3 Reasons Why Mudarabah Financing is More Ethical Than Loans

A Mudarabah contract is based on a partnership in which one partner is the financier (the investor, or rabb-ul-mal) and the other partner (the fund manager, or “mudarib”) manages the financier’s investment in a business activity. Both parties agree in advance to a profit sharing ratio.
With Human Capital Mudarabah, the mudarib receives a lump sum of money today and commits to sharing with rabb-ul-mal a portion of whatever income they earn for a  fixed period of time in which they are fully employed.
An example of Human Capital Mudarabah in action can be found here.
When associating a particular product with Islamic finance, one must address how the product serves or at least does not run afoul any ethical considerations. Here are 3 reasons why I think HCM agreements are superior to debt-based financing from an ethical perspective.
1. HCMs Serve Fairness.
Financing serves the needs of the financiers and the financed alike: financiers gain the opportunity to earn a return while the financed gain access to capital. Since both parties are served, it’s only fair that both parties share the risk.
Interest-bearing loans are unjust because the lender’s return, i.e. the interest rate, is contractually predetermined at a time when the borrower’s benefit from the money is still unknown. Which means risk is being assumed, from a contractual perspective, almost exclusively by the borrower.
The prophet Muhammad, peace be upon him, referred to the inequity of interest-bearing debt saying:
“Allah has forbidden you to charge interest…You will neither inflict nor suffer inequity.”
HCM avoids the inequity of interest-bearing debt by distributing risk equally between the financed and the financier. Both parties win or lose together, and that’s how fair financing should be.
2. HCMs Promote Financial Welfare.
People often have unrealistic expectations for their future income. These expectations lead many to overburden themselves with debt causing their quality of life to suffer.
HCM financing avoids this problem by financing amounts that are commensurate with the investee’s projected future income.
Take the example of Adam, a recent high school graduate who has offers from three different colleges. All three colleges have the same price for undergraduate degrees ($25,000):
The first college offers engineering degrees. HCM investors offer to finance Adam’s degree from this college in return for 10% of his post-graduation income for five years.
The second college also offers engineering degrees but isn’t as good at placing their graduates in jobs as the first college is. HCM investors offer to finance Adam’s degree from this college in return for 15% of his post-graduation income for five years.
The third college offers degrees in music. HCM investors don’t offer financing for this degree since the tuition costs aren’t justified by the expected post-graduation income.
Alternatively, traditional lenders offer Adam $25,000 at a 7% interest rate regardless of which degree or college Adam chooses.
The traditional lenders gave Adam no information about which degree was the wiser economic choice.
Alternatively, HCM investors gave Adam a good sense of which degree makes the most economic sense. They also placed pressure on college #2 to improve their services and for college #3 to lower their tuition costs if they want to remain competitive.
By rewarding high-quality, low cost services, HCM investors increase the quality of products on the market in addition to helping consumers choose between them.
3. HCMs Create Equality of Opportunity.
Since HCM investors can only be successful if the financed person is successful, their financing decisions will be based on answering only one question: how likely is this person to succeed?
In other words, merit is the only criteria for who gets HCM financing. Not how wealthy the person is, who can cosign for them, or the value of the assets they can use as collateral. 
The equality in opportunity created by HCMs is not only consistent with universal notions of ethics, but specifically Islam’s ethical code. The generous Qur’an says:
“Indeed, the most noble of you in the sight of Allah are the most righteous of you.”
It is reasonable to expect that HCM’s merit-based financing will cause a reduction in the levels of income-inequality and more importantly income-immobility present in debt-based economies.

Sign up for our newsletter and receive our “Beginner’s Guide to Halal Investing in Stocks” for FREE!

Enter your email address to subscribe:*