Paper Title: Profit and Loss Sharing Partnership: The Case of the Two Tier Mudarabah in Islamic Banking

Author:        Amine Ben Amar and AbdelKader O. El Alaoui

Publisher:    Emerald International Journal of Islamic and Middle Eastern Finance and Management, Vol. 16 No. 1, 81-102.

This paper mathematically analyzes the two-tier Mudarabah model in an exclusive Islamic financial environment and under dual banking system.

Analysis suggests that the profit-sharing structure is built up by the three parties: the bank, the depositor and the entrepreneur. At the time of signing the Mudarabah contract, it has to be drawn up in a way that, at the ex post, the remuneration of each necessary production factor, capital and labour, should equal its marginal productivity.

However, the model assumed complete information symmetry, complete certainty and considered a one-shot model. Biggest issue in Mudarabah comes in asymmetric incentives, especially in the case of loss. It makes the problem of moral hazard and adverse selection highly important.

Authors note that the nature of profits, losses and risks to be borne differs according to the nature of the stakeholder (depositor, bank or entrepreneur) and its position in the contractual relationship (Mudarib or Rabb-ul-Maal). However, the model could not incorporate information asymmetry, uncertainty and dynamic analysis. It also assumed risk-neutral agents and no output price risk. All of these factors are important features in application of Mudarabah.

Mudarabah is considered to be one of the most preferable modes of Islamic finance. Maulana Taqi Usmani in his book “Introduction to Islamic Finance” stated at least 5 times that Mudarabah and Musharakah are ideal modes of financing respectively on page 12, 17, 72, 107 and 164.

However, one of the major hurdles in the use of Mudarabah for financing is that only Rabb-ul-Maal is 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 participate in the affairs of the business. It is unlike the case in venture capital funds where the venture capitalist could include several covenants for dealing with agency problem and even have a say in appointment of directors and executive management).

Agency and moral hazard problem in Mudarabah deserves serious attention. 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 losses 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!

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 that government prohibits interest based lending and borrowing too. Will the people want to be Rabb-ul-Maal in Mudarabah with bank or 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 has issues in application to say the least.

In practice, running Musharakah is used in some countries like Pakistan. It reduces the element of risk and uncertainty by agreeing to a selected list of deductible expenses. It also equalizes the rate of return to the market rate through tier-wise asymmetric payoff distribution.

It solves the economic problem in Islamic equity based modes of financing, but as per some scholars, it compromises on the essence of risk sharing. Essentially, it becomes a tool of risk-shifting with inexact profit calculation, asymmetric allocation of costs among stakeholders in the project and inexact calculation of even the investment capital.

To overcome problem of uncertain payoffs and asymmetric distribution of losses in Mudarabah, it is confined to use where a risk-shifting based financing portfolio is managed by the Islamic bank, either for retail depositors or for other banks in interbank Mudarabah. However, the promise of inclusivity in Mudarabah can be achieved when its use increases in asset side operations.  The paper did not give more coverage to the problem of moral hazard under information asymmetry and uncertainty in a dynamic model. One way to solve these issues is to use hybrid Mudarabah by asking Mudarib to invest its capital as well and thereby share in risk of loss. It will still be distinct from Musharakah as the management role will be exclusively performed by Mudarib.