Salman Ahmed Shaikh
Islamic finance industry mostly uses LIBOR linked financial contracts which are akin to debt financing than the more preferable participatory modes of Mudarabah and Musharakah. On the other hand, as per the current orthodox understanding and practice of Islamic finance, the often cited preferable modes like Mudarabah and Musharakah are incapable even in a simple model economy with them as the only mode of financing as the discussion below shows.
One of the major impediments in the use of Mudarabah on the asset side of a bank i.e. for financing is that only Rabb-ul-Maal is considered to bear all the financial losses. Therefore, if an Islamic bank enters into the Mudarabah contract as a Rabb-ul-Maal, only the Islamic bank would have to bear all the losses. Mudarib (Fund manager) bears no loss while he has the complete authority in running the affairs of the business. The Rabb-ul-maal (investor) is not allowed to interfere in the affairs of the business. When a loss occurs, the Mudarib acts like an employee of the business and when the profit occurs, he shares in the profit as if he was the only reason behind the profits. This juristic viewpoint didn’t create much problem during early Islamic era when often, the Mudarib was a poor and resource-less person in financial need with limited incentive and authority to enter in corruption and no capacity to participate in loss sharing if the loss was caused by any reason other than negligence on his part.
The principle that loss sharing should be based upon and limited to the amount of capital invested is not a condition mentioned in Quran or Hadith. Fuqaha recommended it, but it does not mean that it can not be modified, especially if doing so is necessary and will make the preferable Islamic modes of financing more applicable. When we make terms and conditions for employment contracts, for appointment of Shariah Advisors etc, any condition not in violation with Islamic principles is allowed and is used. Similarly, limiting loss sharing up to the amount of capital invested is not the only way loss sharing could take place.
Furthermore, in Musharakah, loss participation by all partners across the board is justifiable because all partners are also allowed to work. But, due to the condition in Mudarabah that working partner is the sole authority to make decisions on business, making Rabb-ul-Maal completely responsible for sharing all losses is unjustified in the first place.
In Mudarabah, the prevalent concept of loss sharing makes it different from a General partnership (all partners have unlimited liability) and even with limited partnership (some or all have limited liability). In Mudarabah, Rabb-ul Maal not only has unlimited liability, but no authority to participate in the business. Consider an Islamic economy with Mudarabah on asset and liability side and there is no other instrument used, Mudarib (usually blue chip companies) with no liability to share loss can obtain financing from banks who would be Rabb-ul-Maal in asset side use of Mudarabah. On liability side, bank will be Mudarib and the small savers and investors will be Rabb-ul-Maal. So, any loss incurred by blue chip companies is ultimately paid by small savers and investors who have all the liability to share losses without having a say in the affairs of the business!
Restricted Mudarabah and clause of willful negligence is insufficient to protect them from losses strictly due to business cycle fluctuations. This example shows that with current structure, even Mudarabah used alone in an economy is insufficient to bring about any egalitarian change let alone prove to be more destructive than interest based system.
Let us analyze trust deficit and documentation problems which are cited as reasons why Mudarabah is not being used widely. Relax these assumptions and now consider there is no trust deficit and documentation problem in the economy. If a loss occurs due to business cycle fluctuations, no part of the loss is borne by the business that had all the authority to run the business. The loss is borne not by the bank as well because bank is Mudarib on liability side. All loss is borne by the small savers and investors. Now consider the government prohibits interest based lending and borrowing too. Will the people want to be Rabb-ul-Maal in Mudarabah with bank or be the shareholder in a blue chip company which can take all the money, invest it, earn from it and if loss occurs, pass it onto the small savers! Mudarabah (with current structure) even when assumptions of trust deficit and documentation problems are relaxed and even when there is no competing conventional banking system is ineffective to say the least.
If we look at Mudarabah as it is currently understood, Mudarib is basically an employee who would get Ujrat-e-Misl in case of loss and his compensation will feature some share in profit also. He is not liable to bear any loss. Rabb-ul-Maal is basically the entrepreneur (who has the ultimate responsibility to share losses). How is it a participatory mode then? This should not be cited as a participatory mode with current structure. Secondly, it is also different from a principal agent relationship in corporate form of organization. In that, the principal hires the agent only because of his inability/incapacity, but the rules do not restrict him not to influence agent’s decisions. Important decisions taken by the agent(s) have to be vetted in AGM. Mudarabah rules even do not allow that much participation. So, in my humble opinion, we first need to justify that how Mudarabah is a “just” mode of financing, let alone a participatory one and a most preferable one.
With important covenants in place, equity financing can be used and is used widely. It is interesting to study the size of debt and equity market in developing countries. For instance, in Pakistan, corporate bond market hardly exists, whereas equity financing is more prevalent and widely used. Equity financing through shares will forever deny the claims of bankers in general and Islamic bankers in particular who hide behind trust deficit and documentation problems. Why people invest in shares of companies without any guarantee over par value let alone dividend? This is an important question to answer even if some financial tycoons help promote the practiced Islamic Finance the way it is practiced for commercial reasons.
The prevalent Islamic products which are linked with LIBOR are and will predominantly be used and practiced Islamic finance may remain incapable of providing egalitarian benefits it once promised.
Islamic Financial System: The Way Ahead
Islamic Economics System is a blend of natural features present in Capitalism i.e. right to private property, private pursuit of economic interest, use of market forces etc used along with some distinct features derived through Islamic economic teachings i.e. interest free economy, moral check on unbridled self-pursuit and provision of socio-economic justice to achieve the goals of Socialism as far as is naturally possible without denying individual freedom and profit motive.
In Islamic corporate finance, by looking beyond practiced Islamic finance, we can incorporate following alternatives for corporate finance in sourcing funds i.e.
- Ijarah with embedded call option,
- Limited liability partnership,
- Equity modes like Musharakah and Mudarabah,
- Income bonds and
- Convertible income bonds.
Ijara with embedded option can solve the paradox of unilateral undertaking and convert the sale of put option from the perspective of client into a call option. In Mudarabah, following two covenants can be introduced.
a) Mudarib can be asked to contribute some capital. The contract will still remain different from Musharakah as only the Mudarib is the working partner.
b) Mudarib can be asked to share in loss to some extent.
These two covenants will minimize the problem of adverse selection, moral hazard and agency problem.
In using funds (investments), we can incorporate following alternatives for corporate finance in using funds i.e.
- Islamic income funds,
- Islamic REITs,
- GDP growth rate linked sovereign bonds,
- Income bonds,
- Convertible income bonds,
- Foreign currency reserves,
- Making strategic expansion,
- Equity investments in other companies.
In methods of valuation in Islamic Financial Management, the author suggests an alternate means of pricing capital in interest free economy and use of appropriate discount rate i.e. Nominal GDP growth rate in public finance and also in corporate finance like in CAPM, dividend discount model, project valuation, calculating NPV, FCF, FCFE, valuing income bonds and stocks etc.
There is a need to realize weaknesses in practiced Islamic finance, only then can we look for solutions and in search for solutions, we need to be critical, objective, impersonal, unbiased and open to hear and receive all possible solutions and then accepting and rejecting any of them on the basis of authentic Islamic sources i.e. Quran, way of Prophet Muhammad (pbuh) and Sahih Ahadith rather than on the basis of factional affiliations and blind following. Only then, can we hope to progress towards the goal of an ideal Islamic Economic system.