Mudarabah Islamic banking product
Now, Islamic banking assets rose at USD1.32tln and more than 255 microfinance institutions are providing Islamic financial services in the worldwide, It accumulate value approximately USD628mln in which USD1.28mln transaction happen for the shari’ah compliant product.
Historical Background of Mudarabah:
Islam strongly prohibits interest-based transactions but appreciate business, partnerships and trade. In conventional, interest-based transactions shift the risks from the investor to the entrepreneur. Partnerships also lead both to share profit and loss, which refers risk sharing to risk shifting. But Islam prefers risk sharing rather than risk shifting.
From the beginning of Islamic economy, it is observed that mudaraba and its derivatives were the most important partnerships. Mudaraba was introduced in the Middle East and then extended to the whole of the Islamic world from the Atlantic to the Pacific. It was widen to Europe through the crusaders. Eleanor of Aquitane, Queen of France, brought the Islamic law of Partnerships as well as the Admiralty Law, from Jerusalem to France during the late 12th century. In France, at the Island of Oleron, these laws were incorporated into the Lex Mercatoria – the medieval European law of commerce. Throughout this incorporation, the Islamic mudaraba was called commenda by Europeans. Borrowing the Islamic risk sharing partnerships appears to have had a huge impact on European economic, financial and even political history. After the incorporation, Europe went through a period of massive growth in commerce which known as the “commercial revolution”. In other way around, it was mudaraba/commenda contract (risk sharing) which financed this massive increase of trade both within Europe and across the Mediterranean. There were two Italian city-states named Genoa and Venice specialized in trade between Europe and the Islamic world. Acemoğlu and Robinson had demonstrated that Venice became a super power of the period to its new merchant class using the mudaraba/commenda. There was the beginning of decline for Venice when the old elite began to fear the rising new merchant class and in the meantime, decided to prohibit mudaraba/commenda, during the late 13th century. When the young men of Venice could freely practice the mudaraba/commenda in foreign trade, Venice prospered and became powerful. But when this risk sharing contract was banned and the rising new mercantile class was thrown out from the decision making process and the city began to decline.
There was potential feature of the classical Islamic partnerships is their resilience. A thousand years after their birth, they can be observed in Ottoman finances without any change in their structure. There is one financial instrument, however, which can be considered as typical Ottoman. These were the Cash Waqfs. Cash waqfs were charitable foundations established with cash.
In short, their modus operandi was as follows: A wealthy person donated a certain amount of cash for a charitable purpose. The money was invested and the revenue it generated was spent for the charitable purpose of the donation. When Imam Zufar was asked during the 8th century how a cash waqf should function, he said, the cash capital should be invested with mudaraba. But when Ottoman cash waqfs were studied, it was proved that they did not practice mudaraba. If they had done so, they would have become risk sharing instruments. They applied istiglal, a basically risk shifting instrument instead of risk sharing (Mudaraba).
As it is well known, mudaraba is a risky instrument and it may end up with losses. Such losses can be tolerated only if there is no upper limit imposed on profits so as to compensate the losses with the high profits generated. But maximum profit limits in the range of 5 to 20 percent was the rule in the Ottoman economy. With this profit limit controls waqf trustees refused to apply the risky mudaraba and preferred istiglal. Thus, profit limits imposed by the state executed any potential for risk sharing by cash waqfs. Therefore, risk sharing and profit limits imposed by an authority are not encouraged in the modern era. The earliest solution was found tax-farming. The origins of tax-farming can be traced back to the early centuries of Islam. The Ottoman version of this system was called iltizam. According to iltizam, entrepreneurs were alloted the right to collect taxes. Therefore, taxes were collected by the private enterprise. As a result, it doesn’t consider as risk sharing. The state was shifting all the risks upon the agent or the entrepreneur. Indeed, the entrepreneur not only paid a fixed amount to the state, but he also did not have any guarantee that he would be allowed to collect taxes for a certain period. Moreover, with so much uncertainty and risk shifting, iltizam also contained elements of gharar. The consequence of all this risk shifting and gharar was that the state was not able to earn much. In 1683, when ottoman armies were defeated at the gates of Vienna and the state budget began to exhibit substantial deficits. In 1695 a new system, the malikane (a system of risk sharing), had to be introduced. Now the tenure of the entrepreneur increased to his life-time. In return for this increased reliability of the tenure, the entrepreneurs began to compete in the auctions yielding much higher revenues to the state. The entrepreneur took a great risk and made a very large lump-sum payment up front. In this system, the risks were shared fairly where the entrepreneur lived a long life, he would make substantial profits, and the state would lose. If he lived a short life, the state could take back the tax-farm at his death and re-sell it again at a new auction making substantial profits. With such risk sharing, the gharar was eliminated as well.
From Twentieth Century Developments to the Present:
The greatest development of the 20th century in Islamic finance was the establishment of the first Islamic bank in Mit Ghamr in Egypt by Dr. Ahmed el- Naggar. El-Naggar’s bank was based on a two layer multiple mudaraba. In general, both the liability and the asset sides were designed as multiple mudarabas. Consequently, It was a truly risk sharing system. But it did not last and all the other Islamic banks established later on applied murabaha rather than mudaraba in their asset sides. Thus they abandoned risk sharing and focused on trade financing based on the murabaha mark-up, such as musharaka, murabaha and so on.
Rules and conditions:
1. Two or more people whose are free to agree into contract in which found provider have a specified amount of capital to the other who invest this capital in business to make profit.
2. Earning profit should be clearly distributed to the each party on the agreed ratio. However, the loss of business should be occupied by the mudarib.
3. The investment capital should be in terms of gold, coins, silver or standard money in exchange and it can’t be commodities.
4. The mudarib is full free to run business with the capital as he deems fit. The limitation of mudarib’s freedom may turn into the contract invalid.
5. The duration of Mudarabah should not be predetermined by one party that can terminate agreement by giving any instant notice.
6. The mudarabah should not be restricted to operate business only but it can be extended to industry operation also.
The reasons behind dynamic changes in Mudarabah:
1. To facilitate and encourage the operation of free, fair and transparent markets in the Islamic financial services sector.
2. Enhance the capitalization, efficiency and resilience of Institutions offering Islamic financial services to ensure that they are on a par with international standards and best practices.
3. Enhance the access by all population (Muslims & Non-Muslims) segments to financial services.
4. To meet the social demand of current situation.
5. Develop the required pool of specialized, competent and high-caliber, human capital and ensure utilization of technology.
6. Promote the development of standardized products through research and innovation.
7. Comply with the international, national demand of Mudarabah products.
8. Achieve and sustain the objectives of development policies.
9. Develop a comprehensive and efficient infrastructure for the Mudarabah Product for customer satisfaction.
10. Promote public awareness of Islamic financial services.
11. Strengthen and enhance collaboration among the international Islamic financial infrastructure institutions.
12. Foster collaboration among countries that offer Islamic financial services.
13. Conduct initiatives and enhance financial linkages to develop the existing products with acceptance for all.
14. To compete with conventional banking products, it has to add some features.
15. To make it more acceptable and prompting product among the customers.
16. Technological breakthroughs required to change the nature of traditional mudarabah contract.
17. To ensure wide-ranging access to financial services and to meet the needs of the economy for various types of funds, the domestic markets.
18. To achieve sustainable economic development and flow with social progress.
19. To generate efficient channeling financial resources towards productive opportunities.
20. To enhance linkage with production, investment and trade activities.
Effective Changes in Mudarabah over the decades:
In order to ensure systemic soundness, such banks must be strongly capitalized and of an appropriate economic size with suitable product strategies. The society’s needs for finance are diverse. Commercial banks, investment banks, takaful and the various forms of Islamic NBMFIs perform diverse functions as required for mobilization of funds, asset management, risk intermediation, provision of risk capital and meeting the needs of social development. It has to modify to respond to the rapidly changing environment. The existing Islamic financial architecture requires further strengthening to reflect several external environmental factors as well as structural changes within industry. The recent market conditions have forced institutions to invest in research and to develop new technologies in order to furnish to the growing demand for greater product mix by increasingly judicious consumers. In turn, technology has led to a sharp increase in the number of financial corporations in recent years. These entities sustain competitiveness by crossing traditional boundaries and achieving economies of scale. As a result, a drastic transformation is taking place in the financial services industry in the form of cross-segment mergers, acquisitions and takeovers between banks and securities firms and between banks and insurance companies, acquisition of fund management companies by banks and insurance companies, expansion of financial institutions into new areas through internal growth, such as insurance companies setting up banks and vice versa, insurance companies selling various investment products, and banks setting up securities and fund management operations and involvement of non-financial firms in the financial services business through the extension of credit and financial services to their customers. These worldwide transformations in the financial services industry have very important implications for the development of Islamic banking. The impact of changes in product has significantly identifiable.
Vigorous Impact of changes in product:
The impact of globalization: globalization has an important impact on Islamic banking products. Mudarabah which following the traditional operation system, it was neglected buy the current situation. As a result, the demand of it has gradually decreased. Due to the globalization, the industry has to comply with the current situation, as a result globalization impacted on the existing products on Islamic banking. Therefore, it requires to changes it operation to comply with the global demand and flow.
The impact of technological changes: Islamic banking has passed 3 decades. In between the technology brought changed rapidly which required changes in structure, an operation and management of all sectors. With growing application of information technology also brought out the changes in Islamic banking products to comply with modern technology and demand of customer. Therefore, we can say that, the impact of technological changes brought a new era/ dimensions in mudarabah contract as well as all Islamic banking products in a greater way.
Changes in the regulatory environment: with increased emphasis on risk focused supervisory approaches and market discipline brought dynamic changes in Islamic banking products. Mudarabah has to develop its operation or implementation system to conform to regulatory changes.
Rapid growth in Islamic Banking and Islamic financial markets: Islamic banking products has to come up with dynamic changes in response to market demand, government strategies to promote the industry in some countries, and product innovations based on securitization of Islamic finance contracts. Those factors have highlighted the unique mix of risks and special operating characteristics of Islamic finance, and the need for these to be taken into account in the risk management by Islamic finances. Therefore, it has to be formulating development strategies for Islamic finance. The unique operational features of Islamic finance derive from the contractual design of instruments based on Shari’ah rules and principles, and the overall legal, governance and liquidity infrastructure underpinning Islamic finance. As we have obliged that the changes were required to fulfill the demand of customers, the community and world.
Dynamic contemporary application of Mudabarah:
Mudabarah has been restructured over the long time for the market specialization through the introducing application Islamic product. The mudarib (entrepreneur) are regularly searching new product for the investor that has a great impact on socio-economy development, The mu Now under the mudabarah scheme, entrepreneur introduced new profit sharing product by which ultimate fund supplier can choice one from its available option that is more bring more profit than risk.
In 1983, Siddiqi emphasized the necessity for Islamic banking and finance to base on the profit sharing concepts. In order to attain real success in Islamic banking, the players are to be involved more aggressively in profit sharing concept of mudarabah to replace entirely the institution of interest which is totally forbidden as according to him bank interest is equal to usury or riba. The author totally believed that Islamic banks cannot to be successful if concentration of the banking business is sale and leasing based transactions. According to him, the interest based banking and lending has resulted in injustice and inefficiency and hence, it is necessary for Islamic banking to change its operations based on to profit sharing concept to ensure justice and improved efficiency.
Two tier model: In modern Islamic finance, Mudarabah is commonly done on a two-tier system. Multiple depositors put money into an Islamic bank. The bank then acts as the investor in a variety of entrepreneurs, and shares profits (and losses) with the original first-tier depositors. It is initiated to enhance the products demand among the Muslim and non-Muslims.
In the 1st tier: Depositors considered as investor/ rab-ul-mal and bank considered as Mudarib. In modern days, few banks guarantee the deposit. Therefore, depositors feel safe to provide the fund.
In 2nd Tier: Bank is the provider of capital and entrepreneurs consider as mudarib.
Takaful: Bank mostly get the insurance from takaful to guarantee its capital as they are committed to return the deposit.
There are some anecdotal forms of transaction in the Islamic financial market those are below;
- Simple Partnership:
A situation which associated with a party who provides capital to a mudarib to work with the capital and they participate in profits. The losses will be borne by the fund supplier (rabb-ul-mal) and the mudarib will loses his times and effort.
- General Investment Account (GIA):
General Investment Account is an absolute mudarabah product and the ratio of profit sharing is standard and advertised as a ready package between the bank and the customer. Bank always search profitable investment, they never invest in risky project.
- Specific Investment Account (SIA):
SIA is a restricted mudarabah agreement within two parties, and the fund supplier will accept a ratio that is pre-determined by mutual agreement. This type of account actually a big amount to be invests.
- Project financing.
Bank works as intermediaries for financing in the project. Basically, the fund collects from the mudarabah account holder. Bank impose certain percentage of interest on the lending money, it’s distributed between the mudarabah account holder and bank.
- Letter of Credit based on mudarabah.
It is a new form of business that will enhance an effectiveness of the export import transactions. Letter of credit can be used by using the mudarabah contract. The client will informs his Letter of credit requirements, beside bank will negotiates terms and conditions of the mudarabah financing with the concerning company.
- Unit trust.
The unit trust is Islamic banking product where one investor provides the capital to the unit trusts company and the companies will provides management. Here profits and losses are to be shared between investor and company in according to the agreed profit sharing ratio.
- Mudarabah in takaful
Islamic insurance build up a relationship between takaful company and takaful investor. Now a day, the modern takaful contracts would be modarabah basis for the process. In the principle of mudarabah, the applicants as rab al-mal (investor) appoint the takaful operator as mudarib (manager) to work with the money in investments which are Shariah compliant. The fact is that the takaful participant has not been involved in managing the fund and taking challenges of the market risk.
The Impact of Mudharabah in economy growth:
Justice needs a set of rules or moral values, which everybody receives and devotedly fulfills with. The financial arrangement may be competent to endorse justice if, furthermore to being durable and steady, it pleases at least two conditions based on moral principles. One of these is that the financier should also share in the risk so as not to shift the total weight of losses to the entrepreneur, and the other is that an impartial share of financial capitals mobilized by financial institutes should become available to the poor to help eradicate poverty, enlarge employment and self-employment opportunities and, thus, help diminish inequalities of income and wealth. The financial crisis has “take away” money from the public. Many have lost their jobs and their purchasing power. In the time of crisis, the needs of liquidity are very crucial in order to cure the diseases that are rampant. It is therefore the responsibility of the financial institutions to consolidation Mudharabah as entities has no liquidity to give out. This liquidity will give equal chance to the people to take part in the economy and treatise their necessities. There are people who have the expertise in doing business but have no access to fund. Thus, the institute of al-Mudharabah will provides them liquidity and this will deliver income to them. A firm or company that has access to this money also will provide jobs for the community. Therefore, this will shrink the unemployment rate. Hence through al-Mudharabah there will be more job positions verify that the problem of unemployment can be remedy successfully by it.
Risks Associated with Mudarabah Financing:
Financial risk: Financial risks are the exposures that result in a direct financial loss to the assets or the liabilities of a bank. In the point of mudaraba investments, where the Islamic bank enters into the mudaraba contract as Rabbul-mal (principal) with an external (agent) and the principal-agent problems, the Islamic bank is showed to an enhanced financing risk on the amounts advanced to the mudarib. The character of the Mudaraba contract is that it does not give the bank correct rights to monitor the mudarib (agent) or to participate in the management of the project, which makes judgment and management of the financing risk difficult. The bank is not in a position to know and decide how the activities of the mudarib can be monitored accurately, specially, if claims of losses are made. This risk is mainly present in markets where information irregularity is high and there is low transparency in financial disclosure by the mudarib.
Business risks: BR is related with a bank’s business environment, including macroeconomic and policy concerns, legal and regulatory factors and the overall financial sector infrastructure. Business risk also includes the risk becoming insolvent due to insufficient capital to continue operations. While Islamic financial institutions are exposed to the regular business environment, solvency, and financial sector infrastructure risks.
Rate of return risk: The rate of return risk stops the uncertainty in the returns earned by Islamic banks on their assets. This uncertainty can cause a difference from the expectations investment account holders have on the liabilities side. The larger the difference, the bigger the rate of return risk. Return on the investment of equity partnership by Islamic banks such as mudaraba is not known accurately until the end of investment period. Islamic banks have to wait for the results of their investment to determine the level of return their investment account holders or depositors will earn. If, during this period, the current yield levels or expected rates of returns in the market change, then the investors may expect similar yields from the bank.
Equity investment risk: In applying mudaraba, Islamic financial institutions are exposed to equity investment risk in profit and loss sharing investments on the assets side. Equity investment can lead to volatility in the financial institution’s earning due to liquidity, financing, and market risks associated with equity holdings.
Fiduciary risk: FR leads to the risk of facing legal recourse action in a situation where the bank breaches its fiduciary responsibility toward depositors and shareholders. As fiduciary agents, Islamic banks are expected to act in the best interests of investors and shareholders, and the actions of the bank, the bank is exposed to fiduciary risk.
Credit Risk: CR is the loss of income arising as a result of the counterparty’s delay in payment on time or in full as contractual agreed. In the case of profit-sharing modes of financing like mudaraba the credit risk will be nonpayment of the share of the bank by the entrepreneur when it is due. The problem may arise for banks in this case because of the asymmetric information problem where they do not have sufficient information on the actual profit of the firm.
Download full article click below
No comments:
Post a Comment