Guide to mitigation of risks in a Mudarabah transaction

In-Depth Analysis

From articles 94 through the current discussion, readers may have gathered that, contrary to conventional finance, the risks are not considered alien in Islamic finance, and that accommodating them in a transaction actually acts as a balancing factor between the rights and obligations of the parties over each other. Moreover, the spectacle of not eliminating the risks from Islamic financing transactions allows distributing the odds evenly between the parties, as opposed to conventional financing transactions where the odds are always heavily staked against one party — the borrower (or the obligor as commonly regarded in the loan documentation). When a depositor of an Islamic bank makes a Mudarabah term deposit, he or she (or 'it') immediately gets exposed to the performance risk of the bank. What if the Islamic bank is held back from performing normally (as per depositors' expectations) due to any extraordinary situation, such as the current COVID-19? Please note that the term deposit agreement provides for sharing the actual profit with the depositor during the deposit period based on a distribution ratio. It means whatever actual Mudarabah profit is earned by the Islamic bank during the fiscal periods of the validity of the deposit, the customer will benefit from it. However, in order to ward off any unfavorable situation, the Islamic banks maintain profit reserve accounts where a certain portion of the annual profit is retained for rainy days before distribution. The reserve accounts are dipped in for distribution to depositors and shareholders when the going gets tough and the Islamic bank is finding it difficult to continue to maintain earnings it used to make during the normal market conditions. By utilizing the profit reserve accounts, the Islamic bank is still able to pay near-normal returns by filling the gap between the actual result and the expected one. The question is why does an Islamic bank need to undertake such an effort when it is adequately protected by the deposit contract which does not guarantee any specific return in percentage terms or the amount, and is simply required to distribute whatever it actually earns? Bankers reading this article know how difficult it gets to retain deposits during a crisis situation where the customers who have obtained financing are genuinely unable to pay back to the Islamic bank due to market disruption. In such circumstances, every deposit counts and the profit reserve accounts come in handy to keep the depositors and shareholders content until the economy is able to weather the storm. So therefore, by adopting the profit reserve account policy, the Islamic bank is able to mitigate the risk of losing the depositors, and the depositors' risk of receiving mediocre returns in difficult market conditions is also taken care of.