Mudarabah

Mudarabah is a profit-sharing partnership contract in Islamic finance in which one party, the capital provider (rabb al-mal), entrusts money to another party, the manager or entrepreneur (mudarib), who invests it in a business activity. Profits are divided according to a ratio agreed at the outset, while financial losses fall on the capital provider, except where the manager has been negligent, has acted in misconduct or has breached the terms of the contract.

The contract is one of the main alternatives to interest-based lending in Islamic banking. Instead of earning a fixed return on money lent, which would be riba, the capital provider shares in the actual outcome of the venture.

Partnerships of this kind were common in the trade of pre-Islamic Arabia, where merchants financed caravans led by others, and they were accepted and regulated by the classical jurists as part of fiqh al-mu'amalat, the law of commercial dealings. Similar arrangements appeared in medieval European trade as the commenda, and Jewish law developed a comparable structure, the iska, to allow investment without forbidden interest.

The essential rules, as set out in the classical texts and in modern standards from bodies such as AAOIFI, are broadly these:

• The capital must be known in amount and handed over to the manager.
• Profit must be shared as a proportion of actual profit, for example 60:40. A fixed sum or a fixed percentage of the capital is not allowed, because it would turn the arrangement into a loan with a guaranteed return.
• The manager cannot guarantee the capital. A manager who is honest and diligent bears no financial loss but loses the value of the work done.
• The capital provider does not usually take part in management, though it may set conditions.

A mudarabah may be restricted (muqayyadah), where the capital provider limits the sectors, places or period of investment, or unrestricted (mutlaqah), where the manager has wide discretion.

An investor provides 100,000 to a trader under a mudarabah with a 70:30 profit split in the investor's favor. If the venture ends with 120,000, the profit of 20,000 is shared: 14,000 to the investor and 6,000 to the trader, and the investor also recovers the 100,000 of capital. If the venture ends with only 90,000 and the trader acted properly, the investor bears the 10,000 loss and the trader receives nothing for the work.

Islamic banks use mudarabah mainly on the funding side of the balance sheet. Holders of investment accounts act as capital providers and the bank acts as manager, investing the pooled funds and sharing the profit with account holders at agreed ratios. Banks may then act as capital providers themselves in a second layer of contracts, a structure known as two-tier mudarabah. To smooth returns between periods, many banks keep profit equalization and investment risk reserves, a practice that standard-setters such as the IFSB have addressed in their guidance on displaced commercial risk.

Mudarabah also appears in capital markets as the basis for some sukuk, in takaful models for managing participants' funds, and in project or venture financing. On the asset side, banks tend to prefer sale and lease contracts such as murabaha and ijarah, which produce more predictable returns.

Because the capital provider cannot demand a guarantee, mudarabah exposes it to the manager's honesty and skill, a problem economists describe as information asymmetry and moral hazard. Verifying actual profit requires good accounting and monitoring. Critics argue that the practice of smoothing returns to investment account holders makes them resemble conventional depositors, while the bank holds the funds without the same capital charge, raising both governance and Sharia non-compliance risk concerns. Supervisors and each bank's Sharia supervisory board are expected to check that profit sharing is genuine. Mudarabah differs from musharakah, in which every partner contributes capital and losses are shared in proportion to contributions.