Mudarabah is an old form of business organization approved by Islamic Shari’ah. This paper traces its practice through several centuries of Islamic history. Though its widest application was in trade, it has also been used in non-trading business activities. Its application to agriculture, manufacturing, services and financial sectors poses no serious problems. The author argues that mudarabah or profit-sharing between suppliers of capital and entrepreneurs is especially suitable for the financial sector and a financial sector based oil profit-sharing is superior to the one-based on interest. Sharing is also superior to a hire contract in terms of fairness.

The idea of replacing interest by profit-sharing in the depositor-bank and bank-business relationships, first mooted during the fifties and sixties of this century, has now gained considerable acceptance. We are also noticing a global increase in attention towards 'sharing' rather than claiming a fixed return by some factors of production as exemplified by debt equity swaps and renewed advocacy of applying this principle to the labour market (Weitzman 1984).

Profit-sharing in recent practice of Islamic banking has taken three main forms: simple profit-sharing or mudarabah, partnership which involves participation in management along with sharing in profits, and the corporation or joint stock company in which shareholders supply the capital with which their elected directors run the banking company through hired managers. It is not the Intention of this paper to go into all aspects of these practices. It seeks to focus on the sharing in profits by the depositors as well as by the financial intermediaries, the ultimate source of profits being the business enterprises which actually use the money capital.

As it stands today, simple profit-sharing is the basis of the relationship between Islamic banks and depositors into investment accounts. However, in the Islamic bank -businessman relationship, simple profit-sharing is only one of several options available. Some of the other options are partnership, instalment sale and leasing. Even though in practice the role of profit-sharing and partnership is very small at present, they continue to dominate the theory of' Islamic banking. They are regarded as the norms towards which practice should and would, eventually gravitate. (Khan and Mirakhor, 1987 pp.185-199).

Since the major basis of profit-sharing in modern day Islamic banking is the age-old Islamic contract mudarabah (or qirad), it seems worthwhile to study it in depth. The juristic issues involved have already received some attention (Abu Ghuddah, 1983; Siddiqi. 1988 b; Sharafuddin, 1974). This paper focuses on the economic issues related to mudarabah. However, it is advisable to begin with it brief reference to its basis in the Qur’an and Sunnah as well as its practice through Islamic history. This will help us to have a better idea about the nature, scope and potentialities of profit-sharing in contemporary circumstances.

Even though the widest application of mudarabah had been in trade, it was used in all known forms productive enterprise during various periods of Islamic history. However, since the production structure in earlier centuries was rather primitive, modern operations in agriculture, manufacturing, services and financial sectors have different requirements. The paper discusses these issues and points out how the simple contract of mudarabah can he adapted to meet the needs of modem business enterprises in various sectors.

2. Mudarabah in the Qur'an and Sunnah

Mudarabah or (qirad) is not mentioned in the Qur’an by name. However, the verses legitimizing or recommending economic activities in general and grade in particular cover mudarabah by implication. Attention is especially drawn to verses 4:29; 2:275; and 2:198.

Since trade is for profit, legitimising trade means legitimising profits. If it is legitimate to earn a profit. It should also be legitimate to earn a share out of it. Income through trade and industry is included in the meaning of the term bounty (fadl) in the verses 73:20 and 62: 10.

Men are exhorted to cooperate for good cause, and profit-sharing appears to be well qualified in this regard (al-Dihlawi, Vol.2, p. 116). That brings mudarabah within the purview of the verse 5:2

Profit-sharing between the supplier of money capital and the one actually using it in business wits being practiced in Arabia and elsewhere on the eve of Islam. The Prophet, peace he upon him, endorsed this practice. He had personally engaged in it before he attained to prophethood (Ibn Hisham, pp. 187-98 and vol.3, P.345). Thereafter many of his companions practiced it with his approval (al - Baihaqi, Vol.6. p. 111, Sarakhsi, Vol.22, pp. 18-19). The practice continued after the Prophet, peace be upon him. (Malik kitab al-qirad,: Ibn Sa'd, Vol.3, p.60, al-Baihaqi, Vol 6, p.111 and al-shawkani, vol.5. p. 282.)

3. Mudarabah in Islamic History

Profit-sharing continued to be practiced throughout Islamic history. This is evidenced by the fact that all the compendiums of Islamic law complied during the second century onwards, till date, devote a chapter or a section to mudarabah or qirad along with other forms of sharing.

Historians have recorded numerous instances of mudarabah contracts. We note some of them.

The renowned scholar Sufyan Thauri (d. 126 H.) travelled to Yemen with four thousand dinars on mudarabah basis.

(al-Dhahabi. Vol.7, p.277)

During the reign of the Abbasid Caliph Mansur (136-158 H.) a man named Yasar bin Mahduj entered into mudarabah with his brother-in-law, Siraj and made a business trip to China, making good profits.

(Waki', Vol.2, pp.81-821)

Muhammad bin Nasr al-Marwazi, another eminent scholar (d. 294 H.) had a partner on mudarabah basis.

(al-Dhahabi, Vol. 14, p.361)

(In 321 H.) Baridi devastated the cantonments of Mukrim and Tustar. His most lenient act was to drive to the houses of the moneychangers and take whatever money he found belonging to them or to those who had entered into mudarabah with them.

(Miskawaih, p.2571)

Da'laj (d.351 H.) a noted scholar as well as a prosperous trader of Baghdad owed much of his prosperity to money given to him on mudarabah basis by another businessman.

(al-Dhahabi, Vol. 16, p.341)

Jahwar bin Muhammad (d. 435 H.) who ruled Cordova for sometime used to give public money to traders on the basis of mudarabah.

(al-Dhahabi. Vol. 17, p. 1401)

Ibrahim bin Ali (d.891 H.) as judge of Makkah had sixteen thousand dinars belonging to orphans and those away from the town in his charge. He made the capital grow through mudarabah and other means so that zakat and other maintenance costs could be paid out of profits still leaving a surplus which would be added to the capital.

(al-Sakhdwi, VolA, p.941).

4. Mudarabah in Non-Trading Business Activities

The instances of mudarabah during the time of the Prophet, peace be upon him and the companions relate to trading. The sum of money supplied by the financier was used for buying merchandise to be sold at a profit. Transporting the merchandise to a different place or storing it over time was generally involved even in this simple application of mudarabah. Makkah was a centre for long distance trade. We know that Khadija's mudarabah with the Prophet involved his travelling to Syria. Madinah, on the other hand was predominantly an agricultural habitat with some handicraft as well as local trade. There are numerous reports of sharing arrangements centered round agriculture and horticulture. These are reported and analysed in the chapters of fiqh books dealing with muzara’ah (share -cropping) and musaqat (a special kind of crop-sharing).

In essence they are no different from mudarabah as rightly pointed out by Imam Muhammad bin al-Hasan (Nasa'i: Kitab al-Muzara'ah, Hadith No. 3928). We have also some reports which involve value added through productive activities other than buying and selling, storage and transportation, like weaving, colouring, sewing (Sarakhsi. Vol.22, p.54). In later periods of time we have very clear cases of mudarabah contract being applied to industrial operations. (Goitein. 1968, p.273)

The desirability of applying sharing to non-trade modes of business can also be established on the basis of the fundamentals of shari’ah relating to economic activities. The argument may run as follows: Economic enterprise is permissible in general. It becomes desirable depending upon the ends, e.g. earning a living, spending in the cause of Allah, saving for future contingencies, etc. Cooperation in good cause is good. A transaction is permissible as long as it is free from traits which are undesirable, hence prohibited. These undesirable traits can be summarised as follows:

Mudarabah definitely does riot involve riba or qimar. Whatever the business to which it is applied and the next five traits in the above list (i.e. fraud, coercion, exploitation of need, hoarding and false bidding) are not contract -spec 1 fie. It is only the last two (i.e. hazard and lack of knowledge) which need to be examined when application of mudarabah to non-trade operations is considered. We have to answer a number of questions before taking a stand on this issue.

(i) Do hazard and lack of knowledge necessarily attach to mudarabah in non-trade operations? Are there ways of avoiding them?

(ii) Is gharar or jahl involved? If so, does their quantum exceed permissible limits such that it cannot be ignored, and the operations themselves must be stopped?

(iii) If mudarabah financing is disallowed in certain sectors of the economy, e.g. industries and services, do we have viable alternatives free of hazard and lack of knowledge?

The reason for asking these questions is not far to seek. The incidence of hazard and lack of knowledge is quite extensive in our lives. Productive enterprises are especially vulnerable since they take time and involve the future. Yet it is precisely these areas in which men must work together and working together can be only on the basis of agreed terms and conditions. How can the owners of productive services cooperate and then share the produce? Specifically, how can capital, labour and enterprise come together? In a free economy hire and sharing are the only broad alternatives available if we exclude forced labour, voluntary service and charity. In most cases therefore, the question in the context of productive enterprise boils down to this: Is a hire contract preferable to one based on sharing? Preference should, of course, involve both efficiency and fairness. Avoidance of both hazard and lack of knowledge has been ordained by Shari'ah with a view to ensuring these ends, especially fairness. A comparison between hire and sharing arrangements among factors of production should take this into consideration. We would therefore, examine some cases of applying mudarabah to non-trade operations with the above questions in mind.

5. Mudarabah in Industrial Operations

A pure case of mudarabah in an industrial operation will be one in which one person. A, finances an industrial project, say a shoe factory which is managed solely by another person, B. The factory is set up, from the scratch, with A's money and in the end everything, including the used machinery etc. is sold out, so that nothing remains of the project but cash. Assuming a profitable ending, A's capital would first be paid back to him and the remaining cash will he distributed between A and B in the proportion agreed in the beginning. In case the amount of cash in the end is less than what A had invested, i.e. there is a loss, B gets nothing and A takes back what is left of his capital.

This may be compared with mudarabah financed trade: B buys shoes with A's money and sells them, making a profit or incurring a loss. This simple operation will also involve transportation to another location and/or storage, etc. - operations normally associated with trade.

Both cases involve the usual uncertainties attending business enterprises, even though their scope is larger in the former case as it involves production along with buying and selling. In both cases there is lack of knowledge about what would be actual profits (or losses). But it is not this kind of lack of knowledge or uncertainty which affects the validity of any operation. In the examples under consideration the application of mudarabah poses no problem since operation starts with cash and ends in cash, the definition of profits is clear and the formula for its sharing between A and B agreed. There is no gharar or jahl surrounding these crucial matters. What would affect the validity of the contract is uncertainty or lack of knowledge surrounding what is to be shared, the formula of sharing or any other matters relating to the rights and obligations of A and B. The kind of gharar and jahl which shari’ah seeks to eliminate and, where elimination is not possible, to minimize, is that which emanates from the contract, not the one that naturally attends the activity or operation. The latter is part of the human environment, and largely, beyond human control.

One may agree that there are other differences between trade and industry which should be considered in the context of applicability of mudarabah to non-trading activities. Industrial projects take longer to mature than trading operations. The longer the time the more the risk. But the shari’ah has not related the validity of a contract to the length of time involved or the level of risk involved.

The length of time does not affect any of crucial rights and duties of the contracting parties. Trading operations too may take a long time to complete. In fact some of the instances of mudarabah financed trade cited above took several months to complete, among these is the Prophet's trade with Khadijah's capital which involved travelling to Syria. In later periods we find the Mediterranean trade being financed by mudarabah during the tenth through thirteenth centuries A.D. (4th through 7th centuries Hijri). (Goitein, 1976, pp. 163.176,177,186 and 247; Goitein, 1968, pp.273,335).

As regards the level of risk, it is not obvious that the risks of business are directly related to the length of time involved. Even otherwise, it is not a foregone conclusion that industrial operations are necessarily more risky than trade. In fact risks were very high in case of trade caravans from Makkah to the North and the South, as these caravans were vulnerable to attacks by hostile tribes as well as by professional bandits.

There are certain secondary issues too which might mistakenly be raised in the context of applying to industrial operations. When mudarabah finance is needed for an already operating industrial unit, the net worth of that unit will have to be assessed in order to ascertain the contribution of the new finances to the profits of the enterprise. This will no doubt involve some complicated calculations. But the matter is not unique to industry, the same problem would arise kit case a trader seeks to expand his business by inducting new capital to be obtained on the basis of mudarabah. This issue has been discussed elsewhere (Siddiqi, 1988A, pp.32-35). It has been concluded there that the issue has not caused much problem in the contemporary applications of mudarabah.

One of the problems in calculating the profits of it a mudarabah financed business is the treatment of costs other than those of the goods traded. Modern business whether trade, industry or agriculture, involves a lot of office work and other managerial tasks. Should all these be paid out of the mudarabah capital and treated as costs, or should some of them be regarded as the responsibility of the working party in the mudarabah contract and, therefore, charged to its account? Can the working party in a mudarabah contract draw it salary against its routine managerial work while also sharing the profits? Even though these issues are problematic, they are not insoluble. In fact even the jurists of the fourth century (hijri) are very clear how to handle these issues. Generally speaking they refer to ‘urf (custom) when the contract itself is silent and allow the working party to charge its expenses to the business if it has already been stipulated in the contract (Ibn Qudamah, Vol.5, pp.40,51 ). In any case, what concerns us here is, that it should make no difference whether the financed business is industrial or commercial. Whatever solution is valid for mudarabah financed trade would also be valid for mudarabah financed industry. As a matter of fact the sharp destination between industrial and commercial operations is it modern phenomenon and the early Islamic jurists are not necessarily committed to it. To them trade is what traders do.

6. Mudarabah Financing in the Services Sector

The vast expansion lit the services sector necessitates its special mention. This sector produces and sells services like education, health care, news, information, entertainment, etc. Capital invested in this sector takes the form of building, equipment, highly skilled manpower, communication network, etc. As in the case of industry, it is possible to wind up a services producing unit and convert all its assets to cash. It is also possible to make an assessment of its net worth without actually liquidating it. This being the case in mudarabah financing poses no problem. All that is required for applying mudarabah to any profitable venture is that it should be possible to calculate the profits or losses consequent to the induction of new capital acquired oil the basis of profit-sharing. The nature of the product - whether it is tangible goods or intangible services- does not affect the validity of applying mudarabah. Shari’ah has not linked the validity of mudarabah the nature of the commodity being handled.

Above we have seen that profit-sharing can be applied to all productive ventures irrespective of the nature of the product, degree of risk or length of time involved. What is necessary is that the product should be marketable and it should be possible to calculate the profits. A distinction should he made between profit-sharing and product sharing. e.g. share-cropping (muzara’ah). The latter is subject to some other rules which are not the subject of study in this paper. We wish to point out, however, that it is possible to organise agricultural production too on the basis of profit-sharing rather than product sharing. A may supply the capital to B, who may hire cultivable land, equipment and manpower and buy seeds, fertilizers, etc. out of A's capital. A and B will share the profits when the entire crop is sold. Thus, simple profit-sharing can he applied in all sectors of the economy: industry, trade, agriculture and services. It is not only feasible; in fact, it is a must for a system which prohibits financing on the basis of interest to allow profit-sharing in all sectors.

It is not important whether this takes the form of full-fledged partnership in which all sharers in profits may also participate in management or that of simple profit-sharing (i.e. mudarabah) in which management is done by the working partner, the financiers supply only capital. In reality there may be a whole range of options with full participation and no participation in management being the two extremes. In between these extremes the financiers may have a say in some key matters or in most decisions or, may leave all decisions to the working party, or only have the right to monitor the progress of the project and ensure compliance with certain agreed conditions. The current practice of' Islamic banking is already presenting this latter scenario. What is crucial however, is the possibility for entrepreneurs to obtain finance from others. Since Islam prohibits hiring of finance (i.e. borrowing on interest) and lending without interest is not a practical proposition in the business sector on a large scale, sharing is left as the main alternative. Other alternatives like instalment sale or leasing may not always suit the purpose of the entrepreneur. Prohibiting profit-sharing in any particular sector would, therefore, oblige the firms in that sector to work only with their own capital. In view of the huge capital requirements of modern firms this will play havoc with the economy and is sure to make it incapable of competing in the international market.

A modern economy, which prohibits interest, thereby making loan finance impractical on a large scale cannot afford to disallow profit-sharing in its various forms in any sector of the economy since every sector requires huge amounts of capital and faces competition from abroad.

As stated before, in the Islamic system money capital cannot be hired. Money capital owned by others can only be obtained by a firm as interest-free loan or on the basis of profit-sharing. This does not apply however, to the other factors of production e.g. labour, land and physical capital. In so far as the firm does not own them, it can either hire the services of these factors or acquire their services on a profit-sharing basis. In other words a labourer, skilled or unskilled, the owner of land or the owner of capital goods can either obtain salaries, wages, rents or rentals respectively by hiring out their services or assets; or by exposing themselves to some risk may enter into a profit-sharing arrangement with the user, the firm. The question arises which way is superior, hire or share?

No single answer can cover all eventualities, if by superiority we mean efficiency with fairness. We should also note that while hire is always possible with productive services, profit-sharing is feasible only when the product is marketable so that there is possibility of a 'profit' to be shared. A person building his own house or it government building an office for its own use has no option but to hire the productive services required. But a bridge whose construction is to be financed by a toll tax could be built by acquiring some of the relevant services on a share basis. This applies, in principle, to all production that is meant to be marketed.

Labour must be treated as a special case in view of the fact that, generally speaking, there is nothing else to meet the consumption needs of the labourer and his family except the wages. Therefore, generally speaking, wage labour is not in a position to take risk. At best it can do so only partly - the major part of his income being predetermined in order to provide a firm basis for the family budget. Professional and skilled labour with some savings, could, however, afford to go in for sharing instead of fixed payments in a full-fledged manner.

In this context, it will be interesting to consider the following observations of Ibn Taymiyyah: "One who deliberates on the basic principles would easily conclude that musaqat, muzara’ah and mudarabah are nearer to justice than hire. There is always some risk in hiring because the one who hires may or may not benefit. Contrary to this in musaqat and muzara’ah, they share in profit as well as in loss so that these do not involve risk for one of the two parties as the hire contract does." (Fatawa, Vol.20. p.356).

It should he noted, however, that Ibn Taymiyyah is concerned mainly with the fairness of the contract, not with the efficiency of the arrangement.

An entrepreneur is one who bears the consequences of (risky) decisions taken by him or by those to whom he delegates the power of decision making. It may be it natural person, a group of persons, or a legal entity, corporate or otherwise. It is the entrepreneur who bears losses and reaps profits. We can also recognise him by the negative characteristic that lie cannot be hired. Entrepreneurship cannot have predetermined reward. The reward to entrepreneurship can come only in the form of profits or share in profits. Pure entrepreneurship which works without owning other factors of production, has nothing to lose except its own reward.

Thus we have, in an Islamic economy, two productive services which cannot be hired, but they can only share: Money capital and entrepreneurship. Together they can hire other factors of production, or acquire their services on the basis of sharing. But the other factors cannot 'hire' them, as explained above.

We now turn to the financial sector which deals with money and near money and supplies the services of ‘intermediation’ between savers of fund. Our focus of attention is the bank as financial intermediary. How can it operate?

The role of the bank as a financial intermediary is an entrepreneurial role. Its essence lies in choice between alternative opportunities of profitable placement of funds entrusted to it for this very purpose by its depositors. It is possible to argue that the depositor could hire the bank's services for this purpose i.e. the bank relinquishing its entrepreneurial role in favor of a mere managerial one. The bank would get a fixed fee from its depositors who would then claim the entire profits accruing to their funds (and incur the losses if any). However, such an arrangement will be far inferior to profit-sharing between the depositors and the bank. In case the banks receive a fixed fee for their services the incentive to maximize profits is not as strong as it is in the case it which bank's income is a percentage of the actual profits. The moral hazard implicit in any arrangement between the depositors and the bank is also larger in the fixed fee case.

The worst- i.e, the least efficient and the most unfair arrangement would be that in which the intermediary (bank) promises to pay the depositors a predetermined percentage return, as it is in the interest based system. Its only advantage is that it almost eliminates the moral hazard involved in the other alternatives. The commitment to pay a predetermined return to the depositors obliges the intermediaries (banks) to confine their choices to those alternatives which bring in a predetermined return higher than those claimed by depositors. Their safest bet becomes loans to borrowers with high credit ratings. These are not necessarily the people whose projects are the most productive. (Siddiqi, 1983, pp.69-71 ). Interest as a basis of the arrangement between the depositors and the intermediary is unfair because by obliging the intermediary to seek predetermined returns its shifts the entire risks of using funds in business enterprise on to the ultimate users. Since man's economic environment does not guarantee positive returns to all users of funds all the time, it is unfair for fund owners to insist on that guarantee. It can come only at the cost of some other group in the society.

The best, i.e. the most efficient and the fairest arrangement between fund owners and financial intermediaries is that of profit-sharing, despite the fact that it does involve moral hazard. It is efficient as it makes the reward of the intermediary a function of the actual profits realised as a result of his choice. The intermediary's choice is in principle unconstrained. He can very well go in for financing the most promising projects available. A profit-sharing arrangement, simple or otherwise, between the intermediary and the ultimate user of funds in productive enterprise is the logical corollary of the profit-sharing arrangement between the intermediary and the depositors. Such an arrangement encourages the fund users to maximise profits without burdening them with a predetermined cost of capital (i.e. cost of using the funds supplied to them). Fairness is best ensured by this arrangement as rewards are a function of realised productivity all along the fine: The fund owner, the financial intermediary and the ultimate user of fund in productive enterprise each get a share out of the value added. When the economic environment fails to add any value, or when it erodes part of the value invested in the venture, all the three share in the misfortune; the fund owner loses part of his funds and the intermediary as well as the ultimate user of fund in productive enterprise go unrewarded for their services. Profit-sharing is harmonious with the nature of man's economic environment on both sides of the intermediating institution i.e. with the fund owners as well as with the fund users. Economic environment is characterised by uncertainty of value-products. Some times even the physical results of productive enterprise are not predetermined. But even when they are, the value put on them by society remains uncertain in a free market. The situation is different in a controlled or captive market where values are assigned by decree, sometimes even before the productive process starts. But that is not the context in which we are making this study. Valuation by decree cannot sustain itself for long and on a universal scale. It can only be sustained in some sectors at the cost of the other sectors and that too for a limited period of time.

An unfair distribution of the value product between the three parties involved (i.e. fund owners, intermediaries and fund users) ultimately affects efficiency by affecting the generation of, funds (i.e. savings), distorting their allocation and weakening the incentive for their best use and effective management. An unfair arrangement is bound to become an inefficient one. Financial arrangements which guarantee a fixed return or reward to any of the three parties involved in a situation in which the value product is not and cannot be predetermined, are unfair as well as Inefficient. The only fair and efficient arrangement in such a situation is profit-sharing.

Replacement of interest by profit-sharing has far reaching implications for allocation of investible resources, distribution of the value added and the cash flow in the system. On the international scene, this change would link influx of foreign capital in a country to real productive possibilities in that country. The factor of compound interest being absent, repayment and other entitlements of foreign capital will all be in accordance with the realised results of using that capital. Once the returns to financial capital are made contingent on the realised results of its use the scope of speculative capital movements across the globe will be severely curtailed.

In this paper we have tried to establish that mudarabah (simple profit-sharing) is a way of cooperation among different factors of production firmly rooted in the Qur'an and Sunnah. It has been in practice throughout Islamic history. We have seen that profit-sharing can be applied in all sectors of the economy: trade, industry, services and agriculture. In terms of fairness sharing ranks higher than hiring. We have also noted that when interest is abolished, it is a must to allow profit-sharing in its various forms in all sectors of the economy. We have concluded that profit-sharing is especially suited to the financial sector and that a financial system based oil profit-sharing is superior to one based on interest.