LECTURE 3: INTRODUCTION

TO HISTORICAL ISLAMIC
FINANCE PRODUCTS
MUDARABAH AND ITS
MODUS OPERANDI
The classical mudaraba was an arrangement in which a principal,
rab al-mal, entrusted his capital to an agent, mudarìb, who was to
trade with it and then return to the investor the original capital plus a
previously agreed-upon share of the profits. As a reward for his
entrepreneurship the agent received the remaining share of the
profits.
In general, profit and loss are shared according to the rule: profit
follows mutual agreement and loss follows the capital invested.
 MODUS OPERANDI
Cash

K E
π Loss
Principal Agent

K+ (1-α) π
απ
THE SİMPLE MUDARABA
HAD THE FOLLOWİNG
CHARACTERİSTİCS:
1. There are two partners, a principal (Rab al-mal) and an agent
(Mudarib).
2. Entire capital is provided by the principal.
3. Agent contributes only his time, effort and knowledge. He does not
contribute to the partnership with capital.
4. Agent takes the capital and tries to generate profit with it.
5. Venture is concluded when the agent returns the original capital to
the principal.
6. Profit, if any, is shared either according to mutual agreement or
capital invested. This mutual agreement is in the form of percentages
and it is clearly stated in the contract at the beginning of the venture.
7. If there is loss, entire pecuniary loss accrues to the principal. Agent goes unpaid for
his effort but does not suffer any pecuniary loss.

8. In general, profit and loss sharing is done according to the Hanafite rule: profit
follows mutual agreement, loss follows capital. Since, in mudaraba, the entire capital
has been provided by the principal, entire pecuniary loss accrues to him. Principal
may lose his entire investment in the venture. But notwithstanding this, the principal’s
liability is limited in the sense that he is not responsible for the agent in transactions
with third parties. Indeed, third parties may not even be aware of the investor’s
existence. The responsibility for all contact with third parties resides with the agent.

9. Principal may lose all capital not beyond the original investment.
10. 3rd party not aware of the investors existence.
11. Mudharib may incur loss in negligence.
THE SIMPLE INAN
PARTNERSHIP
The most important characteristic of ‘Inan partnership is the
permission granted to each partner to invest different amounts. By
the same token, equal amount of investment but unequal distribution
of profit is also permitted. Moreover, the partners are not force to
invest their entire property.
In a simple ‘Inan partnership, the agent seeks greater profit share
than is possible in Mudharabah for which he agrees to shoulder
greater risk. He does this by contributing to the capital of the
partnership in addition to his entrepreneurship.
 MODUS OPERANDI
Capital
K1>K2
Principal 1
(Rab al mal) 1

Joint Capital
K1+K2
Managed by
one or both of
the principals Profit Loss

K2

Principal 2
(Rab al mal) 2
Capital + Profit share as mutually agreed (Hanefite)
Capital + profit
( to both share as mutually agreed
principals)

To both principals (In proportion to K1 and K2)

K1: Capital contributed by the first principal
K2: Capital contributed by the second principal
CHARACTERISTICS OF
‘INAN:
1. 2 parties.
2. Both parties contribute unequal amounts of capital.
3. Agent contribute smaller capital than the other partner, also his time, knowledge & effort.
4. Agent takes all capital physically & generate profit.
5. Venture concluded when the agent return back the original capital to the principal.
6. If there’s a profit, share according to mutual agreement in a form of % by Hanafite &
according to other schools, based on capital contribution.
7. Loss – based on capital contribution.
8. Liability to 3rd party – unlimited, several but not joint.
9. Termination:
2 partners – if 1 died & insane, ‘Inan is terminated.
More than 2 partners – partnership will continue.
The died & insane partner’s share will be inherited to his family.
THE SIMPLE MUFAWADA
In still another classical partnership form, the mufawada, partners
contribute capital in exactly equal amounts to the venture and share
profits, as well as losses, in exactly equal proportions.
CHARACTERISTICS OF
MUFAWADAH:
1. 2 parties.
2. Both parties contribute equal amounts of capital.
3. Profit & loss contributed equally.
4. Liability to 3rd party – unlimited, several & joint.
5. Termination:
a) Mutual consent of partners.
b) Expiration of contracts.
c) Accomplishment of aims.
d) If equality of capital lapses.
e) 2 partners – if 1 died & insane, ‘Inan is terminated.
f) More than 2 partners – partnership will continue.
The died & insane partner’s share will be inherited to his family.
THE MULTIPLE
MUDARABAH
Since Islamic law of partnerships allows the agent, to pool the capital
of several principals, total capital entrusted with a single agent can be
considerably enhanced. This brings us to the “multiple mudaraba”.
The term “multiple” here refers to the multitude of principals, who
pool their capital and entrust the thus pooled capital to a single
mudarib, agent.

The great achievement of the multiple mudaraba (and inan) is that it

has made it possible for various merchants to pool capital to finance
an agent. Conversely, a principal is also permitted to finance a
multitude of agents, thus diversifying his risks.
MODUS OPERANDI
K1
P1

K2
P2 Agent π Loss

Pn Kn

Profit on mutual
agreement
According to capital
contribution
CHARACTERISTICS OF
MULTIPLE MUDARABAH:
1. Partnership allows agent to pool the capital of several principals
– total capital entrusted with a single agent can be enhanced.
2. Purpose – economies of scale.
3. Sign separate agreement between all capital provider with 1
agent.
4. Profit – acccording to mutual agreement.
5. Loss – borne by the principals according to their capital
contribution.
6. Agent not liable for the pecuniary loss.
THE EXPANDED INAN
Permited for active ‘Inan partner to enter into a separate partnership
with a 3rd person. If the new partnership is unrelated to the basic
activity of ‘Inan – no need to obtain approval of other ‘Inan partners.
If the new partneship is related – permission is needed.
The active partner can mingle the capital of partnership with his own
capital so as to have a greater bargaining power vis-a-vis a 3rd party.
The active partner can use partnership capital to establish another
‘Inan partnership with a 3rd party.
 MODUS OPERANDI
P2

K1 > K2
P1
Joint Capital Agent
K2 K1 + K2 P2K2
P2

Expanded ‘Inan
Profit on mutual agreement π Loss
K1 + K2 + P2K2
According to capital contribution
K3

P3

Profit on mutual agreement

According to capital contribution

STEPS OF EXPANDED
‘INAN:
1. K1 & K2 is entrusted to P2 as the agent – K1>K2.
2. Then P2 will contribute his own fresh capital – total capital become K1+K2+P2K2.
3. This will make an expanded ‘Inan.
4. P2 will make a separate contract with P3 – with K3 added.
5. Total capital for expanded ‘Inan will be K1+K2+P2K2+K3.
6. Profit declaration:
a) 1st declare to P3.
b) P2 declare his share according to his proportion of additional capital.
c) Remaining will be shared according to mutual agreement between P1 & P2.
Hanafi – Profit according to mutual agreement.
Other school – profit according to capital contribution.
7. Loss – according to capital contribution of all partners.
THE BIRTH AND EVOLUTION
OF MODERN ISLAMIC
BANKING
Islamic finance is considered to be based upon five basic principles:
1. The ban on interest must be obeyed
2. The ban on uncertainty or speculation: uncertainty in contractual
terms and conditions is forbidden. But when all conditions and
terms are known to all parties, risk taking is allowed.
3. The ban on certain products must be obeyed.
4. Profit and loss sharing must prevail. Parties to a financial
transaction must share in the risks and rewards.
5. Each financial transaction must refer to a tangible, identifiable
underlying asset.
Liability side of an Islamic bank is divided into two windows:
demand deposits and investment balances. The model has 100
percent reserve requirement for the demand deposits and no reserve
requirement for the investment window.
This is because, demand deposits are amanah (trust) deposits and the
bank may not use them as the basis for money creation through
fractional reserves. Investment accounts are, however, invested with
the full knowledge of the depositors that their funds are invested in
risky projects and therefore no guarantee is granted.
 ISLAMIC BANK
LIABILITY/DEPOSIT SIDE
(INVESTMENT ACCOUNT)
Depositor/ investor 1
Mudaraba

Islamic Profit Loss

Combined
Depositor/ investor 2 Bank
capital
(mudarib)

Mudarib`s
fee: 20%,
Depositor/ investor n can go upto
40%
Original capital plus
ca.80% of profits Remaining share of
the profits

Shared between the depositors in

proportion to their invested capital
FINANCING SIDE
Murabahah
In modern Islamic finance murabaha is utilized as a mode of asset
financing. The purchase price is a marked-up price, which is made
known before the transaction. Islamic financial institutions (IFI)
executing the murabaha are expected to furnish the purchase orderer
with full and correct information on cost and profit.
Murabaha comprises several other features as well: price of
murabaha sale; asset of murabaha sale; duty of full disclosure of
cost and profit; and wa’d, promise to buy.
 ASSET SIDE
Entrepreneur
1
Islamic Bank Murabaha
Cash from
investment accounts
Profit Loss
Agent Principal

Entrepreneur

n
Mudarib fee
20%-40 %

Investment risk Profit

reserves Equilization
Reserve
CONCLUSIONS:
Modern Islamic banks are facing tough challenges from the
conventional sector;
They are under pressure to provide their depositors rates of returns
commensurate with what the conventional competitors provide;
There is a huge need to introduce completely Shari`ah compliant, or
even better, Shari`ah based instruments to evaluate the needs of these
savers.
Thank you