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Adapting Mudarabah Financing to Contemporary Realities: A Proposed Financing Structure

Author

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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

Suggested Citation

  • Bacha, Obiyathulla I., 1997. "Adapting Mudarabah Financing to Contemporary Realities: A Proposed Financing Structure," MPRA Paper 12732, University Library of Munich, Germany, revised Nov 1996.
  • Handle: RePEc:pra:mprapa:12732
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    File URL: https://mpra.ub.uni-muenchen.de/12732/1/MPRA_paper_12732.pdf
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    References listed on IDEAS

    as
    1. 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.
    2. 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.
    3. 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.
    4. Wilson, Rodney, 1994. "Development Of Financial Instruments In An Islamic Framework," Islamic Economic Studies, The Islamic Research and Training Institute (IRTI), vol. 2, pages 103-115.
    5. Ahmad, Ziauddin, 1994. "Islamic Banking: State Of The Art," Islamic Economic Studies, The Islamic Research and Training Institute (IRTI), vol. 2, pages 1-33.
    Full references (including those not matched with items on IDEAS)

    Citations

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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. Kaouther Jouaber & Meryem Mehri, 2012. "A Theory of Profit Sharing Ratio under Adverse Selection: The Case of Islamic Venture Capital," Post-Print hal-01525795, HAL.
    3. Adil EL Fakir & Mohamed Tkiouat, 2016. "Single or Menu Contracting: A Game Theory Application of the Hersanyi Model to Mudaraba Financing," International Journal of Economics and Financial Issues, Econjournals, vol. 6(1), pages 221-230.
    4. 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.
    5. Kamaruzdin, Thaqif & Masih, Mansur, 2014. "An inquiry into the stability of Islamic Financial Services Institutions in terms of volatility, risk and correlations: A case study of Malaysia employing M-GARCH t-DCC and MODWT Wavelet approaches," MPRA Paper 60248, University Library of Munich, Germany.
    6. repec:dau:papers:123456789/9551 is not listed on IDEAS
    7. Abdou Diaw & Abdoulaye Mbow, 2011. "A comparative study of the returns onMudharabah 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.
    8. Daher, Hassan & Masih, Mansur & Ibrahim, Mansor, 2015. "The unique risk exposures of Islamic banks’ capital buffers: A dynamic panel data analysis," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 36(C), pages 36-52.
    9. Daher, Hassan & Masih, A.Mansur M. & Ibrahim, Mansor H., 2014. "Islamic Banks’ Capital Buffers: Unique Risk Exposures and the Disciplining Effects of Charter Values," MPRA Paper 56947, University Library of Munich, Germany.

    More about this item

    Keywords

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

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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