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Mudarabah and Musharakah
The Financial markets and the financial industry are witnessing the growth of Islamic banking and finance. Although an Islamic banking and finance is a relatively new force in the world of banking but it surely is a force to reckon with. Especially after the recent financial doom which slumped markets world-wide and triggered the global financial crisis. Islamic financial institutions have demonstrated significant resilience and have been less affected compared to the conventional financial institutions because of the prohibitions on excessive leverage. The growth, in both size and in diversity in the Islamic finance industry has been especially robust over the past few years. It is today a USD 1 trillion industry and is growing at a phenomenal pace of 15 percent annually. Apart from its traditional strong hold in the Middle Eastern countries, it has spread its wings to Western countries as well. Islamic finance has a significant presence in Europe and England is touted to be the Islamic finance hub of the western world. Many leading and popular international banks have established Islamic banking ‘units’ or ‘windows’ to provide financial services and products that conform to shariah. There are various modes of financing in Islamic finance and Mudharabah and Musharakah fall within this ambit. They are essential modes of financing and are very widely used by Islamic banking and financial institutions. It goes without saying that all the modes of financing adhere to Shariah principles. The 4 basic elements prohibited in Islamic mode of financing are Interest (Riba), Forbidden or impermissible goods (Haram), Gambling (Maysir) and ambiguity (Gharar).

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is borne only by the owner of the capital. run by a person or a company on the basis of profit sharing. the loss is to be completely borne by the owner of the capital.e. The profits in a Mudarabah agreement may be shared in any proportion agreed between the parties beforehand. and loss. in which case the entrepreneur gets nothing for his labour. The basic tenets of a Mudarabah contract are: • There are two contracting parties to a Mudarabah financing. The profit is shared in pre-agreed ratios. unless caused by negligence or violation of terms of the contract by the ‘mudarib’. However. The latter does not contribute any form of capital. Many Islamic funds operate on the basis of joint Mudarabah. Islamic banks practice Mudarabah in both its forms. i. The proportionate share in profit is determined by mutual agreement. As a financing technique adopted by Islamic banks. the capital owner shall bear the monetary loss and entrepreneur shall loose the reward of his effort. In case of individual Mudarabah.Mudarabah financing: The term refers to a form of business contract in which one party brings capital and the other personal effort. the provider of funds (rab-al-maal) and the entrepreneur (Mudarib). Mudarabah could be individual effort or a joint one. But the loss. is borne by the Islamic bank. • Profit is shared between the capital provider and the entrepreneur according to a pre-determined profit-sharing ratio. it is a contract in which all the capital is provided by the Islamic bank while the business is managed by the other party. The financier is known as ‘rab-al-maal’ and the entrepreneur as ‘Mudarib’. if any. The joint Mudarabah may be between the investors and the bank on a continuing basis whereby the investors keep their funds in a special fund and share the profits. The profit-sharing ratio has to be 2 . an Islamic bank provides finance to a commercial venture. In case of loss. if any.

then the customer is liable for the loss. i. for example. This type of Mudarabah financing may be used for contract financing of a specific project awarded to the customer. In this case. for example stipulate a particular business or particular place for the customer to invest the capital. The customer is bound by all these restrictions and any violation of these restrictions may make the customer liable for the loss. an Islamic banking institution does not impose any limitation on the customer/ partner. At the inception of the Mudarabah contract the contracting parties should agree on a definite proportion of the actual profit to which each of them is entitled. for example. if any. may be used towards financing a customer’s working capital requirements. Under restricted Mudarabah. • In principal any financial loss under Mudarabah financing must be borne by the Islamic banking institution. the Islamic banking institution will not have any recourse to the customer should the business incur losses due to the investment policy as there would have been no such policy prescribed by the Islamic banking institution in the first place. mis-management or breach of contracted terms by the customer. Under unrestricted Mudarabah. However. the Islamic banking institution may specify certain terms and conditions. place of business.e. No particular 3 . Mudarabah financing can be divided into two main types. methods of payment from the customers and period of investment. on the type of business. The most important element of the Mudarabah contract is the distribution of profit. Restricted Mudarabah (Mudarabah al muqayyadah) a n d Unrestricted Mudarabah (Mudarabah Mutlaqah). if the loss is caused by negligence. This type of Mudarabah.mutually consented upon and explicitly stated at the time of contracting (aqad or agreement) and has to be a proportion/percentage of profits.

the profit shall be used to offset the loss at the first instance then the remainder. rather. On this capital they cannot agree on a condition that Rs 60. shall be distributed between the parties according to the agreed ratio. they cannot allocate a lump sum amount of profit for any party. as determined in the above manner. 4 . They can share the profit in equal proportions. if the business has incurred loss in some transactions and has gained profit in some others. the profit-sharing ratio can be anything in these circumstances as agreed upon by the contracting parties.000 out of the profit. and they can also allocate different proportions for the rab-al-maal and the mudarib. if any. you will get 33 percent of the profit. it has been left to their mutual consent. if any. nor can they determine the share of any party at a specific rate tied up with the capital. and if he does it in another town. the rab-al-maal may say to the mudarib at the beginning of the aqad that if ‘you trade in gold. shall be the share of the mudarib.proportion has been prescribed by the shariah. To cite an example. Example. 40 percent of the actual profit shall go to the mudarib and 60 percent to the rab-al-maal or vice versa. that apart from the agreed proportion of the profit. any profit arising out of the business. the mudarib cannot claim any periodical salary or a fee or remuneration for the work done during the Mudarabah contract. For example. nor can they say that 15 percent or more of the capital shall be given to rab-al-maal. It is also allowed that different proportions of profit are agreed in different situations. you will get 50 percent of the profit and if you trade in silver. let’s say the rab-almal provides a capital of Rs 800. Similarly there can be a case where the rab-al-maal can say to the mudarib that if he does business in his city or town. It is important to cite.e. On the other hand.000. However. his share can be 50 percent of the profit. what can be agreed upon according to shariah is the profit-sharing ratio. he can be entitled to 30 percent of the profit. However. i.

when entering into the Mudarabah. Therefore. but it appears from the general principles that no such limit can be fixed. 5 . and some profit has been earned on the principle amount. The only condition is to give a notice to the other party. if the parties agree. However. except a condition which allows what is prohibited or prohibits what is lawful. If all assets are in cash form at the time of termination. if the assets are not in the cash form. and each party is at liberty to terminate the contract whenever he wishes.” Musharakah financing: Musharakah is another popular technique of financing used by Islamic banks. particularly in the light of the famous hadith which says: “All the conditions agreed upon by the Muslims are upheld. that no party shall terminate it during a specified period. It could roughly be translated as partnership. it shall be distributed between the parties according to the agreed ratio. In this technique two or more financiers provide finance for a project. All partners are entitled to a share in the profits resulting from the project in a ratio which is mutually agreed upon. There is a difference of opinion among the Muslim jurists about the question whether the contract of Mudarabah can be in effect for a specified period after which it terminates automatically.Termination of Mudarabah contract: The contract of the Mudarabah can be terminated at any time by either of the two parties. this difference of opinion relates only to the maximum time limit of the Mudharabah. However. so that the actual profit may be determined. except in specified circumstances it does not seem to violate any principle of shariah. On the question whether minimum time limit can be fixed by the parties before which Mudarabah cannot be terminated? No express answer to this question is found in the books of the Islamic Fiqh. the mudarib shall be given an opportunity to sell or liquidate them.

So it can continue so long as the parties concerned wish it to continue. That is the bank gets a dividend on its equity. Thus. All partners have a right to participate in the management of the project. This equity financing arrangement is widely regarded as the purest form of Islamic financing. It also includes a method by which the bank keeps on reducing its equity in the project and ultimately transfers the ownership of the asset to the participants. It could also be applied in agriculture and industry. the partners also have a right to waive the right of participation in favour of any specific partner or person. imports and to issue letters of credit. 6 . However. if any. The period of contract is not specified. the equity held by the bank is progressively reduced. Diminishing Musharakah: In this form of Musharakah equity participation and sharing of profit on a pro-rata basis is allowed. Musharakah form of financing is being increasingly used the Islamic banks to finance domestic trade. the losses. After a certain time the equity held by the bank shall come to zero and it shall cease to be a partner.However. There are two main forms of Musharakah: Permanent Musharakah and Diminishing Musharakah Permanent Musharakah: In this form of Musharakah an Islamic bank participates in the equity of a project and receives a share of profit on a pro-rata basis. The contract provides for a payment over and above the bank share in the profit for the equity of the project held by the bank. are to be shared exactly in the proportion of capital proportion. At the same time the entrepreneur purchases some of its equity. This technique is suitable for financing projects of a longer life where funds are committed over a long period and gestation period of the project may also be long.

Also. The partner is also allowed to appoint a third party to manage the business on behalf of the Musharakah partnership. • The project or business must be permissible by shariah. and not in proportion to the capital invested by him. • While both partners may undertake the management of the business. However. Suppose. such arrangement is allowed. A and B enter in to a partnership 7 . The contributed capital can be either in the form of cash or assets with an ascribed value. Distribution of profit in Musharakah: The distribution of profit is a very crucial issue in a Musharakah contract. If there’s no mention of the proportion of profit then the contract is not valid according to shariah point of view. • Any losses shall be distributed between the partners according to the capital contribution ratio. This is because the ratio of profit for each of the partner must be determined in proportion to the actual profit accrued to the business. The proportion of profit to be distributed between the partners must be agreed upon at the time of inception of the contract.The basic tenets of a Musharakah contract: • Both parties contribute a portion of capital which may not necessarily be equal. Let us take an example to explain the distribution of profit in light of the Musharakah contract. or any rate of profit tied up with his investment. if a partner chooses to withdraw from the management to become a sleeping partner. it is not allowed to fix a lump sum amount for any one of the contracting partners. such losses shall be borne by the respective partner or the management team. if the loss is due to the negligence of the managing partner or management team. The proportion of profit to be distributed between the partners must be mutually pre-agreed upon inception of the contract.

the correct basis for the distribution of profit would be an agreed percentage of the actual profit accrued to the business. it must be expressly mentioned in the aqad (agreement) that it will be subject to the final settlement at the end of the term. Similarly. For example. if they agree between them that ‘A’ will get 20 percent of his investment. the contract will still be pronounced as invalid by shariah. not less. It is this principle that has been mentioned in the famous maxim: ‘profit is based on the agreement of the parties. he must suffer 30 percent of the loss. if a partner has invested 30 percent of the capital. Some scholars assert that the ratio of the profit may differ from the ratio of investment according to the agreement of the partners. the amount drawn by the partner shall have to be returned. not more. 8 . this kind of partnership will be rejected by shariah.and it is agreed between them that A shall be given Rs 20. If a lump sum amount or a certain percentage of the investment has been agreed for any of the partners.000 per month as his share in the profit. According to Muslim scholars the ratio of the share of a partner in profit-loss both must conform to the ratio of his investment. but the loss must be divided between them exactly in accordance with the ratio of capital invested by each one of them. meaning thereby that any amount so drawn by any partner shall be treated as ‘on account payment’ and it will later on be adjusted to the actual profit he may deserve at the end of the term. and the remaining profit will go to B. and any condition to the contrary shall render the contract invalid. But some scholars differ on this profit-loss ratio of investment. but loss is always subject to the ratio of investment. But in case if no profit is actually earned or is less than anticipated. Sharing of losses: The sharing of losses is done in proportion to the investment made by each contracting partner in the venture. According to shariah.

upon which the contract will come to an end. all of them will be distributed at pro-rata basis between the partners. provided the partner gives his other partner/partners notice to this effect. or on their distribution or partition between the partners. then the partners to the contract may agree either on the liquidation of the assets. However. if the assets of the Musharakah contract are in cash form. the Musharakah stands terminated. • If one of the partners wants termination of the Musharakah. the latter shall be preferred. while the other partner or partners like to continue with the business. and no one can compel him on liquidation. will have the option either to draw the share of the deceased from the business.Termination of Musharakah contract: A Musharakah contract can be terminated in case of following events • Every partner in the Musharakah contract has the right to terminate the contract at anytime. all the assets are in joint ownership of the partners. In case of dispute between the partners in the matter where one of the partner seeks liquidation while the other wants the partition or distribution of the non-liquid assets themselves. if the assets are such that they cannot be separated or partitioned.e. Machinery. • If any one of the partners becomes insane or otherwise becomes incapable of effecting commercial transactions. In this case. But if the assets are not liquidated. • If any one of the partners dies during the contract. or to continue with the contract of the Musharakah. then they shall be sold and the sale proceeds shall be distributed. as the case may be. and a co-owner has a right to seek partition or separation. this purpose can be 9 . the contract of Musharakah with him stands terminated. i. because after the termination of Musharakah. His heirs in this case.

he cannot claim more than the ratio of his investment in the project or business venture. causes much harm to human beings. which may differ from the ratio of investment. as in the secular/ western economies. In Mudarabah it means to participate in the business and in the case of Musharakah it means sharing in the assets of the business to the extent of the ratio of financing. Interest or riba at the outset is strictly prohibited in both Mudarabah/Musharakah or in any mode of Islamic financing. However. the ratio of profit allocated to each one of them. this rejection of interest is replaced with the concept that the lender is to assume the risks of the borrower’s business and share in the profits and losses of that business.achieved by mutual agreement. because the termination of the Musharakah with one partner does not imply its termination between other partners. the partners who want to run the business may purchase the share of the partner who wants to terminate his partnership. Benefits of Mudarabah/Musharakah financing on society: Both Mudarabah/Musharakah financing are a part of the Islamic financial system which rejects the concept that a borrower is liable for the repayment of the funds borrowed and a predetermined return on those funds. The partners have the liberty to determine. causes 10 . Under the Islamic system. Conclusion on Mudarabah and Musharakah Financing: Financing through Mudarabah and Musharakah does never mean the advancing of money. In case of loss suffered in the project each partner must bear the loss exactly in the proportion of his investment. in case a partner has expressly excluded himself from the responsibility of work for the business. An investor/financier must share the loss incurred by the business to the extent of financing. regardless of the performance of the borrower’s business. Its institutionalization. In this case. This is because interest as human suffering has shown over centuries. with mutual consent.

Now this is a very different concept of society from that of the contemporary capitalist society. a profitsharing society. and the individual is seen as a consumer. are not based on debt relationships. which is productive in a real sense and the social and economic relationships that have to be built. which is a society where human beings groan under the burden of debt. but upon equity and participation.wealth to be concentrated within the hands of the few. Islam says it has to be a participating. based on a different model. This is due to the Islamic financial system which views equity capital. and in this model. By Islami Tijara team 11 . Mudharabah/Musharakah financing are both based upon equity and profit-sharing. Islam encourages Muslims to invest their money and to become partners in order to share profits and risks in the business instead of becoming creditors. which is something Islam clearly forbids. freedom can be ensured because every individual feels he is a participant in the drama of production and not in any way subject to a debt situation.

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