Principles of Islamic Banking

By:
Prof. Dr. Mohd. Ma’sum Billah
masum@applied-islamicfinance.com
masum2001@yahoo.com
+6019-3699542

INTRODUCTION

Since man is not self sufficient in all matters trade was and still is common practice in the lives of human beings. During the pre-Islamic period, Arabs and the rest of the world were trading based on systems which had in common exploitation. The coming of Islam and the wisdom of the Prophet Mohamed (SAW) revealed to him by Allah (SWT), have cleared the society from all evil doings and have spread justice. Justice was spread in all sectors including the business sector.

Islam permits increase in capital through trade. Referring to this, Allah Almighty says:

“O you who believe, do not consume your property among yourselves wrongfully, but let there be trade by mutual consent...” (An-Nisa’: 29)

In another verse of the Qur’an:

“…whereas Allah permitteh trading and forbiddeth riba…” (Al Baqarah: 275)

Literally, Riba means increase, expansion or growth; technically it refers to the premium or additional amount paid by the borrower to the lender along with the principal amount as a condition for the loan.

In this sense the practice of riba resembles much the practice of interest in the modern banking system whereby the entrepreneurs borrow money from banks on the condition that they will return the amount with a pre-fixed additional amount.

However, in view of the prohibition of interest in Islam, and that banking is vital in economies; it has been agreed on an interest- free system for banking.

The Prophet Muhammad (SAW) said that: “Allah affirms that until one of the two partners breaks the trust, I remain their partner”

Although many types of partnership exist, we will focus in the following on the practices of musharakah (mercantile partnership) and mudharabah (dormant partnership). In fact those practices were already in use during the pre-Islamic period, but the Prophet (SAW) legitimized them as permissible practices under the Islamic Law.

AL- MUSHARAKAH

Literally, al-sharikat means a sharing or a partnership. Technically it means participation of two or more persons in a certain business with defined amounts of capital contributed by each one of the partners.

Al-sharikat is a recognized way of doing business under the Islamic Law. With the arrival of Islam al-sharikat or mercantile partnership was actually legitimized as business practice because it was already widely used during the pre-Islamic period. The Islamic schools of fiqh recognize this type of business they only differ in their conditions of application.

Under the four schools, we have al-mufawadah, al-inan, al-abdan, al wujuh.

The first one is recognized under the …., and is characterized by full authority and obligation ,the second one gives only restricted authority and obligation and doesn’t give any restriction for the age of the partners, in other words there is no need to be adult. Inan is defined as a partnership contract without condition for complete equality.

The following one al abdan is whereby the partners contribute management, labor and skill and is recognized under the...

The last one al wujuh takes place when the partners enter into a contract based on goodwill, credit-worthiness.

Because al inan is the most widely used in modern business nowadays, the following will be based on sharikat al-inan.

In sharikat al inan, all partners need not to be adult, and contribute equal share in the capital which can be in money terms or goods. This partnership is equivalent to a mutual procuration, each partner is answerable to third person for his own transaction.

Concerning the management of the partnership, every partner has equal right of participation unless specified; all of them can participate in the leadership of the company as well as none is in the obligation to assume any role of responsibility however nowadays in modern business, one or two of the partners are selected and given the roles of managers whereby they have to handle most of the work. Moreover when a contract of musharakah is made the condition of agency is automatically presumed to be in existence. All partners act as agent for the others, unless specified.

Upon setting the business and deciding who will take the rein of the business, the profits need to be distributed or the losses borne. In general, the bases for entitlement to the profits of a musharakah are capital, active participation and responsibility. However, the distribution of profit can also be made based on previously agreed terms not a fixed amount but on agreed percentages or ratios between the partners. If any of the partners participate in the success of the company more than the others he is given a bonus profit in the form of a salary.

Truly many are the partners (in business) who wrong each other: not so do those who believe and work deeds of righteousness, and how few are they? (38:24)

Eat not up your property among yourselves in vanities; but let there be amongst you traffic and trade by mutual goodwill...” (4:29)

From the tradition of the Prophet (SAW);

…and there was share between two partners, in a co-ownership, and whenever they withdraw or recess from partnership their properties are to be divided equally (in accordance with their respective participation).

In any transaction the risk of loss is present, and some basic principles have been set for the share in loss, because in the case of musharakah, the loss is the matter of all the partners. The general principle is that loss is to borne by all the partners according to their share in the capital, the one who has invested a lot will lose more than the others. But if the loss has been made by the mistake in judgment of one of the partners or by negligence, and that is proved right then that partner will be the sole bearer of the loss.

MUDARABAH

Mudarabah is a business arrangement whereby an investor or group of investors entrust capital or merchandise to an agent to invest in commercial enterprise. The partner who gives money is called rabb-ul-mal (commendator), and the one who is responsible for work and management is called mudarib.
Sources of ruling of Mudarabah in Qur’an are as follows:

“While others travel in the land (yadribuna fi’l-ard) in search of God’s bounty“ (Al-Muzammil: 20)

“And when the prayer is finished, then you may disperse through the land and seek the bounty of Allah” (Al-Jum’ah:10)

The above verses indicate that the contract of mudarabah is permissible in Islam.

There are also several evidences from the Prophet’s life which approve the use of this type of contract:

‘Abd Allah ibn Mas’ud, a companion of the Prophet, and al-Abbas ibn ‘Abd al-Muttalib, the uncle of the Prophet, engaged in mudarabah contract. The latter having obtained the prophet’s approval for the conditions he imposed upon his agent to whom he entrusted his money.

Profit and loss sharing

Share of profit in mudarabah should be agreed upon by the parties and specified in the contract itself. Proportion should be decided by mutual consent of both parties. However, they cannot apportion a lump sum amount of profit for any party. Division of profit is possible only after capital has been returned to the investor. Apart from the share of profit, the mudarib cannot claim any periodical salary for the work done by him.

Should there be any loss, it will be suffered only by the investor.

Loss distribution rule arises from the market risks; it looks unfair to rabb-ul-mal to bear the risk alone while mudarib goes free. For example, 50,000 is invested in the mudarabah business and sales only amounted to 20,000. The corresponding loss of 30,000 shall fall on rabb-ul-mal. Although mudarib does nod have any financial losses, his loss can be stated in the term of opportunity cost, the money that he could earn by working somewhere else. Mudarib will not bear any loss because he does not invest any capital. His loss is limited to the fact that his work has gone in vain and it did not bring him any benefits. His loss is the time that he spent on doing his job.
However, this principle is limited to the fact that the mudarib has worked and put all his efforts in doing job efficiently. If he was careless about his tasks, he should be liable for the loss.

All assets are owned by the investor. Mudarib is not entitled to claim his share in the assets, even if their value has increased.

Termination of Mudarabah

Both partners have right to leave the contract at any time. The only condition for termination is to give a notice to the other party. At the end of mudarabah all assets shall be liquidated and the money received distributed according to the profit sharing ratio.

Mudarabah in Islamic Banking

Having explained principles of mudarabah we shall discuss its application in todays banking system. Islamic banks use mudarabah as a mean to attract deposits. Mudarabah investment deposits are an investment product based on profit –sharing principle. The bank is in this case mudarib, and depositor is rabb-al-mal. The bank does not guarantee both capital and returns but the returns can be profitable if the investment turns to be successful. This works on a principle no pain no gain.

The use of mudarabah financing in the banking did not get as much attention as its use in fund management. As an example we can mention Lembaga Tabung Haji (LTH) and Metrowangsa case, the latter serving as the mudarib was entrusted to manage LTH’s investments on a profit-sharing basis.

Musharakah and mudarabah as modes of financing.

Musharakah and mudarabah are used by Islamic banks as well other individuals who are willing to finance a project.

The financing can take place on single transaction, whereby one person need to import or export some products but do not have the necessary capital; he might ask the bank or another individual.

In the first case, once the imported goods are sold, then the profit is shared among the partners according to a pre-agreed ratio. If at one point the goods cannot be fully sold and that one of the partners wants to withdraw from the transaction, the other can buy back the share of that partner, at an agreed price on the date of sale.

In the case of export financing, the return is almost already known because one has to export a certain amount of goods at an agreed price with the other party, therefore the investor in the project is more confident and it will be agreed on a percentage of share in the profit; however it can be agreed also that as anything can happen during the delivery due to negligence on the part of the exporter, the last will be sole bearer of the loss, however not in terms of capital.

These practices of Islamic banking are not to be applied only with a start-up business but also for a running business. In other words if in the course of a business, there is a need for more capital, the bank or another individual can volunteer in giving the needed capital; in that case, the already existing capital will be considered as one, the capital will considered as the investment of the person looking for more capital and the new capital will be considered as the share of the new partner/financier in the capital.

Application:

The total business of the value of A is 30 units and B finances another 20 units, raising the total worth to 50 units; 40%having been contributed by B and 60% by A. Therefore A should get 20% of the actual profit .If at the end of the term ,th total profit has increased to 100 units, and that A wants to purchase the part of B then he should pay him 40 units because he owns 40% of the assets of the business. However the partners and the new partner can agree on different terms.

In the case of loss, the rule is that it should be divided between them following the share in the capital.

CONCLUSION

The basic principles of musharakah and mudarabah are:

Nowadays people are more reluctant to follow the Islamic mode of financing based on some assumptions such as a greater risk of loss and the fear of dishonesty.

For the first case, it is argued that the loss incurred by the bank in engaging in a non successful partnership in the form of musharakah or mudarabah, will lead to a loss of the depositors in the bank whom will be less confident in the banks.

But it must be assumed that banks in accepting the contract of financing will examine each and every point of the contract. Moreover, banks will not engage in only one partnership and therefore it is unlickely that all the contracts will lead to a failure and a loss.

In the other case it is argued that dishonest clients may exploit the instrument of musharakah or mudarabah by not paying any return to the financiers. They can always show that the business had made a loss. But if all banks in a country are run on pure islamic pattern with a careful support this theory does not hold because first of all a well designed system of auditing shall be implemented whereby all the clients accounts are controlled.

Islamic banks should consider the mudarabah and musharakah financing models seriously if it desires to command a market niche. Rules of mudarabah protects the bank from moral hazard since firstly, fixed salary does not constitutes mudarabah expenses. Secondly, as a form of unlimited liability partnership, the mudarabah contract will not prevent the rabb-ul-mal to claim the personal wealth of the mudarib.

Islamic banks should see Musharakah and Mudarabah as a fresh opportunity to venture into entrepreneurial financing.