IQRA UNIVERSITY IU

REPORT
Name: RAVI KUMAR

Registration no: 11931

Program: MBA

Subject: Essentials for Islamic Finance

Topic: Modaraba

Day: Monday

Time: 12:00pm To 03:00pm

Submitted On: 22-Dec-2010.

Faculty: Yousaf Ibnul Hassan

 ACKNOWLEDGEMENT

We are grateful to our teacher Mr. Yousaf Ibnul

Hassan for teaching us curriculum of Essentials for
Islamic Finance. His versatile knowledge in the field
of Islamic Finance and unique teaching style has
developed our knowledge and cleared many Islamic
Finance concepts.

I am very grateful to him for assigning this

report, which has further helped us in evaluating
many interrelated dimensions of Islamic Finance
field.

Finally we bestow our thanks to all who has

directly or indirectly supported us with their
assistance and guidance to compose this report and
accomplish broader vision to visualize things in
Islamic Finance concepts.
 Justice is the distinguishing feature of the
Islamic system of life, which covers all aspects
of human existence on earth.
 Islamic Financial System
Here we are concerned with the part of the financial system that deals with institutions to
manage transactions and risks associated with monetary and financial dealings
irrespective. Description of financial system in these terms is not more than a couple
countries old when most of the Muslim world was either colonized or was not operating
on Islamic principles. Islamic history, therefore, would not help in identifying a blue
print of Shari’a compatible financial system. The only source for identifying a blue print
would be able to go to the following two sources.

Shari’a (Islamic Law) as laid down in the Quran and the Sunnah.

1) The literature, on understanding the application of shari’a known as Fiqh

These sources can help us delineate following three main components of the Shari’a
compatible financial system.
 Principles
 Objectives
 Institutions

Principles
The principles can be understood from the set of Islamic injunctions, provisions, rulings
with respect to the financial dealings laid down in Shari’a and Fiqh sources. When
Muslim countries started gaining independence from colonial rules, they inherited
colonial system with its own institutions to deal with monetary and financial matters in
the economy. Several Islamic Scholars, particularly during last century, struggled to
understand the parallel principles embedded in shari’a and Fiqh sources and prepare an
Islamic blue print of a system that will operate on Islamic principles in competition with
the system inherited from colonial rule.

At the outest, it may be instructive to identify approaches that Islamic scholars have taken
towards understanding the principles of financing from various Shari’a rules mentioned
in original sources.

On line of understanding is based on the hadith and The Quran , both entitling finance to
earn a return only if the financing is subjected to bearing the risks in a real transaction for
which it was provided. The principle has been derived directly from the Quranic verses.

Objectives

1. Promoting Production and Exchange in the Economy

2. Ensuring Economic and social justice
3. Maintaining Harmony and Peace in society

Show a clear objective of making markets of goods and services competitive. The rules
aim at eliminating all such obstacles in markets that may lead to inefficiencies in the
production and exchange of goods and services needed for the human well being. The
Shari’a allows relaxations in the general rules and principles, if they happen to distort
production and trade decisions in some exceptional or abnormal situations.

Institutions
In Shari’a and the related Fiqh literature we not only find principles of financing, Shari’a
objectives for a financial system and possible methods of financing, but we also find
what type of institutional setup is needed to make the markets conducive for the
application of Islamic principles and methods of Islamic financing and for the
achievement of Shari’a objectives financial system. Some of the institutional
arrangements required to be developed for the markets to perform according to Shari’a.

Institution of Hisbah
Modern times, however, require different types of Institutional arrangements.
Arrangements for registration and documentation of businesses and maintenance and
monitoring of their accounts is one such arrangement that is required on its own merit but
is more than needed for promoting the financial system. This is what most Muslim
countries are lacking. In the context of information, a unique feature relates to diversity
of Fiqh opinion on various issues. There are five major schools of thought relating to
Fiqh, which though agree on basic Shari’a rules, yet there are differences in the details. In
the context of methods of financing there are substantial differences in details among
different schools. The financing in individual transactions will remain a matter
of deal between the seller and purchaser, or lesser and lessee or investor
and entrepreneur as long as contractual obligations are protected enforced.
There is need for an institution to monitor practices, particularly in the context of
application of shari’a in the market activities and dealings. Such an institution
existed in the early history of Islam when the economy is fully Islamic. This
institution was called Hisbah.

Hisbah was a monitoring and regulatory institution that existed during the early history of
Islamic rule. It operated under the authority of the state to carry out the responsibility of
enjoining what is right, whenever people start to neglect it, and forbidding what is wrong,
whenever people start to engage in it. It was manifestation of the Quranic injunction
(chapter 3: verse 104).

There are other reforms needed to allow market to support the introduction of Islamic
financial system in the economy of some these reforms are mentioned below:

1. Documentation of the business, showing their business history with special

emphasis on financing records of payments of their obligations. This can be done
by private sector or public sector.
2. Ensuring and monitoring account to keep record of fair market value of
businesses
3. Establishing Trade Houses including clearance of parallel forward sales to
facilitate financing according to shari’a rules
4. Promoting venture capital and mutual funds
5. Institutions to deal with issues arising out of diversity in Fiqh rules.
 Islamic economics as a social science is a new discipline in the making. It
reflects the Islamic outlook and offers Islamic solutions to economic
problems. The economic principles and doctrines have long been
researched by Muslim scholars.

Introduction

Modaraba arises where a provider of capital called the rabb al-mal (or a group of such
capital providers) enters into a contract with a manager (called the mudarib) to engage in
any specific trade activity with the objective of sharing the potential profit. At the core of
any mudarabah contract there are four basic conditions between the mudarib and the
capital provider(s) as follows:

􀉾Profit, when realized, has to be shared between the two parties in accordance with a
profit-sharing ratio pre-stipulated at the time of the contract. Loss, in case it arises, would
have to be born entirely by rabb al-mal as the mudarib only loses his or her effort.

􀉾The rab al-mal cannot interfere in the day-to-day management of the mudarabah, apart
from his or her right to restrict possible fields of economic activity for the mudarabah.
This provision, however, has to be made clear within the mudarib contract.

􀀁The mudarib has a ‘hand of trust’ (yad amana) in the management of mudarabah
capital, which means he would work to his best effort and, therefore, cannot guarantee
capital or profit to rabb al-mal.

􀀁Loss of capital can be guaranteed by the mudarib only when such loss proves to be the
result of mismanagement or delinquency of the mudarib; or where such loss results from
a breach of the contract, like violating restricted fields of economic activity.

Objectives of the Modaraba

The Modaraba is floated with a view to:

a) Providing an opportunity to certificate holders to participate gainfully in

economic development of Pakistan and especially in the elimination of RIBA.
b) Earn maximum possible income for distribution to the certificate holders so that
attractive, sound and lawful avenues of investment be provided to them in
accordance with the SHARIAH.
c) Produce appreciation of capital through increase in value of certificate.
d) Generate a long term goal.
Significance of the Modaraba
The Narration of Ibnu Abbas

Ibnu Abbas r.a. reported that: “When our leader Abbas Ibn Abd al-Mutallib gives his
property to someone for Mudarabah, he stipulated conditions for his partner not to
bring the capital throughout the sea; and not to bring with him the capital crossing a
valley; and not to buy livestock with the capital; and if his partner violates the
conditions, he should guarantee the loss occurred. These conditions have been
brought to the attention of Prophet Muhammad (SAW) and he approved them.”
(Mu’jam Al-Awsat; Al-Tabrani).

The Narration of Suhayb

Suhayb r.a. reported that the Prophet Muhammad (SAW) said: “Three matters that have
the blessing (of Allah): A deferred sale, Muqaradah (Mudarabah), mixing the wheat with
barley for domestic use and not for sale.” (Sunan Ibn Majah).

The Tacit Approval of the Prophet Muhammad (SAW)

Mudarabah venture has being practiced before the Prophet’s (SAW) first revelation and
he did not raise or show any objections against the practice. This is considered a tacit
approval by the Prophet Muhammad (SAW).

IJMA
The Muslim jurists have reached Ijma’ among them upon conducting Ijtihad on the
permissibility of the Modaraba contract.

It has also been established that the companions of the Prophet Muhammad
(SAW) such as Umar, Uthman, Ali, Abdullah Ibn Masud, Abdullah Ibn Umar,
Ubaydullah Ibn Umar and A`ishah have placed the property of orphans under the
Mudarabah contract with no objections from other companions.

Limitation and constraints

The main limitation and constraints for the Modaraba would be as follows:

 New equipment deliveries lead times

Due to high demand of caterpillar products in the global market, the lead times on
deliveries are increasing which may create a limitation on Modaraba’s expansion plans in
the short term.

 Skilled Staff Availability

Availability of skilled staff to operate and maintain the equipment can be a constraint on
the Modaraba’s ability in the short term to undertake big projects.
Theoretical framework
The Management Contract:

There are two possible options for the manager / investor relationship in Islamic
investment funds: (1) an agency contract, as it is most commonly adopted (2) or, more
occasionally, the Profit and Loss sharing principle.

The latter is where the Islamic bank performs management under, for example, the
capacity of mudarib, with or without mixing of bank’s funds, visa-vis the community of
investors as the rabb al-mal parties. And since the mudarib will get nothing in the case of
loss, the major attraction of mudarabah management lies in the strong profit incentive for
more efficient management. On the other hand, the agency contract has the special appeal
of generating fee income to the manager as a pre-assigned percentage of the fund’s NAV
(Net Asset Value, as defined above). Unlike the case of mudarabah, where manager’s
income is tied up with net profit, the agency fee is relatively more secure since it is tied
up with the fund’s NAV. Taking the manager as agent and investors as principal, it
should be noted that the agent can only work on best-effort basis, hence cannot guarantee
the desired results to the principal.

Nonetheless, the agency contract has its own incentive-compatible property since the
NAV fluctuates up and down with the market unit value of the fund, thus putting
appropriate pressure on management to perform most efficiently. Furthermore, the agent
may be given a “Performance Incentive” being an amount equal to profits generated
above a certain rate of return on the wakala capital invested for a relevant wakala period.

Distribution of Returns:

The third and final structural feature of Islamic investment funds relates to the
distribution of investment returns to the investor community who subscribed to the fund.
Whether or not the management contract is one of mudarabah or agency, the manager’s
role is to pass the investment proceeds along to the individual investors in terms of
appreciated unit values – or depreciated unit values in the case of loss. In other words, the
manager of an Islamic investment fund cannot guarantee any returns to the investors.
This is an important difference from conventional investment funds where in certain
agent agreements investment returns are guaranteed.

Another important difference relates to the equal treatment (pari passu) of investors in
Islamic funds, as opposed to the possibility of prioritizing the payment of investment
returns in accordance to an agreed preferential order of investment classes. It is a
common practice in conventional funds to issue three or more securities on the basis of
the fund with different levels of default risk, such as security A is the first to be paid off
from the investment proceeds, followed by security B and then the residual goes to
security C, if any. This procedure clearly violates the Shari’ah principle of fair treatment
to investment partners where the same level of investment risk has to be faced by all the
partners and all the net profit has to be distributed on pro rata basis, at the same time to
the investors.
Overview of Modaraba
As noted above, a brief historical background from the early Muslim civilization will
help Underscore the Islamic legacy of banking and capital markets, and hence drive home
the current economic and cultural interaction of Muslim economies with the West as a
healthy heritage from the distant past. It is noteworthy that centuries ago the major Italian
cities which constituted the birthplaces of modern Western capitalism (i.e. Venice,
Genoa, Amalfi and others) borrowed many of Muslims’ financial instruments and
corporate tools, including the accounting principles of book-keeping and Arabic numbers
which gradually replaced Roman numerals. Western economic historians have
unequivocally acknowledged the leading role of Muslims’ booming merchandise across
the Mediterranean with the Italian Cities in lifting Western Europe from its Dark Ages
and bringing about the twelfth century economic renaissance to Europe. In Britannica
this is clearly stated as: “Ironically, the great age of Islam coincided with the low point of
culture in Western

Europe … Arabic rulers of Baghdad in the ninth Century had the bulk of the corpus
Greek Science translated, and soon after, their own scholars advanced further,
particularly in mathematics, astronomy, optics, chemistry and medicine… The twelfth
century saw a heroic programmed of translation of works from Arabic to Latin9)”.

The positive attitude in medieval Islam towards the profit motive was indeed the basic
drive of commerce and trade. At the time when the Muslim state encouraged trade and
supported the profit motive subject to injunctions of Shari’ah, the teachings of the
Christian Church in Western Europe cherished a poverty-oriented culture, hence,
frustrated entrepreneurial motives and accentuated the impact of the Dark Ages in socio-
economic life. In their analysis of Muslims trade with medieval

Europe, economic historians acknowledged the groundbreaking role of mudarabah-

financed trade in acquainting Western Europe with a powerful instrument of corporate
finance, hence opening up immense opportunities of profitable trade across the
Mediterranean. Modaraba came to be known in the Italian cities as
commendo, marking thereafter an important historical phase of corporate
growth in Western Europe which culminated through time into the modern
corporate structure.

The role of a usury-free capital market in early Muslim states was fuelled by rising
demand for liquid capital and credit to both governments and private entrepreneurs. The
simplest manifestation of financial services within the early Muslim states took the form
of moneychangers (sayarifah) who were also partially engaged in the holding of deposits
and the short-term financing of trade.

Conclusion