Mudaraba (مضاربة) is a contract whereby one side the investor or Rabb ul Mal contributes money and the other side work, being the manager or Mudarib. The Rabb ul Mal bears all losses, and the Mudarib earns a profit share:
Mudaraba is a concept to provide capital to somebody undertaking the work. It could be understood as being similar to the function of an asset manager or employed manager of a company.
Legally this concept is established as permissible by the consensus of the scholars and not based on primary sources of the Shariah.
As the profits are shared with the manager (Mudarib) and the capital provider (Rabb ul Mal) but the losses are beared only by the capital provider this mode is also named profit sharing – loss bearing. Before the manager gets his share, the losses, however, if any, needs to be recovered. A wage could be negotiated.
Restricted versus unrestricted Mudaraba
Capital can be provided as being unrestricted for any purpose the manager deems fitting or it is possible to grant it upon conditions what has to be made with it; the latter is technically called restricted Mudaraba (Mudaraba al Muqayyadah), e.g. all investment funds. An unrestricted Mudaraba is called a Mudaraba al Mutlaqah.
Two-Tier Mudaraba was the initial concept for Islamic banking. The structure is set up so the Islamic bank is engaged in two different Mudaraba transactions, one with depositors and one with those who it provides financing. The first Mudaraba is between the bank and the client with surplus capital (depositors) and the second one is between the bank and the clients who require financing.
The first tier Mudaraba between depositors and the Islamic has those depositors acting as Rabb ul Mal and the bank acting as the Mudarib. The depositors place their funds with the bank with no guarantee of principal and a return based on the profitability of the investments made by the bank on their behalf. As with other Mudaraba, the depositors bear any losses and share profits with the Islamic bank according to a pre-agreed ratio.
The second tier Mudaraba between the Islamic bank and those receiving financing has the bank acting as Rabb ul Mal and the customers acting as Mudarib. The bank bears all losses except in cases of fraud by the Mudarib and share profits with the customer according to a pre-agreed ratio.
The concept was developed by Islamic economists as credible alternative to saving accounts. In a two-tier Mudaraba, the bank provides an intermediation role between depositors and customers needing financing and is expected to be able to achieve sufficient diversification and use its greater resources to more adequately protect depositors from risks associated with each individual second tier Mudaraba agreement. However, because the Islamic bank retains liability for all losses, which are then passed along to depositors, it suffers from an informational asymmetry that has limited its use in practice.
Another problem with the two-tier Mudaraba model is that not only do depositors have their principal at risk, they are also likely to see significant swings in the profits paid on their deposits. One solution to the latter problem is to smooth profits across time using a profit reserve, which could lower the volatility for the depositors.
Mudaraba for Insurance
As discussed under Takaful a Mudaraba contract is recommended regarding the funds of the Insurance contract, while the Agency (Wakala) is suggested for the insurance pool regarding the claims to be made.