Case Studies in Islamic Banking and Finance:

Case Questions & Answers

by Brian Kettell
Copyright 2011, Brian Kettell

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Case Study 4: Mudaraba Contract
4.1 LEARNING OUTCOMES
After working through Case Study 4 you should be able to do the following:

r Dene the Mudaraba contract.

r Explain the treatment of money within Islam.
r Distinguish a conventional loan from a Mudaraba contract.
r Describe the elements of a Mudaraba transaction.
r Contrast Mudaraba with the other modes of Islamic nance.
r Describe the different types of Mudaraba.
r Identify the Arabic terminology used in Mudaraba.
r Explain the practicalities of implementing Mudaraba.
r Identify the reasoning behind the Shariaa rulings on Mudaraba.
r Explain the practicalities of implementing two-tier Mudaraba.
r Describe the Shariaa rulings on Mudaraba.
r Identify problems with applying Mudaraba.
r Explain the importance of deferred sales within Islamic nance.
r Explain how Mudaraba can be used for home nance.
r Identify the deferred sale versus prot and loss share contracts.
r Explain how Mudaraba can be used for Islamic fund management.
4.2 MUDARABA AS A MODE OF ISLAMIC FINANCE
Case Abstract
Within the Islamic nancial system the purest alternative to charging and receiving interest
is nancing on a prot and loss partnership basis. The basic principle of prot and loss
sharing (PLS) is that, instead of lending money at a xed rate of return, the banker forms a
partnership with the borrower thereby sharing in a ventures prots and losses. Mudaraba
is a form of partnership where one party provides the funds while the other provides the
expertise and management. Any prots are shared between the two parties according to
pre-agreed ratios, whereas any loss is borne only by the provider of the capital. This case
study describes the workings of the Mudaraba contract.

4.3 MUDARABA AND PLS PURE ISLAMIC BANKING

The basic principle of PLS is that, instead of lending money at a xed rate of return, the banker
forms a partnership with the borrower thereby sharing in a ventures prots and losses. If the
returns are good the prots are shared equitably, and so the return to the investors depends on
the protability of the investment. Nothing is pre-xed.

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The PLS system allows a capital-poor, but potentially promising, entrepreneur to obtain
nancing. The bank, being an investor, has a stake in the success of the venture.
The principle applied is that the entrepreneur, rather than being concerned with debtservicing, can concentrate on a long-term endeavour that in turn will hopefully bring economic
and social benets to the community, as well as to the parties concerned. Muslims argue that
this system is fairer to both parties in the transaction, with the effect that no one exploits
anyone else.
The two purest forms of PLS are Mudaraba, which comes in Tier 1 and Tier 2 versions,
and Musharaka.
Mudaraba is a form of partnership in which one party provides the funds while the other
provides the expertise and management. The two parties share any prots between them
according to pre-agreed ratios, but any loss is borne by the provider of the capital alone.
In contrast, Musharaka is a partnership agreement whereby an Islamic bank provides funds,
which are mixed with the funds of the business enterprise, and sometimes others. All the
providers of capital are entitled to participate in management but are not necessarily required
to do so. Under the Shariaa the prot must be distributed among the partners in pre-agreed
ratios, and any loss is borne strictly in proportion to respective capital contributions.

4.3.1

Mudaraba Prot Sharing Agreement

The Mudaraba contract is structured between the supplier of capital and the entrepreneur who
services it. One party supplies the capital to a second entrepreneurial party (the Mudarib)
for the processing of some business activity on the condition that the resulting prots are
distributed in mutually agreed proportions and all capital loss is borne by the provider of the
capital. In the latter case, the entrepreneur does bear some loss the opportunity cost of his
time and labour but not any direct nancial loss.
The Mudaraba contract is a contract between two parties whereby one party, the Rab ul
Mall (the sleeping partner or beneciary), entrusts money to the other party, the Mudarib (the
working partner or managing trustee). The Mudarib agrees to use the money in an agreed
manner and then return to the Rab ul Mall the principal and the pre-agreed share of the prot.
The Mudarib is then rewarded with the pre-agreed share of the prot.
The predominant manifestation of Mudaraba is the two-tier Mudaraba model. The rst tier
(liability side) is formed when depositors place their funds with an Islamic nancial institution
that takes up the role of the Mudarib. Mudaraba here is the investment deposits side of the
Islamic banks balance sheet. The bank then invests these deposits with entrepreneurs in the
second tier (asset side) where the bank acts as the capital investor. Islamic nancial institutions
prots arise from a percentage of the returns from the second-tier Mudaraba.
The following Shariaa characteristics of Mudaraba are of signicance:

r The division of prots between the two parties must necessarily be on a proportional basis
and cannot be a lump-sum or guaranteed return.

r The investor is not liable for losses beyond the capital he has contributed.
r The Mudarib does not share in the monetary losses except for the loss of his own time and
effort.

r The Mudaraba can be general purpose (unrestricted Mudaraba) or for a specic purpose
(restricted Mudaraba).

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As regards this last point, when the nancial institution invests its own capital, alongside
the capital procured by the bank with the depositors funds, this is known as a prot sharing
unrestricted investment account.
The unrestricted mode of Mudaraba is identical to an investment fund in which managers
handle a pool of funds. The agent-manager has relatively limited liability while having sufcient incentives to perform. The capital is invested in broadly dened activities and the terms
of prot and risk sharing are customised for such investment. The maturity structures range
from short to medium term and it is suitable for commercial activities.
Mudaraba offers the opportunity of pure nance in the sense that the owner of the capital
can invest without having to manage personally the capital investment and without having to
be exposed to unlimited liabilities. However, Mudaraba (and Musharaka) are distinct from
conventional lending with interest receivables in that, it is argued, they maintain a fair balance
between the owner of the capital and the entrepreneur who implements it. Distribution of
prots is agreed according to a predetermined proportion of the total and each party only loses
what they put into the investment, be it capital or labour. As Shariaa scholars put it:
It is important to note that in Mudaraba and Musharaka the principal amount of funds and a
xed prot cannot be guaranteed.

Box 4.1 illustrates the Mudaraba terminology.

Box 4.1 Mudaraba terminology

Mudaraba Tier 1
Rab ul Mall: Bank depositor as supplier/owner of capital; contributes capital, no expertise
Mudarib: Islamic bank as demander of capital; contributes expertise, no capital
Mudaraba Tier 2
Rab ul Mall: Islamic bank as supplier/owner of capital; contributes capital, no expertise
Mudarib: Borrower-entrepreneur as demander as of capital; contributes expertise, no capital

4.3.2

Shariaa Rules for Mudaraba

With a two-tier Mudaraba, the bank and the Mudarib, as depositor, pool funds to fund a
specic enterprise. In this case they are both fund providers (Rab ul Mall). The Mudarib fee
could be a xed fee (to cover management expenses) and a percentage of the prots, or a
combination of the two.
A pure form of Mudaraba is based on PLS, and in this case the only reward to the Mudarib
is the prot share. The balance of the prot of the enterprise, after deducting the prot share
due to the Mudarib, is payable to the bank.
If the enterprise makes a loss the capital providers make the losses.
If the Mudarib receives a fee, and any losses are due to negligence on his part, then he
forgoes the fee.

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4.3.2.1 The Mudaraba Shariaa PLS Allocation Rules

No co-mingling of funds
In this case, the bank and the Mudarib (entrepreneur) do not accrue prot share of the same
amount. The Mudarib can provide capital as well as management expertise and labour. The
bank only provides capital.
Where there is no capital sharing but only prot and loss sharing, the PLS Mudaraba split
will be directly as agreed say 50/50.
Co-mingling of funds
When there is co-mingling of funds between the Mudarib and the bank (Mudaraba funds),
the Mudarib becomes a partner in respect of his funds and a Mudarib in respect of the capital
provider. The prot earned on the co-mingled funds will be divided proportionately to the
amounts contributed. The effect is that the Mudarib takes the prot attributable to his own
funds, both capital share and prots share. The remaining prot is distributed between the
Mudarib and the capital provider according to the provisions of the Mudaraba contract.
There is no co-mingling of funds permitted under the standard Mudaraba contract.

4.4 CASE 1: SHARIAA ISLAMIC BANK

The relationship between the Shariaa Islamic Bank and its investment account holders is
governed by the Mudaraba contract, as shown in Table 4.1.
Table 4.1 Shariaa Islamic Bank: Mudaraba accounts
Average funds available for investment
Shareholders
Investment Accounts: One Year
Investment Accounts: Six Months
Investment Savings Accounts*
Total funds available for investment
Prot-sharing ratio:
Investment Accounts: One Year
Investment Accounts: Six Months
Investment Savings Accounts
Income for allocation
Income to be allocated
*

Dinars

Dinars

150,000,000
450,000,000
700,000,000

130,000,000

1300,000,000
1430,000,000
Mudarib
15%
20%
30%

Investment rate
100%
90%
80%
60%
Depositors
85%
80%
70%

75,000,000

These are investment accounts for short periods

4.4.1

Case 1 Questions

1. Calculate the prot allocated to shareholders and to each class of prot-sharing accounts
before and after the Mudarib share has been paid.


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2. Calculate the rate of return for shareholders and each class of investment account after the
Mudarib share has been paid.


Please ll in Table 4.2 as part of your answer.

Table 4.2 Prot and rate of return calculation
(1) Average
funds available (2) Investment
for investments rate

(3) Weighted
average of
invested funds
(1 2)

(4) Percentage
of weighted
average of
invested funds

Shareholders
Investment
accounts: one
year
Investment
accounts: six
months
Investment savings
accounts
Total funds
available for
investment
(7) Shareholders
(5) Net prot
(6)
from investShareholders share of the
Mudaribs prot*
ments(millions) share of net
prot before the
Mudarib share
(4 5)
Shareholders
Investment
accounts: one
year
Investment
accounts: six
months
Investment savings
accounts
Total funds
available for
investment
*

Column six multiplied by shareholders ratio of prot allocation.

Residual accruing to shareholders after payment to investment account holders.

**

(8) Distributable (9) Rate

prot after
of return
shareholders
(8/1)
share of the
Mudaribs prot
(6 7)**

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Case Studies in Islamic Banking and Finance

4.5 MUDARABA CONTRACT WITH VARIOUS PARTNERS

This section illustrates how a simple Mudaraba contract can be made more exible.
Often a contract may be combined with various other mechanisms for fund raising. In such
a facility, a variety of Mudarib/entrepreneur relationships can contribute to the capital of the
venture as does the Rab ul Mall nancier.
For each of the ve Mudaraba cases listed below, both protable and unprotable scenarios
are possible. For each case study, you are asked to calculate the following and make clear any
assumptions that you have made:

r In the case of prots, the actual prots and capital share received by all the parties.
r In the case of losses, the amount of capital that is returned to all the parties.
4.5.1

Case 2 Questions

The Mudarib contributes none of his own capital into the project. The bank contributes capital
of 100 on a Mudaraba basis. No other capital sources are used. PLS is agreed at a ratio of
50/50. Prots are paid to the Mudarib as a reward for the successful operation of the business.
The balance of any prot is paid to the other partner(s) in the scheme.
Provide the solutions to two potential outcomes:
3. Prots of 10 are made
4. Losses of 10 are made
 3.

 4.

4.5.2

Case 3 Questions

The Mudarib contributes 100 of his own capital into the project. The bank contributes capital
of 100 on a Mudaraba basis. No other capital sources are used. PLS is agreed at a ratio of
50/50. Prots are paid to the Mudarib as a reward for the successful operation of the business.
The balance of any prot is paid to the other partner(s) in the scheme.
Provide the solutions to two potential outcomes:
5. Prots of 20 are made
6. Losses of 20 are made

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 5.

6

4.5.3

Case 4 Questions

The Mudarib borrows 100 capital from the bank which he invests into the project. This loan
must be repaid at the maturity of the project whether prots or losses are made. The bank
contributes capital of 100. No other capital sources are used. PLS is agreed at a ratio of 50/50.
Prots are paid to the Mudarib as a reward for the successful operation of the business. The
balance of any prot is paid to the other partner(s) in the scheme.
Provide the solutions to two potential outcomes:
7. Prots of 20 are made
8. Losses of 20 are made
 7.

 8.

4.5.4

Case 5 Questions

The Mudarib acquires 100 capital through a third party Mudaraba. The Mudarib invests 100 of
his own capital into the project. The bank contributes capital of 100. No other capital sources
are used. PLS is agreed at a ratio of 33/33/33. Prots are paid to the Mudarib as a reward for
the successful operation of the business. The balance of any prot is paid to the other partner(s)
in the scheme.
Provide the solutions to two potential outcomes:
9. Prots of 30 are made
10. Losses of 30 are made

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Case Studies in Islamic Banking and Finance

 9.

 10.

4.5.5

Case 6 Questions

The Mudarib acquires 100 capital from a business partner. The Mudarib invests none of his
own capital into the project. The bank agrees to the partnership agreement and contributes
capital of 100. No other capital sources are used. The Mudarib and the partner agree a PLS
ratio of 50/50. The bank and the Mudarib agree that the bank will receive half of the prot
earned by the Mudarib. Prots are paid to the Mudarib as a reward for the successful operation
of the business. The balance of any prot is paid to the other partner(s) in the scheme.
Provide the solutions to two potential outcomes:
11. Prots of 20 are made
12. Losses of 20 are made
 11.

 12.