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Saturday, February 27, 2010

The issue of moral hazard and adverse selection issues in musharakah contracts and proposal for risk mitigation.

1.0       Introduction

Commonly, business ventures start off with a loan. For Muslims, loans cannot be made or accepted according to traditional banking methods because this invariably entails the payment and receipt of interest and therefore is not permissible. Islamic banking allows prospective clients to borrow money while still adhering to Shariah law through profit-and-loss sharing scheme of financing; mudarabah[1] and musharakah contracts. Musharakah (partnership) is the second basic Profit and Loss Sharing (PLS) concept in Islamic banking. 

In fiqh[2], the concept of musharakah is used in much wider sense. However, in the context of Islamic banking operations, we are concerned with one type of musharakah, that which is known in fiqh as ‘inan (unequal-shares) partnership i.e. sharikat ‘inan fi al-mal[3] since it is this form which is seen to be the most appropriate for Islamic banking environment. To date, because knowledge of Islamic banking among Muslims in Malaysia is shallow, Islamic banks failed to use mudarabah and musharakah as their main business products. As lending has been the traditional approach in banking, Muslims thought that only bai al-inah[4], murabahah and bai bithaman ajil[5] (BBA) serve as the best alternative to lending.

However, Muslims and the public cannot totally be blamed for the lack of use of musharakah contracts in the market. Generally, Islamic banks regard the application musharakah is a risky venture, thus they, in turn, resorts more into application of bai al-inah and BBA. Eventhough the schemes offered are still based on Shariah principles, however, there are different Shariah interpretation and acceptance regarding to the application of bai al-inah and BBA. Many jurists regard both concepts are not in conformity to the maxims; al-ghurm bil ghunm (no pain, no gain) and al-khraj bil daman (profit bearing risk). Saiful Azhar Rosly (2005) quotes that Islamic financial industry lost its identity from over-reliance on bai al-inah and BBA. Over-dependency to these modes of finances have made many IFIs in Malaysia into complacencies and in comfort-zone whilst lose initiative to devise new Islamic financial products. Instead, Islamic banks could venture into musharakah financing with them. Musharakah financing can be utilised for purely commercial purposes which are usually of a short term nature, or for participation in the equity of medium to long term projects. The type of musharakah available are; (a) commercial musharakah, (b) decreasing participation or known as musharakah mutanakisah, and (c) permanent participation. Application of musharakah will let more involvement of Islamic banks in the sense of a real business venture.

1.1             Moral hazard and adverse selection issues in musharakah contracts

Islamic banks all over the world are also, by and large, using the same modes of finance though the degree of use of a particular mode may differ from one bank to another. However, musharakah contracts are not, at present, widely used in Islamic banking. This has raised the issue of what hamper the Islamic banks on the application of this particular financing mode. As mentioned before, generally Islamic banks regard the application of musharakah financing is a risky venture to them. This is due to asymmetry information between Islamic banks and the entrepreneurs and information is at centre of all financial transactions and contracts. Three problems are pertinent:

*     not everyone has the same information;
*     everyone has less than perfect information; and
*     some transactors have ‘inside’ information which is not made available to counterparties to transactions. Thus, decisions are therefore made ex-ante on the basis of less than complete information and sometimes with counterparties who have superior information with the potential for exploitation.

Asymmetry information in this context can be divided into two levels: pre-investment and post-investment. The pre-investment stage, asymmetric information is very high. When the bankers meet the entrepreneurs, knowledge differences between them create asymmetric information. Entrepreneurs usually know their own collateral, industriousness, moral character and business prospects better than the bankers. In essence, entrepreneurs possess inside information about the enterprise for which they are seeking financing. Islamic bankers would benefit from knowing the true characteristics of entrepreneurs and the quality of their proposed ventures. Adverse selection problems arise before the contract is signed because the bank has less information on the project than the entrepreneur (information concerning the characteristics of a venture).

The moral hazard problem occurs at post-investment stage because of the ‘hidden’ action motivated by self-interest of the entrepreneurs which is unknown to the bankers (information concerning the true characteristics of an individual entrepreneur are concealed from the bankers). In practice, it has been observed that while depositors’ preferences for using an Islamic bank may be due to religious reasons, the entrepreneurs who seek financial assistance in these banks may not necessarily have this motive. Since musharakah contracts are primarily equity-based, it is often claimed by critics that under asymmetric information, it will be subject to higher degree of adverse selection and moral hazard compare to conventional debt contracts, which is one of the reasons for their lack of popularity in Islamic banks. For example, is the incentive the entrepreneurs may have in concealing the true level of profits in order to keep a large share of it for him, or by absorbing some of the profits through unauthorized perquisites.

1.2             Strategy to reduce the effects of adverse selections and moral hazards

First, we have to consider a few aspects needs to be taken into consideration in order to regulate and supervise the company finance by way of musharakah contracts;

*    Musharakah financing requires constant vigilance by Islamic banks over utilisation of funds. Islamic banks are likely to increase its staffs by employing financial and legal experts to evaluate projects more thoroughly and to be placed in the directorships of the companies. This will definitely increase the costs and Islamic banks will have to balance it against prospective returns that could be earned by making more efficient use of funds; and
*    Enforcement mechanisms used for aligning the incentives of the borrower with the interests of the lender in conventional banking is by asking borrower to pledge collateral. However, collateral is of limited use in Islamic banking. Classical mudarabah and musharakah is a collateral-free financing. In fact, some Islamic scholars pointed out that collateral are a poor substitute for sound assessment of the project which is a necessary feature of musharakah contracts. The collateral cannot be a substitute for a more careful evaluation of the project financed. This is because the value of collateral can itself be impaired by the same factors that diminish the ability of investors to repay its financing at the first place.

Islamic banks can devise a several steps need to be taken to reduce unnecessary effects from adverse selections and moral hazards in musharakah financing: (i) initial screening, (ii) due diligence, (iii) valuation, (iv) approval and structuring, and (v) monitoring.

Islamic banks obviously seek to attract desirable prepositions yet many unwanted proposals are received; these have to be weeded out as quickly as possible. The preliminary screening process should enable bank managers to form an initial view about the projects. Thus, to enable Islamic banks to screen thousands proposals a year, bank can certainly need an effective screening system to save time and money, and also to prevent agency problems associated with information asymmetry and adverse selection. The agreement towards the proposals can be assessed in relations to the quality of the business plan and basic concept of the project. Islamic banks can also put additional assessment e.g. the personality and track record of the entrepreneurs and its management teams which are considered vital along with the market acceptance of the business.

After that, due diligence process will be conducted. The aim of this cycle is to minimize investment risk and adverse selection by conducting a thorough investigation of the information presented in the business plan. A few methodologies can be employed during this stage. However, generally the bank managers should look into three generic screening criteria: the viability and novelty of the project; the integrity, track record and leadership skills of management; and, possibility of high returns by paying special attention to the financial projections. The investment criteria may also change according to the type of investment. Apparently, this cycle will take considerable time and resources of the bank. Thus, BIMB can reduce the due diligence costs by specializing the funds department according to the industries like what have been done by Big 4 accounting firms.

Valuation is often considered the final phase of due diligence. Any valuation is primarily a function of the bank’s perception of the risk associated with a project in relation to their target rates of returns. The valuation techniques currently adopted by conventional banks involve the use of interest rate (riba) which is forbidden in Islam. Valuation practices vary across the world. Some techniques use multiplication of past or future earnings by a comparable price-earnings ratio, do not involve any explicit reference to interest rates. However, Islamic objections do arise in respect of application of discounting future cash flows (DCF). DCF usually discounts forecast cash flow by a ‘benchmark’ rate of interest, to arrive at a fair valuation or entry price of a project; the interest rate reflects the degree of risk inherent in the proposal. The principle of discounting per se is not prohibited practice. The positive time value of money is well recognized in Islamic jurisprudence, provided that it relates to trade rather than the lending and borrowing of money. It may be acceptable to use interest rates as a benchmark for the inherent risks associated to the projects but however, the use of interest rates for such comparative purposes remains the subject of intense debate in Islamic finance. If the banks are to use the DCF techniques, it is suggested to use a broad spectrum of discount rates in valuing the project and starts from a higher base than the prevailing interest rates and covers a much wider range in order to be prudent in valuing the projects.

In a structuring cycle, the critical question is whether musharakah can provide the required flexibility for efficient risk management. This can be explored in relation to two fundamental dimensions of structuring process: contractual structuring (the covenants included in shareholders’ agreement and any staging agreements); and the selection of financial products, namely the choice between equity, debt or hybrids. In Islamic jurisprudence, parties are free to structure a contract to achieve their mutual economic interests, provided that Islamic principles are not violated i.e. such instruments were used in conjunction with sharikat ‘inan fi al-mal or wakalah[6]. Turning into selection of financial products, the preferred stock; preference shares and convertible debt is prohibited. Thus, bank can finance by way of equity. On the other hand, Islamic banks can opt for ‘diminishing musharakah’ or known as ‘musharakah mutanakisah’ whereby this structure can be fully secured by using company assets as collateral, thus protecting the original capital to some extent until the project achieves profitability. From cash generated through profits, the entrepreneurs can begin to purchase the equity issued. This gain plus gradual redemption of part of the invested capital appears Islamically acceptable. The debt with interest-bearing is prohibited. As an alternative, murabaha or ijarah bonds can be used for funding plant and machinery.

Monitoring cycle can be analysed into few processes. Islamic banks can place the bank managers to be in directorship of the companies invested. One manager can occupy maximum to ten companies effectively. This manager can be the balancing power among other directors from the entrepreneurs’ side. The entrepreneurs should not view directors installed by Islamic banks as necessary evils, rather as valuable new resources. The manager can definitely guide the directors in the best financial directions for the company. He can also advise the company on how to market the products more effectively through networks known in the markets. Alternatively, he can also draw the entrepreneurs’ attention to indicators that set alarm bells ringing, notably decreases in the ratio of tangible assets to total assets or greater R&D intensities. However, the most important role for bank manager to be in place in the directorships is to ensure regular provision of accounting information, in order to prevent information asymmetry and hence moral hazard. By placing the bank manager in the directorship, the potential for entrepreneurs to play around with accounting figures to conceal true level of profits or absorbing some of the profits through unauthorized perquisites can be avoided. BIMB can perform random audit to the company to ensure the company is still on track and will definitely reduce the moral hazard problems.

2.0             Conclusion

Tun Dr. Mahathir Muhammad during his presidency period has urged the banks to start taking risks. Given the need for high technology capital-intensive investments, finance is crucial and banks should lend support. He also said if the banks are not ready to venture into risky investments such as equity financing like what have been done by Japanese banks towards greater financial liberalisation, banks are no better than moneylender and chettiars. Islamic banking is also not spared by Tun Dr. Mahathir Muhammad, at least indirectly. In fact, they should be the most embarrassed, given their privilege to purchase stocks and involve in underwriting of shares are clearly outlined by the Islamic Banking Act (IBA) 1983.

The existences of Islamic banks come not only with profit-motive but also with socio-economic objectives. In conventional banking, most of the funds flow to large industries, multinational corporations and big industrialists. This is because, in an interest-based system, the sole criterion for the distribution of credit is the credibility of the entrepreneur. Therefore, the distribution of credit in a conventional banking sense is directed in favour of large, rich industrialists, whereas in a profit-sharing system, bank finances will be more equitably distributed. This is because the criterion for the distribution of credit is the productivity of the project and therefore, the financing will go to the more productive project, even if the credibility of the enterprises is lower. Islamic banks are the only resorts for small and middle class entrepreneurs who do not get financing even for very good projects from conventional banks. Thus, with musharakah financing contracts, Islamic banks can able to help and contribute into the development of socio-economic of the country.

References :

Rosly, Saiful Azhar. 2005. Critical Issues on Islamic Banking and Financial Markets: Islamic Economics, Banking and Finance, Takaful and Financial Planning. Kuala Lumpur: Dinamas Publishing.
Rosly, Saiful Azhar. 2005. “Potential Use of Salam Financing in Malaysia”. Financial Engineering and Islamic Contracts. New York. Palgrave Macmillan.
Rosly, Saiful Azhar. 1999. “Islamic Banking in Crisis: The Malaysian Case”. Akauntan Nasional. Vol. 12 No.4. Pp13-18.
Munawar Iqbal and Philip Molyneux. 2005. Thirty Years of Islamic Banking. History, Performance and Prospects. New York. Palgrave Macmillan.
Munawar Iqbal and Rodney Wilson. 2005. Islamic Perspectives on Wealth Creation. United Kingdom. Edinburgh University Press.
Munawar Iqbal and David T.Llewellyn. 2002. Islamic Banking and Finance: New Perspectives On Profit-Sharing and Risk. United Kingdom. Edward Elgar Publishing.
Mansoor Durrani and Grahame Boocock. 2006. Venture Capital, Islamic Finance and SMEs: Valuation, Structuring and Monitoring Practices in India. New York. Palgrave Macmillan.

[1] Mudarabah : A profit and loss sharing contract in which one party provides the financial capital and the other manages the enterprise. While profit is shared, loss is borne by the financier.
[2] Fiqh : The science of understanding of divinely-revealed law. Islamic jurisprudence covering all aspects of life including economic.
[3] Sharikat ‘inan fi al-mal : A form of partnership which is termed as limited investment partnership.       
[4] Bai al-inah : Sales and repurchase back. Refers to trading whereby the seller sells his assets to the buyer at agreed selling price (with a specified mark-up) to be paid by the buyer at a later date. After that, the buyer sells back the assets to the seller at a cash price, lower than the agreed selling price.
[5] Bai bithaman ajil : Trading at cost plus specified mark-up. A variation form of murabahah (sale at specified margin) with purchase payments is deferred and payable at a certain particular time in the future (e.g. via installments).
[6] Wakalah : Contract of agency. In this contract, one person appoints someone else to perform a certain task on his behalf, usually against a fixed fee.


  1. assalamualaikum wbt,

    i ould like to ask;what are the remedies in bai bithaman ajil contract?

  2. salam. saya wan nur ashikin wan rezali, accountancy student from UiTM. saya ada assignment regarding the issues arise in the application of Shirkah in this modern life. boleh saya refer pada blog ni? thank you.