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Adapting Mudarabah Financing to Contemporary Realities: A Proposed Financing Structure

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  • Bacha, Obiyathulla I.

Abstract

Islamic banking in Malaysia, despite its recent start, has seen very rapid growth. This growth however has been uneven. While short-term trade financing has always been dominant and grown rapidly, Mudarabah financing by Islamic banks in Malaysia has reduced to insignificantly amounts. Yet, Mudarabah which is based on profit and loss sharing has always been considered to be at the core of Islamic financing and in tune with the shariah’s injunctions against interest based financing. The paper addresses why this has been the case. Using conventional finance theories it is shown that Mudarabah financing has serious agency problems, lacks the bonding effect of debt financing and can induce perverse incentives. Following an analysis of these problems in Part I. Part II compare: Mudarabah with conventional debt and equity financing within a risk-return framework. Using scenario analysis, it is shown 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. Expected returns would be the lowest while risk highest among the three alternatives. This has to do with the structure of Mudarabah financing where strict interpretation of the Shariah requires the financier to absorb all losses, but profits to be shared. It is argued that this inequality in the distribution of risk and returns has caused Islamic banks to reduce Mudarabah financing. Part III proposes an alternative financial arrangement under Mudarabah. Using the principles of mezzanine and vertical-strip financing, currently in use in venture-capital and other high risk financing like Leveraged Buyouts (LBOs), it is shown that a more equitable distribution of risk and returns can be achieved. The proposal requires the mudarib (borrower) to ‘reimburse' the financier in the event of certain outcomes. This reimbursement will be in form of the Mudarib giving up part of his equity to the financier. While this reduces the agency problems and the downside risk faced by the financier it does not eliminate all such risk. Thus, both parties will be required to be responsible and cautious in undertaking new projects. Part IV concludes with an evaluation of the proposed arrangement in the context of the Shariah

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 12732.

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Date of creation: Jun 1997
Date of revision: Nov 1996
Publication status: Published in The Journal of Accounting, Commerce & Finance; Islamic Perspective 1.1(1997): pp. 26-54
Handle: RePEc:pra:mprapa:12732

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Related research

Keywords: An adapted model for Mudarabah; Islamic profit-loss sharing financing;

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References

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  1. Geske, Robert, 1977. "The Valuation of Corporate Liabilities as Compound Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 541-552, November.
  2. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  3. Obiyathulla Ismath Bacha, 1995. "Conventional Versus Mudarabah Financing: An Agency Cost Perspective," IIUM Journal of Economics and Management, IIUM Journal of Economis and Management, vol. 4(2), pages 33-50, DECEMBER.
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Cited by:
  1. Hasan, Zubair, 2012. "Incentive-compatible sukukmusharkah for private sector funding: Comment," MPRA Paper 41916, University Library of Munich, Germany.
  2. Mehri, Meryem & Jouaber, Kaouther, 2012. "A Theory of Profit Sharing Ratio under Adverse Selection: The Case of Islamic Venture Capital," Economics Papers from University Paris Dauphine 123456789/9551, Paris Dauphine University.
  3. Rasem N. Kayed, 2012. "The entrepreneurial role of profit-and-loss sharing modes of finance: theory and practice," International Journal of Islamic and Middle Eastern Finance and Management, Emerald Group Publishing, vol. 5(3), pages 203-228, August.
  4. Abdou Diaw & Abdoulaye Mbow, 2011. "A comparative study of the returns on Mudharabah deposit and on equity in Islamic banks," Humanomics: The International Journal of Systems and Ethics, Emerald Group Publishing, vol. 27(4), pages 229-242, November.

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