Addresses the controversial question of why Islamic banks use conventional interest rate benchmarks (LIBOR) for Mudarabah incentive thresholds. Explains the concept of Islamic financial innovation — including the 'promise to lease' — and how Mudarabah's equity-based nature means the rate serves as a performance benchmark, not an interest charge.
In-Depth Analysis
As discussed in the last article, the interaction with the chairman of the Shariah board on a Mudarabah transaction introduced the author to what he later came to know as 'innovation' in Islamic finance. As mentioned a few times in this series, 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, the author had explained a unilateral document called 'promise to lease' which is obtained by the Islamic bank prior to entering into a financial leasing transaction in order to protect the bank's interest. The 'promise to lease' was an innovation crafted by Shariah scholars in contemporary 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 that on one hand 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. 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. 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. 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. The incentive threshold merely uses a conventional rate as a benchmark — a measuring stick — for determining how much of the profit the Rab Al Maal will retain. The point to note 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.
What You Need to Know
- 1Using LIBOR/conventional rates as a benchmark is a Shariah innovation — it serves as a performance threshold, not an interest charge
- 2The incentive threshold does not collide with core Mudarabah principles: profit is still shared, not predetermined
- 3Mudarabah financing is classified as equity investment, not debt — this lowers the customer's gearing ratio
- 4Innovation in Islamic finance is permissible when it does not breach established Shariah boundaries
- 5The 'promise to lease' precedent in Ijarah demonstrates how Shariah scholars accommodate modern business needs
- 6Islamic banks compete through innovative Mudarabah, Musharakah, and Wakalah incentive structures
Key Statistics
U.S. Market Relevance
As US Islamic finance transitions from LIBOR to SOFR benchmarks, this article explains why using conventional rates as benchmarks is Shariah-permissible. US Islamic banks and fintechs can use SOFR-based thresholds in their Mudarabah products without compromising Shariah compliance, making their products commercially competitive.
Compare Halal InvestmentsFurther Reading
Ready to Apply This Knowledge?
Compare halal financial products using the concepts you just learned.
Compare Halal Investments