How to Make Mudarabah More Applicable in Islamic Banking and Finance

Salman Ahmed Shaikh

One of the major impediments in the use of Mudarabah on the asset side of a bank i.e. for financing is that only Rabb-ul-Maal is considered to bear all the financial losses. Therefore, if an Islamic bank enters into a Mudarabah contract as a Rabb-ul-Maal, only the Islamic bank would have to bear all the losses.  The problem is in the disparity in payoffs if loss occurs in Mudarabah.

The principle that loss sharing should be based upon and limited to the amount of capital invested is not a condition mentioned in Quran. This juristic viewpoint did not create much problem during early Islamic era when in most cases, the Mudarib was a poor and resource-less person in financial need with limited incentive and authority to enter in corruption and limited capacity to participate in loss sharing.

This could be appreciated by looking at the specific rules in Mudarabah highlighting the rights and duties of Mudarib. Mostly, the Mudarib was a skillful, but a poor and resource-starved person in those times as reflected by historical traditions.

In Musharakah, loss participation by all partners across the board is justifiable because all partners are also allowed to work. But, due to the fact that in Mudarabah, the working partner is the sole authority to do the business, making Rabb-ul-Maal completely responsible for sharing all the losses looks unjustified in the first place.

Consider an Islamic economy with Mudarabah on asset and liability side and there is no other instrument used. Mudarib (usually blue chip companies) with no liability to share loss can obtain financing from banks who would be Rabb-ul-Maal in asset side use of Mudarabah. On the liability side, the bank will be Mudarib and the small savers and investors will be Rabb-ul-Maal. So, any loss incurred by companies is ultimately paid by small savers and investors who have all the liability to share losses without having a say in the affairs of the business!

Restricted Mudarabah and the clause of willful negligence is insufficient to protect them from losses strictly due to business cycle fluctuations. This example shows that with current structure, even Mudarabah used alone in an economy is insufficient to bring about any egalitarian change.

Let us analyze trust deficit and documentation problems which are cited as reasons why Mudarabah is not being used widely. Relax these assumptions and now consider there is no trust deficit and documentation problem in the economy. If a loss occurs due to business cycle fluctuations, no part of the loss is borne by the business that had all the authority to run the business. The loss is borne not by the bank as well because the bank is Mudarib on the liability side. All the loss is borne by the small savers and investors.

Now, suppose the government prohibits interest based lending and borrowing too. Will the people want to be Rabb-ul-Maal in Mudarabah with bank or the shareholder in a company which can take all the money, invest it, earn from it and if loss occurs, pass it onto the small savers? Mudarabah (with current structure) even when assumptions of trust deficit and documentation problems are relaxed and even when there is no competing conventional banking system is ineffective to say the least.

In current structure, Mudarib seems to work like an employee with compensation linked with profits. Rabb-ul-Maal is basically the entrepreneur (who has the ultimate responsibility to share losses). It is different from a principal agent relationship in corporate form of organization. In that, the principal hires the agent, but the rules do not restrict him not to influence agent’s decisions. Important decisions taken by the agent(s) have to be vetted in Annual General Meetings. Mudarabah rules do not allow such explicit participation at the moment.

Equity financing through shares poses an important question for bankers in general and Islamic bankers in particular who hide behind the trust deficit and documentation problems. Why people invest in shares of companies without any guarantee over par value let alone dividend and even when the cash inflows are far away from the sight?

With important covenants in place, equity financing can be used and is used widely. It is interesting to study the size of debt and equity markets in developing countries. For instance, in Pakistan, corporate bond market hardly exists, whereas equity financing is more prevalent and widely used. It is because conventional equity based institutions and instruments have over the years developed certain covenants which enable their wide applicability.

In Mudarabah, following two covenants can be introduced to make them more applicable.

a) Mudarib can be asked to contribute some capital. The contract will still remain different from Musharakah as only the Mudarib is the working partner.

b) Mudarib can be asked to share in loss to some extent.

These two covenants will minimize the problem of adverse selection, moral hazard and principal-agent conflict.

There is a famous Hadith which clearly states:

“All the conditions agreed upon by the Muslims are upheld, except a condition which allows what is prohibited or prohibited which was lawful.”

It may be argued that these two covenants may violate the principle of Al-kharaj bil Daman (Link of exposure to risk i.e. one can claim profit only if one is ready to bear the business risk).

These covenants will not result in violation of the said principle because the proposal is not to transfer all liability to the Mudarib and guarantee some fixed profit to the Rabb-ul-Maal. Rabb-ul-Maal will still be liable to bear losses, but Mudarib by way of participation with some capital will also feature in loss sharing.

To structure this model in compliance with principles of Islamic Fiqh, combination of Musharakah and Mudarabah can be used whereby Mudarib in lieu of participation with capital will become a Sharik in the combination. This combination is prevalent in offering liability products and is proposed by Maulana Taqi Usmani in his book “Introduction to Islamic Finance” (p. 36) for project financing as well.

About Salman Ahmed Shaikh

PhD Economics, National University of Malaysia. Assistant Professor of Economics and Finance. Author, Researcher, Teacher and Consultant. He can be contacted at:
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