Salman Ahmed Shaikh

In Mudarabah, only the Rabb-ul-Maal bears all the financial losses as the sole financial investor. 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.  Disparity in payoffs if loss occurs in Mudarabah is one of the major reasons why Mudarabah is hardly used as a mode of finance in corporate financing.

However, the Islamic finance literature builds its case by claiming that it uses risk-sharing based financing models. If one glances through the literature, it is apparent that Mudarabah along with Musharakah are considered as ideal modes of financing.

Maulana Mufti Muhammad Taqi Usmani in his book “Introduction to Islamic Finance” stated on at least 5 occasions that Mudarabah and Musharakah are ideal modes of financing. See pages 12, 17, 72, 107 and 164 of his book. His comments on Murabaha which is the most prevalent mode of financing also deserve serious thinking:

“It should never be overlooked that, originally, Murabaha is not a mode of financing. It is only a device to escape from “interest” and not an ideal instrument for carrying out the real economic objectives of Islam. Therefore, this instrument should be used as a transitory step taken in the process of the Islamization of the economy, and its use should be restricted only to those cases where Mudarabah or Musharakah are not practicable.” (p. 72)

During the early Muslim era, 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.

The specific rules of relationship between Rabb-ul-Maal and Mudarib in Fiqh of Mudarabah highlight the rights and duties of Mudarib. Mostly, the Mudarib was a skilful, but a financially poor person in those times as reflected by historical traditions.

In Musharakah, loss participation by all partners across the board is logically 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 creates loss aversion on the part of financier. It is because of the moral hazard problem. The client which is provided with finance has no responsibility to bear losses due to economic and business reasons. Hence, it may make him less careful, diligent and proactive.

Consider an Islamic economy with Mudarabah on the asset and liability side and there is no other instrument used. Mudarib 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 Mudarib firms is ultimately borne by small savers and investors who have all the liability to share losses without having a say in the affairs of the business.

The clause of willful negligence is insufficient to protect small savers 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 analyse 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 business 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. Trust deficit and documentation problems are not the root problems. The problem from economics perspective is the lack of sound governing framework within the contract’s primary incentive structure. The corporate form of business organization over the centuries improved the agency and moral hazard problem through changes in the way risk, management and profits are shared.

Due to these features in corporate form of business organization, people invest in shares of companies even without any guarantee over par value let alone dividend and even when the cash inflows are far away from the sight in long term projects and growth stocks.

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. Corporations are setup with equity first. Usually, banks finance existing, stable and on-going businesses which are at the stage of business where revenues and profits are positive and stable. In Pakistan, Islamic banks provide less than 5% of their financing to the existing SMEs. No Islamic bank in Pakistan has any microfinance bank or microfinance institution. Thus, start-up finance to micro-enterprises is not channeled through Islamic banks anyways even when debt based financing is used primarily.

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 will share in loss in proportion to the investment capital.

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 participate in loss sharing.

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