Islamic finance structures 101: Mudarabah

In an effort to better understand how sukuk (and other Islamic finance structures) work, I'm doing some research and plan to present, in concise form, an outline of the mechanics of the transactions. If you're already an expert in such matters, feel free to add your comments and criticisms.

We'll start with one of the simpler Islamic structures: the Mudarabah.

In its simplest form, a Mudarabah is an agreement between an investor (also known as the rabb-ul-maal) and an entrepreneur (the mudarib). The investor gives the entrepreneur money to, say, start a business, and the two parties agree beforehand how to share profits.

For the sake of argument, let's say an investor gives Dh1m to an entrepreneur to start a bakery, agreeing that half the profits will go to the investor and half to the baker. The baker then uses the money to rent a commercial space, buy equipment, hire staff and start selling pastries and breads.

If all goes well, the baker begins to make money after his first year in business. If he makes Dh50,000, for instance, Dh25,000 goes to the investor and the other half the baker keeps. The same arrangement continues indefinitely until the business goes bust or until the parties mutually agree to terminate the contract.

If, on the other hand, the business does not succeed - let's say it becomes insolvent after a year - the investor loses all of his money, while the baker does not lose any capital. The baker's loss instead comes in the form of lost time and effort in setting up and running the business.

There is disagreement among Islamic scholars over the question of whether a Mudarabah contract can come with a limited term. Some jurists say that the contract must be open-ended in order to comply with Islamic law. There seems to be general agreement, however, that contracts cannot come with minimum terms.

In modern Islamic finance, Mudarabah is commonly done on a two-tier system. Multiple depositors (the equivalent of investors in the above example) put money into an Islamic bank. The bank then acts as the investor in a variety of entrepreneurs, and shares profits (and losses) with the original first-tier depositors.

Mudarabah is an age-old way of financing enterprises. There's a nice history of its use here.