As discussed in the last article, my interaction with the chairman of the Shariah board on a Mudarabah transaction introduced me to what I later came to know as ‘innovation’ in Islamic finance.
As mentioned by me a few times in this space, the Shariah financing and investment contracts can be taken as ‘cast in stone’ which means you cannot alter the parameters or the sequence of execution of the transaction in any of these contracts. However, it does not mean you cannot develop something creative around them which is relevant to modern era banking and financing techniques.
While discussing Ijarah or leasing, I had explained a unilateral document called ‘promise to lease’ (see articles 62, 64 and 75) which is obtained by the Islamic bank prior to entering into a financial leasing transaction in order to protect the bank’s interest in case the bank purchases the asset but the customer does not come forward to take it on lease from the bank. The wording of the ‘promise to lease’ thus safeguards the bank’s interest in such situations since upon the customer’s default to commence the lease, the bank can sell the asset in the market and the shortfall if any, can be claimed from the customer who provided such a promise to the bank.
A question arises whether such a promise has been part of leasing from the time of early Islam when the leasing structure was perfected and subsequently started to be used. Of course not, since it happened to be a straightforward leasing of assets. As such, the ‘promise to lease’ crafted by Shariah scholars in contemporary Islamic finance can be considered as an innovation in Islamic finance, without breaching any established Shariah boundaries.
Similarly, when we talk about the incentive threshold favoring the Mudarib in a Mudarabah transaction, it is an innovation such that, on one hand, it does not collide with the core Mudarabah principles and on the other, it provides an opportunity to the parties to utilize the Mudarabah contract for a certain commercial purpose which otherwise may not have been possible.
Picture yourself as a busy trader enjoying credit lines from the conventional banks and rolling the borrowed money several times over in a year with a double-digit profit each time, but paying the banks finest interest rates circa a mid-single digit. There arrives an Islamic wholesale banker like me who thinks he has done his homework well and will rope you in as the new valuable customer for the Islamic bank he works for. Pursuant to understanding well your business modus operandi that you rely on banks’ overdraft to carry out local purchasing against cash and sell on credit at an attractive margin, he picks up a Mudarabah contract as the most suitable proposition in comparison to a conventional overdraft.
The Islamic banker provides an explanation that Mudarabah is a high-risk proposition for the Islamic bank and a low-risk one for the customer, and that it is not lending but equity investment by the Islamic bank into your business and as such, you can tell your external auditor not to count your Mudarabah outstanding as ‘bank borrowing’ since its nature is not lending which helps to lower the gearing ratio. You find it very interesting and are about to provide your consent to the Islamic banker but being a shrewd businessman, throw a very intelligent question at him. You ask: “Hang on a minute, if you said a Mudarabah facility is not interest-based borrowing, how will the bank make money from me?”
The Islamic banker explains that for sure you will not be “borrowing” from the Islamic bank and hence there is no question of charging interest. However, the bank shall “share” the profit generated by your business.
Upon hearing this, you jump from the seat: “No way. I am ok with conventional borrowing where I simply pay them a lowest interest rate and the entire profit belongs to me. Thank you very much for your visit. Goodbye.”
The Islamic banker then throws this “innovative” solution at you by saying: “Wait, wait wait. I am not done as yet.” He continues: “You see, by starting to deal with our bank’s Mudarabah facility, you will not be losing anything but merely gain. Whatever best rate you are paying to existing conventional banks, we shall share exactly the same amount of profit with you — nothing more.”
Elaborating this point further, he says: “There will be a ratio of profit sharing between you and the Islamic bank in the Mudarabah contract; however, the agreement will also have a clause whereby we will state that if our share of profit is equal to what you are paying as the interest rate to the conventional bank, we shall grant you any amount over and above such earning as the performance incentive and the end result will be the same as you have been paying to the conventional banks on overdraft.” You provide consent to the Islamic banker to try out the Mudarabah facility if that is the case.
The point to note here is that no trader will ever want to ‘share’ the recurring profit with any third party; nevertheless, he will be more than happy to pay the finance charges which ensures there is no encroachment on the territory of trading profit. In this scenario, how would Islamic banks compete with their conventional peers to get a share of the market? Of course with an innovative approach here and there, including the incentive threshold in Mudarabah, Musharakah and Wakalah contracts.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions of the Dubai Islamic Economy Development Centre, nor the official policy or position of the government of the UAE or any of its entities. The purpose of this article is not to hurt any religious sentiments either consciously or even unwittingly.
Sohail Zubairi is the senior advisor with the Dubai Islamic Economy Development Centre. He can be contacted at [email protected].
Next week: I shall move on from the incentive threshold to discuss the other aspects of Mudarabah.