Principles of the Islamic Banking

One of the most widely quoted operating principles in Islamic banking is the principle of mudharabah, sometimes known as qirad or muqaradah. Mudharabah is a contractual involving two parties which is the provider of funds and the mudharib is agent. There are two ways in which Islamic banks are involved in mudharabah contracts. When clients open investment accounts, the contractual relationship between the bank and the clients is based on mudharabah principles. In this case, the bank acts in its capacity as a mudharib. An Islamic bank could also be the capital provider where it provides financing based on mudharabah principles.

The capital provided should be known as to amount and type, be it in cash or trading assets or any other non-monetary assets. A debt due from a third party or the mudharib himself cannot be considered capital. In good faith, mudharabah capital cannot be guaranteed by the mudharib. However, the provider of capital may request from mudharib a guarantee against his dishonesty or misconduct. If the mudharib violates the terms of the contract, it is considered misconduct. He is the liable to return the capital which is the capital in his possession is a liability.

The amount earned in excess of capital, the profit must be apportioned between the contracting parties. No party can have exclusive right to the profit. The profit sharing ratio must be known at the time of contracting. However, it is permissible for the ration to be subsequently adjusted if so agreed at the time of contracting. This enables the management of the bank, as mudharib, to adjust the profit sharing ratio to give a higher amount of profit to investment account holders and a constant rate of return at times when profits are rather low.

Under mudharabah, the capital provider bears all financial losses. The loss of the mudharib is really an opportunity loss. The time spent on the loss-making contract could have been spent on another contract. However, if the loss arises from the misconduct of the mudharib or though his negligence, he is to bear the loss. It is not clear to what extent he is to bear the loss. Losses are net off against capital on repayment. In the case of long term mudharabah, periodic losses are set off against accumulated undistributed profits.

Profits can only be distributed on realization and on returning the capital to the provider.