Islamic Banking and Impact of Two Tier Mudarabah Finance Essay

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The Term Bank is an Italian driven “banca” which is derived from German – means bench or counter, as Florentine bankers used to use the Benches as their desks with green desk cloths on it for making their activities of transactions. Bank can be defined as a financial institution or organizations permitted by financial authority within a government body or government itself to undertake deposits, pay interests, lend money to the borrowers. The term “Bank” is also defined as “An organization, usually a corporation, chartered by a state or federal government, which does most or all of the following: receives demand deposits and time deposits, honours instruments drawn on them, and pays interest on them; discounts notes, makes loans, and invests insecurities; collects checks, drafts, and notes; certifies depositor’s checks; and issues drafts and cashier’s checks”. Presently the word “bank” is referred to a financial institution which bears a Banking License which could be granted by authorities who supervise the financial institution and allow rights to perform the banking service. “Bank is an institution transecting the business of accepting, for the purpose of lending or investment, of deposits of money from the public repayable on demand or otherwise, and withdraw able by cheques, draft order or otherwise and includes any post office saving bank” Negotiable Instruments Act (1881) Banks offer different services depend on their country they are based in and its type. But usually banks accepts deposits from the common public, lends money to individuals or companies, issues cheques, converts cheques into cash, and managing valuables of its customers. Banks also borrows money by allowing deposits on current accounts and issues the same as banknotes or bonds. Banking involves lending money to its customers on current accounts which is allowed to be returned in instalments for which banks charge interests.

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“Islamic Banking and Impact of Two Tier Mudarabah Finance Essay”

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Evolution of Islamic Banking

Islamic banking is a system of financial activities where transactions are perform as per the Islamic Law which is also called as “Sharia Law” which prohibits accepting or paying interests (Riba) for loans on money lend and also forbids investments into the businesses which perform the activities of providing goods and services which is considered to be against principles of “Sharia”. During the period of Prophet Mohammed (PBUH), the limited banking activity started with the followers used to deposit their money with the prophet or with the first Khalif of Islam Abu Bakr Siddique. In Islamic Golden Age where free markets were exists in the business activities and where the term mercantilism and market economy was introduced which is used to be referred as “Islamic Capitalism”. In this era of caliphate and Islamic capitalism a various forms of techniques and financial concepts were used in Islamic Banking like the mufawada (partnership) , mudaraba (limited partnerships), bills of exchange and the concept of capital ( al-mal) and other concepts like waqfs ( trusts) , loaning, transactions recording (ledgers) etc. Later in the year 1972 the first contemporary Islamic bank was introduced named as Nasser’s Social Bank and in this year the essential tool the Islamic bank – Islamic accounting have came into existence at the University of Cairo. progressively this trend was not limited to the arab world and was spread through out the world. Most of the Islamic countries formed banks which operate on the basis of Sharia Law. The system of Islamic Banking is not only limited to concepts and terms rather it has transformed the system and model into a full fledged system and business. Due to the current financial problems of the world economies and their answer through the old economic systems like capitalism, socialist and mixed economics which is proved to be difficult or impossible leading to many economical ills , poverty and imbalances in social and economical justices, unemployment and many other problems , the world has diverted their attention to solve this issue a renewed interest has been shown in the way the Islamic financial system works, as Islamic economic system obligates the service to man, joined hands co-operation among people , faith in god , and equality in society, and these fundamentals and principles have been laid down by the quran and the Prophet Muhammed (PBUH). Islamic Banking system must adhere to the Islamic principles related to business and financial activities in which it is prohibited to invest or involve in any activity which includes alcohol, gambling etc. and also profit and loss sharing is not equal.

Modern Islamic banking

In the late 40’s the restructuring of banking system based on profit sharing and not the interest exists with Anwar Qureshi (1946), Nayeem Siddiqi (1948) and Mahmud Ahmed (1952). These personalities stressed to have all reformation in commercial banking with the theory of Mudarabha – the Profit and Loss distribution model. Last few decades has witnessed in wider implementation of interest- free banking. And Shariah based assets touched around $400 billion through out the globe (2009), Saudi Arabia, Iran and Malaysia have the biggest sharia based assets, with Iranian banks accumulated for around 40% of the overall assets of the top Islamic banks around the world. The assets of Bank Melli Iran have reached $45.5 billion and Saudi Arabia based bank Al Rajhi Bank and Bank Mellat reached with $39.7 Billion. Islamic banking involves in the same activities as commercial banking but as per the shariah law called as Fiqh al-Maumalat (Transaction Rules), the core rule of Islamic banking is that of profit and loss distribution The fundamental code of Islamic banking is the distribution of profit and loss and the prevention ofA “riba”A (usury). Common terms used in Islamic banking includeA profit sharingA (Mudharabah), safekeeping (Wadiah),A joint ventureA (Musharakah), cost plus (Murabahah), andA leasingA (Ijar). Transactions related to mortgage in Islamic system is done by not allowing the buyer to take the money to buy the item instead the bank buys the item direct from the seller and sell it back to the buyer at a profit and giving provision to the buyer to clear the money to the bank in instalments. This system does not allow explicit profit to the bank , and hence there is no additional fines or penalties for paying late to the bank. The ownership of the item or property is directly registered in the name of the buyer during the initial step of the transaction itself. This process of transaction is called Murabaha. The loaning for vehicles are done in such a way that the vehicle is sold at a higher price then the existing market price to the debtor and the ownership retains with the bank until the loan is paid. Some banks also apply Musharaka al-Mutanaqisa an approached which allows a balanced price in the shape of letting. In this approach the bank and the borrower forms a partnership in which they provide the capital on a predefined percentage to buy the land or property. The property is then rented out to the borrower and charges rent. An inventive approach functional by a few banks for home loans, calledA “Musharaka” al-Mutanaqisa, agree to, for a balanced rate in the form of letting. The bank and borrower form a joint venture entity, both providing funds at a settled ratio to buy the assets. The partnership unit then lease out the property to the borrower and charge lease. “The partnership between two parties, both of them provide capital towards the financing of a project. Both parties share profits on a pre-agreed ratio, but losses are shared on the basis of equity participation. Management of the project is carried out either by either parties or any one of them”.


“Mudarabah” is a particular type of partnership where one partner gives funds to Another for spend it in a business project. The funds comes from the first partner who is called “rabb-ul-mal”, whereas the administration and labor is an elite accountability of the other, who is called “mudarib”. Under this approach the venture capital funding for a business which gives the labor and the financing is done by the bank and the profit and loss are shared equally. This participation of both the parties by arranging the capital and labor reflects the Islamic approach of not allowing only one party to share the profit and other bearing the loss in case of failure and ensuring the balanced distribution of profits. Under this partner ship one party provides money to other to invest in a commercial enterprise. The first party who invest the money is called as “rabb-ul-mal”, and the administration and labor is the only accountability of the other partner known as “mudarib”. It is nothing but a profit sharing contract in which 100 % of the investment is done by one party and the other party provides with knowledge and manage the project. Profits are shared as per the pre defined ratios.

Business of Mudarabah:

The one system of Mudarabah is that the rab-ul-mal may direct the mudarib to use his investment for a particular business specified by the rub-ul-mal and this is called al-mudarabah al-muqayyadah. In case the Rab-ul-mal leaves upon the Mudarib to utilize his capital for any business as per the mudarib then it is called al Al-Mudarabah al- Mutlaqah. Contract can be done by the rabul-mal in mudarabah with one mudarib or more by one transaction. For example the rubul-mal can give money to A and B , where both the A and B can act as mudarib for him and the capital invested will be used by both A and B and the share will be distributed among A and B as per the pre agreed ratio. In this type of activity both the mudaribs act and work as partners in the venture which is considered to be normal business trade, and if they want to go beyond the business activity they should get the permission from the rabul-mal.

Profit & Loss Sharing:

The profit sharing agreement should be done at the beginning of the contract and should be explicitly defined for a valid mudarabah. It is left on the mutual concent of the parties involved by the shariah. There should not be any particular amount of money be set for any of the partner and should be equally shared among the mudaribs. For instance if there is a capital of £ 100000/- it is forbidden to set a condition of sharing a specific amount of profit among mudarib or to be given to rabul-mal rather it can be decided that 40% of the actual profit shall be shared by mudarib and rest of 60% with by rabul-mal or vice-verca. However it is considered to be void in mudarabah to set an proportion of profit at the beginning of the venture, if the rabul-mal directs the mudarib to utilize the capital in a trade which is specified by the rabul-mal. As per the pre defined share of the profit the mudarib is not entitled for any salary or fee or remuneration for the work and time he spends in the venture. However Imam Ahmad allowed the mudarib to get the expenses related to his food from the mudarabah account, but the Hanafi sect has restricted this for the mudarib to get the expenses only if he is out of his town on business trip If the business goes into loss in certain transactions and gain profit in some then the profit acquired shall be used to offset the loss incurred at first then the remaining of the profit shall be shared among the parties as per the agreed ratio.

Termination of Mudarabah:

The termination of contract in mudarabah can be done at any time by any of the two parties; the only condition is to serve with a notice prior to the termination to the party. And if at the time of termination all the assets of mudarabah is in cash and some profit exists then it should be shared among the parties as per the agreed proportion. And in case the assets are not in cash then the mudarib shall be entitled to sell or liquidate the assets in order to ascertain the actual profit to be distributed. There are different views among the Muslim scholars about the contract of mudarabh termination after a period specified. Hanafi and Hanbali shares with view of mudarbah can be restricted to a specific time period of one year or half year which could be terminated after completion of this period without notice. On other had shafai and Maliki have the different opinion and they say that mudarabah should not be restricted for a specific period. However there is no proper answer to this with the Islamic fiqh, but the general principles are used where in there is no time period is fixed and each party is free to terminate the contract after giving notice. With no proper time period set for termination of mudarabah there creates a problems in the present markets as most business activities rely on time period for fruitful results with implying proper efforts and hardworking. If the rabul-mal terminates the contract in mudarabah at the beginning of the contract there could be any profit or earning for the mudarib. And if there is some agreement between at the starting of mudarabah that no party shall stepbacks during the contract period and which does not violate the principles of Shariah and adheres to the famous hadith as ” All the conditions agreed upon by the muslims are upheld, except a condition which allows what is prohibited or prohibits what is lawful” (sunan Abu Dawood, 1981), then it could bring some fruitful results.

Two-Tier Mudaraba

The concept of two-tier Mudarabah was initially used by Islamic Banking. The model is structured for the Islamic banks to engage in two mudaraba activities, the first one with the depositors and the other one is with the person who gives finances. The first Mudaraba is between the bank and the client with surplus capital (depositors) and the second one is between the bank and the clients who require financing. In the first tier Mubaraba contract among the depositors and the Bank , the deposits acts as rabul-mal and the Islamic Bank as the Mudarib. The depositors who act as rabul -mal invest their money into the bank without guarantee of their principal and a return on the profit of their money used by banks on their behalf. And as per mudaraba and pre agreed proportion the losses and profits have to be shared with the Islamic Bank. In tier two Mudarabah between the Islamic banks which provides the finance and act as the Rabul-mal and the receiver of finance from the bank acts as the Mudarib. In this tier the losses incurred by any misuse by the mudarib has to be shared by the Bank and if any profits generated then both shall share as per the pre agreed ratio. Islamic economists developed this concept as trustworthy substitute to saving accounts. The model of two-tier Mudaraba serves as the bank as the middlemen for the depositors and the customers who need finance and who is able to get a sufficient outcome preventing the depositors money from risk. As the Islamic banks posses the liability for any losses incurred which is ultimately suffered by the depositors, and this reason made the use of this type of mudabarah in limited in practice. The other drawback with the two tier Mudaraba is that it is not only the depositors principal is at risk but also suffer many swings in the profit they get from their deposits.

10.0 Consequences in Two-tier Mudarabah Model

In spite of the sound profit potential of mudarabah financing theory, and skill to confront the interest based structure, the method might not construct a infiltrate modify in contemporary Islamic finance. It did blossom as a deposit collect system by means of the Islamic financial institutions. For illustration, mudarabah companies multiplied quick, particularly in Pakistan. However these companies might not discover business investment opportunities adequate to take up mass of the deposits they expected. They were bound, in logic, to make funds in approximate buying and selling of shares at the stock markets. One of the main realistic troubles with mudarabah is the irregular nature of the risks implicated. For the bank depositor the key risks were of bank failure and the uncertainty (“gharar”) concerning the stage of revenue to be shared. With efficient bank rule the danger of bank letdown was negligible on the other hand, and uncertainty still applies to up-and-down interest returns, so this was improbable to frighten depositors, certainly it was the small danger they take that acceptable their repayment. The extra severe difficulty by means of mudarabah arises by bank finance of industry, when there be no security that the bank might get their finances repaid. In addition the danger of getting no earnings was substantial, particularly by means of the kind of small business so as to differentiate a lot of Muslim financial system. There are furthermore ethical risk problems, as business possibly will potentially cover the earnings they prepared to reduce the profits shared, particularly wherever full audits are not obligatory. This is the most important hinder grounds Islamic banking and finance to go after the path of slightest confrontation moreover to obtain protection in the irresponsible exercise of Islamic delayed compulsion deal. The form with the intention of might have face the conventional banking if carefully set up let to be unsuccessful. Presently, Islamic banks have practically no position for mudarabah agreement in their Islamic goods or set of choices. In Malaysia by the end of 2003, mudarabah accounts for 0 percent of total banking goods. Soaring non-payment in mudarabah agreement comprise for all time exists the difficulty meant for Islamic banks. However, in my view bank must take up a accurate procedure to assess the mudarib as well as business enterprise that it mean to spend. The normal technique of range of mudarib or industry must be capable to recognize the largely credit worthy clientele and feasible businesses.

11. Conclusion

The apparatus and organization of profit distribution under financial assistance, identified as mudarabah be essential toward source enlistment within the Islamic trade and industry order. Mudarabah is the mainly adequate structure of apparatus which is support on “shirkah” or profit distribution. Interest occured on the investment, is in infringement of shariah do not symbolize price of production. Designed for that because Islam highly promotes profit distribution which mudarabah plays a very important role of direct the excess funds to arrears part in contemporary Islamic banking and finance. The two-tier mudarabah forms characterize an supreme form of economic intermediation with the aim of replacing the interest based structure. Interest based system being unfair, do not presume any hazard of provided the investment despite the consequences of the result of project. The interest behavior mechanism consequently directs the financial system in to an incompetent condition go up against to profit sharing that is engage in price conception. Justice is greatest guarantee by profit distribution agreement as plunder are a purpose of realize output that direct to every one of the concerned parties. In to facilitate, Islamic bank as a deposits accept establishment be different from a conventional at this point of time, where to facilitate entrepreneurs to split the hazard. Regardless of the information it is regarded as a powerful characteristic of Islamic finance, form have been strike by main obstacle that might observe Islamic banks additional abandon to perform. Islamic banking practice in mudarabah have not been good. On the other hand, the reimbursement of practicing two-tier mudarabah form outweighs its shortcoming. Islamic banks must not fail to notice this issue and keep away from irresponsible practice of delayed agreement. Shirkah agreement has constantly been experienced by Muslims; consequently present Islamic banks a appropriate form to engage in financial conciliator function.

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Islamic Banking And Impact Of Two Tier Mudarabah Finance Essay. (2017, Jun 26). Retrieved June 29, 2022 , from

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