Mudarabah contract needs modification: Here’s why

As the world seeks alternatives to debt financing, Islamic finance has risk-sharing contracts that could be a solution.

The Mudarabah contract, in particular, is well suited as a risk-sharing financing contract. It had been successfully adapted by the Italian city states to fund the European renaissance. It later resurfaced as the venture capital financing technique that made Silicon Valley what it is today.

Yet, today, one would be hard pressed to see Mudarabah financing on the asset side of most Islamic bank balance sheets. Even among sukuk, Mudarabah-based sukuk are a rarity.

To understand this irony, one has to separate the philosophy from the operational features of the contract. The early Italians and contemporary venture capitalists kept the philosophy, but tweaked the operational mechanics. And that may be what we would need today within Islamic finance.

Classical Mudarabah

In classical Mudarabah, one party, the rab-ul-mal or financier, provides the capital, while the other party, the mudarib, provides the entrepreneurship and effort to run the business.

The underlying contractual relationship is that of a partnership, with the rab-ul-mal as the silent or sleeping partner. Profits derived from the business or investment are shared

by the two parties according to a predetermined profit-sharing ratio. This could be, say, 70:30, with the larger portion accruing to the mudarib. In the event of losses, the Shariah stipulates that all losses must be borne by the financier.

Yet, the financier is not allowed to interfere in the running of the business. Thus, a Mudarabah arrangement looks very much like an equity investment by a shareholder in a public-listed company. In fact, Islamic banks consider Mudarabah financing to be the equivalent of equity financing.

However, Mudarabah financing is really a hybrid. It is neither equity nor debt because to a mudarib, the financing is like conventional equity for the following reasons: (i) There are no “fixed” annual payments that are due (unlike interest); (ii) payments made to the Islamic banks come from profits, much like dividends, they need to be paid only if there are profits; (iii) the Islamic bank cannot foreclose or take legal action if there are no profits and therefore nothing to be shared; and (iv) like equity, using Mudarabah financing does not increase a firm’s risk the way debt financing does through increased financial leverage.

On the other hand, Mudarabah has features of debt such as: (i) It represents a “fixed” claim by the Islamic bank, this being the initial amount plus whatever accrued profits (or losses) that are due to the bank; (ii) like debt, Mudarabah financing is terminal, the mudarib can end the relationship by repaying the principal and accrued profits to the Islamic bank.

Hybrid in Nature

Thus, unlike equity, which represents an unlimited and perpetual claim on the company, Mudarabah represents a fixed and terminable claim, much like debt. Hence, the earlier argument that Mudarabah is really a hybrid in the conventional sense.

Unfortunately, as Mudarabah has the features of both debt and equity and the Shariah prohibits the rab-ul-mal from interfering in the business but requires him to absorb all losses, the agency problems (conflicts of interests) of Mudarabah are higher than that of debt or equity.

While profits will be shared and are revenues less costs, the mudarib has the incentive to increase those costs that accrue to him as benefits. The allocation of overheads and other costs to the project, the use of transfer pricing, etc, are ways by which the profits to be shared can be minimised.

As the rab-ul-mal cannot interfere in the business, he cannot put in place the internal controls that conventional equity holders can. Given the fixed and terminal claim of Mudarabah, adverse selection and moral hazard problems of debt can also exist within Mudarabah relationships.

Classical Mudarabah, therefore, is an entirely trust-based contract. Trustworthy behaviour is essential for its proper functioning.

This explains the dearth of Mudarabah financing among Islamic banks today. Yet, as proven in the case of Silicon Valley and medieval Europe, it can work if its operational features can be modified.

Modifications on how costs are to be enumerated, which costs are to be allowed, the use of industry benchmarks and best practices, and the use of equity kickers to hold the mudarib responsible would all bring in the type of controls now lacking. With good internal controls and transparency, development infrastructure could be funded using such modified Mudarabah contracts.

With almost all Organisation of Islamic Cooperation countries running budget deficits, the financing of development infrastructure is a critical issue. The continued use of debt to fund development is not sustainable. The consequences of debt-reliant growth is obvious. Too many countries have been brought to their knees as a result of debt.

Modified Mudarabah sukuk can be the means to fund development without leverage. Given their hybrid features, they can be a new asset class and one not easily susceptible to contagion.

Would Shariah scholars allow the needed modifications? They should. There is nothing sacred about these contracts. The Quran does not prescribe these contracts. Falling within the ambit of Fiqh Muamalat, innovation can and should be undertaken, if not for anything else, at least to get the world out of its debt trap.