Microfinance is defined to be providing small loans to poor people who are traditionally excluded from the financial system. Microfinance is a powerful tool to fight poverty. Microfinance means building financial systems that serve the poor and helps them raise income, build their assets, and cushion themselves against external shocks. Microfinance will reach its full potential only if it is integrated into a country's mainstream financial system. According a CGAP survey almost 72% of people in Muslim countries do not use the formal financial services because financial system is interest-based which is prohibited in Islam (Karim, Tarazi and Reille, 2008).
The Islamic world is enormous with approximately 1.2 billion people across different countries. However, poverty is rampant and widespread across the Islamic world. Access to finance is very low based on their religious beliefs. This is a huge population under poverty and needs immediate and significant consideration to achieve the goal of making poverty history by 2015 as pledged in the Millennium development goals.
These poor Muslim micro entrepreneurs need and demand access to financial services which do not compromise their religious beliefs of interest prohibition. Their demand can be met by designing financial products which are compatible with norms of Islamic finance which are based on prohibition of interest, avoidance from Gharar, Halal or permissible use of funds and non exploitation.
The Islamic alternative to interest-based conventional loan is partnership based, trade based or lease-based credit that permits the ownership and/or use of commodities or physical assets needed for productive enterprise. Partnership based modes work on profit and loss sharing and there exists a mutual agreement between financier and micro entrepreneur for a specific business. Combination of business contracts in this category includes Mudaraba, Musharka and diminishing Musharka. Our current write up is focused only on Mudaraba.
What is Mudaraba
Mudaraba is an Arabic word which means a business (project) in which capital is provided by one party (a company or individual) while effort and skill are contributed by the other party (beneficiary, entrepreneur or borrower). "Mudaraba" is a kind of partnership where one partner provides financial capital or (Capital) to the other for investing it in a commercial enterprise. The owner of financial capital is called "rabb-ul-mal", and the partner with entrepreneurial skills is called the "Mudarib". Work and management is the sole responsibility of Mudarib and "Rabb-ul-Mal" or capital owner is a sleeping partner. The capital owner has a choice to impose a restriction on "Mudarib" about the nature of business for investment. If he imposes a restriction on "Mudarib" this will be called as "Restricted Mudaraba" otherwise it will be "Unrestricted Mudaraba". The capital owner can engage more than one person as "Mudarib" but for the sake of simplicity we will only consider a two-party Mudaraba.
Distribution of profit in Mudaraba It is necessary for the validity of Mudaraba that profit sharing ratio is agreed between the parties; right at the beginning of the contract profit sharing has to be in proportionate terms and a "Lump sum" amount cannot be allocated either to capital owner (Rabb-ul-Mal) or to the Mudarib. Profit Sharing ratios may take many variations under different situation. Share in expected profit is the reward for both parties. "Mudarib" can claim any compensation as salary for the work he has done. However he can claim logical business expenses on actual basis subject to certain conditions. If the Mudarib has undertaken more than one business initiatives and has incurred loss in some transactions and has gained profit in some others, the profit shall be used to offset the loss at the first instance, and then the remainder, if any, shall be distributed between the parties according to the agreed ratio. In case of overall loss the capital owner will lose his capital and "Mudarib" will lose his potential reward from profit. Neither party can claim financial compensation in case of loss.
Termination of Mudaraba The contract of Mudaraba can be terminated at any time by either of the two parties. The only condition is to give a notice to the other party. However to avoid adverse effects for both parties they can specify the conditions which may lead to termination of Mudaraba while entering into the contract.
A Mudaraba Model of Microfinance Under a Mudaraba contract the bank provides the capital needed for a micro enterprise while the micro entrepreneur offers labor and expertise. The profits (or losses) from such financing are shared between the bank and the entrepreneur at a fixed ratio. Financial losses are assumed entirely by the microfinance program; the liability of micro entrepreneurs is limited to their time and effort. The contract between the Microfinance program and the entrepreneur is known as restricted Mudaraba because the Microfinance program agrees to finance specific business activities by micro entrepreneurs and to share relative profits according to an agreed percentage. To engage in Mudaraba transactions a bank must meet the following legal obligations:
Assumptions of the Model
A person approaches the Islamic Microfinance program with his request of financing. A loan officer from the program will check the qualifying criterion and if qualified will ask about his/her business activities. By interviewing client Loan officer assesses the suitable product. If the business nature of the customer is such that it is possible to calculate the profits easily he will adopt Mudaraba as the right product to be offered to client. We suppose that prospective "Mudarib" is a grocery store owner and he wants to add a cold dink corner to his existing business where he will be selling cold drinks of a famous brand like "Coca Cola or Pepsi". Since being the famous brand sale and purchase prices are known and profits can be calculated. It is assumed that prices and profits margins do not change over the span of Mudaraba so that assumption of fixed profit remains true.
Famous cold drink brands provide sellers with deep freezer to chill their products free of cost and electricity charges are to be paid by seller. It is assumed that prospective "Mudarib" is able to calculate the electricity cost of the deep freezer. Such an understanding of cost is necessary as he will not be selling cold drinks alone but a variety of other items as well. Upon getting all the necessary details and successful completion of required verifications Islamic Microfinance program approves his application and enters into Mudaraba agreement with him on following terms and conditions: i. Contribution of Islamic Microfinance program will be Rs, 10,000 and the "Mudarib" will contribute by his labor. ii. Profit sharing ratio is 20:80 i.e. Share of Islamic Microfinance Program will be 20% while that of Micro enterprise or Mudarib is 80%. iii. Tenure of Mudaraba will be one year. iv. As Microfinance program cannot remain partner for indefinite period. For successful completion of Mudaraba "Mudarib" or micro enterprise will purchase the capital invested by the Microfinance program over the period of Mudaraba.
For the sake of simplicity it is assumed that Invested capital is divided into 12 equal shares and "Mudarib" will buy one (01) share on monthly basis. Profits will also be shared on Monthly basis. In this case "Mudarib" will buy a share worth Rs.833.33 on Monthly basis or 8.33% of total share.
Now the amount disbursed to the Mudarib for onward investment in Cold drinks business. According to our assumption of fixed profit micro enterprise earns a profit of Rs. 2000 till the end of 1st month. During the 1st Month Microfinance program was 100% owner of capital so it will receive Rs. 400 as profit share while the profit share of micro enterprise or "Mudarib" will be Rs. 1400. As per agreement micro enterprise will bur a share from invested capital worth Rs. 833.33/. Total payment by the "Mudarib" to the program will be:
Opalesque Islamic Finance Intelligence
Tuesday, March 22, 2011
Featured Structure: Islamic Business Contracts and Microfinance A case of Mudaraba, By Azhar Nadeem