The Mudaraba Contract: An Important Islamic Finance Concept

Mudaraba Contract

Mudaraba contract is one of the main Islamic Finance products. In this article, we will talk about what is Mudaraba and the types of Mudaraba. Also, we will discuss some of the challenges that come with the product.

What is Mudaraba?

Mudaraba refers to a bank’s investment made on behalf of a customer. It takes the form of a contract between two parties; one providing the financial capital and the other contributing expertise, and the parties agree to share any profits made in advance. To put it another way, the bank engages in Shari’a-compliant investments and splits the profits with the customer. In case there is no profit, the loss is borne by the customer. Mudaraba is a contract in which one party (the investor or Rabbul Mal) pays money and the other party (the management or Mudarib) performs the task. If the project is profitable, the parties share the profit according to the predetermined ratio.
You can understand Mudaraba as being similar to the function of an asset manager.

Restricted versus Unrestricted Mudaraba

Unrestricted capital can be provided for any purpose that the manager considers fit (Mudaraba al Mutlaqah). Restricted Mudarabah refers to a Mudarabah contract in which the investor has specified investment details and has limited the working partner to such details (Mudaraba al Muqayyadah).

Two-tier Mudaraba

Two-tier Mudaraba was the initial concept for Islamic banking. The structure was created so that the Islamic bank can engage in two different Mudaraba transactions; one with depositors and one with those to whom it provides financing. The first Mudaraba is between the bank and the client having surplus capital (depositors) and the second one is between the bank and the clients who require financing.

The concept was developed by Islamic economists as a credible alternative to saving accounts. So in a two-tier Mudaraba, the bank provides an intermediation role between depositors and customers.

Issues with Mudaraba

One of the major challenges of the Mudaraba form of funding is that there is no legal foundation in most countries’ current business laws, particularly in Muslim-minority countries, that can be relied on in the event of a disagreement. As a result, the Mudaraba Agreement must be comprehensive and include all relevant information.

The other main flaw is that specifying a time limit (timeframe) in the Mudaraba. It renders the void because the idea of Mudaraba is to continue the contract until the other partner completes the work and collects the proceeds.

The Mudaraba Agreement must be comprehensive and detailed to cover all aspects of the work and how to deal with each possible risk. The financial structuring should be appropriate to the type of project in hand in order to minimise the possibility of a mismatch between spending and work completion and misappropriation of funds.

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