

A conventional bank borrows funds from depositors, and hence "owns" such borrowed funds. This means the conventional bank bears all the risk when it lends these funds to a third party.

Islamic banks do not "borrow" funds from depositors and therefore do not assume "ownership" of these funds.

The banks' responsibility to their depositors instead follows from the fact the banks have assumed the role of a trustee or agent and "handle" the depositors' funds.

The writer is the vice-president and head of Sharia structuring, documentation and product development, Dubai Islamic Bank.