ISLAMIC FINANCIAL MANAGEMENT

Assignment
ISLAMIC FINANCIAL MANAGEMENT ASSIGNMENT

Table of Contents
1.0 RISK ......................................................................................................................................................... 3
1.1 Concept of risk.................................................................................................................................... 3
1.2 Risk in association with Peril, Hazard and Loss ................................................................................. 4
1.3 Types of Risk ....................................................................................................................................... 5
1.3.1 Essential risks .............................................................................................................................. 5
1.3.2 Prohibited Risks ........................................................................................................................... 6
1.3.3 Permissible Risks ......................................................................................................................... 7
1.4 Classification of Risk ........................................................................................................................... 8
1.4.1 Pure and speculative risks........................................................................................................... 8
1.4.2 Static and dynamic risks.............................................................................................................. 8
2.0 Murabahah and Mudarabah Contracts ............................................................................................... 10
2.1 Mechanics of a Murabahah contract ............................................................................................... 10
2.2 Features and conditions of Murabahah contracts .......................................................................... 11
2.3 Difference between Bai’bithaminajil and Tawarruq in relation to Murabahah contract ............. 13
2.4 Inherent risks of Mudarabah contract............................................................................................. 14
3.0 Partnership Contracts .......................................................................................................................... 16
3.1 Rights & Liabilities in partnership contracts ................................................................................... 16
3.1.1 Rights and Liabilities of Mudarabah contract .......................................................................... 16
3.1.2 Rights and Liabilities of Musharakah contract ......................................................................... 18
3.2 Application of partnership contracts in a modern economy .......................................................... 19

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1.0 RISK
Risk is present in every aspect of human life. Humans are continuously exposed to the possibility
of meeting catastrophes and disasters, giving rise to misfortunes and sufferings such as the
premature death of a family’s bread winner, disabilities, accidents, destruction of business or
wealth, etc.

Allah in Surah Al-Baqarah (2:104) said,” We will surely test you through some fear, hunger, and
loss of money, lives and crops. Give good news to the steadfast.”

1.1 Concept of risk.

Risk is an inseparable element of not only business world it is also inseparable of human life as
well. According to business dictionary risk is defined as a probability or threat of damage, injury,
liability, loss, or any other negative occurrence that is caused by external or internal vulnerabilities,
and that may be avoided through preemptive action. Risk has several meanings. As a noun term
risk refers to the possibility of loss or damage of money or property. As a verb it refers to expose
someone or something to danger, failure or loss.

According to Vaughan & Vaughan (2008) Risk is a condition in which there is a possibility of an
adverse deviation from a desired outcome that is expected or hoped for (Vaughan & Vaughan,
2008). Jorion (2007) define risk as the volatility of unexpected outcomes, which can represent the
value of assets, equity, or earning (Jorion, 2007).

Depending on the discipline the definition of the term risk may varied. According to financial
discipline the term risk is the probability that an actual return on an investment will be lower than
the expected return. In insurance the term risk is a situation where the probability of a variable
(such as burning down of a building) is known but when a mode of occurrence or the actual value
of the occurrence (whether the fire will occur at a particular property) is not. In securities market
the risk is the probability of a loss or drop in value (Business Dictionary, n.d.).

On the other hand Lahsansa (2014) broadly categories risks into two types which are business risks
and financial risks. Business risks are those that the corporation assumes willingly to create a
competitive advantage and add value for shareholders, this includes business decisions companies
make and the business environment in which they operate. However, financial risk is related to
possible losses owing to financial market activities.

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According to Ahcen (2011) when there is a potential of returns, there is high risk, and the risk and
return grow in that concept accordingly, so the higher the risk the greater the returns, and it is
common to observe that risk is associated with the return in that concept (Ahcene, 2011).

Islamic Sharia, neither denies risk nor prevents people from taking risk. No Risk No Gain is a
maxim that does not have contradiction with the Islamic financial system. However, this does not
mean people should seek uncertainty or risk. Islamic Sharia has placed rules and legislations that
organized manners of dealing with risk; whether in term of avoiding, taking or sharing it
(Mohammed, 2013).

Islamic Sharia treated risks differently with conventional financial system. In conventional
financial system risk is mainly transferred to debtors and borrowers, but Islamic financial system
is a sharing system of profit and loss that works to achieve equity and fair finance and investment.

1.2 Risk in association with Peril, Hazard and Loss

According to Ahcen (2011) risk is used as synonyms of hazard, danger, peril, jeopardy. Peril is a
close concept of risk. This is why it is defined as a synonym to risk. It is defined as serious danger,
or the fact of something being dangerous or harmful. Thus, peril is the cause of a loss (Ahcene,
2011). The examples of peril include floods, theft, death, sickness, accidents, fires, tornadoes, theft
and vandalism. Risk is the uncertainty about the happening of an event that can create loss, whereas
peril is the cause of the loss.

On the other hand, Hazard is used on both as noun and as a verb. As a noun it is a thing that can
be dangerous or cause damage, a fire/safety hazard. For instance, growing levels of pollution
represent a serious health hazard to the local population. However, as a verb it can be to make a
suggestion or guess which you know may be wrong, or to risk something or put it in danger
(Ahcene, 2011).

Risk professionals refer to hazards as conditions that increase the cause of losses. Hazards may
increase the probability of losses, their frequency, their severity, or both. That is, frequency refers
to the number of losses during a specified period. Severity refers to the average dollar value of a
loss per occurrence, respectively. Professionals refer to certain conditions as being “hazardous.”
For example, when summer humidity declines and temperature and wind velocity rise in heavily

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forested areas, the likelihood of fire increases. Conditions are such that a forest fire could start
very easily and be difficult to contain. In this example, low humidity increases both loss probability
and loss severity. The more hazardous the conditions, the greater the probability and/or severity of
loss.

Loss is defined as the outcome. For example if driver does not have proper driving license the risk
is very and the peril will be accident which causes the losses. The Loss could be the outcome of it
which could be monetary and nonmonetary losses from the accident.

In differentiating peril from hazard the peril is the cause of loss and hazard is the source of danger.
For example when a building is burns from the fire. Fire could be the peril which causes the loss
and the hazard could be faulty wiring which cause the risk of fire. The loss could be the actual loss
causes from this fire.

1.3 Types of Risk

According to Hassan (2009) risk can be classified into three categories which are essential risks,
prohibited risks and permissible risks.

1.3.1 Essential risks

Essential risks are the risks that are inherent in all business transactions. Their risk is necessary
and must be undertaken to reap the associated reward or profit. It must be borne in order to earn
revenue or profit. Scholars developed the legal maxims “al-kharaj bi al-daman” (profit goes with
liability) to indicate that risk goes hand-on hand with profit. This mean the higher the risk is the
higher the profit can be expected. The maxim asserts that the party enjoying the full benefit of an
asset or object should bear the risks of ownership.

For example a buyer who has the right to return an asset purchased is entitled to utilized it before
it is return to the seller. It is justified because the buyer bears liability to indemnify the asset in
case of damage or loss. Conversely, since the option reduces the buyer’s risk, some jurists hold
the view that it has an effect upon the price.

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1.3.2 Prohibited Risks

Prohibited risks are in the form of excessive gharar. Islamic Scholars defined gharar in two forms
which are uncertainty and deceit. Quran has clearly forbidden all business transactions, which
cause injustice in any form to any of the parties. It may be in the form of hazard or peril leading to
uncertainty in any business, or deceit or fraud or undue advantage (Obaidullah, 2005).

Gharar relates to the ambiguity or ignorance of either the terms of the contract or in the object of
the contract. Thus, sale can be void due to gharar, due to risks of existence and taking possessions
of the object of sale on one hand, and uncertainty of the quantity, quality, price and time of payment
on the other. This type of risk is prohibited by Islam as it will lead to injustice, create harm to one
of the contracting parties, and almost inevitably lead to disputes. Obaidullah (2005) categorized
these prohibited risks into four categories which are;

Settlement risk

Settlement risk is seen to be present when the seller has no control over the subject matter. A
typical example is a sale without taking possession. The evidence of prohibition of this form of
risk is from the following Hadith of Sahih Muslim. Ibn Abbas reported Allah’s Messenger (PBUH)
as saying: He who buys food grain should not sell it until he has taken possession of it.

Example of this kind of risk the sale of fish in the water: The sale of fish in the water, which is not
yet caught is null and void as it is not in a state of property.

Inadequacy and Inaccuracy of Information:

Uncertainty may be caused by lack of adequate value-relevant information. The prohibition this
kind of transection are from the following report of Ibn Umar. Ibn Umar reported that the people
of pre- Islamic days used to practice habal-al-habala, which implies that a man would buy the
unborn offspring of a she camel. Allah’s Messenger (pbuh) forbade that transaction.

Scholars of fiqh have described gharar as involving want of knowledge with regard to the price,
the subject matter, or with regard to the characteristics of the price or of the subject-matter, the
date of settlement of contract etc. Gharar also refers to possibility of deceit, fraud, which may be
due to deliberate withholding of value-relevant information by either party in a contract.

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Complexity in Contracts

Gharar also refers to undue complexity in contracts. Shariah does not permit interdependent
contracts. For instance, “combining two sales in one” is not permitted.

Pure Games of Chance (Al-Qimar & Al-Maisir)

Another form of prohibited risk is al-qimar & al-maisir or pure game of chances. The prohibition
of pure game of chances also found in Quran chapter 2 verse 219. “They ask thee concerning wine
and gambling. Say: `In them is great sin and some profit, for men; but the sin is greater than the
profit.’ They ask thee how much they are to spend; say: `what is beyond your needs’. Thus doth
Allah make clear to you His signs: in that ye may consider”

From the above verse, it is clear that the Quran prohibits contracting under conditions of gambling
(qimar).

1.3.3 Permissible Risks

The third type of is permissible risk. Permissible risks are those risks which does not fall in the
above two categories. Islamic Sharia legitimizes the management of this kind of risk and allow
people to determine the method of dealing with it, as long as it does not involve a clearly prohibited
means. Prophet (PBUH) said “You know better (than me) about your worldly affairs”

Unlike Riba, uncertainty is acceptable at some degree in Islamic framework and prohibitions
comes from excessive gharar. Examples of acceptable uncertainty includes exogenous uncertainty
and Endogenous uncertainty.

Exogenous uncertainty are the factors affecting the exogenous variables such as consumer’s taste
and firms’ technologies. Even though the economic system cannot reduce exogenous uncertainty,
insurance may help to soften its impact upon individuals (AL-SAATI, 2003).

On the other hand, Endogenous uncertainty concerning the operation of the economic system in
market economy, like the buyer uncertainty about the suitability of the seller he meets, or the
quality of the commodity he buys or the term of the trade that will take place. This uncertainty can
be reduced to some extent by individuals who take the trouble to search extensively, but it can be
created by sellers who change their prices frequently and unpredictably, so the endogenous

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uncertainty is a result of economic agents’ decisions and the task of economist to explain and
predict (AL-SAATI, 2003).

Similarly, risks such operational risk, liquidity risk, credit risk, market risk are regarded as
permissible risks since, these risks also does not fall under previous two categories. These are the
risks faced by Islamic financial institutes and they may accept it or avoid it.

1.4 Classification of Risk

Risk can be classified into several categories. Among these classifications are:

(i) Pure and speculative risks;

(ii) Static and dynamic risks
Explain both categories of risk. Give examples in both cases.

1.4.1 Pure and speculative risks

Pure risk is used to designate those situations that involve only the chance of loss or no loss. Such
as the person who bought a machine the risk of damage is surrounding his item, and there is a
possibility to be destroyed, so the possible outcomes are loss or no loss. The distinction between
the two risks is important in order to prevent the risk, and plant for the return as well.

On the other hand, speculative risk describes a situation where there is a possibility of loss, but
also a possibility of gain, such a gambling. In the world of trade an entrepreneur faces speculative
risk in seeking profit. If his investment in a business is rejected by the market then he will make
loses, and conversely he may gain and make profits if his products are well accepted by the market.

1.4.2 Static and dynamic risks

Static risks involve those losses that would occur even if there were no changes in the economy.
Basically these losses does not arise from the impact of negative economy but from the parties
involved in the business and trade whether they are individual or companies or institution and
mostly as a result dishonesty among the people, and poor business attitude and moral. As result of
this, it is difficult prevent and control the static risk (Ahcene, 2011).

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On the hand, dynamic risks are those resulting from changes in the economy, changes in the price
level, consumer tastes, income and output, and technology may cause financial loss to members
of the economy. This type of risk is considered less predictable than static risks. However the
society may benefit from it over the long run, since they are the result of adjustments and
misallocation of resources. Dynamic risk can be prevented base on the economy forecasting and
business trade and economy report and statistics (Ahcene, 2011).

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2.0 Murabahah Contracts

Murabahah is derived from Ribh, which means gain, profit or addition. In Murabahah, a seller has
to reveal his cost and the contract takes place at an agreed margin of profit. This contract was
practiced in pre-Islamic times. A renowned Hanafi jurist Al-Marghinani has defined Murabahah
as “the sale of anything for the price at which it was purchased by the seller and an addition of a
fixed sum by way of profit”. Ibn Qudama, a Hanbali jurist, has defined it as “the sale at capital
cost plus a known profit; the knowledge of capital cost is a precondition in it. In a Murabaha
contract the buyer must know the original price, additional expenses if any and the amount of
profit. Accordingly, Murabaha is a contract of trustworthiness

The Murabahah contract is one of the most popular contracts of sale used for purchasing a product.

2.1 Elements & Process of Murabahah contract

Murabahah contracts will be fulfilled with three basic elements, which are, its subject matter, its
contracting parties and sighah.

1- Subject matter: The subject matter of Murabahah contract refers to the product and the
selling price. In a Murabahah Contract the traded goods must be real but not necessary to
be tangible. Nontangible goods includes rights and royalties since it have a value and which
could be owned and can be sold.
2- Contracting Parties: Contracting parties includes the seller and the buyer. In a Murabahah
contract there must be a seller who is regarded as financier and the buyer known for
customer.
3- Sighah: Sighah refer to the offer and the acceptance. Murabahah contract shall be consists
of the offer by one party and the acceptance by another party.

Murabahah contract is consist of six simple steps. Following are the basic steps in a Murabahah
contract.
1- The first step of a Murabahah contract is the signing of a master agreement between buyer
or the client and seller the financial institute. This agreement is a promise of selling and
buying of a product on an agreed ratio of profit added to the cost.

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2- The second step of a Murabahah contract is the appointment of client as an agent for
purchasing product on behalf of financier. An agency agreement between agent and the
financier will be signed on this stage.
3- After appointment of agent the agent may buy the product on behalf of financier.
4- The forth step of Murabahah contract is to inform the financier that the agent has bought
the product on behalf of financier and the same time, makes an offer to purchase it from
the institution.
5- Fifth step is conclusion stage where the institute accepts the offer and ownership and risk
of the product is transferred to the client.

In some Murabahah contracts, the financier bought the product himself and handover it to
client himself instead of appointing client as an agent to buy the product on behalf of the
financier.

2.2 Features and conditions of Murabahah contracts

In order to be a sharia complaint Murabahah contract there are various conditions to be fulfilled
some of the key conditions are as follows;

2.2.1 Knowledge of Initial Price

The seller must state the original price and the additional expenses incurred on the sale item and
he must be just and true to his words. The additional expenses such as transport, processing and
packing charges, etc. that enhance the value of the commodity in any way, and that are added as a
custom by the merchant community in the original price, can be added into the purchase price to
form the basis of Murabaha.

If the seller gives an incorrect statement about the original price/cost of goods, the buyer, according
to Imam Malik, may rescind the sale unless the seller returns to him the difference between his
real and the stated cost, in which case the sale is binding. The Hanafis give the buyer the
unqualified option to rescind, while the Hanbalis consider the sale binding after the return of the
difference between the correct and the stated costs. The Shafi‘es have two versions, one of which
agrees with the Hanbalis and the other with the Hanafis.

2.2.2 Knowledge of Profit margin

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Seller must inform the profit margin as well. Otherwise, it will not be regarded as Murabahah,
rather it might be normal sale. The margin of profit on the price so reached has to be mutually
agreed upon between buyer and seller. The price, once fixed as per agreement and deferred, cannot
be further increased except for rebate received from the supplier as mentioned above.

2.2.3 Disclose all aspects of the product

The prospective seller in Murabaha is required to disclose all aspects relating to the commodity,
any defects or additional benefits and the mode of payment to the original seller/supplier. All
schools of thought are unanimous on the point that the buyer in Murabaha ought to be informed if
the original price was on credit, since credit prices are often higher than cash prices. All also agree
that the original purchase price deliberately inflated violates the concept of Murabaha. If an Islamic
bank receives a rebate for goods purchased, even after the Murabaha sale of such a contract, the
client/buyer is entitled to benefit from the rebate as well.

2.2.4 No Ribawi items shall be involved

No ribawi item shall be involved in Murabahah contract, the product traded using Murabahah
scheme cannot be paid as per the barter system trading from some ribawi items which are
prohibited by the Prophet (S.A.W), namely, gold for gold, silver for silver, wheat for wheat, flour
for flour, dates for dates and salt for salt and barley for barley unless the weight, measurement and
the calculation are equal.

2.2.5 Initial contract must be valid

The initial contract must be valid, the traded commodity must be lawfully owned by the seller
according to Shariah requirements.

The subject of sale should be lawful and an object of value. A thing having no value according to
the usage of trade cannot be sold; similarly, the subject of sale should not be a thing used for any
prohibited purpose, e.g. pork, wine, etc.

The subject of sale must be in the physical or constructive possession of the seller at the time of
sale. Constructive possession means that the buyer has not taken physical delivery of the goods,
but the ownership risk of the goods has been transferred to him: the goods are under his control
and all rights and liabilities of the goods have passed on to him. For example, A has purchased a

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car from B, B has not physically handed over the car to A but has placed it in a garage which is in
the control of A, who has free access to it – the risk of the car has practically passed on to him, the
car is in the “constructive possession” of A and he can sell the car to any third party.

2.2.6 Debts cannot be the subject of Murabahah

Credit documents that represent debt owed by someone cannot be the subject of Murabaha, first
because debt cannot be sold except when it is subject to the rules of Hawalah and second because
any profit taken on the debt would be Riba.

2.3 Difference between Bai’ bi-thamin ajil and Tawarruq

Even though the term Murabahah in Islamic Fiqh does not directly related to financing, most of
the Islamic financial institutes uses Murabahah contracts extensively. In fact, Murabahah becomes
so popular among financial institutes because of it uses with several other tools such Bai’ bi-thamin
ajil and Tawarruq.

Murabahah can be used as an alternative to interest-based financial only when it comes with
deferred payment basis. However, Murabahah does not necessary involves credit. Therefore, tools
like Bai’ bi-thamin ajil is needed to be bunched together with Murabahah for providing an
alternative solutions of interest based financial transactions. Bai’ bi-thamin ajil or Bai’ Mu’ajjal is
refers to sale of goods or property against deferred payment (either in a lump sum or instalments).
Unlike Tawarruq, Bai’ bi-thamin ajil is not a type sale but it is mechanism of payment settlement
by providing facility scheme to the buyer to pay on deferred payment basis, instead of paying the
whole amount in lump sum.

Tawarruq is another financing product that is cited as a classic case of hiyal, or legal stratagem,
but has been permitted by mainstream scholars under certain conditions. Tawarruq becomes a
source of funds by combining two separate sale and purchase transactions. An individual in need
of funds purchases a commodity on a deferred payment basis from a seller and then sells the same
in the market in order to realize cash. This is considered a hiyal, since the individual concerned
has no real intention of buying or selling the commodity. He engages in these purchase and sale
transactions for realization of cash.

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Scholars have permitted Tawarruq since it fulfills a genuine need – the need for funds. It is
permitted as long as it does not violate the norms of Shariah. Hence, all care should be taken to
ensure that it does not involve riba. The first and foremost requirement is the involvement of a
third party in the transactions. The client must sell the commodity in the market place to a third
party. Otherwise, it would be a case of bai-al-einah.

In Tawarruq, therefore, one needs to exercise extra care and subject the product to an additional
dose of investigation before accepting it as Shariah compatible. More so, when the bank asserts
that the terms of the tawarruq based product are same as the credit terms of other conventional
financing products.

2.4 Inherent risks of Mudarabah contract

Mudarabah” is a special kind of partnership where one partner gives money to another for investing
it in a commercial enterprise. The investment comes from the first partner who is called “rabb-ul-
mal”, while the management and work is an exclusive responsibility of the other, who is called
“mudarib” (Usmani, 1998). Another famous Islamic financing tool is Mudarabah contract. Unlike
Murabahah, Mudabarah contract is partnership contract where both parties carry certain levels of
risks. Following are the inherent risks in a Mudarabah contract.

Credit Risk

Credit risk is generally defined as the potential that the counterparty fails to meet its obligations in
accordance with agreed terms. Islamic financial institute may hold the role of Rabb-ul maal and in
that situation there is a risk of a counterparty’s failure to meet their obligations in terms of receiving
deferred payment and making or taking delivery of an asset. A failure could relate to a delay or
default in payment. The invested capital in a Mudharabah contract will be transformed to debt in
case of proven negligence or misconduct of the Mudarib.

Equity Investment Risk

Equity investment risk can be defined as the risk arising from entering into a partnership for the
purpose of undertaking or participating in a particular financing or general business activity and
in which the provider of finance shares in the business risk (Febianto, 2012). The characteristics

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of equity investment include considerations as to the quality of the partner, underlying business
activities and ongoing operational matters. In Mudharabah contract, the risk profiles of potential
partners are crucial considerations for evaluating the risk of an investment to undertake of due
diligence.

Market Risk

In general, market risk can be defined as the risks that influence the value of a large number of
assets or the systematic and unsystematic risks originating in instruments and assets traded in well-
defined markets that cause their price volatility (Febianto, 2012). Islamic financial institution
defines market risk as the risk that arises from fluctuations in values in tradable, marketable or
leasable assets and in off-balance sheet individual portfolios. Market risk can be classified into
four categories namely benchmark rate risk, foreign exchange rates risk, equity prices risk and
commodity prices risk.

Liquidity Risk

Liquidity risk is risk arises due to insufficient liquidity that reduces bank’s ability to meet its
liabilities when it falls due (Febianto, 2012). Islamic Financial Institutes defines it as potential loss
to Islamic financial institution arising from their inability either to meet their obligations or to fund
increases in as-sets as they fall due without incurring unacceptable costs or losses.

Rate of Return Risk

Rate of Return Risk is an overall balance sheet exposure where mismatches find between assets
and balances from fund providers. It is the Mudarib’s responsibility to manage the Rabb-ul maal’s
expectations and the liabilities (Febianto, 2012).

Operational Risks

Operational Risks arises from failures of managing internal controls involving processes, people
and systems and from external events (Febianto, 2012).

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3.0 Partnership Contracts

Basically in Islamic finance, there are two primary tools that can be categorized as partnership
contracts, namely:

I. The Mudhrabah;
II. The Musharakah; contracts

Mudarabah” is a special kind of partnership where one partner gives money to another for investing
it in a commercial enterprise. The investment comes from the first partner who is called “rabb-ul-
mal”, while the management and work is an exclusive responsibility of the other, who is called
“mudarib” (Usmani, 1998). On the other hand, Musharakah contract is a joint enterprise in which
all the partners share the profit or loss of the joint venture (Usmani, 1998).

3.1 Rights & Liabilities in partnership contracts

Mudarabah and Musharakah contracts has various rights and liabilities and some of such rights are
differ from contract to contract and the involvement of the person. Following are the rights and
liabilities of Mudarabah and Musharakah contracts.

3.1.1 Rights and Liabilities of Mudarabah contract

Mudarabah contract is famously known as trustee partnership contracts where one partner or
partners may bring the capital and the other partner or partners may take care of the management
of the partnership. The capital provider is known as Rabb-ul-maal and the manager is known as
Mudarib. Therefore some rights and the liabilities of Rabb-ul-maal and Mudarib are different due
to the nature of their involvement.

Rights and liabilities on contribution of capital

Since, Rabb-ul-maal is responsible for the capital he has the rights and authorities for claiming all
outstanding capital upon liquidation or maturity. If there is any amount due to capital provider
including profit shall be deemed as debt due to the capital provider. The Rabb-ul-maal has the right
to require the manager to arrange for an independent third party performance guarantee. The
guarantee shall be executed as a separate contract and be utilised to cover for any loss or depletion
of capital in the event of misconduct, negligence, dishonesty, fraud or breach of the terms of the
contract. The third party guarantor shall be independent from the manager.

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In Mudarabah contracts the liability of Rabb-ul-maal is limited to his investment, unless he has
permitted the Mudarib to incur debts on his behalf. The capital assets purchased by the Mudarib
are solely owned by the Rabb-ul-Maal, and the Mudarib can earn his share in the profit only in
case he sells the goods profitably. Therefore, he is not entitled to claim his share in the assets
themselves, even if their value has increased.

Rights and liabilities of manager

Mudarib shall have the exclusive right to manage the Mudarabah venture. Rabb-ul-maal shall be
precluded from managing the venture. However, Rabb-ul-maal has the right to information
regarding the conduct of the manager. Mudarib shall not be liable for any loss of capital unless
such loss is due to the manager(s) negligence, dishonesty, misconduct or breach of terms of the
contract. Mudarib shall be personally responsible to ensure the proper management of the capital
is in the interest of the capital provider. The manager of a Mudarabah contract may assign the
capital to another manager in another Mudarabah contract with the consent of the Rabb-ul-maal.

Losses

Loss shall be solely borne by the capital provider except in the event of misconduct, negligence or
breach of contract by the manager. The manager may not undertake to bear the loss. The manager
may bear the loss at the time the loss is realised without any prior condition or undertaking. The
capital provider may take collateral from the Mudarib, provided that the collateral could only be
liquidated in the event of negligence or misconduct or violation of the terms of contract by the
Mudarib. Operating loss shall be recognised when the loss occurs during the course of ordinary
business. The losses may be carried forward to the next period and subsequently, be set-off against
prior or future profit.

It is not permissible to include a condition in Mudharabah contract that stipulates a pre-determined

fixed amount of profit to one partner which deprives the profit share of the other partner. The profit
in the form of certain percentage shall not be linked to the capital investment amount. However, a
profit sharing ratio may be ultimately translated into a fixed percentage based on the amount of
capital investment. The parties to the contract may agree to set aside a portion of the profit as a
reserve (e.g. profit equalisation reserve) or for any other purpose. However, for capital protection
purposes, the reserve may only be taken from the profit portion of the Rab-ul-maal. The partners

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may mutually agree to set aside a portion of the profit to a third party who is not involved in the
partnership. The manager shall not be permitted to earn a fee in addition to the share of profit in
the Mudarabah contract.

3.1.2 Rights and Liabilities of Musharakah contract

Musharakah contracts are known as joint venture partnerships where all partners contribute
entrepreneurship and capital and all partners have the right to take part in the management of the
company. Therefore all partners have similar rights and liabilities unlike Mudarabah contracts.

Loss and the Liability

In Musharakah contracts all the partners share the loss to the extent of the ratio of their investment.
The liability of the partners in Musharakah contracts are normally unlimited. Therefore, if the
liabilities of the business exceed its assets and the business goes in liquidation, all the exceeding
liabilities shall be borne pro rata by all the partners. However, if all the partners have agreed that
no partner shall incur any debt during the course of business, then the exceeding liabilities shall be
borne by that partner alone who has incurred a debt on the business in violation of the aforesaid
condition.

Assets

In Musharakah contracts, as soon as the partners mix up their capital in a joint pool, all the assets
of the Musharakah become jointly owned by all of them according to the proportion of their
respective investment. Therefore, each one of them can benefit from the appreciation in the value
of the assets, even if profit has not accrued through sales.

Contract Termination

Every partner has the right to terminate Musharakah at any time after giving his partner a notice
to this effect. If any one of the partners passes or becomes insane or incapable of effecting
commercial transactions, the Musharakah contract will be terminated.

Sleeping partner

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If one of the partners puts a condition that he will not work in the partnership and will stay as a
sleeping partner throughout the period of Musharakah, then his share of profit cannot be more than
the ratio of his investment.

3.2 Application of partnership contracts in a modern economy

Various forms of partnership contracts are applied in modern economy in various business
transactions.

Investment deposits

All deposits are pooled, the bank invests the pooled amount in business, all direct expenses are
charged to the pool while expenses related to the general management or Head Office expenses
are borne by the bank (Mudarib) itself, and the net proceeds are distributed among depositors
according to the stipulated ratios. Different weightages can be assigned to different depositors
depending upon their tenure and size, subject to the condition of sufficient disclosure to all
depositors. For the purpose of profit distribution among partners, there is constructive liquidation
after a tenure or accounting period and then the joint relationship starts afresh for the next
accounting period.

Letter of Credit (L/C)

Mudarabah can be best used for financing of import trade on a single transaction or consignment
basis in the case of a firm order and L/C without margin, where the whole investment has to be
made by the bank. Its use is also possible for running businesses, project financing and for the
purpose of securitization.

Musharakah can be applied in trade finance without complexities, since the chances of fraud,
negligence and other problems are relatively lower in international trade than in other

Musharakah-based projects. A bank may enter into a Musharakah arrangement with a client who
intends to import; the bank may also appoint him as agent for acquisition and disposal of the goods
after the same are imported; an L/C could be opened in the bank’s or the client’s name. The net

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profit out of this limited purpose Musharakah will be shared between the bank and the client in an
agreed ratio. The above procedure can also be adopted in respect of bills drawn under inland L/Cs.

In the case of export finance under L/C, the goods will be acquired and made ready for shipment
on a Musharakah basis. The client will prepare the export documents strictly in accordance with
the terms of the L/C and undertake to indemnify the bank for any loss in case of his failure to
honour his commitment. Export proceeds will be distributed according to the agreed ratio. If there
is no L/C involved, the merchandise will be made ready for export under joint ownership of the
bank and the client. However, details of all such transactions will have to be worked out in
consultation with the commercial bankers who are actually involved in the business.

Project Financing

If the financier wants to finance the whole project, the form of Mudarabah can be used. If
investment comes from both sides, the form of Musharakah would be more suitable. In this case,
if the management is the sole responsibility of one party, a combination of Musharakah and
Mudarabah can also be used according to the rules.

Securitization

Musharakah can easily be adopted as a basis for securitization, especially in the case of big projects
where huge amounts are required. Every subscriber can be given a certificate representing his
proportionate ownership in the assets of the joint business, and after the project is started by
acquiring substantial nonliquid assets, these Musharakah certificates can be treated as negotiable
instruments and can be bought and sold in the secondary market.

Sukuk

Musharakah and Mudarabah Sukuk can be issued as redeemable certificates by or to the corporate
sector or to individuals for their rehabilitation/employment, for purchase of automobiles for their
commercial use or for the establishment of high-standard clinics, hospitals, factories, trading
centres, endowments, etc.

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