- Contract : Mudarabah Contract
- Definition : Profit and Loss Sharing
- Transaction : Entrepreneurial venture
- Category : Investment
- Secondary contract : Nil
- Commonly used for : Fixed Deposit, Current Account, Savings Account, Interbank Transactions
Mudaraba was a favourite contract amongst Islamic Bankers. It allowed for the notion of investments and profit sharing, while employing investment strategies that mitigates the risk to investments. It is being used for various types of deposit contracts; savings account, current account, term deposits and investment account.
In Malaysia, Mudaraba-based products are classified as Investment Accounts (not Deposits) i.e. non-capital protected, returns based on profit and potentially loss-sharing. This is based on the Investment Account guidelines issued by BNM in 2014.
WHAT IS MUDARABAH?
The contract of Mudaraba is a profit sharing joint-venture where the Investor (as Rab Ul Mal) offers to provide funds to the manager/Bank (as Mudharib) to manage the funds (Ras Ul Mal) in Shari’a compliant investments over a specific length of time.
All the funds for investment are collected in a pool of funds which will be used to invest in profitable ventures. Both the Rab Ul Mal and the Mudharib will agree to a Profit Sharing Ratio (PSR) prior to the start of the investment joint-venture. The profit shared between the Rab Ul Mal and the Mudharib shall be after deduction of management fees and any agreed Profit Equalisation Reserve (PER). Should the investment fail to generate an income or suffers a loss, the Rab Ul Mal shall have to bear the loss of the investment, except when the Mudharib is proven negligent or fraudulent.
AAOIFI’s verbatim Definition of Mudharaba
It is a partnership in profit between Capital and Work. It may be conducted between Investment Account Holders as Providers of Funds and the Islamic Bank as a Mudharib. The Islamic Bank announces its willingness to accept the funds of Investment Account Holders, the sharing of profits being as agreed between the two parties, and the losses being borne by the provider of funds except if they were due to misconduct, negligence or violation of the conditions agreed upon by the Islamic Bank. In the latter cases, such losses will be borne by the Islamic Bank. A Mudaraba contract may also be concluded between the Islamic Bank, as a provider of funds, on behalf of itself or on behalf of the Investment Account Holders, and business owners and other craftsmen, including farmers, traders, etc. Mudaraba differs from what is known as speculation which includes an element of gambling in buying and selling transactions.
TYPES OF MUDARABAH INVESTMENT ACCOUNTS
There are two types of Investment Accounts, namely:
- General / Unrestricted Investment Account (Mudharaba Al Mutlaqah)
The Investor allows freedom for the Bank to undertake in any Shari’a-compliant investment as he seems fit and within the normal course of business. The funds will be deposited into a General Investment Account pool which will be used by the Bank to manage the funds so long as the investment is made in the best interest of the Investor.
With this type of account, the Investment Account Holder authorises the Islamic Bank to invest the account holder’s funds in a manner which the Islamic Bank deems appropriate without laying down any restrictions as to where, how and for what purpose the funds should be invested. Under this arrangement the Islamic Bank can commingle the Investment Account Holder’s funds with its own funds or with other funds that the Islamic Bank has the right to use (e.g. Current Accounts). The Investment Account Holders and the Islamic Bank generally participate in returns on the invested funds. (AAOIFI 2008)
- Specific / Restricted Investment Account (Mudharaba Al Muqayyadah)
The Bank is given specific instructions by the Investor to invest in a particular Shariah-compliant business venture, where the funds will not be co-mingled in the general investment pool of funds. The funds will be deposited in a Specific Investment Account where the Bank will invest the funds into instruments identified by the Investor as instructed or outlined in an investment agreement.
With this type of account, the Investment Account Holder imposes certain restrictions as to where, how and for what purpose his funds are to be invested. Further, the Islamic Bank may be restricted from commingling its own funds with the restricted Investment Account funds for purposes of investment. In addition, there may be other restrictions which investment account holders may impose. For example, Investment Account Holders may require the Islamic Bank not to invest their funds in instalment sales transactions or without guarantor or collateral or require that the Islamic Bank itself carry out the investment rather than through a third party. (AAOIFI 2008)
THE INVESTMENT PROCESS
- The Bank, as Mudharib, has the responsibility to prudently invest the funds deposited into the investment pool in low / medium risk short-term investments to mitigate the investment risks.
- The Investor’s fund shall be invested in Shari’a compliant investment instruments such as the Islamic Money Market, Islamic Interbank Investments or other investments such as Sukuks. Alternatively, the funds can be used for Islamic financing of assets, when available.
- Investor specifies the amount and duration of the investment. Both the Investor and the Bank agrees on the PSR at the start of the investment period and may not be changed once the funds are invested.
- Upon maturity, the Bank will divest the funds and make the capital available to the Investor.
- The Bank will declare the profit (if any) for the investment at quarterly investment cycles. The profit to be distributed between the Bank and the Investor, calculated after deducting costs and expenses related to the investment based on the agreed PSR.
UTILISATION OF FUNDS
The funds for the investment pool will invested in selected Shari’a compliant investments with maturities of up to 1 year. The investor agrees to allow the Bank to manage the funds based on the Bank’s expertise and discretion.
RECOGNITION OF PROFITS AND BEARING OF LOSS
Profit is recognised upon realisation of the investments at the end of each investment cycle and shall be paid to the Investor according to the terms of the individual Mudaraba contract.
Under the BNM Rate of Rate of Return framework, the profit calculation and distribution must strictly follow the format outlined by BNM, via specific calculation templates. This is to ensure transparency in calculation of the profit and its distribution according to disclosed rules. Failure to comply with the methodology will result in stiff reprimand by BNM.
DISPLACED COMMERCIAL RISKS
The idea of Mudarabah and sharing of risks (and therefore sharing of profits) means that the investors gets a return based on actual performance. But Banks (being Banks) always intend to manage the returns to the investments as conventional banks do, which is “fixed”. Because of this, Banks recognised another type of risks for Islamic Banks i.e. Displaced Commercial Risks.
Displaced Commercial Risks simply mean this; the Bank intends to pay an indicative return to customers, but because the returns to the investment / asset was unable to “perform” or pay as expected (real performance), the Bank faced a risk that they are not able to meet the expected returns for their customers. To stabilise the returns on the investments, Profit Smoothing Techniques are used to improve the returns on the investments.
There are 2 scenarios when it comes to Profit Smoothing Techniques. For example the indicative (target) returns on the investment is 5.0% per annum:
- When the actual performance is HIGHER i.e. 6.0% per annum, the Bank will retain 1.0% into the reserves thus retaining a net returns of 5.0% per annum. This 1.0% is kept until re-distributed in the future.
- When the actual performance is LOWER i.e. 4.50% per annum, the Bank will “boost” the returns by 0.50% thus returning a rate of 5.0% per annum to investors. This 0.50% is taken from one of the few reserves available or other sources (explained below).
In general, there are 4 commonly used Profit Smoothing techniques in the market to manage the returns on Mudarabah.
- The use of Profit Equalisation Reserve (PER) where a certain level of returns is deducted from the Gross Distributable Amount. This is the most popular methodology used but also the most controversial one
- The waiver of Mudarib Share of Profit. While Mudarabah operates by a Profit Sharing Ratio (for example PSR of 70 Customer : 30 Bank), the Bank can improve returns by waiving its share of the profits (Tanazul) to improve the overall returns to the customer. If the Bank’s share of profit is 30%, the Bank may waive some or all of its profit and dump it into the Pool of Income to improve overall rate of returns.
- The use of Investment Risk Reserves (IRR). Although similar to PER, IRR is deducted from the Net Distributable Amount and usually used to reduce the returns to achieve stability. The amount may or may not be re-invested into the pool of Income to improve returns.
- Hibah or “Gift” payments from other income sources into the Investment return pool. Where all else fails, there is nothing better than a direct injection of funds into the Income Pool to improve overall returns. Such injection can come from the Retained Earning, Transfer of fund from other Non-Mudarabah Income Pools, or a straightforward “gift” payment from Shareholders Funds.
PROFIT EQUALISATION RESERVE
In the event of loss to the Investor’s investment, the Bank may return a portion of the Profit Equalisation Reserve (PER) in order to stabilise the Investor’s overall returns or reduce the following month’s PER ratio.
There is a general methodology to treating the losses for Investments, with the following steps to be met:
- The loss should first be deducted from any undistributable profits on the investment. This implies to PER.
- Any loss amount in excess of the above to be deducted from provisions for investment losses. This implies the use of any allocated reserves.
- Any remaining amount after the above, is to be deducted from the respective equity shares held by the Islamic Bank and the Investment Account Holders, according to each party’s equity contribution. This implies compensation via Shareholders Funds.
For losses resulting from the Bank’s misconduct or negligence, the following method of compensation must be followed:
- The compensation to be deducted from the Bank’s Share of Profits. This means the Mudharib Fees may end up being zero.
- Any shortfall will be met by Shareholders Funds (equity).
The current scenario (since 2011) is that BNM no longer encouraged the use of PER and has placed strict requirements if a bank wants to use it. As a result most Banks (if not all) have felt it is difficult to comply with the requirements and had now stop using PER as a smoothing technique, especially since the Investment Account guidelines was issued in 2014. To read the Guidelines on PER, click here.
PAYMENT OF PROFIT AND REALISATION OF LOSSES
The profit from the investment will be paid at the end of the investment cycle. The profit from the investment can be distributed based on the following scenario:
- Profit paid on the expiry of the investment contract. Profit and principal will be paid to investor if the expiry of the investment equals to the investment cycle.
- Profit paid after the expiry of the investment contract. On expiry of investment contract, the principal will be returned to the investor while the profit will only be paid once declared at the end of the investment cycle.
- Profit paid before the expiry of the investment contract. Usually applicable when there is interim payment of profit. For example, the investment contract is for a tenor of 1 year, and profit is declared and paid each quarter. The investor can choose to withdraw the profit each quarter and the principal plus final profit will be paid at the end of the investment cycle.
The Bank can choose to pay additional profits to a particular Investor segment but the additional amount must be deducted from the Bank’s own share of profit i.e. the Mudharib pool of profit. It must not diminish the pool of profits attributable to the Investors. However, this method is now no longer encouraged as it is deemed as profit smoothing technique following the introduction of the Investment Account framework in 2014.
In cases where there is partial withdrawal of the principal, the Bank can provide a reduced rate of return on the amount withdrawn while the remaining portion will be entitled to the full rate of return upon maturity. The calculation of the partial withdrawal profit will be based on the formula for premature withdrawal as above. The total profit will only be payable at the end of the investment tenure.