Definition
Mudarabah, or the so-called silent partnership in Western finance is characterized with the giving of the capital by a partner who is called "rabb-ul-mal" to another person who is called the mudarib (Omar, et.al, 2013). Simply, the investment comes from the rabb-ul-mal, who is oftentimes referred to as the first partner, while the management of the investment is the sole responsibility of the mudarib or the working partner. In today's business concept, rabb-ul-mal are commonly banks, financing companies, and other intermediaries that provide necessary capital to businesses. In concept, mudarabah is an Islamic financing system that enables people to acquire capital for business ideas without direct violation on the prohibition of interest.
Here are some of the basic components of the mudarabah, as a distinct Islamic kind of partnership:
* In mudarabah, investment is the sole responsibility of the first partner or the rabb-ul-mal (Islamic Banker, 2011). The contract restricts the mudarib in sharing investment into the business. The mudarib shares only his talent and his time, just like the convention being used for the working partner of the Western partnership system (although, the working partner can still invest specific amount of money in the venture).
* Karim & Archer (2013) noted that the rabb-ul-mal has no specific, either direct or indirect, rights or responsibility to meddle with the affairs of the business; the decision making and the management of the business must be delegated in full monopoly to the mudarib,
* Mudarabah provides that in case of losses, the mudarib cannot be forced or required to share with the said loss (Islamic Banker, 2011). Rather, the loss is solely the burden of the rabb-ul-mal who provided the necessary investment or capital for the business.
* In mudarabah, the ownership of all the assets of the company is retained by the rabb-ul-mal, and the mudarib has no right over them, exempt the due usage for the creation of wealth. This means that even if the value of assets increase over the past years due to appreciation or good management, the mudarib cannot claim share over them.
Strictly, the concept of mudarabah is consistent with the ideas of partnership, but it is not consistent with the demand of partnership for equal rights to intervene in the decision making process on where their money will be invested. Yet, it must also be noted that in this concept of Islamic partnership, the mudarib serves as the financial manager and executor of the investment, but he is also entitled to profit sharing aside from the basic compensation.
Mudarabah can be executed in two approaches and ways. First, the unrestricted mudarabah partnership provides that the rabb-ul-mal can only specify the profit-sharing scheme that will be used, but the rabb-ul-mal does not specify the manner, time, work, and other conditions necessary for the business establishment and operation (Omar, et.al, 2013). Secondly, the restricted mudarabah allows the rabb-ul-mal not only to specify the profit-sharing rules, but also the conditions of the business work, place, and such other concerns. However, this does not allow the rabb-ul-mal to meddle with the affairs of the business when it is also operating and after the terms are met.
Liability Issue
In mudarabah, it is important to note the sharing of loss. Of course, the rabb-ul-mal has the right to create rules and agreements on how profit should be shared with the mudarib. However, this inherent right does not cover any demand for rules and terms on how losses are to be shared between parties (ʻUs̲mānī, 2004). By convention and definition of mudarabah, there is no actual sharing of loss, but losses are the liability of the investor or the rabb-ul-mal. The mudarib or the working partner is already considered losing in the sense that his time and effort were invested into the business that failed. And provided that loses are incurred due to the negligence and mismanagement of the mudarib, loss sharing can be applied (Timm, 2007). Yet, the principle is only applied within the definition or statement of losses categorized under the mudarib’s misconduct and negligence; all others will be carried for the rabb-ul-mal’s responsibility.
According to Karim (2010), the focus of the mudarabah is to eliminate the concept of the traditional lender/borrower relationship and to put a new concept of entrepreneur/investor relationship, in the perspective of Islamic banking system. As noted earlier, mudarabah ensures that there will be no violation on riba prohibition or the interest-bearing investment which is inadmissible in Islamic finance. In mudarabah, interest is not anymore a concern, but this special kind of partnership works for the sense of profit sharing between two parties, thereby forming a relationship between them.
However, if we look closely at the liability we find some issues that must be addressed properly. Of course, the liability of the rabb-ul-mal is only up to the amount of capital or finance being invested or entrusted to the mudarib. Comparing it with the Western idea of partnership, rabb-ul-mal, in this instance, can be considered as a limited-liability partner. For losses that are incurred by the business, provided that these losses are not due to the negligence and misconduct, or fraud and dishonesty of the mudarib, that are beyond the investment of the rabb-ul-mal, creditors cannot run after the assets of the first partner – and even to the working partner’s assets.
Karim & Archer (2013) noted that mudarabah is a profit-sharing and loss-bearing investments. Of course, when the business is making profit, rabb-ul-mal is entitled to receive the share of profits, as provided by the terms and conditions made prior to the entrustment of the money or capital to the mudarib. Yet, during losses, no term and condition is applied. The simple convention is that if the business needs to wind up due to large loss over its operations and the impossibility of making profit or even in coping up with the losses, the amount of loss will be credited wholly to the investment of the rabb-ul-mal, and the remaining assets will be returned to rabb-ul-mal. This concept is consistent to the mudarabah character which states that all assets are owned by the rabb-ul-mal.
On the side of the rabb-ul-mal, we find that mudarabah concept in negative effect because losses are made, even in good faith and without fraud and misconduct, without the direct discretionary supervision of the financier. This means that the financier has no other choice, but to accept the reality that the invested capital won’t be recovered anymore. Yet, if we look at the side of the mudarib, we also find the concept of mudarabah in the same negative notion. When losses are incurred and the business winds up, all assets will be returned to the rabb-ul-mal after all creditors are satisfied, but the mudarib receives nothing even if he has helped to acquire or grow those assets.
Moreover, the mudarabah concept becomes more of gambling investment, the same was the Western speculation investment. On the side of the rabb-ul-mal, it is a form of gambling over the outcome of something that he does not have control over with. While for the mudarib, it is betting time and effort with the hope and desire that one day the efforts will pay off and even if he hasn’t invested on the venture, he gets a sizable share. Simply, mudarabah has a problem with extent of liability, the form of liability shared between parties, and the equal sharing of risks taken with the business is engaged.
Mismanagement, Corruption, Etc.
According to Dabashi (1989), the pre-Islamic Arab culture was a normal society that looked for ways to survive, and one of the indigenous Arab enterprise which enabled Arabs to exploit SyrianYemenite commercial potentials. He further noted that the survival of the Arab culture and the striking prosperity during the early Islamic period can be traced to the pre-Islamic institutions that had been adopted and improvised by Islamic leaders. Mudarabah is one of these pre-Islamic institutions adopted for Islamic values. The Prophet had been a mudarib to his wife even prior to the establishment of Islam (Karim, 2010). This simply means that mudarabah was adopted by Islam as a tool for the survival of culture and as a potential to exploit the potential of other neighbors.
Based on this history, we see a massive problem and question. As much Shari’ah forbids the exploitation of others or even the defrauding of others for the selfish benefits, mudarabah’s context can be traced to the exploitation of others for the sake of gaining for one’s self. As discussed in earlier section, there is a problem of riba in mudarabah concept. It is gaining interest and profit for money that is not actually yours, in the perspective of the mudarib, while in the perspective of the rabb-ul-mal, it is gaining profit from the effort and strength of other people.
However, Dabashi (1989) noted that mudarabah also provided a way for merchants to come into a single commercial force. This resulted to closer ties between them and for the initiation of culture of helping each other. This even progressed Mecca into one of the leading international trade markets. Mudarabah was instrumental in the creation of commercial culture that can be still be found in today’s Islamic society – brotherhood and trust on each other. Rabb-ul-mal must trust that the mudarib will protect his investment and will manage them properly as to avoid bankruptcy. Moreover, it also creates a better relationship between as they see a mutual bond between them, rather than just a commercial context that can be found common in Western business perspective.
By convention, the mudarib or the seller must declare the cost and profit of the enterprise to the buyer or the first partner (Ismal, 2013). As outlined in the characteristics of the mudarabah, honesty is a very important value of the partnership. This is done to ensure that the interest or investment of the rabb-ul-mal is protected from unscrupulous handling by the mudarib. In fact, when proven that the mudarib conducts that business in fraud and dishonesty resulting to losses, the losses due to this extent must be covered by the mudarib. However, in this simplistic contract between partners wherein the rabb-ul-mal can only designate the terms and conditions of the profit sharing and does not have discretionary rights in decision-making and operations, the mudarib has high tendency of corruption by overstating the cost of the business and thereby underdeclaring profit to be shared with the rabb-ul-mal. When this happens, the rabb-ul-mal is robbed off his opportunity to gain from the investment in the right way and the mudarib gains too much from his effort. Yet, when losses happen, the gains of the mudarib will not be affected, but the investment of the rabb-ul-mal will be lost.
According to Saleem (2012), the mudarib does not need or does not guarantee the rabb-ul-mal that the capital will be returned or will gain profit. Although, the mudarib must take all the necessary steps to avoid incurring losses for the business, he is held responsible when these things happen. Unlike in the Western business environment wherein the CEO can be fired if the expectations of stockholders are not met, in mudarabah, there is no such thing as firing of the mudarib because of slow growth or incremental losses during operations. In fact, the rabb-ul-mal does not have rights to look at the records and books of the business because that would invalidate the value of trust being superior in the mudarabah context.
As a result of the laxity of accountability, mismanagement usually occurs, either intentionally and unconsciously. And the worst thing is that it would be hard for the rabb-ul-mal that mismanagement and extreme negligence really happen as the cause of the business loss. This difficulty leads to the direct judgment that losses will be covered by the investment of the rabb-ul-mal on the business. Thus, creating a clean slate for the mudairb while causing financial strain on the part of the rabb-ul-mal.
Principal-Agent Conflict/Inequality
By form, mudarabah is a principal-agent relationship in a relaxed manner (Ahmed, 2011). The principal-agent context of the Western business environment provides that the financier or the principal knows the ins and outs of the business and can directly influence the decision of the business operations or projects. However, in the mudarabah context, this is eliminated to emphasize the importance of trust. The allowance to the mudarib in managing the business is deeply embedded on the reality that trust won’t be real if there is too much friction between two parties. It is only through the value of trust that mudarabah can be real. Although the rabb-ul-mal is not guaranteed by the mudarib that the capital will be returned and profit will be made, the rabb-ul-mal must trust that the mudarib will manage the investment properly as much as he trusts him the capital as well. There is asymmetrical trust between two parties, which built the relationship of brotherhood between them as the primary goal of the Islamic finance system, even in insurance.
In fact, the rabb-ul-mal cannot specify the amount of money he is expecting to gain from his investment. There is no such thing as capital-profit ratio of expectation, which is common in Western business environment. The rabb-ul-mal must not estimate the profit that will be earned in the process. Instead, the rabb-ul-mal must provide a big allowance of trust on the potential of the mudarib in managing the business.
But in this concept of business contract, the value of accountability and information sharing becomes a fundamental issue that sometimes strain the relationship of two parties, especially during times of crisis. Of course, in today’s Islamic finance, mudarabah becomes a two-tier system wherein the investors of the bank become the rabb-ul-mal and the bank becomes the mudarib; and in the second level, the bank becomes the rabb-ul-mal and the partner is the mudarib. In this system, we see that the bank has no right to ask for accountability and information sharing from the mudarib. Yet, if they won’t be doing this, as the mudarib of small investors, they are also put into question. Herein the value of trust is transformed in the value of accountability and knowledge.
There is a conflict of inequality that arises in the context of trust. Is it really distrust to ask someone over the affairs of concerns that he has interest on? It is beyond trust when a party asks for simple information on how things are going? Yet, we see that accountability is always the motivation of going after discretion and power on how to run a business. For instance, accountability won’t become a reason for a bank to meddle with the affairs of the business, rather the expertise of the people in the bank can be a reliable and valuable resource for suggestions in decision-making.
If we look closely, mudarabah as an issue of taking things to the extreme. Just because the rabb-ul-mal must trust that the mudarib will manage the capital properly becomes a fundamental reason why accountability and suggestions from rabb-ul-mal must be eliminated and reduced even if it could have helped the business to prosper. It must be understood that the goal of the mudarib is to ensure profit for the business so he may be able to get his share. This means that the mudarib must get the necessary help he can to ensure profit, but by eliminating the help of the rabb-ul-mal, it would be hypocritical for the mudarib to ask help from other people or consultants. In essence, the question on practicing another and keep another principle becomes an inflammatory factor to the failure of mudarabah.
Conclusion & Recommendations
Ahmed (2010) noted that in mudarabah, investment account holders (IAHs) of banks maintain quasi-liability because they absorb the losses in the two-tier system of mudarabah. In order to fight this system of liability, it is necessary for the bank as the mudarib of IAH to create a credit risk for these investments. Of course, it should be noted that risk is not part of the Islamic financial system and should be discarderd, but the capital should be mediated with banking risks. This would ensure that capital goes to the right investment without endangering the rights of IAH to gain profit.
In the same class, the question of moral hazard and full liability becomes an issue of high concern. Commercial banks that are acting as mudarib of IHA shares with the profit if the investment makes money, but they don’t share with losses when their partners or mudaribs (in banks perspective) failed to manage the capital well. Instead the entire liability is transferred to the rabb-ul-mal or the IAH. To reduce the commercial risk and attract more investors, Ahmed (2010) provided the necessity of creating moral hazard. This means that banks increase the profit share of IAH who agrees to place their capital on areas that involve high risks. By providing commercial risks, the quasi-liability of IAH is equaled with the share of profit in positive light. The knowledge of commercial banks on high risks areas of investment becomes a fundamental strategy to ensure risks being treated as they are, rather than just assuming and depending on trusts.
Mudarabah is a very essential Islamic finance approach. It provides the best possible ways to ensure that commercial and financial activities are supported in a better way. However, when too much is involved due to the complexity of today’s business environment, it is always important to keep things balance. The balancing act would ensure that investments of IAH or rabb-ul-mal is protected from mismanagement and direct corruption. And the other way around, it ensures that the interest of the mudarib is also protected to ensure that they make profits and gain from their effort.
I believe that mudarabah is a very effective method of building business relationship without the expense of brotherhood. If practiced the right way, mudarabah provides the best means to conduct financial values and ensure that commercial progress happens. And of course, mudarabah can be mixed with other Islamic financing values to create more potent business tools.
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