EconPapers    
Economics at your fingertips  
 

Adapting Mudarabah Financing to Contemporary Realities: A Proposed Financing Structure

Obiyathulla Ismath Bacha

MPRA Paper from University Library of Munich, Germany

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

Keywords: An adapted model for Mudarabah; Islamic profit-loss sharing financing (search for similar items in EconPapers)
JEL-codes: D82 G32 (search for similar items in EconPapers)
Date: 1997-06, Revised 1996-11
References: View references in EconPapers View complete reference list from CitEc
Citations View citations in EconPapers (5) Track citations by RSS feed

Published in The Journal of Accounting, Commerce & Finance; Islamic Perspective 1.1(1997): pp. 26-54

Downloads: (external link)
http://mpra.ub.uni-muenchen.de/12732/ original version (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: http://EconPapers.repec.org/RePEc:pra:mprapa:12732

Access Statistics for this paper

More papers in MPRA Paper from University Library of Munich, Germany
Address: Schackstr. 4, D-80539 Munich, Germany
Contact information at EDIRC.
Series data maintained by Ekkehart Schlicht ().

 
Page updated 2014-03-31
Handle: RePEc:pra:mprapa:12732