Islamic banks apply Mudarabah

Islamic banks apply Mudarabah

Islamic banking, also known as non-interest banking, operates on principles of Islamic law (Sharia) which prohibits collecting or paying interest. Instead, Islamic banks use profit-and-loss-sharing arrangements called Mudarabah as an alternative to interest-based financing.

What is Mudarabah?

Mudarabah is an arrangement between an Islamic bank and a client in which the bank provides 100% of the capital for a project while the client provides expertise, management and labor. Profits from the project are shared between the bank and client at a predetermined ratio, while financial losses are exclusively borne by the Islamic bank.

Mudarabah enables Islamic banks to earn profits for depositors instead of paying guaranteed interest, which is prohibited. At the same time, it allows clients of the Islamic bank to obtain finance without interest payments. Applied correctly, it results in equitable risk and profit sharing between the financier and the entrepreneur.

Types of Mudarabah Agreements

There are two major types of Mudarabah agreements:

Two-Tier Mudarabah

This is the most common type used by Islamic banks. The bank acts as the capital provider to businesses and entrepreneurs. It is similar to many types of business financing and credit options offered by conventional banks.

In a two-tier Mudarabah, the Islamic bank provides the capital required by a chosen client to finance a project or business venture. For example, an entrepreneur requiring $100,000 to open a restaurant can enter into a Mudarabah contract with the Islamic bank, which provides the entire amount.

The client can then use their expertise to manage the restaurant while sharing a percentage of the profits with the Islamic bank based on the terms of the contract. The bank can also charge consultancy fees for services provided to the client. If the restaurant suffers losses, the Islamic bank absorbs it all under a two-tier Mudarabah.

One-Tier Mudarabah

In a one-tier Mudarabah, the client acts as a partner (rabb-ul-mal) along with the Islamic bank to provide financing to a project requiring capital.

For example, the client can deposit $50,000 with the bank to finance a real estate project. The bank then provides additional capital to meet the project’s needs, say $200,000.

Here the client and the bank jointly finance the project as partners through capital investment. They subsequently share profits according to each party’s proportional contribution.

However, losses are divided based on equity share – the bank takes a greater share as it contributed 80% of the capital. The client also shares in some part of the losses, unlike a two-tier Mudarabah.

Also read: How to Get profit with interest ratio, Which Banks give more profit In Pakistan

Application of Mudarabah by Islamic Banks

Islamic banks use Mudarabah agreements in various forms to conduct business and earn profits for their depositors.

The primary use is for financing private or public companies seeking working capital or project finance. Similar to conventional banking, Islamic banks study the viability of proposals before entering into a Mudarabah contract with the client.

Islamic banks also use interbank Mudarabah — partnering with other Islamic banks to jointly finance large projects or infrastructure ventures. This spreads the risk and enables pooling of funds.

For individual customers, Islamic banks apply Mudarabah via savings accounts and fixed deposits. Customers place deposits expecting to earn profit income instead of interest. The bank aggregates these deposits in a joint pool and invests them in Sharia-compliant financing activities to generate gains. After deducting administrative costs and fees, the net profits are shared with all depositors according to a pre-agreed ratio. Any losses are borne entirely by the bank without passing it to individual depositors.

Some Islamic banks also use Mudarabah for transactional products like credit cards. As an alternative to fixed interest charges on outstanding balances, the cardholder and bank can agree to share profits from the fund pool in which the Islamic bank invests the credit amount.

Conclusion

As a core principle of Islamic banking, Mudarabah allows financial institutions to conduct ethical financing and commercial activities without dealing in interest. By sharing risks and profits, it ensures equitable distribution of wealth gained through partnerships between finance providers and entrepreneurs. Though certain aspect like deposit insurance may require further standardization, Islamic banks apply Mudarabah in diverse ways to offer Sharia-compliant returns to account holders while providing essential capital to businesses and development projects.

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