INCEIF

The Global University in Islamic finance

Kuala Lumpur, Malaysia

CIFP

Two-tier Mudarabah as a mode of Islamic Financial Intermediation

Semester January 2010

Name: Masniza binti Maisham

Matric No: 1000098
 ABSTRACT

Mudarabah contract is one of the most important

financial instruments offered by of an Islamic Financial
Institutions (IFI) to replace the riba’-based products in
investments. This paper is a partial fulfilment for
SH1003 of CIFP. It will explore and analyze the
innovation of Islamic contract namely two-tier
mudarabah contract as a mode of Islamic financial
intermediation. In addition, it will discuss the opinions,
application and issues in implementation of this contract.

KEY TERMS OF THE RESEARCH : Mudarabah; Two-Tier Mudarabah; Islamic

Banking; Islamic Finance;

i
 TABLE OF CONTENTS

Abstract ………………………………………………………………………. i
1. Introduction …………………………………………………………………… 1
2. Understanding Mudarabah .………………………………………………….. 4
3. Mudarabah Application ………………………………………………………. 6
4. Two-tier Mudarabah ..………………………………………………………… 8
5. Legitimacy of two-tier Mudarabah …………………………………………. 11
6. Issues in Implementation ……………………………………………………. 14
7. Summary ……………………………………………………………………... 17
8. References ……………………………………………………………………. 18

ii
1. INTRODUCTION

Interest (riba’) is prohibited in Islam as it appears explicitly in Al-Quran. Since

Al-Quran is the undisputed source of guidance in Islam for all Muslims, there is
unanimous agreement on the fact that Islam has forbidden the practice of riba’.
Besides, riba‟ is considered as an act of injustice because it creates oppression
that exploits people‟s need. For this reason, Islamic banking has been introduced
as an alternative to conventional banking practising interest-based to its
customers.

The prohibition of interest essentially implies that there can be no gain

without risk-sharing, which implies that if someone wishes to get returns he must
be liable for the loss. No risk, no gain is actually the basic juristic principle of
Shariah. Shariah legal maxim “profit must be accompanied with responsibility” (al-
kharaj bi-al-daman) or “No reward without risk” (al-ghurm bil ghonm), the
criterion of legality of any return on capital, meaning that one has to bear loss if
he wants to get any profit over his investment.

Both conventional and Islamic systems permit and encourage active

investment, which rewards labour and capital from realized profits. Both also
permit and encourage passive investment in shareholder companies, which too

1
reward capital from realized profits in the form of dividends. In both cases any
realized loss is borne by the capital-providers.

But any investment that brings in riba’ income or financing that involves
the payment of riba’ is prohibited in Islam. This leaves the Muslim passive
investors who cannot or will not buy shares in a company and Muslim
entrepreneurs, who do not have their own capital or cannot raise share capital but
need seed capital and/or additional funds, in a difficult situation.

When Islamic banking was launched some decades ago, the operations
was primarily based on profit and loss sharing arrangements such as mudarabah
and musyarakah. However, due to various business considerations, the practice of
such arrangements in Islamic banking is different from the theoretical aspirations.
Modern Islamic banks seem to prefer using fixed income instruments such as
murabahah, bai’ bithaman ajil, ijarah and etc. rather than venturing into
partnerships as the core business.

Numerous efforts have been made by Islamic banking and finance to

promote the usage of mudarabah but the practice is still viewed to be extremely
risky. Islamic banks take into consideration of the risk which is in their nature
being a business entity.

Without realizing it there is actually many capital-holders/potential

investors who wish to earn an income from their capital but have neither the time
nor the skills necessary to enter into a project. They may range from simple wage
earners who have saved some money, pensioners who have received a lump sum
payment, trusts and institutions with whom some capital has been entrusted, to
insurance companies and individuals who have inherited a fortune. The size of
their capital too may vary from hundreds and thousands to millions.

They want to invest their capital in a profitable undertaking, but may not
know any entrepreneurs who wish to embark on a project and are looking for
financiers. Even if they find one, they may not have the necessary skills to assess
2
the viability of the project or the ability and integrity of the entrepreneur. On the
other hand, entrepreneurs who have viable project proposals may not know those
who have the required funds and are willing to invest in their projects.

This is where the need arises for a financial intermediary who could bring
the investor, financier and the entrepreneur together.

Conventional banks are able to perform the role of a financial

intermediary very effectively and efficiently. Capital holders deposit their funds
with the bank and there are entrepreneurs that submit their project proposals to
the bank. The bank examines the business plan and if it is satisfied that the project
could bring in sufficient income to allow the repayment of the principal and
interest provided that sufficient collateral is also available, the bank advances a
loan. The bank does not get involved with the project; whether the
entrepreneur/borrower makes a profit or loss he pays the principal and interest on
due dates, or the bank has recourse to the collateral. The bank accepts of the
depositor‟s capital, guarantees its full return, and pays him an interest (or return
on his „investment‟) at a fixed rate, and uses the capital to grant loans to
borrowers.

But the interest rate given to the depositor is always smaller than the rate
the bank charges the borrower, and the difference goes to cover its own expenses
and profits. This seems to work very well if people have no doubts about paying
or receiving interest, despite the built-in injustice to both the entrepreneurs and
the depositors. But some people are beginning to have doubts, and Muslims are
prohibited from earning an income in this fashion. Islamic banking is a response
to their concern as an alternative method to address the need and minus the
injustice.

Taking consideration on the above situation, we shall see later on Islamic

response to their concern.

3
2. UNDERSTANDING MUDARABAH

The Majallah al-hakam a-Adliyayah ot The Mejelle (Ottoman code of Islamic

civil law) defines mudarabah as “a kind of partnership on the condition, that the
capital is to be found by one, and the labour & work by the other and that one of
the conditions of mudarabah is “that the capital be delivered to the mudarib”

“Mudarabah contract is a profit sharing contract between the entrepreneur and the
capital provider. Mudarabah contract is applied in deposit taking arrangement
such as current account, savings account and investment account. The contract is
also applied in inter-bank investment and Islamic bonds. In takaful industry,
mudarabah contract is used as one of the operational model as well as being
applied for the takaful funds.” BNM (2007)

Mudarabah is defined in different ways by jurists but relatively the same

in term of two parties involved which are the rabb mal and mudarib; and the
purpose of the contract is to gain profit even though they don‟t clearly stated it.

There is no explicit injuction from the Al-Quran in permitting mudarabah

by the jurists have found some verses in the Al-Quran indicating the legality of
mudarabah. In one of the verse, Allah says, “Others travelling through land
seeking of Allah‟s bounty.” Even though, the verse does not directly address the
legality of mudarabah, it is interpreted to mean those who travel for the purpose
of trading and seeking permissible income, including those who work with
another‟s capital in exchange for part of the profits.

As for the Sunnah, the legality of mudarabah is divided into two groups
of evidence. The first group is mainly the act of the Prophet Muhammad (pbuh)
and the second group is mainly from the Prophet‟s sayings or endorsements to
mudarabah contracts practised during his time.

4
 There was clear evidence that the Prophet himself worked as mudarib for
Khadijah before he was appointed as a Prophet. It also reported in a hadith by the
authority of Ibn „Abbas as a tacit approval from the Prophet on mudarabah
whereby Ibn „Abbas‟s father imposed condition whenever he gave his money in a
mudarabah that the mudarib will not take his money across the sea, into any
valley, or buy any animal with a soft belly, and if the mudarib were to do so, then
he must guarantee the capital. The Prophet heard this practise and permitted it.

In addition, the Companion practises on mudarabah are also cited as

supporting mudarabah.

Relying on all such evidence and alike, Muslim jurists have agreed
unanimously that mudarabah is permissible. However, diverse of opinions of the
jurists are found which happens due to the fact that some jurists believe that
mudarabah defies analogy.

5
3. MUDARABAH APPLICATION

The concept of mudarabah which based on the principles of profit-loss-sharing

(PLS) is an alternative of the interest-based system in banking industry.
Mudarabah contract involves two parties namely, investor/capital holder (rabb
mal) and entrepreneur (mudarib).

The investor shall provide all capital to fund an investment, which is

exclusively managed by the entrepreneur in accordance with agreed business
objectives. Profits are distributed according to a pre-agreed rate between the two
parties. On the other hand, if the investment is a loss, the investor is not entitled
to a guaranteed payment and the investor will bear all losses unless they have
occurred due to misconduct, negligence, or violation of the conditions mutually
agreed by entrepreneur.

A clear illustration can be seen in Figure 1 below.

latipaC
tcejorP
laM bbaR biraduM /kroW/
)knaB( )ruenerpertnE( sgnikatrednU
tiforP/nruteR

Figure 1 – Mudarabah Financing Illustration

6
 Currently, most Islamic banks do not favour Investment/Equity financing
or Mudarabah financing because of the risk involved. The bank shall act as rabb
mal to contribute finance or fund to the entrepreneur acting as mudarib to work
on its project undertaken. The bank is not even allowed to make any decision on
the work.

In case of a loss, which doesn‟t result from negligence or misconduct on

the part of the entrepreneur, the bank has to bear all the losses and the
entrepreneur‟s loss lies in not getting any reward or compensation for his effort.
There is the possibility of the project failure is due to moral hazard 1 whereby the
entrepreneur can divert revenues from the project either through the consumption
of perks or through wasteful spending.

1
Aggarwal and Yousef (1996) research shows that high moral hazard and adverse selection problems are
factors that Islamic bank focus more on debt-like instruments rather than equity financing.

7
4. TWO-TIER MUDARABAH

Mudarabah is essentially an agreement between a financier and an entrepreneur,

the principals based from the Figure 1 illustration. However, taking consideration
the potential investors/capital-holders mentioned earlier who are interested to
invest but do not possess the skill or knowledge to enter into any project and the
entrepreneurs who need financier to embark into a project, Islamic banks has the
opportunity to act as an intermediary between them.

Taken account of the modern social structure and context, the pioneers of
Islamic banking brought in an intermediary between the principals and created a
two-tier mudarabah. It was suggested that a two-tier mudarabah would be the
most suitable structure to be subscribed by the Islamic banks.

This modified form of mudarabah was introduced in the form of PLS

investment accounts and financing arrangements. Banks may acquire deposits on
the basis of mudarabah and advance the same to a third party to conduct business
on the basis of another mudarabah.

In the first leg of two-tier mudarabah, the depositor or rabb mal shall
deposit in the investment account in which the bank acts as the mudarib in
providing business financial expertise. Islamic banks are permitted to trade with
depositors‟ funds and have full discretion to manage funds as it deems fit but
within Shariah parameters. For this reason, the bank shall enter into the second
leg of mudarabah contract whereby, the bank now acts as a rabb mal, providing
capital through mudarabah financing to entrepreneur, mudarib who wish to
embark into a project and requires a financier.

Figure 2 illustrates two-tier mudarabah currently practiced by Islamic

banks.

8
 biraduM sa knaB
dnuF latipaC ruenerpretnE
rotisopeD ) biraduM(
) laM bbaR( laM bbaR sa knaB

nruteR nruteR

Figure 2- Two-Tier Mudarabah Illustration

Islamic bank invests funds at depositors‟ risk but being a trustee, the bank
is accountable to depositors in case of negligence. If negligent, Islamic bank is
responsible to return depositors‟ capital along with the anticipated profit. This is
what we call as a fair play as required by Shariah principles.

In the second leg of two-tier mudarabah, the bank (rabb mal) is permitted
to obtain guarantees or securities from entrepreneur (mudarib) for his proper
conduct. However, such guarantees or securities can only be executed by the rabb
mal if certain damage to mudarabah is caused due to mudarib‟s negligence. In
case of genuine loss to mudarabah, it will be borne by the rabb mal.

To make two-tier mudarabah effectively works, Islamic bank must seeks

feasibility study from client which is the entrepreneur, exhibiting where and how
the funds will be utilized to earn profit for mudarabah. Rabb mal may restrict
mudarib‟s activities to a certain transaction or territory. Otherwise, mudarib has
full power to run mudarabah. If mudarib fails to return mudarabah capital to
rabb mal on completion of mudarabah term, it will be an event of default on
mudarib‟s part and the mudarabah equity will transform into a debt on mudarib
entrepreneurs.

9
 Muhammad Ayub (2007) listed out the Islamic banking products and
services with their modes and basis. Based from the list, Islamic banking products
and services using the mode and basis of mudarabah can be categorized as
follows:

I. Deposits – fund mobilization

The products and services are saving deposits, general investment
term deposits (similar to conventional fixed deposit), special
investment deposits, individual portfolios.

II. Trade finance, corporate finance

The product and service offered is only for project finance.

III. Treasury
The products and services are money market – inter-bank, fund
management, and sukuk.

There are other categories mentioned by Muhammad Ayub (2007)

relating to Agriculture, forestry and fisheries; and Personal advances (including
consumer durables and housing) but none mudarabah-based instruments was
offered.

10
5. LEGITIMACY OF TWO-TIER MUDARABAH

According to the majority scholars, the main instrument by which the interest-
based system has to be replaced is PLS, encompassing musyarakah, mudarabah
and their variants. The idea of replacing interest by profit sharing in the depositor-
bank and bank-business relationships gained considerable in the 1980s and 1990s.
(Muhammad Ayub, 2007)

Also, majority scholars have recommended extensive use of mudarabah.

This includes an economist, Nejatullah Siddiqi who has discussed thoroughly the
extended scope of mudarabah. According to Siddiqi (1991), mudarabah is a way
of cooperation among different factors of production firmly rooted in the Al-
Quran and Sunnah. When interest is abolished, it is a must to allow profit-sharing
in its various forms in all sectors of the economy and it is especially suited to the
financial sector.

Mudarabah financing was a commonplace during the life of Prophet

Muhammad (pbuh). However, no instance can be traced whereby one party
obtained funds on mudarabah from another party and forwarded the same on
mudarabah to a third party to conduct business.

According to Prof. Dr. Muhammad Anwar (2000), Khattab2 writes,

“fuqaha are in agreement that a mudarib is not entitled to forward mudarabah
money to a third party for business”. As such, the validity of the two-tier
mudarabah is questionable. However, Khattab had also noted that fuqaha allow
such arrangement provided the depositor grants permission to do so. This
allowance becomes the basis for recommending two-tier mudarabah.

The jurists differ widely on the ruling regarding to two-tier mudarabah.

Most of the jurists from all school of thoughts disallow the mudarib to invest in a

2
Muhammad Sharfuddin Khattab (1998) writes “Mudharaba System in Islamic Fiqh “

11
two-tier mudarabah and become the rabb mal to that second leg of mudarabah
without prior approval from the first rabb mal. If the first rabb mal allows the
mudarib to enter into the second mudarabah, the jurists agree that the second
mudarabah is valid but differ to the position of the mudarib in the second leg.

The Hanbalis and the Malikis opine that the position of the first mudarib
transforms as an agent in the second mudarabah contract and as an agent is not
entitled to any profits because he contributes neither capital nor work to that
venture.

According to Shafi‟is, if the first rabb mal gives money to the mudarib
and stipulates that he must give the capital to another, than it is for sure that he is
merely an agent instead of a mudarib and he is not entitled to any profits.
However, if the money is given to him so that he can become mudarib and at the
same time allowing him to give the money to someone else as capital; if he works
with money, then he can share the profit according to their agreement but if he
gives the money to the second person, his position is now transformed to an agent
to the mudarabah contract concluded between the first rabb mal and second
mudarib. Hence, he is not entitled to any profit at all.

According to Hanafis, if the mudarib enters into a mudarabah contract

with another partner using the mudarabah capital with the permission from the
first rabb mal, the contract is valid and he is considered as mudarib in the first
tier and rabb mal to the second tier mudarabah. This opinion was considered the
most suitable one in the modern commercial activities.

We can agree that the first opinion that the first mudarib in a two-tier
performs no work is untrue. The first mudarib plays a very significant role
actually in ensuring the credibility of the mudarib as well as the viability of the
venture in the second tier mudarabah. This obviously requires expertise and skill
which has been performed by the first mudarib before the capital is given to the
second mudarib.

12
 Opinion from jurists such as Sami Hamoud, Muhammad Abdullah al-
„Arabi, etc. seem to be more adoptable in modern practices of Islamic banking
and finance. They opine that the mudarib remains as the mudarib in the first tier
mudarabah and becomes the rabb mal in that second tier mudarabah. As for the
division of the profit, it will be done first in the second tier mudarabah. The profit
acquires by the original mudarib shall then be distributed in accordance to the
agreed ratio in the first tier mudarabah contract.

13
6. ISSUES IN IMPLEMENTATION

Besides the issues in implementation of two-tier mudarabah contract mentioned

earlier, this contract inherent the same issues of the original mudarabah. The
issues includes the effect of time, dissolution of contract, fixing duration, rights to
terminate contract, fixation of period, capital mixing by mudarib and guarantee to
losses.

6.1 Effect of time

Normally, mudarabah contract will take effect immediately after the

contract has been concluded. However, sometimes the rabb mal may want
to suspend the execution of the contract, so as to start at a future date. This
is due to the concern of the rabb mal of losing the potential mudarib but at
the same time the appropriate time to invest in a business venture is in a
near future. The contract shall be concluded but it will only take effect
later as agreed.

Shafi‟is and Malikis opine that the effect of mudarabah cannot be

suspended or delayed. However, Hanafis and Hanbalis opine otherwise
but the parties involved agreeable to the arrangement.

6.2 Dissolution of contract

Mudarabah contract is a non-binding contract (aqd ghayr lazim) meaning

that it may be terminated unilaterally by any of the parties. Most of the
jurists differ in their opinion regarding to the rights of dissolving the
contract by the parties.

However, Imam Malik ruled that once work starts, the contract
became binding on both parties and he argues that dissolving the contract

14
 may harm the other party may lead to losses. This contradicts the ultimate
objective of Islamic law that is preventing harm.

6.3 Fixation of duration

Malikis and Shafi‟is disallow any fixation of duration in mudarabah

contract. However, Abu Hanifah and Ahmad allow this practice due to
demand on constant and complex efforts. It should be upheld that if the
parties agree that no party shall have the right to terminate the contract
within a certain period of time; this condition should be valid and
enforceable upon them.

The opinion of allowing fixation of period of the mudarabah

seems to be more facilitative in today‟s business especially in modern
banking and financial practices. Even AAOIFI standard allows the
fixation of period for the mudarabah including the Academy of Fiqh.

6.4 Mixing capital

Majority of the jurists claimed that the mudarib is not entitled to mix the
capital of mudarabah with another capital, be it his or a third party‟s
capital except rabb mal permits it. The Shafi‟is disallow mixing of capital
even with permission by the rabb mal, with the exception of al-Mawardi.

However, the Hanafis opine that the mudarib is allowed to mix

capital with another‟s even without permission if it is a custom of the
merchants. Same goes for the Malikis, regulating that in certain
circumstances the mixing is either compulsory (wajib) or recommendable
(nadb).

Modern Islamic banks in practice allow mixing of funds but to

benefit themselves of this privilege, prior permission of depositors is
obtained.
15
6.5 Guarantee to losses

The jurists have unanimously agreed that the mudarib is a trustee in

respect of the capital that was entrusted to him. As such, he cannot afford
to bear any losses unless upon his fault or negligence.

The Malikis, Shafi‟is and Ahmad opined that the mudarib is not
responsible to guarantee the losses as regard the capital and any condition
to do so will invalidate the contract.

While the Hanafis and Hanbalis are in opinion that the contract is
valid but the condition is deemed to be void. However, it is permissible
for a third party other than the mudarib to undertake voluntarily that he
will compensate the mudarabah losses. This is only provided that this
guarantee is not linked in any manner to the mudarabah contract.

16
7. SUMMARY

One of the very serious consequences of using modes of trade as modes of

financing is that Islamic financial institutions are confined to financing short-term
trade, and are unable to finance long-term projects in industries, agriculture,
services, etc. Currently, Islamic banks do not provide mudarabah financing in
view of the high risk involved in doing business with small medium enterprises.
Islamic banks can do better by offering products with equity features so as to
lessen tying up their business with credit and interest-related parameters for
performance of equity products are based on real economic activities with the
bank taking an active role. Exposure of the ventures risks is a law in nature that
all parties concerned must dutifully observe under the principle of “no pain no
gain” (al-ghorm bil ghonm) which also reject riba (interest) as a legitimate gain.

In order to bring about a riba’-free economy, the Islamic banking system

has to be riba’-free. Its commercial enterprises have to be financed by equity
capital, and its investments have to be on a PLS basis. This paper has reviewed
and discussed mudarabah contract and its innovation namely two-tier mudarabah
contract. Two-tier mudarabah contract taken into account the present-day
realities and adaptability in modern Islamic banking practise. Seeing that the true
role of Islamic banking as financier and intermediary rather than a trader or
entrepreneur. Two-tier mudarabah contract is proven to be well-accepted by
modern Islamic banking and finance industry.

17
15. REFERENCES

Aggarwal, R. and Yousef, Tarik (1996-draft), “Islamic Banks and Investment

Financing”.
Bank Negara Malaysia (BNM) (2007), Shariah Resolutions in Islamic Finance. BNM,
Malaysia.
Dr. Muhammad Nejatullah Siddiqi. (1991), “Some Economic Aspects of Mudarabah”,
Vol, No.2.
INCEIF (2010), CIFP Manual: Shariah Rules in Financial Transaction. INCEIF, Kuala
Lumpur, Malaysia.
Prof. Dr. Muhammad Anwar (2000), “Islamicity of Banking and Modes of Islamic
Banking” International Islamic University Malaysia.
The Mejelle, (Complete code on Islamic civil law based on the Hanafi School of the
Ottoman Empire), Kuala Lumpur: The other press, 2003.

18