Fundamentals of Islamic Finance Contracts and Their Applicability in Various Business Scenarios

Mudarbaha

Mudarbaha is a bilateral contract of partnership, which can be described as a profit sharing contract where the profit of the project is distributed between the capital owner and the financial institution (mudarib) according to a specific predefined distribution ratio.

Using the above definition, mudarbaha can be conceptually used in two different business lines:

  1. Deposit products.
  2. Equity-based financing.

Figure 1 shows how mudarbaha can be used as a deposit product.

Figure 1: Using Mudarbaha as a Deposit Product

Steps involved:

  • Customer/depositor (the rab-ul-mal) provides the funds to the bank.
  • Bank invests the funds in projects and various assets and is responsible for managing the entire operation.
  • Profit from the mudaraba activity is shared between the bank and the deposit account holder in a pre-agreed ratio.
  • The bank does not bear any loss but remains responsible for negligence.
  • The bank may receive compensation from the account holder (mudarib fees) in return for management of their funds and is obliged to return the capital to the mudarib.

Extending the same concept to equity-based financing, the instrument becomes applicable in a scenario where the roles are reversed. Consequently the investor becomes the mudarib and bank/financial institution acts as rab-ul-mal, as shown in Figure 2.

Figure 2: Using Mudarbaha for Equity-based Financing

Steps involved:

  • Bank and client discuss the business plan.
  • Bank in this case (rab-ul-mal) provides capital to the investor (mudarib).
  • The recipient of the funds (the mudarib or the manager) manages the entire operations by engaging in investment/trading activities.
  • In return, the mudarib pays rab-ul-mal’s share of profit and returns mudarbaha capital to the rab-ul-mal on liquidation of the contract.
  • Rab-ul-mal in this case will bear all the loss unless the mudarib violates the agreement.
  • Mudarib fees for management of funds and losses if any can be deducted from the capital before returning.

Therefore, the mudarbaha instrument can be used in either deposit products or as well as in equity-based financing.

Figure 3: Mudarib and Rab-Ul-Mal Differ Depending on the Type of Mudarbaha

Musharakha

Musharakha is another instrument whereby the customer and the bank agree to combine financial resources to undertake any type of business venture and manage the same according to the terms of the agreement. This is a form of partnership between the bank and its client, whereby each party contributes capital in equal or varying degrees, to establish a project or share in an existing one.

Figure 4: Pooling of Bank and Customer Resources with Musharakha

Steps involved:

  • Client approaches the bank with the request for financing.
  • Client and bank discuss business plan and jointly contribute to capital of the venture.
  • They also jointly set up the business venture and manage its operations, sharing the responsibilities as per pre-agreed terms.
  • Business generates profits or losses.
  • These profits are shared between the bank and the customer in the pre-agreed ratio. Losses are shared strictly in proportion to their respective capital contributions.
Musharakha investment

The Musharakha instrument can be used by the bank to hold equity in another entity for investment purposes. On the other hand, musharakha financing facility may be provided by bank to their customers where both become partners and mutually agree to contribute capital for a specific project. In such contracts they share any profit or loss arising from the business activities according to a pre-agreed ratio.

Figure 5: Responsibilities of a Musharakha Agreement

In case of a diminishing musharakha, the bank’s share in the equity is diminished each year through the partial return of the capital. This would be the main difference in terms of the mechanism of operation in comparison to a constant musharakha.

Diminishing musharakha as a concept is very renowned in mortgage financing markets. In this case, the property is jointly purchased and owned by the bank and the client. In turn there is an ijaraha concept, where the property is rented out to the client who pays rentals as per the agreed schedule. However, in this specific case, the client will pay an additional amount in extra to the rental, thereby reducing the share of the Bank by that extra amount. In other words, increasing the client ownership to that extent.

In consequence, musharakha can be used in varying business lines such as:

  • Mortgage financing, specifically properties under construction.
  • Any kind of project financing.
  • Specific investment purposes.

Innovation is the Way Forward

Once the fundamentals of all these instruments are clearly analysed, there are two possible ways forward:

  • To extend the usage of the instrument in different business lines, such as using a musharakha for issuing a letter of credit (LC). Or, for example, why not also use mudarbaha for project financing?
  • Combine instruments to structure further innovative contracts, such as mudarbaha with musharakha. In such a case, there is contribution of capital from both bank and the entrepreneur, with former playing the role of a sleeping partner. Therefore, the entrepreneur is responsible for managing the entire operations and accordingly the ratio of the profit share can be capped of the bank or limited to the capital contribution. Another possibility would be to combine qard-ul-hasan with musharakha. Qard-ul-hasan is a benevolent finance provided on a goodwill basis. Considering specific projects would yield results only after few months of operation, qard-ul-hasan could be provided during the commencement of the project. At a later stage of the same project, musharakha contract can come into effect to ensure profit sharing.

There could be many innovative combinations one can come up with nonetheless; one needs to ensure that for all such combinations the foundation or the pillars of Islamic Finance is not compromised. In other words, Shariah compliance is mandatory.

Conclusion

The key point to note is that similar to the above instruments, various other identical Islamic instruments can be used in different lines of businesses. However, it is critical to understand the fundamental principles of the Islamic instruments. This understanding, coupled with the fact that pillars of the Islamic finance not being compromised will lead to both an innovative and creative way of getting into new Islamic business lines and enable risk to be managed effectively by using different instruments.

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