Critical analysis on mudarabah

Problem statement

Islam prohibits interest, but the practiced Islamic finance contracts link cash flows with an interest based benchmark; hence, there is a need to study whether the preferable equity mode of Mudarabah is usable in Islamic finance and what contractual arrangements could be needed to make it usable.

Critical analysis on mudarabah

Maulana Taqi Usmani (2004) in his book “Introduction to Islamic Finance” stated at least 5 times that Mudarabah and Musharakah are ideal mode of financing respectively on page 12, 17, 72, 107 and 164. His comments on Murabaha which is the most prevalent mode of financing also deserve serious thinking:

“It should never be overlooked that, originally, Murabaha is not a mode of financing. It is only a device to escape from “interest” and not an ideal instrument for carrying out the real economic objectives of Islam. Therefore, this instrument should be used as a transitory step taken in the process of the Islamization of the economy, and its use should be restricted only to those cases where Mudarabah or Musharakah are not practicable.” (p. 72)

One of the major hurdles in the use of Mudarabah on the asset side of a bank i.e. for financing is that only Rabb-ul-Maal is considered to bear all the financial losses (Shaikh, 2010). Therefore, if an Islamic bank enters into the Mudarabah contract as a Rabb-ul-Maal, only the Islamic bank would have to bear all the losses. Mudarib (Fund manager) bears no loss while he has the complete authority in running the affairs of the business. The Rabb-ul-maal (investor) is not allowed to participate in the affairs of the business (it is unlike the case in VC funds where the Venture Capitalist could include several covenants for dealing with agency problem and even select BoD and BoM and change them accordingly). When a loss occurs, the Mudarib acts like an employee of the business and when the profit occurs, he shares in the profit as if he was the only reason behind the profits.

Bacha (1997) highlighted serious agency problems in Mudarabah and argued that it lacks the bonding effect of debt financing and can induce perverse incentives. Using scenario analysis, he showed that for a ‘borrower’ faced with the alternative of using Mudarabah, debt or equity financing, Mudarabah would be best in a risk-return framework. For a financier faced with the same three alternatives however, Mudarabah financing would be the worst. Agency problem of mud. Viewpoint on m. from signaling hypothesis and bondind effects.

Likewise, Khalil et al. (n.d), Dar & Presley (2000), Warde (1999) and Rosly & Zaini (2008) also highlighted the structurally chronic agency problem in Mudarabah.

Now, we analyze these proposals and see how effective they could be in solving the agency problem in Mudarabah. The proposal by Bacha (1997) is only applicable while the Mudarib is a corporation having its own paid up capital. His proposal tries to solve the problem after it has occurred rather than preventing it beforehand. Another possible problem with this proposal is the fact that market value of shares of the Mudarib’s corporation could be anything at the time loss occurs in the joint venture of Mudarabah. Sarker’s proposal is also focused on incentivizing than preventing the problem beforehand. It also fails to solve the problem of adverse selection which requires a preventive measure than just incentives. Tier wise profit sharing structure is not completely agreed upon by scholars worldwide.

To overcome agency problems, several researchers gave their solutions. Bacha (1997) proposed that the Mudarib must ‘reimburse' the Rabb-ul-Maal in the event of certain outcomes. This reimbursement will be in form of the Mudarib giving up part of his equity to the financier. Sarker (n.d) favored incentives for honesty like providing stake in the ownership, linking transfer of ownership through granting bonus shares on the performances, build reserve scheme to induce to hold company shares and provision for profit- related pay linking with the declaration of profits etc. to reduce the agency problem. Central Bank of Malaysia allowed tiered profit sharing structure in Mudarabah (Shariah Parameter Reference 3 for Mudarabah, Bank Negara Malaysia).

Karim (2000) argued that agency problem could be resolved with Mudarib contributing some capital or collateral in the project. Adnan & Muhammad (2008) argued that while cases of negligence of mudarib leading to losses are taken care of in mudarabah, proper systems should evolve to establish such negligence and ascribe the losses to the mudarib. Khan (2003) and Tegani (2003) suggested banks to guarantee investment deposits by ‘Tabarru’ to minimize agency problem.

The problem is in the disparity in payoffs if loss occurs in Mudarabah. In Mudarabah, to be willing to take higher risk, the financier would demand higher returns reflected in demand for higher PSR (Profit Sharing Ratio). But, with higher, PSR, the Mudarib’s motivation and incentive diminishes especially if the Mudarib requires bearing no financial losses and already having means of sustenance with another business line.

In Musharakah, loss participation by all partners across the board is justifiable because all partners are also allowed to work. But, due to the fact that in Mudarabah, the working partner is the sole authority to do the business, making Rabb-ul-Maal completely responsible for sharing all losses is unjustified in the first place.

Date: 2016-03-03; view: 778