The Validity of Two Tier Mudharabah

By right, the majority of Muslim scholars disallowed the practice of the two tier mudharabah (mudharib yudarib) without ‘the consent and approval’ by the investor in the first tier mudharabah. With reference to al-Sarakshi; “It is not permissible for the mudharib to enter the second tier mudharabah which results the second mudharib will share the profits whilst the the first rabbul mal has only consented to only share the profits with the first mudharib”.

However, in according to Hanfis the two tier mudharabah was valid with the condition the rabbul mal in the first tier mudharabah gave his consent for the mudharib to enter the second tier mudharabah. Modern Muslim scholars take this opinion with regards to this matter.

The Two Tier Mudharabah

With the passage of time, the business practices become more complex and widespread over the world. Even, some buyers and sellers are not ‘physically attended in the same majlis’. They are just connecting to each other thru various sophisticated technologies like email, video conferencing, ‘social networking portal’ and others. In the present day, the concept of ‘e-trading’ becomes more popular among the Muslims. In Malaysia for example, there are some companies more encouraging their ‘potential clients’ to execute buying and selling of their products or services via e-trading. The various government agencies also encourage people to settle all the related bills via online services portal. Under this kind of situation, the role of financial intermediation such as banks is becoming much important in facilitating such kind of the modern business nature.

If we turn to many years back, most of the business ventures were conducting in a way that ‘sellers and buyers’ physically present and ‘face-to-face’ to each other to conclude the deals. Whereby, the market segment during the time is not quite widespread as at today.

With regards to this importance, Islamic financial intermediation has to play the similar roles as the conventional practice but as an alternative for those who want to be away from the riba’ based system. A part of that, Islam introduced a concept of two-tier mudharabah to be practiced in the Islamic financial intermediation in order to mobilize funds from the surplus users to the deficit users with the purpose of business and profit sharing. Pertaining to this, it gives freedom to the Islamic financial intermediation to expand partnership to create a pool with a large number of capital providers as passive partners.

The above diagram, summarizes the concept of the two-tier mudharabah in Islamic financial intermediation.

In the very early stage, Islamic financial intermediation more emphasized to the concept of interest free banking i.e. Islamic bank as an alternative to ‘the conventional banking’ which had already been realized since more than 400 years ago whereby interest based lending and borrowing was the primary ground of its operations which is totally prohibited by Islam.
In the early 1960s the efforts had been started by the academicians and Islamic movements to study about the reality of interest free banking practices. Finally after ‘head and tale’, the first shariah based principle banking was established under the flagship of Mit Ghamr Savings Bank in Egypt, 1963. From the point of time, Islamic banking had become more and more widespread over the world and not only limited the Muslim countries but also to the non-muslim countries like China, United States, Korean and some others.

Now, we back our discussion to the two-tier mudharabah model practiced by the Islamic financial intermediation as an alternative to ‘lending and borrowing based on riba’ or interchangeably refers to the interest rate.

Basically, it is a ‘musharakah company’ which establishes and running the operation of a bank or financial intermediation to mobilize funds from the surplus users on profit sharing basis then extends these funds to the deficit users on the same basis.

The ‘musharakah company’ which acts a parent company of the bank was set up based on the initial capital contributed by the shareholders. The shareholders might be individual investors, corporate investors and government investment arms. In the case of first Islamic bank in Malaysia, that is Bank Islam Malaysia Berhad (BIMB) which started its operation in 1983, its major shareholder is Lembaga Urusan Tabung Haji (LUTH) that is one of the statutory bodies of Malaysia government to manage pilgrimage to perform ‘hajj’ in Mecca.

As shareholders of the musharakah venture, they could be directly involved in the management of the financial intermediation or thru their representatives in the board of directors or just being a ‘passive partner’. If all the shareholders agreed to involve in the management, each and everyone should be treated as an agent of another. All the business matters which are carried out must be in consensus or authorization by other shareholders.

In case of profit, there must be a pre-agreed ratio before the musharakah took place. If not, no validity could be effective between the contracting parties. For a passive partners, the pre-agree ratio should not be exceeded to their capital contribution ratio.

In term of losses, it is based on the capital contribution ratio by the shareholders. If let say a shareholder contributed 30% of the initial capital, he (she) should not be liable to the losses which is more than 30% of his (her) capital contribution.

A part to the termination without the closing down of the business operations of the financial intermediation, if anyone from the shareholders decided to end his (her) musharakah contract, there must be a mutual agreement to presume business as normal. This is because under musharakah, one shareholder does not imply his (her) termination between the other shareholders. Then, the leaving shareholder may take back his capital proportion or sell to the other shareholders with mutual agreement and fair valuation agreed by all shareholders.
Since the flexible structure of different tiers has become the basis of modern Islamic financial intermediation, therefore we shall look at two level of mudharabah:

(1) The first tier mudharabah
(2) The second tier mudharabah

The Concept of Mudharabah

Before we move on further to the concept of two-tier mudharabah, let’s briefly define what actually mudharabah is. Historically, different scholars had put their own interpretations which the differences were only about the depth and breadth of the definitions.

The above diagram shows a traditional flow of mudharabah practice which implies ‘rabbul mal’ as a capital provider and investor to the ‘mudharib’ which the latter acts as an entrepreneur to establish and manage the mudharabah venture with pre-agreed ratio of profits upon the completion of the venture. It seems more emphasized to the relationship between the investor and entrepreneur rather than the creditor and debtor in the conventional practice.

In case of losses which caused by the natural impacts of business cycle’, investor will absorb fully 100% and the entrepreneur only loses in term of his opportunity cost. That means he receives nothing for his entrepreneurship in the venture. However, if the losses incurred due to the negligence or mismanagement by the entrepreneur, he should also be liable to a certain portion of the losses.

Amongst the definitions of mudharabah which were prescribed by the prominent Muslim scholars as per below:

(1) Malikis – “A trading agency in delivered cash for a portion of profits”

(2) Shafie – “An agreement between an owner of capital and a worker which the former hands on the capital to the latter to establish trading. Upon the completion of the trading, the arising profits will be shared between them”

(3) Hanbali – “A contract which a person hands on his capital to another for the purpose of trading and the profits arose from the trading will be shared according to their stipulation”

(4) Hanafi – “A partnership which associates with profit sharing whereby capital is provided by one side and workmanship by the other side”

(5) Majallah – “A partnership which one party acts as supplier of the capital and another party contributes his works. The former is called ‘owner of capital and the latter is workman”

(6) Ibn Rusyd – “It happens when a party gives his property to another with trading motive and if the ventures generate profits, mudharib will share the profits as per agreement, one third or one-forth or one-fifth”

The Early Practice of Mudharabah

The Prophet Muhammad (SAW) , he was the one who ‘initiated’ the mudharabah venture in several business expeditions with Saidatina Khatijah (RA) later his wife, a successful businesswoman during pre-Islamic era. The popularity of the Prophet Muhammad (SAW) as a trustworthy man (al-ameen) had attracted the latter to appoint him as ‘mudharib or entrepreneur’ in the business venture and she herself acted as ‘rabbul mal’ or capital provider. Upon the completion of the venture, both of them entitled the ‘profit sharing’ at pre-agreed ratio decided before commencing of the venture.

As a matter of facts that Saidatina Khatijah (RA) was very ‘satisfied’ with the ‘entrepreneurship’ of the Prophet Muhammad (SAW) and also with the ‘profits’ that he brought ‘home’. To her, the appointment of Prophet Muhammad (SAW) as the entrepreneur was proven whereby the profits received much better rather than previous expeditions, besides there was no hanky-panky.

Financial Intermediation

Financial intermediation plays important roles in dealing with the complexity of modern business transactions. The primary roles of the financial intermediation are the transformation of asset, conducting of payments, brokerage and transformation of risk. Historically, it had realized since 400 years ago with the establishment of the first conventional banking namely Banco Della Pizza at Rialto, Venice in 1587. In the very early days, it was only functioning to facilitate the business traders in term of ‘payment’ and safekeeping. However, the nature of financial intermediation has drastically changed over the past three decades due to the globalization and liberalization in business activities.

Basically, the conventional financial intermediation operates under ‘the interest based lending and borrowing’ between the surplus users of funds and deficit users of funds. The former is called creditor and the latter is called debtor. Thus, it seems more emphasized on the relationship between the creditor and debtor. The ‘interest’ is treated as a ‘fixed price’ for the loan giving to the debtor and also as a return for ‘putting off’ today’s consumption to get a fixed return in the future.

A majority of Muslim scholars agreed that interest can be treated as riba’ and being interchangeably used for one another. Even, there is a modern Muslim Scholar like ‘Sheikh Tantawi who just passed away few days ago classified ‘interest’ not as the same with riba’. Muslims nowadays are more favorable to the opinion of majority that riba’ and interest are sharing ‘the same boat.’

The ground of the practice is the interest based lending and borrowing from the surplus users to the deficit users. The surplus users inclusive of households, firms and government will deposit or lend their surplus money to the financial intermediation with the principal and return guaranteed at a fixed interest rate. In order to deliver the promise, the financial intermediation will further lend it to the deficits users inclusive of the households, firms and government with the latter promise to guarantee the payment of principal together with the ‘rewards’ at fixed interest rate imposed by the former. The deficit users are charged at a higher rate and above the rate that are given to the surplus users. The two ‘different rates’, then will be the ‘gross profits’ of the financial intermediation.

By the arising of awareness to practice Islam a way of life among the Muslims over the world, efforts to derive interest-free banking principle had been taken place by Muslim scholars with the basic guidelines of al-Qur’an and as-Sunnah of the Prophet Muhammad (SAW). Amongst the principles that had been derived for the purpose of eliminating riba, gharar and maisir elements are such as mudharabah, musharakah, wadiah, amanah, wakalah, kafalah, rahn and hawalah. These principles have been suited with current needs of the Muslims by the Islamic financial intermediation as to gradually away them from the usage of conventional financial intermediation for so long.

The Institution of Al-Hisbah

ALLAH SWT created man with greediness by nature to promote his hard works towards His bounties. However, the excessive and continuing greediness out of the control leads to injustice to the rest of the world. The Prophet Muhammad SAW said about man’s greediness in his hadith by saying:

“The son of Adam, if he had two valleys of gold, he will demand for a third valley and will not satisfied until he bites the dust”

Thus, the complexity of economic activities in our modern age will create harmfulness to the people if there are no regulatory frameworks to monitor and control. This is against to the objectives of Islam which brings peacefulness to all people regardless of religious and tribal status. A part from that, Islam makes a collective duty to promote good behavior and prevent bad behavior in the society. Whereby ALLAH SWT mentioned in the Holy Qur’an in surah al-Imran, verse 104:

“Let there arise from you a group calling to all that is good, enjoining what is right and forbidding what is wrong. It is these who are successful”

Thus, the existence of al-hisbah institution is essential as mentioned by ALLAH SWT in the above verse. Al-hisbah or a public regulatory body of the state has critical roles to safeguard the good social and economic life of the society so that each individual has equal treatments and opportunities to feed his/her life. Economically, the al-hisbah institution which is headed by al-muhtasib has to establish four essential roles as follows:

First of all, is to enforce proper ethical behavior and to restrain unethical behavior among all the economics agents in the economy i.e. households, firms and government. By having investigative and enforcement powers, al-hisbah will act accordingly to make sure all of them are conducting their economic activities within the limitations prescribed by ALLAH SWT in the Holy Qur’an and the Prophet Muhammad’s hadith. It is a duty to prevent them from the misuse of the divine guidance for the sake of their own interest to avoid ‘havoc’ among people in the society. The Prophet Muhammad SAW said pertaining to this matter as:

“Al-Qur’an is not only a counter fact to win over the argument. In fact, it is a universal guidance for all”

Nowadays in Malaysia, the government has established institutions to carry most likely similar roles of al-hisbah institutions such as ‘Jabatan Kemajuan Islam Malaysia (JAKIM)’, ‘Majlis Mufti Kebangsaan’ and all religious institutions at the states level such Jabatan Agama Islam Islam (JAIS),’Majlis Agama Islam Negeri Sembilan (MAINS)’, ‘Majlis Agama Islam Pahang (MAIP)’ and others.Secondly, to provide public goods and services which are not being produced by private firms because of no profitable return to them. Islamic economy does only not confine the diversifications of goods and services only to their marketability and profitability. There are some other goods which are really needed by the society as a whole but are not being marketable and profitable to produce by private firms such as street lighting, schools, universities worshipping places, playgrounds and etc.

In the case of Malaysia as a recognized Islamic countries in the world, the duties have been carried out thru various ministries and government agencies with their respective functions whether at state or federal level.

Thirdly, to act as solely market regulator in the economy which to avoid market violence and abuse among the players. By such authority, al-hisbah institution will legalize the registration and licensing of all business firms in the market. This is kind of practice is to establish a proper and effective supervision and regulations of the market so that it will efficiently and prudently operate. In the long run it will lower the cost of business in the economy later it will prolong the effect to the price paid by the households and then lesser the burdens. If the market is poorly regulated, there is a tendency in misleading of economic agents to create ‘havoc’ and harmfulness to the others. For instance in Malaysia, the government has taken the initiatives to establish the ‘Securities Commissions (SC)’ to regulate and monitor the capital market in the country with the objective to preserve the rights and welfare of investors.

In the modern days with the ‘secular practice of al-hisbah’ since the colonial dominations, cheating and no transparency in the ground of business transactions have caused the excessive increasing cost of production. Then, such cost will be burdened back to the households by higher price of goods and services in the market. Without such guidelines and strict enforcement by the ‘secular al-hisbah’, most of the awarded government contracts imply the very expensive cost of production. Then, of course it will imply a higher cost of production to the firms. Then, it will directly or indirectly be borne by the households!

Finally, it is to act as consultative and informative council to the market players in the economy. The institution of al-hisbah provides consultations and information to the households and firms about the market procedures and legislations imposed by the state authority such as certification procedures of halal products, good corporate governance in business transactions and shariah compliance. These all can be done thru seminars, short-term courses and face to face appointment at very affordable cost. Such information can also be distributed to via publications of journals, books, magazines and by developing official websites. They need such information to decide on business transactions. For example, the households need the clarity of status of halal before purchasing any products and services in the market. Without such information, it is not possible to practice in according to shariah with the complexity of the present business trends.

The Islamic Worldview

The worldview relates to people’s perceptions or outlooks to their worldly life and the universe. This ‘well grained perceptions and outlooks’ later will form the worldview of people which then create the meaning and purpose of their life in this world.

In the secular perspective, each individual has different set of perceptions in his life which leads to the formation of different worldview among the people. According to Chapra, the different worldview among the people is being a source of dissimilar end means of human life. He further denotes that the worldview as a set of implicit or explicit assumptions about the origin of the universe and the nature of human life.

Referring to the Islamic point of view which proposed by a modern great thinker and scholar Syed Muhammad Naquib al-Attas where he asserted about the vision of reality and truth (ru’yat al-Islam li al-wujud). In the real life, knowledge is a light (an-nur) of life which shaping its meaning and purpose. In order to reach at that point, the worldview must be instilled with the knowledge so that to create ‘a meaningful and purposeful life’. The worldview itself cannot ‘stand alone’ without the formation of systems or institutions in the society. There are two major systems which having great impacts to the life of the people namely as social and economic system. A part from that, secularism treats knowledge as an essential ground in shaping and developing of any systems in order to bring ‘fruitfulness’ or ‘manfaat’ to the people. The economic system under the ‘secular roof’ is developed on the ground of ‘secular worldview’ where the source of knowledge derives from rationality and passions of men. There is no connectivity with the source of divine knowledge. So, this brings ‘no real fruitfulness or ‘manfaat’ of the system to the people which they only are not supposed to live in their ‘own economic circle’ by accumulating mass wealth in the absence of feeling to others and forget their hereafter’s portion after the death. This is because ‘rationality and passions’ always dealing with only the reality and very far from something that is not real like people’s feeling, punishment of heaven and hell and life after death. Thus, the economic transactions are being conducted with the manner of ‘selfishness’ and far from ‘fear of God’. In the long run, it will create ‘havoc’ in the society which leads to injustice to people. Pertaining to this, Islam also emphasizes the concept of knowledge in shaping the worldview as the ‘formulating ground’ of the economic system. This was proven when ALLAH SWT first created the Prophet Adam, he was taught to learn things as stated in the Holy Qur’an:

“And He taught Adam the nature of all things; then He placed before the angels, and said; “Tell me the nature of these if you are right” (al-Baqarah: 31)

Akin also to the prophecy of Muhammad SAW, the first revelation sent down to him started with the word of ‘iqra’ which means to read. ALLAH SWT said in surah al-Alaq:“Read in the name of God who created” (al-Alaq : 1)

In Islam, the source of knowledge is more comprehensive, not only compounded to the ratioality and passions of men. The prime source of knowledge is prolonged to the divine guidance inclusive al-Qur’an and al-hadith. The rationality and passions are only treated the secondary sources and subjugated to the tracts of ALLAH SWT. This is a contrary to the secularism, which placed the rationality and passions as the prime source of knowledge. Islam argues on this proposition due to the limitations and weakness nature of men which are not able ‘to know’ or ‘predict’ something far behind the reality. That is why we need the divine guidance to tackle such limitations and weakness so that the economic system created implies the true color of men nature to live in peace and harmony.

The worldview will establish the doctrine regardless whether it is Islam or secular. In secularism, the ‘economic doctrine’ is absolute and no influenced by the other superior doctrines such as religion. Then, it is very ‘adjustable’ towards to the reality against people’s needs, passing of times and geographical differences at ‘any angles’ inclusive the ‘grounded principles and methodology’. Anyhow, Islam does not place the economic system as an absolute doctrine. It is subjected to the doctrines of Islam as a final and superior doctrine. As far as we are concerned, Islamic worldview is developed based on three principles of ‘Aqeedah’ (belief in ones of God), ‘Ibadah’ (God to man relationship) and ‘Muamalat’ (Man to man relationship), the adjustments to suit the reality only occur to ‘branches (furu’) of the principles ‘ and the methodology, not to all ‘angles’ as what practiced by secularism.