What is Wealth Creation in Islam?
Islamic financial instruments/transaction that facilitates halal earning
Mudarabah (Profit and Loss Sharing)
This is a contract between two parties; one provides the capital and the other provides the labour to form a partnership to share the profits by certain agreed proportions.
Profits generated are shared between the parties according to a pre-agreed ratio—usually either 50%-50%, or 60% for the mudarib and 40% for rabb-ul-mal. If there is a loss, the first partner “rabb-ul-mal” will lose his capital, and the other party “mudarib” will lose the time and effort invested in the project.
The structure of Mudarabah is very similar to that of venture capital where the venture capitalist finances the entrepreneur who provides management and labour, so that both profit and risk are shared. Such participatory arrangements between capital on one hand and labour and management on the other, reflect the view of Islamic banking proponents that under Islam the user of capital would not bear all the risk/cost of a failure. And that this would result in a balanced distribution of income and prevent financiers from dominating the economy.
The rabb-ul-mal may specify a particular business for the Mudarib, in which case he shall invest the money in that business only. This is called al-Mudarabah al-Mqayyadah (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 rabul-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 jointly, and the share of the mudarib shall be distributed between them according to the agreed proportion. In this case, both the mudaribs shall run the business as if they were partners inter se.
The mudarib or mudaribs, as the case may be, are authorized to do anything which is normally done during the business. However, if they want to do extraordinary work, which is beyond the normal routine of the traders, they cannot do so without express permission from the rabb-ul-mal.
This is a financial contract between two or many parties to establish a commercial enterprise based on capital and labour. The profit and loss are shared at an agreed proportion according to the amount of contribution. Since Islam has prohibited interest, this instrument cannot be used for providing funds of any kind. Therefore, musharakah can play a vital role in an economy based on Islamic principles.
Interest predetermines a fixed rate of return on a loan advanced by the financier irrespective of the profit earned or loss suffered by the debtor, while musharakah does not envisage a fixed rate of return. Rather, the return in musharakah is based on the actual profit earned by the joint venture.
The financier in an interest-bearing loan cannot suffer loss while the financier in musharakah can suffer loss if the joint venture fails to produce fruits. Islam has termed interest as an unjust instrument of financing because it results in injustice either to the creditor or to the debtor. If the debtor suffers a loss, it is unjust on the part of the creditor to claim a fixed rate of return; and if the debtor earns a very high rate of profit, it is injustice to the creditor to give him only a small proportion of the profit leaving the rest for the debtor.
This mode is often used in investment projects, letters of credit, and the purchase of real estate or property. Musharakah may be “permanent” (often used in business partnerships) or “diminishing” (often used in financing major purchases, see below). In Musharakah business transactions, Islamic banks may lend their money to companies by issuing “floating rate interest” loans, where the floating rate is pegged to the company’s individual rate of return so that the bank’s profit on the loan is equal to a certain percentage of the company’s profits.
1. In the modern economic system, it is the banks which advance depositors’ money as loans to industrialists and traders. If industrialists having only ten million of their own, acquire 90 million from the banks and embark on a hugely profitable project, it means that 90% of the project has been created by the money of the depositors while only 10% has been created by their own capital. If this huge project brings enormous profits, only a small proportion i.e., 14 or 15% will go to the depositors through the bank, while all the rest will be gained by the industrialists whose real contribution to the project is not more than 10%. Even this small proportion of 14 or 15% is taken back by the industrialists because this proportion is included by them in the cost of their production. The net result is that all the profit of the enterprise is earned by the persons whose own capital does not exceed 10% of the total investment, while the people owning 90% of the investment get no more than the fixed rate of interest which is often repaid by them through the increased prices of the products.
On the contrary, if in an extreme situation, the industrialists go insolvent, their own loss is no more than 10%, while the rest of 90% is totally borne by the bank, and in some cases, by the depositors. In this way, the rate of interest is the main cause for imbalances in the system of distribution, which has a constant tendency in favor of the rich and against the interests of the poor.
2. Conversely, Islam has a clear-cut principle for the financier. According to Islamic principles, a financier must determine whether he is advancing a loan to assist the debtor on humanitarian grounds or desires to share his profits. If he wants to assist the debtor, he should resist from claiming any excess on the principal of his loan, because his aim is to assist him. However, if he wants to have a share in the profits of his debtor, it is necessary that he should also share in his losses. Thus, the returns of the financier in Musharakah have been tied up with the actual profits accrued through the enterprise. The greater the profits of the enterprise, the higher the rate of return to the financier. If the enterprise earns enormous profits, all of them cannot be secured by the industrialist exclusively, but they will be shared by the common people as depositors in the bank. In this way, musharakah tends to favor the common people rather than the rich only.
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