Understanding Mudarabah

One of the Islamic principles is that there should be no reward without risk-bearing. This principle is applicable to both labour and capital. As no payment is allowed to labour unless it is applied to work, so no reward for capital should be allowed unless it is exposed to business risks.

Consider two persons, one of whom has capital but no special skills in business, while the other has managerial skills but possesses no capital. They can co-operate in either of two ways:

1. Debt-financing (the western loan system). The businessman borrows the capital from the capital-owner and invests it in his trade. The capital-owner is to get back his principal and an additional amount on the basis of a fixed rate, called the interest rate, as his compensation for parting with liquidity for a fixed period. The claim of the lender for repayment of the principal plus the payment of the interest becomes viable only after the expiry of this period. This payment is due irrespective of whether the businessman has made a profit using the borrowed money. In the event of a loss, the borrower has to repay the principal amount of the loan, as well as the accrued interest, from his own resources, while the capital-owner loses nothing. Islam views this as an unjust transaction.
   
   
2. Mudarabah (the Islamic way, or PLS - Profit Loss Sharing). The two persons co-operate with each other on the basis of partnership, where the capital-owner provides the capital and the other party puts his management skills into the business. The capital-owner is not involved in the actual day-to-day operation of the business, but is free to stipulate certain conditions that he may deem necessary to ensure the best use of his funds. After the expiry of the period, which may be the termination of the contract or such time that returns are obtained from the business, the capital-owner gets back his principal amount together with a pre-agreed share of the profit.
   
   
   
   
   
   
   

The ratio in which the total profits of the enterprise are distributed between the capital-owner and the manager of the enterprise is determined and mutually agreed at the time of entering the contract, before the beginning of the project. In the event of loss, the capital-owner bears all the loss and the principal is reduced by the amount of the loss. It is the risk of loss that entitles the capital-owner to a share in the profits. The manager bears no financial loss, because he has lost his time and his work has been wasted. This is, in essence, the principle of mudarabah.

There are at least three reasons for considering the mudarabah relationship to be more just than the creditor-debtor relationship:

(i)  Both parties agree on the ratio in which profits will be shared between them.

(ii) The treatment of both parties is uniform in the event of loss, since if the provider of the capital suffers a reduction of his principal, the manager is deprived of a reward for his labour, time and effort.

(iii) Both parties are treated equally if there is any violation of the agreement. If the manager violates anyone of the stipulated conditions, or if he does not work, or is instrumental in causing loss to the business by negligence or bad management, he will have to bear the responsibility for the safe return of the whole amount in question. If, on the other hand, the provider of the capital violates any of the stipulated conditions, for example, by withdrawing his funds before the stipulated time, or by not providing part or full funds at the promised time, etc., he will have to pay the manager a reward equivalent to what he would have earned in similar work.

Mudarabah is the basis of modern Islamic banking on a two-tier basis.

1st tier: The depositors put their money into the bank's investment account and agree to share profits with it. In this case, the depositors are the providers of the capital and the bank functions as the manager of funds.

2nd tier: Entrepreneurs seek finance from the bank for their businesses on the condition that profits accruing from their business will be shared between them and the bank in a mutually agreed proportion, but that any loss will be borne by the bank only. In this case, the bank functions as the provider of capital and the entrepreneur functions as the manager.

Thus, under an Islamic banking system, the cost of capital is not analogous to a zero interest rate, as some people wrongly assume it to be. The only difference between Islamic banking and interest-based banking in this respect is that the cost of capital in interest-based banking is a predetermined fixed rate, while in Islamic banking, it is expressed as a ratio of profit.