Mudaraba as a Mode of Islamic

Finance
Prof. Javed Anwar
 Mudaraba as a Mode of Islamic
Finance
• Mudaraba is a partnership in profit between capital and
work. It is conducted between investment account holders,
as owners of capital, and the Islamic bank as a Mudarib
(managing partner).
• The Islamic bank announces its willingness to accept the
funds of investment account holders with the sharing of
profits being as agreed between the two parties and the
losses being borne by the owner of funds unless they were
due to misconduct, negligence or violation of the conditions
agreed upon by the Islamic bank.
• A Mudaraba contract may also be concluded between the
Islamic bank, as a provider of capital on behalf of itself or
on behalf of investment account holders, and business
owners.
 DEFINITION OF MUDARABA

• The term refers to a form of business contract

in which one party brings capital and the other
brings personal effort and time to a business
transaction. The proportionate share in profit
from the business deal is determined by mutual
agreement. But the loss, if any, is borne only
by the owner of the capital, in which case the
entrepreneur gets no share of the profits for his
labour. The financier is known as Rab ul Mall
and the entrepreneur as Mudarib.
 DEFINITION OF MUDARABA

• As a financing technique adopted by Islamic

banks, it is a contract in which all the capital is
provided by the Islamic bank while the other
party manages the business for an agreed
wage. The profit is shared in pre-agreed ratios,
and any loss, unless caused by negligence or
violation of terms of the contract by the
Mudarib, is borne by the Islamic bank. The
bank passes on this loss to the depositors,
known as investment account holders.
 DEFINITION OF MUDARABA

• To repeat, there is no loss sharing in a

Mudaraba contract.
• Profit and loss sharing is what takes place with
the Musharaka contract.
• The Mudaraba contract may better be
represented by the expression ‘profit sharing’.
 DEFINITION OF MUDARABA
• Mudaraba is an Islamic contract in which one
party supplies the finance and the other party
provides management expertise in order to
undertake a specific business transaction. The
party supplying the capital is called the owner of
the capital.
• The other party is referred to as the worker or
agent (the Mudarib) who actually runs the
business.
• Under Islamic jurisprudence, different duties and
responsibilities have been assigned to each of
these two parties.
DEFINITION OF MUDARABA
 Types of Mudaraba

• There are two types of Mudaraba:

– Mudaraba Al Muqayyadah (restricted
Mudaraba). Under this scheme the Rab ul
Mall may specify a particular choice of
business or a particular place of business for
the Mudarib, in which case he must invest
the money in that particular business or
place.
 Types of Mudaraba

• There are two types of Mudaraba:

– Mudaraba Al Mutlaqah (unrestricted Mudaraba).
Under this scheme the Rab ul Mall gives full
freedom to the Mudarib to undertake whatever
business it deems fit.Without the consent of the
Rab ul Mall, however, the Mudarib cannot invest
money with anyone. The Mudarib is authorised to
do whatever is normally done in the course of
business, but cannot undertake something beyond
the normal routine of the business without the
express permission of the Rab ul Mall.
 Types of Mudaraba

• The Mudarib is also not authorised to

– keep (work with) another Mudarib or a partner;
– mix its investment in that particular Mudaraba
without the consent of the Rab ul Mall.

– To help clarify the Mudaraba arrangement, please

see the flow chart in Figure 5.1, which depicts a
two-tiered contract as described in the next section.
 Two-tier Mudaraba and the Asset and Liability
Structure of an Islamic Bank
• Islamic bankers have adapted and refined the
Mudaraba concept to form what is known as the
two-tier Mudaraba.
• In this arrangement, the Mudaraba contract has
been extended to include three parties: the
depositors as financiers, the bank as an
intermediary and the entrepreneur who requires
funds.
• The bank acts as an entrepreneur or Mudarib
when it receives funds from depositors and as a
financier (Rab ul Mall) when it provides the funds
to entrepreneurs.
 Two-tier Mudaraba and the Asset and Liability
Structure of an Islamic Bank
The main conditions associated with a Two-tier
Mudaraba contract are as follows:
– 1. The bank receives funds from the public on the
basis of unrestricted Mudaraba. These funds are
also called ‘unrestricted investment accounts’.
There are no constraints imposed on the bank
concerning the kind of activity, duration and
location of the enterprise wherein it invests the
finance. However, a Mudaraba contract cannot be
applied to finance haram activities (that is, those
forbidden by Islam). Such a contract would be
considered null and void.
 Two-tier Mudaraba and the Asset and Liability
Structure of an Islamic Bank
The main conditions associated with a Two-tier
Mudaraba contract are as follows:
– 2. The bank has the right to aggregate and pool the
profit from different investments, and share the net
profit (after deducting administrative costs, capital
depreciation and Islamic tax) with depositors,
according to a specified formula. In the event of
losses, the depositors lose a proportional share or
the entire amount of their funds. The return to the
financier has to be strictly maintained as a share of
profits.
 Two-tier Mudaraba and the Asset and Liability
Structure of an Islamic Bank
The main conditions associated with a Two-tier
Mudaraba contract are as follows:
– 3. The bank applies the restricted form of Mudaraba when
funds are provided to specified entrepreneurs. The bank has
the right to determine the kind of activities, the duration
and the location of the projects, and to monitor the
investments. However, these restrictions may not be
formulated in a way so as to harm the performance of the
entrepreneur. When a project is undertaken, the bank
cannot interfere with the management of the investment nor
take part in the daily operation of the business. Thus loan
covenants and other such constraints, considered usual in
conventional bank lending, are not allowed in PLS-based
Islamic banking.
 Two-tier Mudaraba and the Asset and Liability
Structure of an Islamic Bank
The main conditions associated with a Two-tier
Mudaraba contract are as follows:
– 4. Under a Mudaraba, the Rab ul Mall cannot demand any
guarantee from the Mudarib, such as insisting on a return
of the capital with a fixed profit, because the relationship
between the investor and the Mudarib is a fiduciary one:
that is, a legal relationship between the parties. The
Mudarib is deemed to be a trustworthy person.
Accordingly, the bank cannot require any guarantee such as
security and collateral from the entrepreneur in order to
insure its capital against the possibility of an eventual loss.
Such a condition would make the Mudarib’s contract null
and void. But a guarantee from an independent third party
is allowable.
 Two-tier Mudaraba and the Asset and Liability
Structure of an Islamic Bank
The main conditions associated with a Two-tier
Mudaraba contract are as follows:
– 5. The Mudaraba contract should assign a profit
rate for each party. The rate should be a ratio, and
not a fixed amount. Assigning a fixed amount to
either party invalidates the Mudaraba due to the
possibility that the profit realised may not equal
the sum so stipulated. Before arriving at a profit
figure the Mudaraba venture should be converted
to a monetary amount and the capital should be set
aside. The Mudarib is entitled to deduct all
business-related expenses from the Mudaraba
capital.
 Two-tier Mudaraba and the Asset and Liability
Structure of an Islamic Bank
The main conditions associated with a Two-tier
Mudaraba contract are as follows:
– 6. The liability of the financier is limited
exclusively to the capital provided. On the other
hand, the liability of the entrepreneur is also
restricted, but in this case solely to his labour and
effort. Nevertheless, if negligence or
mismanagement can be proven, the entrepreneur
may be liable for any financial loss and be obliged
to remunerate the financier accordingly.
 Two-tier Mudaraba and the Asset and Liability
Structure of an Islamic Bank
The main conditions associated with a Two-tier
Mudaraba contract are as follows:
–7. The entrepreneur shares the profit
with the bank according to a previously
agreed profit division. Until the
investment yields a profit, the bank is
able to pay a salary to the entrepreneur.
This salary is determined on the basis
of the ruling market salary rates.
 Sources of Finance for an Islamic Bank
• An Islamic bank is traditionally organized as a joint stock
company with the shareholders supplying the initial capital.
• It is managed by the shareholders through their representatives
on the board of directors. Its main business is to obtain funds
from the public on the basis of Mudaraba and to supply funds
to entrepreneurs on the same basis.
• Its gross income comprises the share in the actual profits of the
fund users, in accordance with an agreed ratio of profit
sharing.
• The bank retains, in favour of its shareholders, part of the
profits according to deposits, in accordance with the
predetermined profit-sharing ratio.
 WHAT MAKES MUDARABA SHARIA’A COMPLIANT?
• Origin of the Term Mudaraba
– The word Mudaraba is derived from the Arabic term darb
fi al-ard, which means those ‘who journey through the
earth (yadribuna fi al-ard) seeking the bounty of Allah’
(Qur’an, S. 73: 20). Because of his work and travel, the
Mudarib becomes entitled to part of the profits of the
venture.
– In terms of the Sunnah, Jurists rely on the precedent of the
contract of Mudaraba concluded by the Prophet
Mohammed with Khadija prior to his marriage to her, as a
result of which he travelled to Syria. Thus the legal
evidence employed in support of the Mudaraba mode of
finance comes from both the Qur’an and the Sunnah.
 WHAT MAKES MUDARABA SHARIA’A COMPLIANT?
• Evidence of Legality Under the Sharia’a (Hadith)
– It was proved in the Sira biography of the Prophet, that before
prophethood, he travelled to Syria as a Mudarib using the capital of
Khadija, and the Messenger of Allah related that he approved it.
– The Companions of the Prophet transacted, using Mudaraba, and none
of them was reported to have an adverse opinion of the contract. There
has also been a consensus among the Ummah, for many generations, on
the permissibility of Mudaraba.

– Others travelling through the land Seeking of Allah’s bounty. Al-

Muzzammil 20
– It is no crime in you if ye seek of the bounty of your Lord. Al-Baqara
198
 SHARIA’A RULES CONCERNING MUDARABA
• The Sharia’a rules have been set out by Usmani (1999):
1. It is a condition in Mudaraba that capital must be specific,
given that its return to the owner is mandatory at the
settlement of the Mudaraba. So its amount must be
known at the outset of the contract. Uncertainty about the
amount of capital necessarily leads to uncertainty about
the amount of profit.
2. It is a condition that capital must be the normal currency
in circulation. However it can be merchandise, under the
condition that it is evaluated at the outset of the contract,
and the agreed upon value becomes the capital of the
Mudaraba.
 SHARIA’A RULES CONCERNING MUDARABA
• The Sharia’a rules have been set out by Usmani (1999):
3. It is a condition that the capital must not be a liability or debt
on the Mudarib. The Mudarib is a trustee.
4. It is permissible for a Mudarib to mix its own private capital
with the capital of the Mudaraba. Thus it becomes a partner,
as well, and its disposal of capital on the basis of Mudaraba is
permissible.
• It is a condition that the capital of Mudaraba must be delivered
to the Mudarib because not delivering it imposes constraints
on the Mudarib and restricts its power of disposal. Some of the
Jurists permit the capital owner to withhold capital and to
release it gradually, according to the needs of the Mudarib.
 SHARIA’A RULES CONCERNING MUDARABA
• The Sharia’a rules have been set out by Usmani (1999):
6. If two or more Islamic banks are involved the
distributable profits are divided between them, and
the owner, proportionate to the amount of capital
provided by each.
7. It is permissible to impose restrictions on the
Mudarib if the restriction is beneficial and does not
constitute a constraint on the agent achieving the
profit required and is not counterproductive to the
purpose of the Mudaraba.
8. It is permissible for the Mudarib to hire an assistant.
 SHARIA’A RULES CONCERNING MUDARABA
• The Sharia’a rules have been set out by Usmani (1999):
9. The disposal of the Mudarib is confined to what is
conducive to the Mudaraba. It must lend or donate
nothing of the Mudaraba capital. The Mudarib is
also not allowed to purchase, for the Mudaraba,
with more than its capital, nor is it allowed to go
into partnership with others using the Mudaraba
capital. All of the above, however, is permissible if
the capital owner consents and authorizes the agent
to use its discretion.
 SHARIA’A RULES CONCERNING MUDARABA
• The Sharia’a rules have been set out by Usmani (1999):
10. No security on the Mudarib shall be stated in the
Mudaraba contract except in the case of negligence
or trespass, because the Mudarib is a trustee on what
is under its control. Capital is judged to be a deposit.
It is permissible to take a surety or mortgage from
the Mudarib to guarantee the payment in case of
negligence, trespass or violation of the conditions.
But it is impermissible to take that as a guarantee for
capital or profit, because it is impermissible for the
Mudarib to guarantee capital or profit.
 SHARIA’A RULES CONCERNING MUDARABA
• The Sharia’a rules have been set out by Usmani (1999):
11. It is a condition that profit should be specific,
because it is the subject of the contract and it being
unknown abrogates the contract. The contracting
parties should stipulate, in the contract, the profit
shares in a percentage form for each party. It is
impermissible to stipulate a lump sum as profit to
either party.
 SHARIA’A RULES CONCERNING MUDARABA
• The Sharia’a rules have been set out by Usmani (1999):
12. Profit in Mudaraba is distributed according to the
agreement of the two contracting parties. They may
agree on specific ratios, whatever they consensually
agree. It is a condition that the capital owner alone
bears the loss. The Mudarib bears none of the loss
because a loss is a decrease in capital and the capital
belongs to the owner.
 SHARIA’A RULES CONCERNING MUDARABA
• The Sharia’a rules have been set out by Usmani (1999):
13. The Mudarib collects its share of the profit only
after obtaining the permission of the capital owner.
Also the Mudarib is entitled to collect its share of
profit only after the capital is recovered, because the
Sharia’a principle states that ‘profit is protection to
capital’.
 SHARIA’A RULES CONCERNING MUDARABA
• The Sharia’a rules have been set out by Usmani (1999):
14. The ownership of the Mudarib becomes secure after
the liquidation of the Mudaraba and the capital
owner has recovered its capital. Some of the Jurists
hold the view that auditing is like division and
possession. If two parties reach a final settlement
after the liquidation of the assets and then leave the
Mudaraba, it is considered to be a new Mudaraba
and neither one makes good the loss of the other.
 SHARIA’A RULES CONCERNING MUDARABA
• The Sharia’a rules have been set out by Usmani (1999):
15. The Mudaraba is terminated if one of the two
parties rescinds it, given that it is an optional not a
binding contract. Some Jurists hold the view that
Mudaraba is binding and it cannot be rescinded if
the Mudarib has commenced work.
 PRACTICAL EXAMPLES OF MUDARABA

• Mudaraba is considered to be the essential

mode accredited by the Islamic banks in their
relationship with the depositors who tender
their moneys to the bank as capital owners to
be invested by the bank as Mudarib. This is on
the basis of profit sharing according to specific
• ratios agreed upon.
• See Table 5.1 for a representative example of
profit payout ratios for Tier 1 Mudaraba
accounts.
Comparison of Mudaraba with the Conventional
Banking Equivalent
Mudaraba: Differences from the Other Islamic
Financing Techniques