Mudarabah and Musharakah Participatory Modes of financing

Essentials of Islamic Banking and Finance

Mudarabah

Contents
Introduction Mudarabah;
Profit / Loss Distribution;

Kinds of Mudarabah

Termination of Mudarabah Mudarabah Vs Musharakah Scope of Mudarabah for Banking System

Risks
Practical examples

Mudarabah - Introduction
Mudaraba is a kind of partnership where partner involve in

business; Mudarabah is partnership between persons in which one partner gives money to another for investing in profitable avenues. The investor (fund provider/supplier) is called Rabb-ul-Maal while the person who utilizes this fund (the fund manager) is called Mudarib; Mudarib is exclusively responsible for management of the business. Rabbul Maal (fund supplier) does not have any right to interfere in business affairs.

Mudarabah - Introduction
Mudarabah Capital:
In principle, the capital of Mudaraba should be provided in the form

of cash. However, it may be presented in the form of kind i.e. tangible assets which will be valued as per mutual consent; The value (in cash) of the assets will be the Mudaraba capital; The Capital of Mudaraba should be clearly known to the contracting parties and defined in terms of quality and quantity in a clear manner; Debt (receivable) can not be the capital of Mudarabah.

Mudarabah - Introduction
Mechanism of Profit and Loss distribution:
The contracting parties should stipulate in the contract the profit

shares (in defined terms) for each one; The profit sharing ratio should be:

Specific; and of the profit expected to be earned by the venture; Unknown ratio; A ratio attributed to future settlement; A ration linked with the capital (in terms of x% of the capital); A lump sum settlement as profit;

Therefore following method is not allowed:

Mudarabah - Introduction
Mechanism of Profit and Loss distribution:
Losses in Mudaraba shall only be born by Rabb-ul-Mal and not by

the Mudarib; Mudarib will also suffer loss in shape of not receiving anything as profit; The Mudarib shall only be responsible for losses if the loss happened due to his negligence and willful misconduct.

Mudarabah - Types
There are two types of Mudarabah:
Restricted Mudarabah (Mudarabah Muqayyadah):

It is a kind of Mudarabah in which the capital provider restricts the Mudarib to perform business with certain restrictions. These restrictions may be for place (geographical restriction), particular type of investment (sector wise restriction) or any other restriction provided these restrictions do not unduly constrain the Mudarib from business operations.
It is a kind of Mudarabah in which the capital provider (Rabbul Maal) does not put any restriction the Mudarib.

Unrestricted Mudarabah (Mudarabah Mutlaqah):

Mudarabah - Rules
Supply of funds:
The basic feature of Mudaraba is that the the capital is provided by

Rabbul Maal and the Mudarib is responsible for the management only; However, it is allowed for Mudarib to add capital into the business of Mudaraba if agreed with Mudarabi; In such cases Musharaka and Mudaraba are combined. For example, Zuhaib gave to Rahman Hayder Rs.100,000/- for Mudaraba. R. Hayder added Rs. 50,000/- from his own with the consent of Zuhaib; This type of partnership will be treated as a combination of Musharaka and Mudaraba; Here the Mudarib may allocate for himself a certain percentage of profit on account of his investment as Sharik, and at the same time he may allocate another percentage for his management and work as a Mudarib.
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Mudarabah - Rules
Termination of Mudarabah:
The contract of Mudaraba can be terminated at any time by either

of the two parties after giving a notice to the other party. If all assets are in form of cash and some profit has been earned on the principle amount, it shall be distributed between the parties according to the agreed ratio. If the assets of the Mudaraba are in other form the Mudarib shall be given an opportunity liquidate them and the actual profit may be determined.

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Mudarabah Vs Musharakah
Mudarabah:
The contribution comes

Musharakah:
The contribution comes

from Rabbul Maal (the investor).

The Rabbul Maal (investor)

is not permitted to manage the business. The Mudarib will only manage the business. The Mudarib can also invest in the capital of Mudarabah.

from all partners in form of cash, commodities, services or liability in the case of reputation partnership.
The work, as a general rule,

is to be done jointly by the parties. A partner or some partners may be sleeping.

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Mudarabah - Application
Scope of Mudarabah for Banking System:
Mudaraba as a mode of finance used by Islamic Banks for the

following purpose: Relationship with depositors;

The depositors provide moneys to bank as Rabb-ul-Mal to be invested by bank as Mudarib on the basis of profit and loss sharing on pre agreed specific ratio;

Islamic bank can also use this mode through providing capital in a

business and sharing in the profit with pre-agreed ratio;

Large Enterprise financing; Project Finance; Business ventures; Private equity;

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Mudarabah - Application
Depositors and Islamic bank relationship:
Mudaraba is used by Islamic Banks for taking deposit from

depositors; The depositors provide moneys to bank as Rabb-ul-Mal to be invested by bank as Mudarib on the basis of profit and loss sharing on pre agreed specific ratio;

DEPOSITS
MUDARABAH PROFIT & LOSS SHARING PROFIT

DEPOSITORS

ISLAMIC BANK

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Mudarabah Application (Deposit [Liability] management)

POOL MANAGEMENT Pools according to (1) size of deposit, (2) Tenure
S i z e o f D e p o s i t S T U V W X M N O P Q R

Time (tenure)
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Issues in Mudarabah
Problems and Risks for Islamic Banks:
Mudarabah is among the preferable modes of financing which is also

heavily recommended by scholars and Ulema, but certain difficulties are there in application of this mode. Some are given below:

Mudaraba is considered to be very high risk financing activity. Collateral can be asked but could not be used in case of real loss. Banks existing competencies in project evaluation and related techniques are limited. Dual book keeping trends in market. No legal mechanism for treatment with Mudarabah.

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Musharakah

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Contents
Introduction; Types of Musharakah;

Basic Rules in Musharakah;

Termination of Musharakah; Security / Collateral in Musharakah; Musharakah Management and Liability;

Profit / Loss Distribution ;

Application of Musharakah As a Mode;

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Introduction
Musharakah is a newly invented terms by Ulemaa; The actual term used by Fuqahaa (classical Islamic scholars) was

Shirkah (or Sharikah); Lexical meaning of it is sharing/merging; Technically: Commingling by two or more persons either their capital/money or work or obligations to earn a profit or a benefit or a yield or appreciation in value and to share the loss according to their proportionate ownership; Now the term Musharakah is popular; There are different types of Shirkah which have been explained by Fuqaha; See next slide for details:

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Types of Shirkah

SHIRKAH (Partnership)
Shirkat-ul-Milk (Joint ownership)

Optional

Forced Shirkat-ul-A'qd (Business partnership)

Amwaal (partnership with capital)

A'amal (partnership in work)

Wujooh (reputational partnership)

Mufawadah (100% equality in shares of partners)

Al Inaan (Variability in shares of partners)

Mufawadah (100% equality in shares of partners)

Al Inaan (Variability in shares of partners)

Mufawadah (100% equality in shares of partners)

Al Inaan (Variability in shares of partners)

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Basics of Musharakah
There are some basic features of Musharakah:
Mixing of Capital (joint ownership);

Asset or property or anything that can accept partnership;

Rights and Responsibilities; Sharing of profit and loss

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Basics of Musharakah
According to the nature of partnership (Musharakah) there are three

possible structures of Musharakah:

Permanent Musharaka:

Permanent Musharaka is a partnership of permanent nature i.e. a going concern; Musharakah can be for a limited time period, after that it will be redeemed; Redemption of Musharakah will take place through sale of shares from one partner to other partner or third person (in market/exchange); This type is usually used for business ventures; A Musharakah in which a partner buys the share of the other partner gradually until the ownership of the asset or property is completely transferred to second partner; According to this concept, a financer (bank) and its client participate in a joint commercial enterprises or property or asset and the client gradually buys banks share.

Temporary (Redeemable) Musharaka;

Diminishing/declining Musharaka

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Basics of Musharakah
Capital of Musharakah should be in cash form; It may be in kind; In such case the value should be agreed; Different currencies should be converted or valued into the currency

of Shirkah; Capital should be under the disposal of the manager; Debt alone can not be contribution in Shirkah; Capital can be varying among the partners;

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Basics of Musharakah
Management of Partnership:
In principle each partner has right of Musharakah management;

The partners may appoint a managing partner by mutual consent;

Some of the partners may decide not to work for the Musharakah

and work as sleeping partner; It is not allowed to specify a fixed remuneration to a partner Musharaka who manages funds or provides some form of other services, such as accounting; However, it is permissible to give him a greater share of profit than he would receive solely on the basis of his share in the partnership capital; According to a view it is also permissible to appoint his as an employee and giving him remuneration for his services;

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Basics of Musharakah
Profit Sharing ratio:
Ratio or the basis for sharing profit should be decided in the

beginning of partnership; Profit should be allocated in percentages of earning and not in a sum of money or a percentage of the capital or investment; It is not necessary for sharing profit according to proportionate capital contribution; A sleeping partner cannot share in the profit more than the percentage of his capital; The partner may at the later stage agree to change the profit sharing ratio, and on the date of distribution, a partner may surrender a part of his profit to another partner;

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Basics of Musharakah
Sharing of Loss:
As a matter of principle the loss has to be shared according to the

ratio of capital contribution; No partner can make his share or portion of share guarabteed from loss; Any such agreement will make the Musharakah void and null
Guarantee of principle:
Guarantee from one partner to other partners profit or capital or

part of capital is not allowed; Security can be asked for misconduct or negligence; A third party may provide a guarantee to make up losses of one or all partners;

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Basics of Musharakah
Termination of Musharakah:
Every partner has a right to terminate the Musharaka at any time

after giving notice to the partner and the Musharaka will come to an end. In this case, if all the assets of the Musharaka are in cash form then they will be distributed pro rata between the partners. In case they are mixed assets the partners may agree either on:

The liquidation of the assets (market price), or On their distribution among the partners as they are; or Purchasing from one partner share of other at any agreed price between them.

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Application of Musharakah
Musharakah could easily be used as a vast mode of financing for

almost every financial need. Below are some fields where this mode can easily be applied:
Long-term Finance Running Finance (limited scope) Investment Banking Project Financing Private Equity Placement Redeemable capital investment

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