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Obiyathulla Ismath Bacha

Department of Business Administration

Kulliyyah of Economics & Managements

International Islamic University Malaysia

November 1996


No.1, June 1997)



Obiyathulla Ismath Bacha Department of Business Administration Kulliyyah of Economics & Management International Islamic University Malaysia 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.

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 type Financing by Islamic banks in Malaysia has reduced to insignificant amounts. Yet, Mudarabah financing 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 Shariah's prohibition of conventional debt financing rests on the inherent inequity of such lending. The lender is not exposed to any of the project/business risk yet receives a fixed return regardless of outcome. Thus the emphasis on a more 'equitable' profit and loss based system.

Despite this congruence, there has been a steady decline in the proportion of Mudarabah type financing by BIMB (Bank Islam Malaysia Berhad) the country's largest Islamic Bank. For the latest fiscal year 1994, Mudarabah constituted a mere 0.33 % of the bank's total customer financing.

Objective and Justification of Study

This paper examines why Mudarabah has declined in importance as a financing vehicle. In addressing this, an evaluation is made of Mudarabah financing in the light of conventional finance theories and identifying the underlying problems. An alternative financing arrangement for Mudarabah is then proposed to overcome the identified problems. Aside from being a new and unique attempt, such an analysis can be useful to both the Islamic and conventional finance theorist. It is hoped that with attempts such as this, the current dichotomy between Islamic jurists whose frequent abstraction from practical realities and finance professionals who have to grapple with contemporary issues can be bridged.

The paper is divided into four parts. Part I examines Mudarabah financing in the light of conventional finance theories and identifies the underlying problems of Mudarabah. Part 11 compares Mudarabah with conventional debt and equity financing within a risk-return framework.

Part III proposes an alternative financial arrangement for Mudarabah financing. Part IV evaluates the proposed Mudarabah arrangement and concludes.

Mudarabah; An Overview

In Mudarabah financing, one party, the Rab-Ul-Mal or financier, provides the capital, while the other party, the Mudarib, provides the entrepreneurship and effort to run the business. The underlying contractual relationship is that of a partnership, with the Rab-Ul-Mal as the silent or sleeping partner. Profits derived from the business or investment are shared by the two parties according to a predetermined profit-sharing ratio (PSR). This could be, say, 70:30, or 80:20, with the larger portion accruing to the Mudarib. In the event of losses, the Shariah stipulates that all losses must be borne by the financier. Any party may terminate the Mudarabah agreement at any time. Finally, in a Mudarabah arrangement, the financier is not allowed to interfere in the running of the business. Thus, a Mudarabah arrangement looks very much like an equity investment by a shareholder in a public listed company. In fact, Islamic banks consider Mudarabah financing to be the equivalent of equity financing.

However, for reasons cited below, given the features and the underlying Shariah law, Islamic bank Mudarabah financing is really a hybrid. It is neither equity nor debt because it has to a Mudarib, the financing that he gets from an Islamic bank is like conventional equity for the following reasons: (i) there are no ''Fixed'' annual payments that are due (unlike interest); (ii) payments made to the Islamic banks come from profits, much like dividends -- they need be paid if and only if there are profits; (iii) the Islamic bank cannot foreclose or take legal action if there are no profits and therefore nothing to be shared; and (iv) like equity, using Mudarabah financing does not increase a firm's risk the way debt financing does through increased financial leverage.

On the other hand, Mudarabah financing can appear to the Mudarib as a conventional debt for the following reasons: (i) It represents a “fixed” claim by the Islamic bank on his company, being the initial amount plus whatever accrued profits (or losses) that are due to the bank. (ii) Like debt, Mudarabah financing is terminal, that is, the arrangement can be ended either by mutual prior agreement or by one party. The Mudarib can end the relationship by repaying the principal and accrued profits to the Islamic bank.

So, unlike equity which represents an unlimited and perpetual claim on the company, Mudarabah, despite the features that make it seem like equity, represents a fixed and terminable claim, much like debt, hence the earlier, argument that Mudarabah is really a hybrid in the conventional sense.


The Agency Problem Of Equity Financing If Mudarabah is a hybrid in the conventional sense, what does it imply about the extent of its agency problems? An agency problem is really an incentive problem that arises from conflicts of interest among parties to a transaction or financial arrangement. The agency problem of equity arises from the divergence between managers who is in the firm and equity holders who own it.

This often leads to a divergence in objectives. While an equity holder’s objective would be firm value maximization, managers being utility maximizes might want to increase benefits that accrue to them and not that of shareholders.

In its mild form this divergence could be in the form of increased pay and fringe benefits or perks that managers give themselves from corporate resources. A more acute form of the agency problem could be in the form of extreme wastage, efforts to entrench themselves and their interest through the use of such instruments as golden parachutes, issuing of poison pills, or even the acceptance of negative net present value (NPV) projects that harm the corporation over the longer term but enhance management's position in the short term.

The Agency Problem of Debt Financing

The agency problem of debt financing really arises in two forms: First in the form of “Levered Equity as a Call Option on the firm” and second in the form of “Moral Hazard”. “Levered Equity as a Call Option on the firm” refers to the resulting payoff to an equity holder when he combines his equity with debt financing. Since equity represents a residual claim whereas debt a ‘fixed’ claim on a firm’s assets, an equity holder who uses large amounts of debt to finance a project gets to keep all accumulated value beyond the ‘fixed’ claim of the debt holder. Should the project be successful, this residual value that accrues to equity holders alone could be really large. On the other hand should the project fail the equity holder’s loss is limited to the amount of his equity.

The payoff to such a situation resembles the payoff to a call option.

Since leveraging their equity with debt can potentially enable them to reap huge profits while limiting their downside risk, the incentive for equity holders who use borrowed funds would be take on high risk, high return projects. This incentive to take on very risky projects is the Moral Hazard problem. It happens because equity holders get to keep everything beyond debt-service requirements if a project succeeds but would lose only their equity if it fails. The smaller the proportion of equity to debt the more acute would this agency problem be.

The Agency Problems of Mudarabah Financing

Having outlined the agency problems of conventional equity and debt, we now examine the agency problems associated with Mudarabah financing. As Mudarabah has the features of both debt and equity and the Shariah prohibits the Rab-Ul-Mal from interfering in the business but requires him to absorb all losses, it can be shown that the agency problems of Mudarabah will be higher than debt or equity.

Does Mudarabah have the agency problem of equity? Yes. Because, profits will be shared and profits are revenues less costs, the Mudarib will have every incentive to increase those costs that accrue to him as benefits. For example, every one dollar increase in fringe benefits or perks that the Mudarib provides for himself from the business will mean a one dollar increase in his utility.

Though profits would reduce as a result by one dollar, his share of the profit (if any) would be less

- perhaps 70 cents. (Assuming PSR of 70/30). Thus, it will always be in the Mudarib's interest to keep increasing his benefits until the marginal utility from increased benefits equals the reduction in his share of profits. If we brine into this the reality of taxes (where fringe benefits are not taxable or at least at a lower rate) and the fact that the Rab-Ul-Mal can-not interfere in the business and therefore cannot put in place the internal controls that conventional equity holders can, it is clear this type of agency problem would remain in Mudarabah.

In addition to the benefits problem just described, there is another more serious kind of problem with Mudarabah that does not exist with conventional equity. This has to do with cost allocation.

Imagine a company that resorts to Mudarabah financing to finance a single project or to establish a new subsidiary. Then the Islamic bank that Provides the financing has claims to only the profits earned by the project or subsidiary, not that of the overall company. Since the profits to be shared will depend on costs, the company will have all the incentive to allocate as much overhead and other costs to the Mudarabah financed project or subsidiary. Aside from allocation of overheads, the company could also use full-costing as opposed to incremental costs as 'it really should. Furthermore, if the subsidiary does any transaction with other divisions of the same company, then transfer pricing could also be used to reduce profits in the Mudarabah financed subsidiary. In each case, profits will be siphoned from the Mudarabah financed unit to other units. This 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 the company’s assets.

As Mudarabah financing constitutes a fixed and terminal claim as does debt, much of the agency problems of debt remain in Mudarabah. Levered equity as call option on the firm remains, albeit in a slightly altered form. Though the profit potential is slightly diminished (since 30% of profits goes to Rab-Ul-Mal), the downside risk is now also smaller, as the Rab-Ul-Mal absorbs all losses.

Overall, levered equity as call option on firm remains very much intact. And as such, so does the Moral Hazard problem. The incentive to take on risky projects would be even greater in Mudarabah than debt financing since Rab-Ul-Mal absorbs all losses.

In concluding on the agency problems associated with Mudarabah financing, it is quite clear that compared to either conventional equity or debt, Mudarabah financing in its current form will have much higher agency problems1.


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