CH 5 Islamic Finance

• Mudaraba is an equity-based contract and form of trust financing in Islamic finance
• Musharaka is a joint-venture partnership, unlike Mudaraba

Key Parties in Mudaraba:

• Rab al Maal provides the capital
• Mudarib manages the business with time, expertise, and skills
• Rab al Maal cannot interfere with daily business operations but may specify management conditions
• Mudaraba is a passive partnership
• Rab al Maal is a sleeping partner, while the Mudarib is the managing partner
• Capital from the Rab al Maal is called Ras al Maal
• Rab al Maal can access information and monitor activities, similar to a limited partner or mutual fund investor

Profit and Loss:

• A profit-sharing ratio is agreed upon at the contract's start, based on actual profit excluding invested capital
• Monetary losses are borne by the Rab al Maal
• Mudarib loses time and effort if there are losses, unless caused by misconduct, negligence, or violation of conditions
• Rab al Maal's liability is limited to their capital contribution

Contract Termination:

• Mudaraba contracts can be terminated unilaterally with notice or mutually at any time

Mudaraba for Financial Intermediation in Islamic Banks:

• Islamic banks use Mudaraba for financial intermediation
• Islamic banks function as conventional banks, set up as corporations with capital from shareholders
• Core business of banking involves matching surplus with deficit units
• Islamic banks source funds from depositors on a Mudaraba basis
• Funds are supplied to borrowers/entrepreneurs using the Mudaraba instrument

Two-Tier Mudaraba:

• Islamic banks use this system to replace conventional interest-based financial intermediation with profit/loss sharing
• Three parties are involved: depositors/investors, borrowers/entrepreneurs, and the Islamic bank as intermediary

Liability/Deposit Side (Tier One):

• Banks receive funds from depositors into current, savings, and investment accounts
• Depositors are the Rab al Maal
• The bank is the Mudarib
• Current/savings accounts are demand deposits that can be withdrawn anytime
• Current accounts do not earn profit, they are for safekeeping
• Savings accounts provide safekeeping and small profit
• Investment accounts are based on the Mudaraba contract, clients expect a return
• Investment accounts are either restricted (specific) or unrestricted (general)

Asset/Financing Side (Tier Two):

• Bank acts as the Rab al Maal, providing capital to borrowers/ventures (capital users)
• Islamic banks use share capital, current, savings, and investment accounts for financing
• Central bank regulations dictate how much of current accounts can be used for financing

Bank Financing:

• Banks can finance using current accounts within limits and at the bank's own risk
• Restricted investment accounts have mutually agreed upon conditions for business types, periods, and locations based on client preference
• Savings accounts and unrestricted investment accounts have no restrictions; funds can be co-mingled with bank funds for Shariah-compliant ventures
• Islamic banks finance entrepreneurs via restricted Mudaraba, limiting activities, duration, and location with monitoring rights
• Restrictions should not interfere with daily operations

Conventional vs Islamic Banking:

• Conventional banking guarantees capital on deposits, current, savings, and term accounts
• Islamic banking does not allow capital guarantees, except for current accounts held as Amanah for safekeeping
• Islamic banks take measures to reduce depositor risk and ensure competitive profit to compensate for lack of capital guarantee
• Shariah scholars advise Islamic banks to mix their own capital with depositors' funds for better project selection

Risk Exposure:

• On the asset side, Islamic banks are the Rab al Maal and exposed to capital loss when financing borrowers/entrepreneurs
• Islamic banks maintain adequate capital, invest in diversified portfolios, and thoroughly assess project feasibility/profitability to protect capital outlay and depositor funds
• They may ask for collateral/third-party guarantees within Shariah boundaries

Guarantees:

• Rab al Maal cannot demand a guarantee from the Mudarib for repayment of capital or fixed profit
• Entrepreneur's liability is limited to time/effort, unless loss is due to negligence, requiring them to compensate the financier
• Banks can initiate legal proceedings and recover dues from collateral/guarantees if the entrepreneur deliberately fails to make repayments
• Banks cannot ask the Mudarib to guarantee against business risk
• Rab al Maal's liability is limited to the funds invested

Profit Calculation:

• Islamic banks' gross profit comes from sales, investments, and financing transactions related to common Islamic banking products
• Fee-based income is added, and expenses, including overheads and Zakat (Islamic tax), are deducted to arrive at gross operating profit/loss
• Islamic banks share gross operating profit with savings, restricted, and unrestricted investment account holders based on pre-agreed profit-sharing ratios
• Banks receive the remaining profit, distribute dividends to shareholders, or retain the profit

Depositor Returns:

• Islamic banks can aggregate funds from depositors to apply them to various projects from which the bank earns profit
• In case of loss in any financing project of the bank it bears the loss as Rab al Maal
• Depositors will lose a part of their deposits if the bank makes a loss

Provisions and Reserves:

• Modern Islamic banks include provisions and reserves to reduce risk and stabilize returns for account holders
• International regulators AAOIFI and IFSB have allowed such reserves and provisions
• Central banks encourage reserve funds
• Islamic banks set aside common provisions for doubtful accounts, decline in investment value, and contingent liabilities based on best judgment
• Provisions need to be disclosed to all stakeholders

Profit Equalization Reserve:

• This allocation from Mudaraba profit is made before allocating any amount to the Mudarib
• It aims to maintain the level of return for investment account holders

Investment Risk Reserve:

• This allocation from Mudaraba profit is done after the share of the Mudarib has been allocated
• It aims to protect investment account holders from future losses

Mudaraba as Limited Recourse Debt Finance:

• The Mudarib is indebted to the Rab al Maal
• Rab al Maal has claim to business cashflows until original capital recovery
• After this, the profit-sharing mechanism takes place
• It applies only to project cashflows, not other assets
• On the downside, the claim is like a debt investment and the investor has priority until their investment is paid off
• Rab al Maal has a claim to the profit of the project only
• Once the breakeven point is reached, on the upside, the investor no longer has any priority and it becomes like an equity investment
• Calculation and distribution of Mudaraba profit is done at regular periods
• Part of the profit from the venture is used to repay the initial capital and the remainder of the profit is shared in the pre-agreed ratio

Types of Mudaraba:

Mudaraba al Muqayyadah (Restricted):

• The Rab al Maal provides parameters or restrictions within which they prefer the mudarib to invest their funds, like: -Restrictions on type of investment -Restriction on the place or location of the investment -Restriction on the time of the business venture
• Rab al Maal does not interfere in the everyday operations of the business
• Applied for restricted or specific investment accounts where the depositors specify their projects

Mudaraba al Mutlaqah (Unrestricted):

• There are no restrictions imposed on the Mudarib
• The Mudarib has complete authority and freedom to chose the type of project, only bound by Shariah and legal parameters
• Applied to unrestricted or general investment accounts, where the bank co-mingles the funds

Operational viewpoints:

Bilateral or simple Mudaraba:

• Only includes two parties, the provider or Rab al Maal and the entrepreneur or Mudarib

Multilateral Mudaraba

• Several capital providers whose funds are collectively provided to one Mudarib or entrepreneur

Two-tier Mudaraba or re-Mudaraba

• Includes three parties involved in two Mudaraba contracts
• The Mudarib of the first contract becomes the Rab al Maal in the second Mudaraba and provides capital to a second Mudarib

Shariah Conditions Related to Mudaraba:

• The Prophet served as a Mudarib with his wife Khadija serving as Rab al Maal
• Muhammad Taqi Usmani identified the Shariah rules:

  • Capital:

  • The total amount of capital must be known to both parties

  • Needs to be returned to the Rab al Maal on settlement of the Mudaraba -Capital can be calculated in the normal currency of the land -Value of calculation in the normal currency must be stipulated in a contract

    • Rab al Maal gives the capital to the Mudarib on trust as investment, not as debt

  • Profit sharing:

  • Shariah treats the shared profit as protection of the capital and this allows the investor to recover capital first from the profit and only then is the profit shared

  • Profit sharing is based on a pre-agreed ratio or percentage, but is never a lump sum

    • If the Mudaraba contract includes more than one Rab al Maal, then profits are distributed amongst them in the proportion of their capital investment, after deducting the Mudarib's portion.

  • Financial loss: -The capital provider is completely responsible for any financial loss

  • The entrepreneur is liable to lose their time and effort and would not be getting any profit in case of loss.

  • Restrictions: -The Rab al Maal can invest their funds in a restrictive manner

  • Restrictions should not prevent the Mudarib from executing their business activities and earning a profit.

    • The Rab al Maal does not get involved or interfere in the management of the business invested in. The Mudarib is not permitted to lend or donate the Mudaraba capital or to enter into partnership with other Rab al Maal without the permission of the original Rab al Maal.

  • Security or guarantee

  • The Rab al Maal cannot ask for any security or guarantee from the Mudarib against repayment of capital or for a fixed profit amount

  • A security or guarantee can be taken by the Rab al Maal from the Mudarib against losses that may occur due to negligence or mismanagement of the Mudarib.

  • Termination: -Can be made by both party's mutual content, following the contractual rules

    • In termination scholars suggest non-cash assests are liquidated through net asset valuing assets -If both prefer both Rab al Maal and Mudarib can agree for the Mudarib can buy the Mudaraba units from the Rab al Maal to avoid liquidation

Additional Conditions Related to Mudaraba:

• Liability of the Rab al Maal -Limited to the capital invested and could be tangible or intangible assets and can be given in a lump or installments
• Liability of the Mudarib -The limitation of labor, time and Mudaraba skills provided
• Reciprocity -There can be no responsibility transfer to another mudarib without the original Rab al Maal
• Mixing of Funds -Can not be done without the prior consent the original Rab al Maal

Other Conditions:

• Mudarab cannot mix funds without original Rab al Maal's consent
• Islamic banks can combine depositor funds as Rab al Maal
• Islamic banks pool profits from Mudaraba investments as Rab al Maal, sharing after operational costs
• Shariah boards and AAOIFI allow reserve funds for stable profits
• If the Islamic bank suffers loss, depositors lose proportionally
• Mudarib liable if found guilty of negligence
• Losses may be ordinary (offset profits) or capital (requiring renegotiation)

Challenges and Problems:

• Rab al Maal needs to completely trust the Mudarib
• Islamic banks operate Mudaraba on both sides, face difficulties on demand side
• Insufficient legal protection
• Entrepreneurs want to consider it equity, and banks prefer it to be debt
• High risk if funding isn't reliable or legal protection is minimal

Practical Applications:

• Common in financial mediation of Islamic banks
• General and specific financial accounts
• Capital financing of venture projects

Comparison with Conventional Banking:

###Conventional Banking:

• Deposits based on fixed or market interest rates
• Bank lends on interest; rates paid by borrowers unrelated to profits
• Bank-depositor paid interest is not related to the earning

###Islamic Banking:

• The shared based deposits and loss agreement

###Accounting Issues:

• Set be standardized regulatory bodies with clear recording of the bank assets, liabilities and all income and expenses for stakeholders. -The value that is used to measure bank capital -The amount capital from the Mudarabah agreement -Any losses that have happened before agreement. -Mudarabah must always come in its fair market price value -Capital for the loss comes from the Rab al Maal -The Mudarabah Agreement for liquidations must be balanced by both parties

Key terms:

• Bilateral Mudaraba
• Investment risk reserve
• Mudaraba
• Mudaraba al Muqayyadah
• Profit equalization reserve
• Mudaraba al Mutlaqah
• Multilateral Mudaraba
• Two-tier Mudaraba