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About Mudaraba and Istisnaa

Islamic banking practices adhering to the rules of Sharia have come into being and have then been modified to address the specific requirements of a growing Islamic clientele. Banks and other financial institutions have also been motivated by an urge to benefit the community as a whole. Of the various types of Islamic financial practices, Mudarabah and Istisnaa are some of the available forms. They are widely in use in many parts of the world and have been proven to bring on financial benefits to all parties who have entered into the contractual agreement.

What is Mudaraba?

The Mudaraba form of financing was in existence long before the advent of Islam; it was once prevalent amongst Arabs. It is an agreement between two parties—one party wishes to initiate a project or take part in an ongoing one in order to make profits and another party possesses the capital to fund the project. The former is the borrower in this contractual relationship and the latter, the financier. The role of the financier in this contract is solely to furnish the funds and discuss with the borrower and come to an agreement regarding how to run the project. The borrower then takes over and manages the day-to-day functioning of the project.

If the project makes profits, then the borrower, who is also the entrepreneur, and the financier share the profits according to a ratio agreed to when entering into the contract. If there are losses, they are borne wholly by the financier. The borrower too doesn’t earn anything by way of putting in his efforts. This is in essence the modus operandi of a Mudaraba contract, as has been practiced for ages.

Application of Mudaraba

This form of financial contract is much-prevalent and preferred amongst both capital owners and prospective entrepreneurs who nurture hopes of setting up and being at the helm of their own business. In fact, the contract acts as the platform where the two parties meet—an opportunity for the capital owner with no entrepreneurial abilities to invest in a profit-making venture and reap riches and for the entrepreneur, to not only give shape to his business but also be in charge of it. Mudaraba can be a win-win situation for both parties and hence this form of financial contract has lures aplenty for both.

What is Istisnaa?

Istisnaa is a form of sales contract, which according to one school is an agreement entered into with a manufacturer to order him to produce a specific commodity. It is believed to be the most flexible amongst all other Islamic financial contracts in its genre. The flexibility arises from the fact that payment and delivery terms can be agreed upon and modified based upon negotiations. In this type of contract, the good to be manufactured is clearly specified in the agreement and it has to be produced. The payment can be deferred and may be associated with specific milestones in the life cycle of the project.

As per the rules of this kind of a contractual agreement, a bank or any other financial institution can buy the product and then sell it after receiving cash on installment or on the basis of deferred payment. The rules also permit the financial institution to first enter into the contract as a seller to negotiate with a party who demands to buy a specific good. The financial institution can then draw up a parallel Istisnaa contract, according to which it can operate as a buyer and collaborate with another party to manufacture the goods specified in the first contact.

Application of Istisnaa

The sound financial principles of the Istisnaa mode of contract make it a viable option for financing diverse types of projects: residential and commercial construction, setting up of industrial plants, infrastructure development like roads, and manufacturing of industrial goods and machinery. It can also be effectively and profitably used in projects that involve export financing. Istisnaa is preferred for construction as it basically functions as a Murabaha during the construction phase and then turns into an Ijara or Musharaka.

It is a favored mode of financial agreements in funded projects where production is quantifiable, for example, in the food processing industry. It is also used in sectors where production demands the use of sophisticated technology, such as in aircrafts, ships, and locomotives.

The widespread application of Mudaraba and Istisnaa only goes on to prove the overwhelming success of Islamic banking practices in funding projects, both small and large scale.