Mudarabah and Musharakah -

Participatory Modes of financing

Essentials of Islamic Banking and Finance

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Mudarabah

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Contents

 Introduction – Mudarabah;
− Profit / Loss Distribution;
− Kinds of Mudarabah
 Termination of Mudarabah
 Mudarabah Vs Musharakah
 Scope of Mudarabah for Banking System
 Risks
 Practical examples

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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.

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 Definition

• This is a kind of partnership where one

partner gives money to another for
investing in a commercial enterprise.

• The investment comes from the first partner

who is called “Rabb-ul-Maal” (Investor)
while the management and work is an
exclusive responsibility of the other, who is
called “Mudarib” (Working Partner) and
the profits generated are shared in a
predetermined ratio.

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 Types of Mudarabah

1. Al Mudarabah Al Muqayyadah
(Restricted Mudarabah)

1. Al Mudarabah Al Mutlaqah
(Unrestricted Mudarabah)

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 Al Mudarabah Al Muqayyadah
(Restricted Mudarabah)

Rabb-ul-Maal may specify a particular business or a

particular place for the mudarib, in which case he shall
invest the money in that particular business or place. This
is called Al Mudarabah Al Muqayyadah (restricted
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.

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 Al Mudarabah Al Mutlaqah
(Unrestricted Mudarabah)

• Rabb-ul-maal gives full freedom to Mudarib to

undertake whatever business he deems fit, this is
called Al Mudarabah Al Mutlaqah (unrestricted
Mudarabah)
• However, he is not authorized to:
a) keep another Mudarib or a partner
b) mix his own investment in that particular
Mudarabah without the consent of Rabb-ul Maal.

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 Authority of Rabb-ul-Maal

Rabb-ul-Maal has authority to:

a) Oversee the Mudarib’s activities and

b) Work with Mudarib if the Mudarib consents.

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 Different Capacities of the Mudarib

1. Ameen (Trustee): The money given by Rabb-

ul-maal (investor) and the assets required
therewith are held by him as a trust.

2. Wakeel (Agent) :In purchasing goods for trade,

he is an agent of Rabb-ul-maal.

3. Shareek (Partner): In case the enterprise earns a

profit, he is a partner of Rabb-ul-maal who
shares the profit in agreed ratio.

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 Different Capacities of the Mudarib

4. Zamin (Liable): If the enterprise suffers a loss

due to his negligence or misconduct, he is liabel
to compensate the loss.

5. Ajeer (Employee): If the Mudarabah becomes

Void due to any reason, the Mudarib is entitled
to get a fee for his services.

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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;

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 Capital of Mudarabah

– 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.
– The capital in Mudarabah may be either cash
or in kind. If the capital is in kind, its
valuation is necessary, without which
Mudarabah becomes void.

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 Distribution of Profit & Loss

• It is necessary for the validity of Mudarabah that the

parties agree, right at the beginning, on a definite
proportion of the actual profit to which each one of
them is entitled.
• They can share the profit at any ratio they agree
upon.
• However in case the parties have entered into
Mudarabah without mentioning the exact
proportions of the profit, it will be presumed that
they will share the profit in equal ratios.
• Some incentives my be given to the Mudarib.

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 Distribution of Profit & Loss

• Apart from the agreed proportion of the profit,

the Mudarib cannot claim any periodical salary
or a fee or remuneration for the work done by
him for the Mudarabah.

• The Mudarib & Rabb-ul-Maal cannot allocate a

lump sum amount of profit for any party nor can
they determine the share of any party at a
specific rate tied up with the capital.

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 Distribution of Profit & Loss

EXAMPLE

If the capital is Rs.100,000/-, they cannot agree on a

condition that Rs.10,000 out of the profit shall be
the share of the Mudarib nor can they say that
20% of the capital shall be given to Rab-ul-Maal.
However they can agree that 40% of the actual
profit shall go to the Mudarib and 60% to the
Rab-ul-Maal or vice versa.

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 Distribution of Profit & Loss

• If the business has incurred loss in some

transactions and has gained profit in some
others, the profit shall be used to offset
the loss at the first instance, then the
remainder, if any, shall be distributed
between the parties according to the
agreed ratio.

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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;
− Therefore following method is not allowed:
► 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;

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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.

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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 Vs Musharakah
 Mudarabah:
− 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.
 Musharakah:
− The contribution comes
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;
► Import & export Financing

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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 &

DEPOSITORS LOSS SHARING
ISLAMIC BANK

PROFIT

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Mudarabah – Application (Deposit [Liability] management)

POOL MANAGEMENT
Pools according to (1) size of deposit, (2) Tenure

S
i A B C D E F
z
e

o G H I J K L
f

D
e M N O P Q R
p
o
s
i S T U V W X
t

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.
► Bank’s 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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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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 Termination of Mudarabah

• Mudarabah can be terminated any time by either

of the two parties by giving notice.
• If Mudarabah was for a particular term, it will
terminate at the end of the term.
• Termination of Mudarabah means that the
Mudarib cannot purchase new goods for the
Mudarabah. However, he may sell the existing
goods that were purchased before termination.

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 Distribution at Termination

• If all assets of the Mudarabah are in cash

form at the time of termination, and some
profit has been earned on the principal
amount, it shall be distributed between the
parties according to the agreed ratio.
• If the assets of Mudarabah are not in cash
form, they will be sold and liquidated so
that the actual profit may be determined.

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 Distribution at Termination

• If there is a profit, it will be distributed

between Mudarib and Rab-ul-Maal.

• If no profit is left, Mudarib will not get

anything.

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 Collective Mudarabah

• “Collective Mudarabah” means a joint

– Pool created by many investors and handled over to a
single Mudarib who is normally a juristic person.
• Collective Mudarabah creates two different relationships:
– Relationship between investors inter se, which is
Shirkah or Partnership.
– Relationship of all the investors with mudarib, which
is mudarabah.

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 When Mudarib is a Juristic Person

• Who is the Mudarib?

• Shareholders?
• Management or Directors?
• Juristic Person
• Expenses of Mudarabah
• Direct expenses are borne by the Mudarabah pool.
• Indirect expenses are borne by the mudarib.

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 Running Mudarabah

• Investors come in and go out at different dates

• Profits are calculated on daily product basis.
• Redemption before maturity
• If the assets of mudarabah are in illiquid form, an
investor may redeem his share by selling it to the
pool..
• If the assets are in liquid form, a provisional
amount may be given to him subject to final
settlement

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Case Study 1

• Profit is calculated after deducting the operating

expenses.
• The profit sharing ratio between Islamic bank and the
investment account holders (assume only one
investment account) is 75% for investment account
holder and 25% of Islamic banks. Islamic banks act as
a Mudarib for fund management. Unrestricted
Investment Accounts (UIA) is 70% of total investors'
deposits. The Mudaraba contract states that Islamic
bank can only deduct the operating expenses before
distributing the income to the investor sand Mudarib.
The total revenue and expenses of Islamic bank is $
120,000 and $ 110,000 respectively. The deductible
operating expenses are 65% of total expenses. Find
the profit distributable among the Unrestricted
Investment Account holders? 33
Solution

Answers:
Operating expenses = 110,000 x 65% = $ 71,500
Profit = Revenue – operating expenses.
(120,000 – 71,500 = $ 48,500)

The share of UIA = 48,500 X 70% = $ 33,950

Profit distributable to investment account
holder = 33,950 x 75% = $ 25,462.5

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Case study 2

• Two tiered Profit and Loss sharing

• An Islamic bank has Restricted Investment Account
(RIA) based on Mudaraba contract sharing profit and
loss, 25% (Islamic bank): 75% (Investment Account
holders). Under the agreement of RIA Islamic bank
can only use the fund in the restricted or specified
business activity. Real estate financing is one of the
investments categorized under RIA contract. The
Islamic bank invested $ 450,000 with a reputable
investment company for one year with the agreement
to share the profit and loss of 40% (Real Estate Co.)
and 60% (Islamic bank). At the end of the year the real
estate company earned $ 250,000 as profit. Find the
income distributable to the RIA holders.
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Solution

• Tier 1: Islamic bank and Real Estate Company

• Islamic bank = 250,000 x 60% = $ 150,000,
• Real Estate Co. 250,000 x 40% = $ 100,000

• Tier 2 : Islamic bank and RIA holders

• Islamic bank = 150,000 x 25% = 37,500 and

• RIA = 150,000 X 75% = $ 112,500
• Profit rate for RIA = 112,500/450,000 = 25%

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Case Study 3

• Capital contribution by the Mudarib.

(Sometimes the Mudarib contribute additional
capital, in this case the first the profit or loss
belongs to the Mudarib will be distributed and
then the rest will be shared between the
investor and the Mudarib. The profit and loss
sharing ratio between the investor and Islamic
bank is 20% of Islamic bank and 80% of
investment account holders. The Islamic bank
invested with their additional capital of 30% in
a project. Find if the project earned a profit for
the year is $ 150,000 or loss of $ 100,000 how
much both Islamic bank and the investment
account holder will get as a return. 37
Solution

Profit $ 150,000
1. First bank's share of additional capital (150,000 X 30% = 45,000)
2. The balance will be shared between Islamic banks and Investment
account is(150,000 – 45,000 = 105,000).
3. The investment account holder will get 105,000 X 80% = $ 84,000.
4. The Islamic bank will get 105,000 X 20% = $ 21,000 + 45000
(Mudarib contribution) =$ 66,000
Loss $ 100,000
1. First bank's share of additional capital for loss (100,000 X 30% =
30,000)
2. The balance $ 70,000 will be shared only by an Investment account
holder.

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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 Al Inaan Mufawadah Al Inaan Mufawadah Al Inaan

(100% equality (Variability in (100% equality (Variability in (100% equality (Variability in
in shares of shares of in shares of shares of in shares of shares of
partners) partners) partners) partners) partners) 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;
− Temporary (Redeemable) Musharaka;
► 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;

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Diminishing/declining Musharaka
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 bank’s share.

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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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• Reported by Abu Hurairah R.A.
that the Prophet S.A.W said
“Allah had said that: “I am the
third of the partners, as long as
any one for them does not betray
the other. If he/she does betray
the other, I will withdraw (Move
away) from them”.

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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;

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– 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 him 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;

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−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
guaranteed from loss;
− Any such agreement will make the Musharakah void and
null
 Guarantee of principle:
− Guarantee from one partner to other partner’s 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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QUESTIONS

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Case 1

• The Islamic bank entered an agreement with a

corporation for joint venture project. Both the
Islamic bank and corporation agreed to use
their expertise in the project. 30% of
management fee are to be apportioned from
the profit of which 40% for bank and 60% for
corporations. The balance is to be shared
between Islamic banks and Corporation, based
on their capital contribution. The total capital
need to for the project is $ 800,000 of which
Islamic bank contributed $ 500,000
and Corporation contributed $ 300,000.Find
the income of the bank and corporation if
the profit from the project is $ 300,000 57
Solution

1. Find the Profit and Loss sharing ratio. Corporation 300/800 =

37.5%. Bank 500/800 = 62.5%2.

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Case 2

Partner admitted to the Joint venture

Crescent Publisher in an Islamic book publishing company owned by
Abdullah. Abdullah valued the business through a consultancy company
and the current worth of the business is $ 25,000. Abdullah got a
contract from an international publisher to publish the book in the local
language. The contract is signed for one year and Abdullah is in need
for $ 15,000 as working capital to run the operation. Abdullah
approached his friend Anwar and Anwar agreed to become the partner
under the Musharaka contract sharing profit and loss. The net income
to be shared between the partners. Both agreed to share the profit
equally.
1. Find how much Abdullah and Anwar will get if the value of the joint
venture is $ 50,000at the end of the year. Find the profit rate for
Anwar
2. Find if there is loss of $ 10,000 in the business

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Solution

1. Increase in the capital need to be shared based on PLS

not based on capital contribution. An increase in the
value = 50,000 – 40,000 = 10,000 will be shared $ 5,000
for Abdullah and $ 5000 for Anwar. So Anwar will get $
5000 + $ 15000 = $ 20,000 from the contract. The profit
is 5000/15000 * 100 = 33.33%

2. The loss will be shared based on Capital contribution.

Capital contribution Abduallah (60%) and Anwar (40%).
So, Anwar will get (15,000 – 4000) = $ 11,000 at the end
of the contract.

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Case 3

Investor invested PKR 600,000 and the Bank

has contributed PKR 300,000. The return for
the year is around 12%. If the investor wants
to have a profit of 70% on his/her investment
and the bank wants to receive 60% on
investment.

a. Determine the profit sharing at the end of

the contract.
b. If there was a loss of PKR 300,000 then
determine the loss for both parties
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