Tuesday, October 13, 2009

Misgiving on Mudharabah as mode of financing

Mudharabah-financing works as an instrument and alternative to risk-free investment which in reality does not really exhibit the true principle of Islamic investment which is risk-sharing. Islam is the religion that promotes justice in its rules and regulations. Burdens that borne by one party should be felt by other involving parties to make it balance and to justify the spirit of cooperation and mutual aid on the action of the parties through binding the risk-sharing condition on the contract.

In brief, mudharabah-financing was initiated during the pre-Islamic period (jahiliyyah) by Hashim ibn Abd Manaf ibn Qusayy at the fifth Century A.D in order to control the destructive potential of ‘ritual suicide’. The suicide was committed by Meccans if they experienced business disasters (Muhammad Anwar, 2001). It was then recognized by the prophet (peace be upon him) in post-jahiliyyah period and Muslim exercised it as legal transaction in financing their trade ventures. Some opinions has said that Mudharabah has been practiced by the prophet (peace be upon him) with Khadijah (R.A), but critical analysis of the said narrations will show that it was not the contract of Mudharabah, but that of fixed Ujrah (labour charges) (Tanzilur Rahman, 1999). The acceptance of mudharabah practices is also shows that Islam is the religion for all and not coming to existence for rejecting or replacing non-based revelation activities totally but rather it combines three main elements in its approaches; there are introduction, rejection and modification.

Mudharabah is an agreement between financiers (rabb-al-mal) who provide capital to the business-proposed with the entrepreneur (mudharib) who manage and run business activities. However, it does not confine for both parties to be entrepreneur and not the capital provider or vice versa in a particular time. They can stand for both in where parallel on the stipulated agreement. The idea of mudharabah contract is to seek earnings by having consent from both parties to distribute the generated profits from business activities based on the profit-sharing-ratio (PSR). The capital contribution can be in form of real assets or money. The guided principles underlines on the mudharabah financing will determine the crudeness of this joint-venture financing (LearnIslamicFinance.com):

1. Financing through Mudharabah does not mean the advancing of money but rather the participation in the business.

2. An investor or financier (rabb-al-mal) must share the loss incurred by the business to the extent of his financing.

3. The partners are at liberty to determine, with mutual consent, the ratio of profit allocated to each one of them, which may differ from the ratio of investment. However, the partners who have expressly excluded himself from the responsibility of work for the business cannot claim more than the ratio of his investment.

The capital providers can invest their money by making restriction on the particular business only. This type we called as al-Mudharabah al-muqayyadah (restricted mudharabah). The capital whether in form of money or real property can also be invested in any form of businesses which the mudharibs want to run with. This form we call as al-Mudharabah al-mutlaqah (unrestricted Mudharabah) (Taqi Usmani, 2007).

Mudharabah-financing can also work with musharakah in other word the principle used in musharakah combined or applied in mudharabah. This case happens when the mudharibs want also to invest in the Mudharabah scheme where despite being the entrepreneur, the mudharib will also work as a capital provider (Taqi Usmani, 2007).

The most common arguments against theoretical and empirical issues regarding Al-Mudharabah are discussed by Iqbal and Molyneux (2006) when some economists such as Stiglist and Weiss (1981) held perception that sharing arrangement such as profit and loss sharing are less efficient. A system that emphasis on partnership becomes an equity-based system with no debt and when the depositors become shareholders is deem to be risky. Among the arguments that being highlighted are such as problem of asymmetric information and the cost involved in reducing it, the problems of moral hazard, adverse selection problem, the agency costs and the need for monitoring the counterparties' behavior.

Most of the institutions have these kind of perceptions towards the sharing arrangement such as profit and loss sharing may argue that agency problem could not be avoided under the behavioral assumption of self interest. This is because the agent may not spend their best effort since they are not using their own money but others, therefore it is very risky.

However, whilst this position has it supporters, their arguments are untenable because in examining the argument that profit and loss sharing financing is too risky for banks to adopt, Iqbal and Molyneux (2006) found two fallacies in this line of arguments. First, the variability in the rate of return is not the only risk involved in financial contracts. Second, the so called 'fixed return' contracts, like interest based contracts may not in fact yield a fixed return.

Besides, when the proposed institutions exposed to greater risks and the variation of the rate of ultimate return to the banks of their investments is greater and resulted from large scale resorting to PLS instruments could pose much more serious risk and hazards. Moreover, Akacem and Gilliam (2002) and Mehmet (2007) thinks that profit sharing concept may approach to market solution because it requires direct involvement of civil society, managerial skills and expertise in overseeing different investment projects from the banks. The banks need to have a correct perception in considering the superiority of Al-Mudharabah. Therefore, the argument that Al-Mudharabah contracts are too risky for the above mentioned institutions to adopt is not convincing.



Asyraf Wajdi, and Nurdianawati Irwani Abdullah. (2006). The Ideal Of Islamic Banking: Chasing A Mirage? Retrieved January 16, 2009, from www.asyrafwajdi.com/download.php?f=0013(downloaded-from asyrafwajdi.com).pdf

AIMS-UK Islamic Banking and Finance, Musharakah and Mudharabah as Modes of Financing, retrieved 24 March 2009, from www.LearnIslamicFinance.com.

Funding a Bussiness, (2009). retrieved 24 March 2009, from http://www.smeinfo.com.my/

Mehmet Asutay. (2007). Conceptualisation of the second best solution in overcoming the social failure of Islamic finance: Examining the overpowering of homoislamicus by homoeconomicus. IIUM Journal of Economics and Management 2007, 15, 1-17.

Munawar Iqbal, and Molyneux, P. (2005). Thirty Years of Islamic Banking: History, Performance and Prospects. London: Palgrave Macmillan.

Mohammed Akacem, and Gilliam, Lynde. (2002). Principles Of Islamic Banking: Debt Versus Equity Financing, Middle East Policy, 9 (1), p124-138.

Muhammad Taqi Usmani, (2007). An Introduction to Islamic Finance, Maktaba Ma’ariful Qur’an, pg 49.

Muhammad Anwar. (2001) Development of Mudharabah Instruments: Understanding Their Profitability, Securitization and Negotiability Aspects, IIUM Journal of Economics and Management 9, no.2, International Islamic University of Malaysia. Pg. 3

Tanzilur Rahman, 1999, Mudharabah and The Pakistan Perspective, retrieved 24 March 2009 from www.irtipms.org/OpenSave.asp?pub=67.pdf

SME Annual Report 2007 by Bank Negara Malaysia (BNM), retrieved 23 March 2009, from http://www.smeinfo.com.my/

Ibn Yusof
13 October 2009 /
11.28 p.m

*This article is extracted from a research paper done by me & my group entitled ''Mudharabah:Solution To Unemployment Crisis''. Download the full paper here.

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