Sample paper on Islamic Banking (Mudarabah)-Get A Similar Paper Written From Scratch Cheap and Fast

Abstract

This paper focuses on Islamic bank transactions, and the differences between Islamic bank and conventional bank. Islamic banks follow sharia law, which is based on Quran and Sunnah, which provides the financial instruments Mudarbah, Murabaha, Musharakah, Istisnaa, Salam, etc. This project will discuss “Mudarabah” is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprise. The investment comes from the first partner who is called “rabb-ul-mal”, while the management and work is an exclusive responsibility of the other, who is called “mudarib.

Table of Contents

Abstract……………………………………………………………………………………………………….. 2

Introduction ……………………………………………………………………………………………….. 3

Islamic Banking ………………………………………………………………………………………….. 4

History of Islamic Banking…………………………………………………………………………. 5

Islamic Bank Features ……………………………………………………………………………….. 5

Objectives of Islamic Banking:…………………………………………………………………… 6

Islam’s Approach to Ethical Investment……………………………………………………. 7

Differences between Islamic and Conventional banks…………………………….. 8

Mudarabah……………………………………………………………………………………………….. 10

Rules of Profit & Loss in Mudarabah ……………………………………………………………………………. 10

Rules for Termination of Mudarabah Contract ………………………………………………………. 11

Types of Mudarabah……………………………………………………………………………………………………………. 12

Mudarabah Expenses………………………………………………………………………………………………………….. 14

KFH Financial Performance…………………………………………………………………….. 16

Conclision………………………………………………………………………………………………….. 16

References ……………………………………………………………………………………………….. 17

Introduction

Islamic banking is a financial entity that follows sharia laws that are dependent both on quraan and sunnah. Islamic banks invest in business that does not oppose with the Islamic sharia prinicipal and practices. Kuwait Finance House was established in the State of Kuwait, in 1977, as the first bank operating in accordance with the Islamic Shari’a. KFH is listed in Kuwait Stock Exchange (KSE), with a market capitalization of KWD 2.667 billion as of 31 December 2008. Assets total KWD 11.291 billion and deposits amount to KWD 7.262 billion. It has been awarded Best Islamic Bank in the world from CPI Financial institution for the year 2014 and the number of banks has increased after that.

Mudarabah is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprise. The investment comes from the first partner who is called “rabb-ul-mal”, while the management and work is an exclusive responsibility of the other, who is called “mudarib”. The rabb-ul-mal may specify a particular business for the mudarib, in which case he shall invest the money in that particular business only. This is called al-mudarabah al-muqayyadah (restricted mudarabah). But if he has left it open for the mudarib to undertake whatever business he wishes, the mudarib shall be authorized to invest the money in any business he deems fit.

Islamic Banking

slamic banking refers to a system of banking or banking activity that is consistent with the principles of the Shari’ah (Islamic rulings) and its practical application through the development of Islamic economics. The principles which emphasise moral and ethical values in all dealings have wide universal appeal. Shari’ah prohibits the payment or acceptance of interest charges (riba) for the lending and accepting of money, as well as carrying out trade and other activities that provide goods or services considered contrary to its principles. While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to provide an alternative basis to Muslims although Islamic banking is not restricted to Muslims.

the above diagram shows the Islamic financial system

History of Islamic Banking

The first Islamic bank was in Egypt 1963 was in mitt ghamar. It was based on profit sharing rather than commercial bank. In 1970 lahur and Pakistan recommended the creation of Islamic banks and Islamic development banks 1974 established organizations of Islamic countries (OIC) . also, in 1975 there was dubai islamic bank which was the first privet commercial bank. Then in 1977 have faisel Islamic bank of sudan and Kuwait Finance House is the first Islamic bank in Kuwait. It is providing a wide range of shariah compliant products and services covering banking, real estate, trade finance, investment portfolios and corporate, commercial and retail financial markets. KFH is now a market leader not only in the Islamic banking industry, but also in the banking sector as a whole.

Islamic Bank Features

An Islamic bank has several distinctive features as compared to its conventional counterpart. Six essential differences as below:

Abolition of Interest (Riba): Since Riba is prohibited in the Holy Quran and interest in all its form being akin to Riba as, confirmed by Fukaha and Muslim economists with rare exceptions, the first distinguishing feature of an Islamic bank must be that it is interest-free, while the abolition of Riba would be the first and essential difference between the conventional interest-based commercial banks and Islamic banks, if would not the constitute the only difference between them. The nature, outlook and operations of an Islamic bank would have to undergo a complete transaction.
Adherence to Public Interest: Activity of commercial banks being primarily based on the use of public funds, public interest rather than individual or group interest will be served by Islamic commercial banks. The Islamic banks should use all deposits, which come from the public for serving public interest and realizing the relevant socio-economic goals of Islam. They should play a goal-oriented rather than merely a profit-maximizing role and should adjust themselves to the different needs of the Islamic economy.
Multi-Purpose Bank: Another substantial distinguishing feature is that Islamic banks will be universal or multi-purpose banks and not purely commercial banks. These banks are conceived to be a crossbreed of commercial and investment banks, investment trusts and investment management institutions and would offer a variety of services to their customers. A substantial part of their financing would be for specific projects or ventures. Their equity-oriented investments could not permit them to borrow short and lend long. This should tend to make them less crisis-prone compared to their capitalist counterparts. Since the overnight, call loan or very short-term inter-bank market may be available to them only to a limited extent, they may have to make a greater effort to match the maturity of their liabilities with the maturity of their assets.
More Careful Evaluation of Investment Demand: Another very important feature of an Islamic bank is its very careful attitude towards evaluation of applications for equity oriented financing. It is customary that conventional banks evaluate applications, considers collateral and avoids risks as far as possible. Their main concern does not go beyond ensuring the security of their principle and interest receipts. Since the Islamic bank has in built mechanism of risk-sharing, it would need to be careful more careful. It adds a healthy dimension in the whole lending business and eliminates a whole range of undesirable lending practices.
Work as Catalyst of Development: Profit-Loss-Sharing being a distinctive characteristic of an Islamic bank, if fosters closer relations between banks and entrepreneurs. It helps develop financial expertise in non-financial firms also enables the banks to assume the role technical consultants and financial advisors and act as catalysts in the process of industrialization and development. The bank would take care of all the responsible and agreed financial needs of their clients thus relieving them of the need to run around for funds to overcome their normal liquidity shortages.

Objectives of Islamic Banking:

The primary objective of establishing Islamic bank all over the world is to promote, foster and develop the application of Islamic principles, law and tradition to the transaction of financial, banking and related business affairs and to promote investment companies, enterprises and concerns which shall themselves be engaged in business as are acceptable and consistent with Islamic principles, law and traditions. But the objective of Islamic bank when viewed from the context of its role in an economy, its specific objectives may be enlisted as following:

To offer contemporary financial services in conformity with Islamic Shariah;

To contribute towards economic development and prosperity within the principles of Islamic justice;

To facilitate efficient allocation of resources;

To help achieving stability in the economy;

Islam’s Approach to Ethical Investment

Given that many ethical funds have similar characteristics as Islamic funds, it is important for ethical investors attracted by the appeal of Islamic principles as well as the performance of Islamic investments to understand that there are additional prohibitions that must be applied on the products offered. These restrictions which are essentially self-imposed based on belief and conviction act a moral compass; the monitoring of the prohibitions by a Religious (Shari’ah) Supervisory Board may have prevented Islamic financial institutions to deviate from a faith-based system and absorb the shocks within the conventional financial system.

The important principles for Islamic financial instruments for participation and investments that require strict adherence, while providing good returns, are:

Investments must be free of interest, speculation and gambling, all are considered as forms of exploitation

Investments are made in permissible activities

Investments must be separately approved by an independent Shari’ah supervisory board to ensure Shari’ah principles are strictly adhered to and deviations and wayward business practice penalised, for example in Islamic finance requires penalties to be paid to charity

Differences between Islamic and Conventional banks

The oversight of a sharia board

A sharia board consists of Islamic scholars who are qualified to give opinions on Islamic business contracts. In a commercial bank, the board is also involved in supervising bank operations to make sure they comply with sharia principles.

You may wonder why a bank needs a sharia board to ensure its compliance with sharia principles. If the basic distinction between conventional and Islamic banking hinges on interest, can’t Islamic banks satisfy the requirement by just making sure none of their transactions involves charging interest?

Islamic banks and other financial institutions must comply with a variety of principles besides avoiding interest. Islamic finance is based on four core principles:

Prohibiting usury
Avoiding speculation
Avoiding gambling
Investing ethically

Interpreting each principle is more difficult than you may think. Scholars spend their lifetimes learning all they can about the intent and past interpretation of sharia law, and they still often have differing opinions about it.

Making sure that Islamic banks comply with sharia isn’t easy — hence the necessity of the sharia supervisory board. This board is the backbone of an Islamic bank; it plays a vital role in establishing and operating the bank.

Concepts of money and the basis of transactions

To say that Islamic banks are different from conventional banks because the former don’t charge interest is accurate, but it’s only the tip of the iceberg. That difference is just one of many ways that the fundamentals of Islamic banking differ from those of conventional commercial banking.

The basic purpose for establishing an Islamic bank is to promote and encourage Islamic principles. Conventional banks are profit-making organizations that generally aren’t based on religious principles. That said, earning money is also a primary function of an Islamic commercial bank. Although the bank has a specific religious purpose, it can’t serve that purpose unless it also meets the objective of earning money.

A bank serves no purpose at all if it can’t stay in business!

Islamic banks operate based on Islamic business law (called fiqh-u-muamalat) for their basic transactions, and they also follow the financial laws and regulations of the countries in which they operate. Conventional banks likewise operate based on a country’s financial laws and regulations, but they don’t have contact with any religious body.

Islamic scholars recognize that money has value, but with limitations. For example, money can’t become more valuable simply because time is passing. However, the value of money can increase if it’s invested in a project that itself is increasing (in size, in success, and so on).

Relationships with clients or customers

When you deposit your paycheck in a conventional bank, your relationship with that bank is one of creditor to debtor; the bank has a responsibility to pay back your money with or without interest according to your account contract. Similarly, the roles reverse when the bank provides you with a loan.

The relationship between a customer and an Islamic bank is completely different; the debtor and creditor relationship does exist at times in Islamic banking. To understand the relationship between the customer and Islamic bank, you must know what contract that relationship is based on.

Investments in the bank

Investments in conventional commercial banks are based on guaranteed principal and earning a fixed amount of income.

For example, say that a customer in a conventional bank deposits $10,000 in a six-month term deposit. After six months, the bank has a liability to pay back the customer the principal plus the interest rate charged for six months. Even if the bank lost the money in an investment, the bank is still liable to pay back all the money due.

In Islamic banking, the concept of investment is different. Although the customer deposits the money in order to earn extra income for her savings, her principal and returns aren’t guaranteed. Suppose the Islamic bank loses money because of an unexpected business failure. In this case, the bank isn’t liable to pay the money to its customer.

Mudarabah

“Mudarabah” is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprise. The investment comes from the first partner who is called “rabb-ul-mal”, while the management and work is an exclusive responsibility of the other, who is called “mudarib. The rabb-ul-mal may specify a particular business for the mudarib, in which case he shall invest the money in that particular business only. This is called al-mudarabah al-muqayyadah (restricted mudarabah). But if he has left it open for the mudarib to undertake whatever business he wishes, the mudarib shall be authorized to invest the money in any business he deems fit. This type of mudarabah is called ‘al- mudarabah al-mutlaqah” (unrestricted mudarabah)

A rabbul-mal can contract mudarabah with more than one person through a single transaction. It means that he can offer his money to A and B both, so that each one of them can act for him as mudarib and the capital of the mudarabah shall be utilized by both of them jointly, and the share of the mudarib shall be distributed between them according to the agreed proportion. In this case both the mudâribs shall run the business as if they were partners inter se.

The mudarib or mudâribs, as the case may be, are authorized to do anything which is normally done in the course of business. However, if they want to do an extraordinary work, which is beyond the normal routine of the traders, they cannot do so without express permission from the rabb-ul-mal.

Rules of Profit & Loss in Mudarabah

Profit may be distributed at any agreed ratio.
In case of loss, all loss will be borne by the “Rabb-ul-Mal”. Mudarib’s share of profit will not be given to Rabb-ul-Mal.

Different Capacities of Mudarib

Ameen (Trustee): The capital of Mudarabah is an Amanah in the hand of Mudarib, therefore if any loss incurs to business without negligence of Mudarib, Mudarib will not be liable for that loss.

Wakeel (Agent): When Mudarib starts the business, he becomes an Agent of Rabb- ul-Mal. Therefore, all the business activities will be carried out on behalf of the principal. And if principal (Rabb-ul-Mal) gives any instructions, Mudarib is bound to comply with these instructions.

Shareek (Partner): In case of profit, Mudarib is partner in that business to the extent of his profit share.

Dhamin (Liable): If Mudarib disobeys the instructions of Rab- ul-Mal, he is liable for loss.

Ajeer (Employee): If Mudarabah becomes void due to any reason, then Mudarib is Ajeer. He is entitled to get normal salary (Ujrat-e-Misl).

Rules for Termination of Mudarabah Contract

Each partner can terminate Mudarabah at any time.
If a time period is fixed in Mudarabah, then all partners will be responsible for the completion of this period.
Physical liquidation is not necessary, constructive liquidation can also be performed.
After liquidation all business expenses will be deducted from the capital.
Mudarib will bear all those expenses which are normally considered the responsibility of Mudarib. Although, the expenses which are not considered the responsibility of Mudarib will be deducted from the entire capital.
Capital of investor will be returned to him. Remaining amount will be the profit and distributed according to agreed ratio.

this diagram shows the mudaraba transaction

Activity:
1: Bank and Client discuss business plan; Bank provides funds to client towards

capital investment;

Client sets up the business and manages its operations;
Business generates positive or negative profits;
Profits if positive are shared between Client and Bank as per a pre-agreed ratio;
Profits if negative are absorbed by Bank; effectively bringing down the value of the asset created with its investments

Types of Mudarabah

There are 2 types of Mudarabah namely:

Al Mudarabah Al Muqayyadah: Rab-ul-Maal may specify a particular business or a particular place for the mudarib, in which case he shall invest the money in that particular business or place. This is called Al Mudarabah Al Muqayyadah (restricted Mudarabah).

Al Mudarabah Al Mutlaqah: However if Rab-ul-maal gives full freedom to Mudarib to undertake whatever business he deems fit, this is called Al Mudarabah Al Mutlaqah (unrestricted Mudarabah). However Mudarib cannot, without the consent of Rab-ul-Maal, lend money to anyone. Mudarib is authorized to do anything, which is normally done in the course of business. However if they want to have an extraordinary work, which is beyond the normal routine of the traders, he cannot do so without express permission from Rab-ul-Maal. He is also not authorized to:
a) keep another Mudarib or a partner
b) mix his own investment in that particular Modarabah without the consent of Rab-ul Maal.

Conditions of Offer & Acceptance are applicable to both. A Rab-ul-Maal can contract Mudarabah with more than one person through a single transaction. It means that he can offer his money to ‘A’ and ‘B’ both so that each one of them can act for him as Mudarib and the capital of the Mudarabah shall be utilized by both of them jointly, and the share of the Mudarib.

Difference between Musharakah and Mudarabah

Musharakah Mudarabah

All partners invest. Only Rab-ul-Maal invests.
All partners participate in the management of the business and can work for it. Rab-ul-maal has no right to participate in the management which is carried out by the Mudarib only.
All partners share the loss to the extent of the ratio of their investment. Only Rab-ul-maal suffers loss because the Mudarib does not invest anything. However this is subject to a condition that the Mudarib has worked with due diligence.
The liability of the partners is normally unlimited. If the liabilities of business exceed its assets and the business goes in liquidation, all the exceeding liabilities shall be borne pro rata by all partners. But if the partners agree that no partner shall incur any debt during the course of business, then the exceeding liabilities shall be borne by that partner alone who has incurred a debt on the business in violation of the aforesaid condition. The liability of Rab-ul-maal is limited to his investment unless he has permitted the Mudarib to incur debts on his behalf.

As soon as the partners mix up their capital in a joint pool, all the assets become jointly owned by all of them according to the proportion of their respective investment. All partners benefit from the appreciation in the value of the assets even if profit has not accrued through sales. The goods purchased by the Mudarib are solely owned by Rab-ul-maal and the Mudarib can earn his share in the profit only in case he sells the goods profitably.

Investment

In Mudarabah, Rab-ul-maal provides the investment and Mudarib the management therefore the Rab-ul-maal should hand over the agreed investment to Mudarib and leaves everything to Mudarib with no interference from his side but he has the authority to:

a) Oversee the Mudarib’s activities and
b) Work with Mudarib if the Mudarib consents.

In what form should the capital be? Should it be liquid or non-liquid assets like equipment, land etc. can these form a capital?

The basic principle is that the capital in Mudarabah is valid just the way as it is in Shirkah which according to Hanafi fiqh should be in liquid form but according to other scholars equipment, land etc can also be included as capital. However all agree on the following:

Assets other than cash can be used as an intermediate step, meaning:

However this is subject to the determination of exact amount of the assets before it is used for Mudarabah. If the assets are not correctly evaluated, the Mudarabah is not valid.

Mudarabah Expenses

The Mudarib shares profit of the Mudarabah as per agreed rate with the investor but his expenses like meals, clothing, conveyance and medical are not borne by Mudarabah. However, if he is traveling on business and is overstaying the night, then the above expenses shall be covered from capital. If Mudarib goes for a journey which constitutes Safar-e-Sharai (more than 48 miles) but does not overstay the night, his expenses will not be borne by Mudarabah.

All expenses which are incidental to the Mudarabah’s function like wages of employees/workers or Commission in buying/selling or stitching, dyeing expenses etc have to be paid by the Mudarabah. However all expenses will be included in the cost of commodities which Mudarib is selling for eg. if he is selling ready made garments then the stitching, dyeing, washing expenses etc. can be included by the Mudarib in the total cost of the garments.

If the Mudarib manages the Mudarabah within his city , he will not be allowed any expenses, only his profit share. Similarly, if he keeps an employee, this employee will not be allowed any expenses, just his salary.

If the Mudarabah agreement becomes Fasid due to any reason, the Mudarib’s status will be like an employee, meaning:

a) whether he is traveling or doing business in his city, will not be entitled to any expense such as meals, conveyance, clothing, medicine etc.
b) he will not be sharing any profit and will just get Ujrat-e-Misl (ordinary pay) for his job.

Rs.100,000/-, they cannot agree on a condition that Rs.10,000 out of the profit shall be the share of the Mudarib nor can they say that 20% of the capital shall be given to Rab-ul-Maal. However they can agree that 40% of the actual profit shall go to the Mudarib and 60% to the Rab-ul-Maal or vice versa.

It is also allowed that different proportions are agreed in different situations. For example, the Rab-ul-Maal can say to Mudarib “If you trade in wheat, you will get 50% of the profit and if you trade in flour, you will have 33% of the profit”. Similarly, he can say “If you do the business in your town, you will be entitled to 30% of the profit and if you do it in another town, your share will be 50% of the profit”.

Apart from the agreed proportion of the profit, as determined in the above manner, the Mudarib cannot claim any periodical salary or a fee or remuneration for the work done by him for the Mudarabah.

All schools of Islamic Fiqh are unanimous on this point. However, Imam Ahmad has allowed for the Mudarib to draw his daily expenses of food only from the Mudarabah Account. The Hanafi jurists restrict this right of the Mudarib only to a situation when he is on a business trip outside his own city. In this case he can claim his personal expenses, accommodation, food, etc. but he is not entitled to get anything as daily allowances when he is in his own city.

If the business has incurred loss in some transactions and has gained profit in some others, the profit shall be used to offset the loss at the first instance, then the remainder, if any, shall be distributed between the parties according to the agreed ratio.

The Mudarabah becomes void (Fasid) if the profit is fixed in any way. In this case, the entire amount (Profit + Capital) will be the Rab-ul-Maal’s. The Mudarib will just be an employee earning Ujrat-e-Misl.

The remaining amount will be called (Profit).

This profit will be shared in the agreed (pre-agreed) ratio.

KFH Financial Performance

In KFH, exposure

Arises from fluctuations in exchange rates, share prices, real estate prices and in the value of inventories and commodities.

The market risks that the bank is exposed to be limited as all Islamic financing and investment transactions are interest Free. Islamic finance contracts i.e. Mudarabah and Musharakah are based on profit and loss sharing.

	2011	2012	2013
Deposits	8.882 Million	9.339 Million	10.104 million
Mudarabah earning	2.44%	8.10%	8.45%

We can see that the performance of KFH has grown much than previuos years and the mudarabah earning has grown.

Conclision

References

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