The major drawback of Mudarabah from the bank’s asset perspective for financing is the tolerance of all financial losses by Rabb-ul-Maal only. So, when an Islamic bank agrees upon a Mudarabah contract as a Rabb-ul-Maal, then that bank has to pay for all the losses. The disproportion in case of loss situations is the main problem of Mudarabah.
The principle relating the sharing of loss and limiting it to the capital invested is not discussed in Quran. This perspective was appropriate in early Islamic era, when Mudarib was usually poor, having limited financial resources. This incompleteness refrained him from entering corruption and has no capacity of participating in sharing of loss when it occurred due to his own negligence apart from other reasons.
This fact can also be valued by having a glance at the rules defining Mudarabah, which explains the rights and duties of Mudarib. The traditions and Riwayat portray that Mudarib is poor and resource-starved man yet a skillful person of those times.
In Musharakah, as all the partners are required to work, so loss participation by all partners present in the board is justified. But, as far as Mudarabah is concerned, the complete authority of business rests with the working partner, and Rabb-ul-Maal is solely responsible for bearing the losses, which gives an unjustified view at a glance.
As an example, consider an Islamic economic system with Mudarabah as the only instrument used on asset and liability side. The Mudarib which are generally blue chip companies have no liability to share the loss and get the financing from banks, which act as Rabb-ul-Maal from the point view of assets in Mudarabah. From the liability perspective, Mudarib is the bank, while small savers and investors fall in the category of Rabb-ul-Maal. Thus, all the losses experienced by the blue chip companies are paid off by small savers and investors, and are also responsible for sharing the losses without interfering in business affairs.
Restricted Mudarabah along with deliberate negligence is not sufficient to guard them against losses occurring from business cycle fluctuations. The following example depicts that with the existing system, Mudarabah solely cannot bring about sufficient egalitarian change.
Now let’s examine trust deficit and documentation issues leading to the rare usage of Mudarabah in economic systems. Firstly relax these assumptions and focus on the trust deficit and documentation problem in the economy. The losses occurring due to business cycle fluctuations are not tolerated by the business which had the power to run the business. Not only has the bank born the loss, as it is also Mudarib from the liability perspective. Small savers and investors bear all the losses encountered.
Now suppose that interest based lending and borrowing is prohibited by the policies of the government. Will the people be interested in being Rabb-ul-Maal in Mudarabah, where all the money is taken by bank or shareholder in blue chip company, and they can easily invest or earn from it, and in case of loss it is passed on to the small savers? With the existing system, which relaxes the assumptions of trust deficit and documentation problems having no conventional competitive banking system, Mudarabah seems to be unproductive.
For the current system, Mudarib works similar to an employee where compensation is related to the profits. The entrepreneur-having the responsibility of sharing losses is Rabb-ul-Maal. The principal agent relationship present in corporate sector of organizations is different from it. The principal agent relationship includes hiring of agents but the policies have no obligations regarding the influence of principal on the decisions of the agent.
The equality in financing positions to be a pivotal question for general and Islamic bankers who are surrounded by trust deficit and documentation problems. Why people would be keen in investing in companies which provide no guarantee over par value let alone dividend and lack cash inflows to a great extent?
Equity financing is widely used with important agreements in place. In developing countries, the study of debt size and equity market is of great interest. For example, in Pakistan, there is a mild existence of corporate bond market, while equity financing covers the most part of the market. The development of certain agreements by conventional equity based institutions and instruments is the core reason behind their extensive application.
In order to make Mudarabah more effective, the following two covenants can be introduced:
a) Some capital is to be contributed by the Mudarib. This will be different from Musharakah because the sole working partner is Mudarib.
b) The loss can be shared by Mudarib to a limited extent.
The problem of adverse selection, moral hazard and principal-agent conflict could be avoided to a great extent by the inclusion of these two covenants. A famous Hadith clarifies the fact that the all conditions agreed by the Muslims are supported except for the ones which permits unlawful acts which have been prohibited.
Arguments can be made over these two agreements who would violate the principle of Al-Kharaj Bil Daman (The risk of exposure i.e. one can claim profit only if the one is ready to bear the business risk).
These arguments will not result in violation because of the principle because the given proposal does not transfer all the owed money to the Mudaribs and confirmed some fixed profit to the Rabb-ul-Maal. Rabb-ul-Maal will be legally responsible to bear losses, but Mudarib will also bear some loss sharing in participation with some capital.
To make this model under the supervision of Islamic Fiqh, combining Musharakah and Mudarabah can be done, whereas if Mudarib is included in the combination will eventually be a Sharik. This combination is widely spread in distributing liability products and is proposed by Maulana Taqi Usmani in his Book “Introduction to Islamic Finance” (p. 36) for project financing as well.
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