Principles of Islamic banking and finance/PIBF201/Variable income Islamic modes of finance/Mudarabah: Benefits and Difficulties

Mudarabah remains the most preferred modes of financing among all the Islamic religious scholars. For the early proponents of modern Islamic banking and finance, mudarabah, along with musharakah that you will learn in the next section, was to become the main vehicle for business transactions replacing interest. However, while they numerated a number of benefits of profit and loss sharing techniques, they did not address the issue of agency problem in these modes of financing, specifically that of mudarabah. Islamic bankers and other practitioners in the Islamic financial industries have found difficulties in using it a larger scale. In this section we will look at both the benefits and difficulties of using mudarabah financing.

Benefits of Mudarabah Financing

A number of studies have examined the implications of mudarabah mode of finance in the contemporary world. Through the help of mathematical models, it has been shown how the application of mudarabah (and musharakah) financing may enhance investment, bring about financial stability and generate desirable income distribution pattern (Khan, 1986 ;Siddiqui & Zaman, 1989a ; Siddiqui & Zaman, 1989b ;Fardmanesh & Siddiqui, 1994 )

Higher Levels of Investment

These models confirm the intuitive point that compared to a debt arrangement, both under deterministic and probabilistic framework, mudarabah and musharakah finance lead to higher level of investment as new projects continued to be undertaken as long as there is a positive return.

Distribution of Income

Poor and Rich in Thailand

It also shows that under these Islamic techniques of finance, compared to a debt system, a greater portion of profits is allocated to the providers of funds if the economy is performing well. On the other hand, in bad conditions, the providers of fund receive a lower return and in extreme cases, they may get a negative return. This has a stabilizing effect on the economy.

It emphasizes the point that by doing away the issue of collateral, mudarabah finance is particularly capable of attracting those potential entrepreneurs who are unable to provide any collateral. This possible increase in the supply of entrepreneurs would decrease the power of existing entrepreneurs and can lead to a desirable distribution of income by discouraging concentration of wealth in fewer hands.

Financial Stability

File:Stock Market Crash.JPEG

Stock Market Crash

It is further emphasized, how an economy based on the institution of interest is inherently unstable and how the Islamic techniques of finance based on profit and loss sharing has the potential to provide financial stability.

Difficulties and Problems in Mudarabah Financing

While the benefits of mudarabah financing are generally recognized, many people have explained the difficulties Islamic banks and other financial institutions face in its operation; agency problem being the most crucial one. They have attempted to explain why the share of Mudarabah financing has been negligible in overall financing of Islamic Banks (Bacha, 1995 ; Bacha, 1997 )

Bacha uses a series of theoretical models and several concepts widely used in main stream literature on finance. He stresses that Mudarabah financing is susceptible to acute agency problem. He claims that when compared to western techniques of finance, Mudarabah contains certain features of both debt and equity finance. To a Mudarib, the Mudarabah financing that he gets from an Islamic bank is like conventional equity for the following reasons:

1. there are no fixed annual payments that are due
2. payments made to Islamic banks come from profits much like dividend
3. Islamic banks cannot foreclose or take legal action if there are no profits and therefore nothing to be shared and
4. like equity, using Mudarabah financing does not increase a firm's risk as debt financing does through increased financial leverage. On the other hand, according to Bacha, Mudarabah financing has following characteristics which makes it closer to debt financing:

• it represents a fixed claim by Islamic bank on Mudarib's company
• like debt, Mudarabah financing is terminal, that is, the arrangement can be ended by mutual agreement or by one party. The Mudarib can end the relationship by repaying the principal and accrued profits to the Islamic bank.

According to Bacha, as Mudarabah financing has the features of both debt and equity financing, agency problems associated with both debt and equity finance are thus present in Mudarabah financing. Moreover, as Shariah prohibits the Rab-Ul-Mal from interfering in the business and at the same time makes him liable for all the losses, agency problems of Mudarabah financing are more severe than debt or equity.

Like equity finance, in Mudarabah financing, a Mudarib has every incentive to increase those costs which accrue to him as benefits. Similarly, in case of financing a new project or to establish a new subsidiary, a Mudarib will have all the incentives to allocate as much overhead and other costs of his original (or parent) company, to the Mudarabah financed project or subsidiary. The shuffling of profits from one unit to another does not happen in conventional equity financing since equity has an unlimited and perpetual claim on all of the company’s assets.

Bacha further claims that, compared to equity finance, Mudarabah financing constitutes a fixed and terminal claim as does debt. The agency problem of debt finance i.e., levered equity as call option on the firm, remains in Mudarabah finance though in a slightly altered form. Furthermore, the incentive to take on risky projects would be even greater in Mudarabah as Rab-Ul-Mal takes all the losses.