Mudarabah is an Islamic mode of financing between the bank, providing a specified amount of capital, and the Mudarib, providing management for carrying out the venture, trade or service with a view to earning profit. It is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprise. The former is called Rabb - ul - mal and the latter is called Mudarib.
Thus, Mudaraba is a contract between those who have capital and those who have expertise, where the first party provides capital and the other party provides the expertise with the purpose of earning Halal (lawful) profit which will be shared in a mutually agreed upon proportion. This type of business venture serves the interest of the capital owner and the Mudarib (agent).
The capital owner may not have the ability or the experience to run a profitable business. On the other hand, the agent (the Mudarib) may not have adequate capital to invest in a business or project. Therefore, by entering into a contract of Mudarabah each party complements one another, allowing a business venture to be financed.
- The bank provides to the customer (Mudarib) all the capital to fund a specified enterprise.
- The customer does not contribute capital but contributes management expertise (or entrepreneurship).
- The customer is responsible for the day to day management of the enterprise and is entitled to deduct its management fee (Mudarib fee) from the enterprise's profits.
- The Mudarib fee could be a fixed fee (to cover management expenses) and a percentage of the profits or a combination of the two.
- Classical Mudarib fee is based on percentage of the profits only.
- The balance of the profit of the enterprise is payable to the bank. If the enterprise makes a loss, the bank (as the fund provider or rab al maal) has to bear all the losses unless the loss has resulted from negligence on the part of the Mudarib. The Mudarib, in turn, will lose his efforts.