Why 'one-size-fits-all' approach cannot be applied in Islamic investment contracts

In-Depth Analysis

On several occasions in this series, the author has referred to the high point in Islamic finance: the 'one-size-fits-all' approach found in conventional banking cannot be applied here. The four sale-based contracts — Murabahah, Salam, Istisnaa, and Ijarah — are used in different situations. Similarly, the three investment contracts serve different risk appetites and circumstances. The Mudarabah contract is where one party provides 100% funding but without permission to participate in managing the business, whereas the other party who did not invest a penny is given full control. Then comes the Musharakah contract where both parties are investing capital (that could be with any ratio) and are permitted to jointly run the day-to-day business affairs. The last one is the Wakalah (investment agency) contract where the full capital is provided by one party who also decides how, where, and for how long it will remain invested, and the other party has no say in it except to comply with the instruction. When analyzing all of this, the author's conclusion is that the Mudarabah contract is the high-risk proposition, the Musharakah contract falls under a medium-risk venture, whereas the Wakalah contract is the low-risk undertaking. These different risk levels are commensurate with the varied nature of people: some want to take high risk anticipating a high return, some are content with modest risk and want to remain involved, and the last ones want to be sure of what is happening and merely instruct the agent to act upon them. At the end of the agreed Mudarabah tenure, the profit is determined and distributed between the parties according to the pre-agreed distribution ratio. The ratio of distribution of profit must be agreed between the Rab Al Maal and the Mudarib from the outset and clearly entered into the Mudarabah contract. The profit share of each party is stated as a percentage of the actually realized profit, not a lump sum amount which may have no relevance to the actual profit. Any condition that allocates a lump sum amount to one party would not be consistent with the paradigm of sharing the profit, because a Mudarabah contract is in essence a partnership in profit. On the other side, the Mudarib shall only be entitled to share the Mudarabah profit, and must not be paid any fee to manage the Mudarabah affairs. The basis for the impermissibility of simultaneously receiving a share of the profit and a fee for managing a Mudarabah is because the fee is a known amount and the principle of Mudarabah is based on sharing the actual profit which is an unknown amount. However, it is permissible that the Rab Al Maal voluntarily grants an incentive to the Mudarib out of the share of its own realized profit.