LECTURE 3: INTRODUCTION TO HISTORICAL ISLAMIC FINANCE PRODUCTS MUDARABAH AND ITS MODUS OPERANDI The classical mudaraba was an arrangement in which a principal, rab al-mal, entrusted his capital to an agent, mudarìb, who was to trade with it and then return to the investor the original capital plus a previously agreed-upon share of the profits. As a reward for his entrepreneurship the agent received the remaining share of the profits. In general, profit and loss are shared according to the rule: profit follows mutual agreement and loss follows the capital invested. MODUS OPERANDI Cash K Principal K+ απ E Agent (1-α) π π Loss THE SIMPLE MUDARABA HAD THE FOLLOWING CHARACTERISTICS: 1. There are two partners, a principal (Rab al-mal) and an agent (Mudarib). 2. Entire capital is provided by the principal. 3. Agent contributes only his time, effort and knowledge. He does not contribute to the partnership with capital. 4. Agent takes the capital and tries to generate profit with it. 5. Venture is concluded when the agent returns the original capital to the principal. 6. Profit, if any, is shared either according to mutual agreement or capital invested. This mutual agreement is in the form of percentages and it is clearly stated in the contract at the beginning of the venture. 7. If there is loss, entire pecuniary loss accrues to the principal. Agent goes unpaid for his effort but does not suffer any pecuniary loss. 8. In general, profit and loss sharing is done according to the Hanafite rule: profit follows mutual agreement, loss follows capital. Since, in mudaraba, the entire capital has been provided by the principal, entire pecuniary loss accrues to him. Principal may lose his entire investment in the venture. But notwithstanding this, the principal’s liability is limited in the sense that he is not responsible for the agent in transactions with third parties. Indeed, third parties may not even be aware of the investor’s existence. The responsibility for all contact with third parties resides with the agent. 9. Principal may lose all capital not beyond the original investment. 10. 3rd party not aware of the investors existence. 11. Mudharib may incur loss in negligence. THE SIMPLE INAN PARTNERSHIP The most important characteristic of ‘Inan partnership is the permission granted to each partner to invest different amounts. By the same token, equal amount of investment but unequal distribution of profit is also permitted. Moreover, the partners are not force to invest their entire property. In a simple ‘Inan partnership, the agent seeks greater profit share than is possible in Mudharabah for which he agrees to shoulder greater risk. He does this by contributing to the capital of the partnership in addition to his entrepreneurship. MODUS OPERANDI Capital K1>K2 Principal 1 (Rab al mal) 1 Joint Capital K1+K2 Managed by one or both of the principals Profit Loss K2 Principal 2 (Rab al mal) 2 Capital + Profit share as mutually agreed (Hanefite) Capital + profit share as mutually agreed ( to both principals) To both principals (In proportion to K1 and K2) K1: Capital contributed by the first principal K2: Capital contributed by the second principal CHARACTERISTICS OF ‘INAN: 1. 2 parties. 2. Both parties contribute unequal amounts of capital. 3. Agent contribute smaller capital than the other partner, also his time, knowledge & effort. 4. Agent takes all capital physically & generate profit. 5. Venture concluded when the agent return back the original capital to the principal. 6. If there’s a profit, share according to mutual agreement in a form of % by Hanafite & according to other schools, based on capital contribution. 7. Loss – based on capital contribution. 8. Liability to 3rd party – unlimited, several but not joint. 9. Termination: 2 partners – if 1 died & insane, ‘Inan is terminated. More than 2 partners – partnership will continue. The died & insane partner’s share will be inherited to his family. THE SIMPLE MUFAWADA In still another classical partnership form, the mufawada, partners contribute capital in exactly equal amounts to the venture and share profits, as well as losses, in exactly equal proportions. CHARACTERISTICS OF MUFAWADAH: 1. 2 parties. 2. Both parties contribute equal amounts of capital. 3. Profit & loss contributed equally. 4. Liability to 3rd party – unlimited, several & joint. 5. Termination: a) Mutual consent of partners. b) Expiration of contracts. c) Accomplishment of aims. d) If equality of capital lapses. e) 2 partners – if 1 died & insane, ‘Inan is terminated. f) More than 2 partners – partnership will continue. The died & insane partner’s share will be inherited to his family. THE MULTIPLE MUDARABAH Since Islamic law of partnerships allows the agent, to pool the capital of several principals, total capital entrusted with a single agent can be considerably enhanced. This brings us to the “multiple mudaraba”. The term “multiple” here refers to the multitude of principals, who pool their capital and entrust the thus pooled capital to a single mudarib, agent. The great achievement of the multiple mudaraba (and inan) is that it has made it possible for various merchants to pool capital to finance an agent. Conversely, a principal is also permitted to finance a multitude of agents, thus diversifying his risks. MODUS OPERANDI P1 K1 K2 P2 Pn Agent Kn Profit on mutual agreement According to capital contribution π Loss CHARACTERISTICS OF MULTIPLE MUDARABAH: 1. Partnership allows agent to pool the capital of several principals – total capital entrusted with a single agent can be enhanced. 2. Purpose – economies of scale. 3. Sign separate agreement between all capital provider with 1 agent. 4. Profit – acccording to mutual agreement. 5. Loss – borne by the principals according to their capital contribution. 6. Agent not liable for the pecuniary loss. THE EXPANDED INAN Permited for active ‘Inan partner to enter into a separate partnership with a 3rd person. If the new partnership is unrelated to the basic activity of ‘Inan – no need to obtain approval of other ‘Inan partners. If the new partneship is related – permission is needed. The active partner can mingle the capital of partnership with his own capital so as to have a greater bargaining power vis-a-vis a 3rd party. The active partner can use partnership capital to establish another ‘Inan partnership with a 3rd party. MODUS OPERANDI P2 P1 K1 > K2 K2 Joint Capital K1 + K2 Agent P2K2 P2 Profit on mutual agreement Expanded ‘Inan K1 + K2 + P2K2 π According to capital contribution K3 P3 Profit on mutual agreement According to capital contribution Loss STEPS OF EXPANDED ‘INAN: 1. K1 & K2 is entrusted to P2 as the agent – K1>K2. 2. Then P2 will contribute his own fresh capital – total capital become K1+K2+P2K2. 3. This will make an expanded ‘Inan. 4. P2 will make a separate contract with P3 – with K3 added. 5. Total capital for expanded ‘Inan will be K1+K2+P2K2+K3. 6. Profit declaration: a) 1st declare to P3. b) P2 declare his share according to his proportion of additional capital. c) Remaining will be shared according to mutual agreement between P1 & P2. Hanafi – Profit according to mutual agreement. Other school – profit according to capital contribution. 7. Loss – according to capital contribution of all partners. THE BIRTH AND EVOLUTION OF MODERN ISLAMIC BANKING Islamic finance is considered to be based upon five basic principles: 1. The ban on interest must be obeyed 2. The ban on uncertainty or speculation: uncertainty in contractual terms and conditions is forbidden. But when all conditions and terms are known to all parties, risk taking is allowed. 3. The ban on certain products must be obeyed. 4. Profit and loss sharing must prevail. Parties to a financial transaction must share in the risks and rewards. 5. Each financial transaction must refer to a tangible, identifiable underlying asset. Liability side of an Islamic bank is divided into two windows: demand deposits and investment balances. The model has 100 percent reserve requirement for the demand deposits and no reserve requirement for the investment window. This is because, demand deposits are amanah (trust) deposits and the bank may not use them as the basis for money creation through fractional reserves. Investment accounts are, however, invested with the full knowledge of the depositors that their funds are invested in risky projects and therefore no guarantee is granted. ISLAMIC BANK LIABILITY/DEPOSIT SIDE (INVESTMENT ACCOUNT) Depositor/ investor 1 Mudaraba Depositor/ investor 2 Islamic Bank (mudarib) Combined capital Mudarib`s fee: 20%, can go upto 40% Depositor/ investor n Original capital plus ca.80% of profits Remaining share of the profits Shared between the depositors in proportion to their invested capital Profit Loss FINANCING SIDE Murabahah In modern Islamic finance murabaha is utilized as a mode of asset financing. The purchase price is a marked-up price, which is made known before the transaction. Islamic financial institutions (IFI) executing the murabaha are expected to furnish the purchase orderer with full and correct information on cost and profit. Murabaha comprises several other features as well: price of murabaha sale; asset of murabaha sale; duty of full disclosure of cost and profit; and wa’d, promise to buy. ASSET SIDE Islamic Bank Murabaha Entrepreneur 1 Cash from investment accounts Profit Agent Principal Entrepreneur n Mudarib fee 20%-40 % Investment risk reserves Profit Equilization Reserve Loss CONCLUSIONS: Modern Islamic banks are facing tough challenges from the conventional sector; They are under pressure to provide their depositors rates of returns commensurate with what the conventional competitors provide; There is a huge need to introduce completely Shari`ah compliant, or even better, Shari`ah based instruments to evaluate the needs of these savers. Thank you