An Evolution of Mudarabah Contract: A Viewpoint From Classical and Contemporary Islamic Scholars

Procedia Economics and Finance 35 ( 2016 ) 349 – 358

Available online at www.sciencedirect.com

(http://creativecommons.org/licenses/by-nc-nd/4.0/).

Peer-reviewed under responsibility of Universiti Tenaga Nasional

doi: 10.1016/S2212-5671(16)00043-5

ScienceDirect

7th International Economics & Business Management Conference, 5th & 6th October 2015

An Evolution of Mudarabah Contract: A Viewpoint From Classical

and Contemporary Islamic Scholars

Noraina Mazuin Sapuan

a,*

Department of Finance and Economics, Universiti Tenaga Malaysia, 26700 Muadzam Shah, Pahang, Malaysia

Abstract

Currently, in the competitive Islamic financial system, mudarabah (profit sharing) is seen as an alternative mechanism in

financing techniques that differentiate it from the conventional financing that consist interest mechanism. Sin

ce its introduction,

mudarabah (profit sharing) has gone through various evolution to fulfill the needs of the fast-developing Islamic financial

mark

et. However, in the current Islamic financial system, mudarabah (profit sharing) has become less preferable compared to

Islamic debt financing instruments such as m

urabahah and bai’ bithaman ajil. This is caused by the existence of asymmetric

information that continuously presents in mudarabah (profit sharing) contracts and creates problems of adverse selection and

moral hazard. Due to this, mudarabah (profit sharing) has declined it importance as a financing vehicle. Therefore, the objectives

f this study are twofolds, first, to examine the thought and evolution of mudarabah (profit sharing) from the viewpoints of

classical an

d contemporary Islamic scholars and second, to evaluate the asymmetric information that continuously exist in this

pe of contract.

Peer-reviewed under responsibility of Universiti Tenaga Nasional.

Keywords: Mudarabah (profit sharing) contract; evolution; classical; contemporary Islamic scholars

1. Introduction

*Corresponding author. Tel:+60-9-455-2020; fax: +60-9-455-2006

Email: Noraina@uniten.edu.my

(http://creativecommons.org/licenses/by-nc-nd/4.0/).

Peer

-reviewed under responsibility of Universiti Tenaga Nasional

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350 Noraina Mazuin Sapuan / Procedia Economics and Finance 35 ( 2016 ) 349 – 358

Equity financing instruments for Islamic business contracts are based on the mudarabah (profit sharing) and

musharakah (profit loss sharing) prin

ciples. These financing methods are an alternative to conventional debt

financing that is based on rate of interest (riba). Equity financing involves mutual sharing of risks and profits,

depending on the performance of the investment project. In the case of mudarabah (profit sharing), the contracting

parties i.e. the fund provider (rabbulmal)-who supplies the financial capital and the entrepreneur (mu

darib)-who

supplies the expertise and management, will collectively take part in profit sharing venture. Profits derived from the

pro

ject will be shared according to the predetermined profit-sharing ratio such as 60:40 or 70:30 by both parties. In

e event of failure, all losses must be borne by the fund provider (rabbulmal), while the entrepreneur (mu

darib)

would have lost his time and effort.

However, from the practical side, mud

arabah (profit sharing) contract is less preferred compare to debt

financing instruments because of the asymmetric information problems that continuously exist in this mode of

financing. The asymmetric information on mudarabah (profit sharing) contract, especially on the asset side,

ormally occurred as an entrepreneur (mudarib) who manage the mudarabah (profit sharing) fund have full control

the project and have more information regarding the project and its prof

itability which the Islamic bank (rabbul

mall) does not usually have access to. The inefficiency in information delegation will generate two major problems,

i.e. adverse selection and moral hazard that makes it difficult f

or the contracting parties to achieve an optimal

contract. Due to this, there is a lack of

interest among Islamic financial institutions to use mudarabah (profit sharing)

as a financing vehicle. According to Bacha (1997), mud

arabah (profit sharing) has lower expected returns and

higher risks; this inequality in the distribution of risk and return has caused full-fledged and window Islamic banks

to red

uce the utilization of mudarabah (profit sharing) financing in their investment.

Therefore, the objectives of this study are twofolds: first, to exa

mine the thought and evolution of mudarabah

(profit sharing) contract from the viewpoints of classical a

nd contemporary Islamic scholars, and second, to evaluate

the inherent problems i.e. assymetric information that prevail in this type of contract.

The remainder of this paper proceeds as follows: Section 2 briefly reviews the mudarabah (profit sharing) from

e classical islamic scholars viewpoint. Section 3 discusses the evolution of m

udarabah contract from

contemporary islamic scholar viewpoints. Section 4 highlights the asymmetric information problem in mudar

abah

(profit sharing) contract. Finally, section 5 concluded the study.

2. Mudarabah (profit sharing) Fro

m The Classical Islamic Scholars Viewpoint

Mudarabah (

profit sharing) is one of the earliest business forms used by the pre-Arabs for trade activities.

Different terms are used to mean mudarab

ah (profit sharing): muqaradah is commonly used by the Hanafi and

Hambali scholars and qirad is used by the Maliki and Shafie scholars.

Even though mudar

abah (profit sharing) has no basis in the Quran or the Sunnah, it was employed by the early

Muslims to conduct trade. The term “mudarabah (profit sharing)” is derived from al-darb al-ard which means

“

traveling through the land” as mentioned in the following verse of the al-Quran:

“….others traveling the land seeking of Allah’s bounty” (Al-Muzzammil: 20).

It was also approved by Prophet Muhammad (S.A.W) as reported by Suhayb r.a.:

“Three m

atters that have the blessing (of Allah (S.W.T)) i.e. a deferred sale, muqaradah (mudarabah (profit

sharing)), mixing the wheat and barley for domestic use and not for sale” (Sunan Ibn Majan)

Mudarabah (profit sharing

) is also known as “silent partnership” (Al-Zuhayli, 2007) whereby it involves a

financier (rabbulmal), who provides a specific amount of capital and acts as a sleeping or dormant partner and an

entrepreneur (mudarib), who acts as a trustee or a business agent. The mudarib is required to utilize and manage the

capital in

prudence and good manner to generate optimal profits for the mudarabah (profit sharing) investment,

hile adhering to the laws of Shariah. The mudarib does not invest any property in the business venture except for

is knowledge and skills. He is also not entitled to claim any wage for conducting the business venture. Mudarabah

(profit sharing) is one of the oldest

business forms used by the pre-Arabs for trade activities. Literally, the word

mudarabah (profit sharing) is derived from the phrase “al-darbfi al-ard”

which means to make a journey (ISRA,

2011). The literal meaning of this partnership is that, in the past this contract required the parties involved to make a

journey to run their business.

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Noraina Mazuin Sapuan / Procedia Economics and Finance 35 ( 2016 ) 349 – 358

Generally, mudarabah (profit sharing) is a partnership in profit whereby one party provides capital (rabbul

maal) and the other party (mudarib) provides labour. The profit, if any, will be shared between them at a mutually

agreed ratio, In case of a loss, it will be borne by the fund provider (r

abbul maal) and the mudarib will lose his

efforts.

Different terms have been used for mudar

abah (profit sharing) such as muqaradah that was commonly used by

the Hanafi and Hambali scholars and qirad was used by the Maliki and Shafie scholars. Mudar

abah (profit sharing)

is also known as “silent partnership” (Al-Zuhayli, 2007) whereby it involves a financier/fund provider (rabbul

al), who provides a specific amount of capital and acts as a sleeping or dormant partner and an entrepreneur

(mudarib), w

ho acts as a trustee or a business agent.

2.1 Legitimacy of Mudarabah (

profit sharing) Contract

The legitimacy of mudar

abah (profit sharing) contract has been established in the Quran, Hadis and the

consensus of Muslim scholars (Ijma’). The pesimissibility of mudarabah (profit sharing) contract has been

entioned in the following verse of the al-Quran:

“….others traveling the land seeking of Allah’s bounty” (Surah Al-Muzzammil: 20)

There two hadiths which stated this partnership arrangement and approved by the Prophet Muhammad (S.A.W):

“Ibnu Abbas (may Allah be pleased with him

) reported that: “When Abbas Ibn Abd al-Muttalib gave his property

to someone for mudarabah (profit sharing), he stipulated conditions for his partner not to bring the capital onto the

sea; and not to bring with him the capital crossing a valley; and not to buy livestock with the capital; and if his

partner violates the conditions, he should guarantee the loss occurred. These conditions have been bought to the

attention of Prophet Muhammad (peace be upon him) and he approved them”.

(Narrated by Al-Bayhaqi in Al Sunan al-Kubra, as cited in Abdul Rahman, 2012)

2.2 Pillars and Conditions of Mudarabah (profit sharing)

2.2.1 Sighah (Ijab and Qabul)

Basically, the condition related to the sig

hah of mudarabah (profit sharing) is similar to those other contracts

which constitute an offer and acceptance. Mudarabah (profit sharing) is concluded when the parties use words that

clearly indicate the contract of mudar

abah (profit sharing) in their offer and acceptance.

2.2.2 The Contracting Parties

The contracting parties consist of fund provider (r

abbul maal) and entrepreneur (mudarib) that have a sound

mind and able to take responsibilities. Fund provider (r

abbul maal) will provide capital to the entrepreneur

(mudarib) for investing it in a business enterprise b

y applying his skills and efforts.

2.2.3 Subject Matter and Conditions of Mudarabah (profit sharing)

(i) Types of Capital

There are various opinions on the types of capital for muda

rabah (profit sharing) contract. Mudarabah (profit

sharing) capital is the wealth entrusted to the mudarib for productive use and at the same time to promote mutual

oodwill between the contracting parties. According to Ibn Rushd, one of Maliki scholar, the majority of the jurists

agree that the investment capital should be in the form of monetary assets or currency (dinar or dirham) as it

possesses intrinsic value as a medium of exchange and legal tender that is accepted by all parties involved in the

contract (Borhan & Sa’ari, 2007).

Meanwhile, most Islamic scholars rule out the use of non-monetary assets or in kind as capital, as it generates

unc

ertainty (gharar) on the estimation of the initial value of the assets, which may be different according to the

person

s evaluating the said property. Furthermore, the fluctuation of prices of non-monetary investments may lead

to in

equitable advantages and disadvantages between the contracting parties. For example, if the prices of

commodities increase when the contract is executed, the entrepreneur will benefit from the price rise as his share of

352 Noraina Mazuin Sapuan / Procedia Economics and Finance 35 ( 2016 ) 349 – 358

profits will increase upon termination of the contract. Meanwhile, if the price declines, the market value of the

commodities drops and investors have to face losses and less profit distribution (Borhan and Sa’ari, 2007).

wever, two legal scholars, Ibn Abi Layla and Al-Awzai both dissents on the issue, perm

itting the use of non-

monetary assets as capital (Al-Zuhayli, 2007).

On the other hand, Abu Hanifa, Malik and Ibn Hanbali permit listing the price of non-monetary assets as

mudar

abah (profit sharing) capital. The mudarib can sell the assets provided by

the fund provider (rabbulmal) and

use the price as capital for the contract. However, al-Shafie disagrees with this idea due to the inexistence of

phy

sical assets upon the contract (al-Zuhayli, 2007).

Most Islamic scholars also agreed that the capital should not be in the form of debt owned by the potential

entrep

reneur from the fund provider (rabbulmal) (Al-Zuhayli, 2007). The rationale of this ruling is to prevent

mudar

abah (profit sharing) from becoming a mode for the r

abbul maal to recover his debt and as a result gain

benefit from the charge or interest. However, if the debt has been paid to the rabbul maal and then the money

deliv

ered again to the entrepreneur upon his need, the silent partnership remains valid. If the creditor instructs the

debtor to use the money that he owes him as capital, the contract is rendered defective. Abu Hanifa, the Malikis, the

Shafies and the Hanbalis agree that if the debtor continues to use the money he is owed, all profit and losses from

the investment would be his and the debt remains intact (Al-Zuhayli, 2007).

In order to collect debt from debtors, all scholars agree that th

e capital provider or creditor may hire an agent to

do the task on his behalf and then use the money as capital in the silent partnership. In the case of deposit money,

the Hanafis, Shafies and Hambalis, if someone is entrusted with a deposit and the depositors ask him to use the

oney as capital in silent partnership between them, the contract is valid. However, the Maliki scholars believe that

pawned and deposited money is too similar to debts and thus do not qualify as capital.

Meanwhile, in terms of capital protection, all classical s

cholars collectively agree on the prohibition of a

guarantee scheme for mudarabah (profit sharing) because it is not relevant to mudarabah (profit sharing) ventures.

Since mudar

abah (profit sharing) operates under a profit-loss-sharing scheme and not a loan, therefore collateral and

guarantees are not required. According to Rosly (2005) the idea of giving guarantees on mudarabah (profit sharing)

contracts diverges from the basic philosophy of profit, loss sharing, i.e. al-ghorm bil ghonm (no reward without

ris

k).

(ii) Distribution of Profits and Losses

The entrepreneur (mu

darib) is required to utilize and manage the capital in prudence and good manner to

generate optimal profits for the mudarabah (profit sharing) investment, while adhering to the laws of Shar

iah. The

entrepreneur (mudarib) does not invest any property in the business venture except for his knowledge and skills. He

is also not entitled to claim any wage for conducting the business venture.

The fund provider (

rabbulmal) and entrepreneur (mudarib) are eligible to attain shares of profits in return for

the investment capital of the former and the latter, for his effort to materialize the profit through business ventures.

All Islamic scholars agree that the ratio in which the profits are to be distributed needs to be determined ex-ante to

avoid an

y disagreement after the business has been conducted. The ownership of the capital or invested assets

remain with the fund provider (rabbulmal) at all times. The fund provider (

rabbulmal) is liable in the event of losses

incurred by market risks, while the entrepreneur (mudarib) will lose his time and effort. T

he liability of the fund

provider (rabbulmal) in mud

arabah (profit sharing) is limited to the extent of his contribution to the capital and no

more. However, if the loss is due to negligence or moral hazard (ghasib), the loss will be absorbed by the

entrepreneur (mudarib).

(iii) The Role of Contracting Parties in Mudarabah (profit sharing) Contract

Mudarabah (p

rofit sharing) contracts can be divided into two types, namely unrestricted (al-mudarabah al-

mutalaqah) and restricted (al-mudarabah al-muqayyadah).

In the unrestricted case, the agreement does not specify

the time period, the location of the business and the specific type of trade or service to be carried out. Meanwhile,

under restricted mudarabah (profit sharing), the entrepreneur (mu

darib) is confined to certain conditions set forth by

the fund provider (rabbulmal). If the entrepreneur (mudarib) fails to comply with the restrictions of the fund

prov

ider (rabbulmal), he will be fully responsible for any resulting losses.

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Noraina Mazuin Sapuan / Procedia Economics and Finance 35 ( 2016 ) 349 – 358

The Maliki and Shafie scholars approve that mudarabah (profit sharing) contract should be unrestricted as it

encourages the entrepreneur to find more opportunities for better profit-earning. However, Abu Hanifa and Ahmad

Ibn

Hambali agree on restricting certain aspects of the mudarabah (profit sharing) contract, e.g. the time period and

choice of the right agent in order to reduce business risks (Al-Zuhayli, 2007).

(iv) The Dissolution and Termination of Mu

darabah (profit sharing) Contract

The mudar

abah (profit sharing) contract is designed to fulfil the needs of the fund provider (rabbulmal) and the

entrepreneur (mudarib) and to protect their interests. The contract is n

ormally dissolved when both parties have

agreed on the completion of the business venture with the settlement of profit distribution and closing of accounts.

All the Islamic sc

holars agree that mudarabah (profit sharing) is non-binding before commencement of the

work and may be dissolved by either party. According to al-Zuhayli (2007), the Hanafi, Hambali and Shafie scholars

agree th

at either party can dissolve the contract at any time and that the contract is automatically terminated with the

death of either party. But the Maliki scholars disagree with the other scholars and assert that once work begins, the

contract becomes binding on both parties. In the case where one of the parties dies, the contract can be inherited by

his heirs. According to non-Shafie scholars, the contract is also terminated if one of the parties becomes mentally

stable; however, the Hanafis rule that the mudar

abah (profit sharing) contract will not be void if the rabbul maal

is put under legal guardianship.

In terms of capital requirement, the Hanafi scholars rul

e that the contract can be dissolved only if the

partnership capital is in monetary form. But the Shafie and Hambali scholars agree that the dissolution of the

partnership is valid even though the capital is non-monetary, as long as both parties agree to sell it and share the

prof

it according to the pre-determined ratio.

3. Contemporary Islamic Scholar Viewpoints

3.1 The Dynamic Evolution of Mudarabah (Profit Sharing) Contract

The development of new products in the modern Islamic financial system is based on the rulings of

ntemporary scholars that the contract is valid as long as it does not contradict the provisions in the al-Quran and

Sun

nah. This belief is consistent with the opinion of Ibn Taymiyya (peace be upon him).

“The underlying principle in contracts and stipulations is

permissible (ibaha) and valid. Any (contracts and

stipulations) is prohibited and void only if there is an explicit test (from al-Quran, the Sunnah and consensus) or a

qiyas

, proving its prohibition and voiding.”

(Narrated by Ibn Taymiyya in al-Fatawa,

as cited in Abdul Rahman, 2012)

Generally, many contemporary Islamic economic scholars enco

urage the usage of profit loss sharing (PLS) i.e.

mudarabah (profit sharing) and m

usyarakah (profit loss sharing) instruments due to its absence of riba and gharar

for the development of current econ

omic activities. However, in reality the PLS contract is less favoured by

financial institutions because of various barriers such as legal requirements and moral hazard problems.

3.1.2 Two-Tier Mudarabah

Generally, the mudar

abah (profit sharing) contract consists of one rabbul maal and one mudarib. However,

according to Maliki scholars there is no restriction on the number of investors (rabbul maals) or entrepreneurs

(mudaribs) in

the same contract with the permission of the capital provider.

According to the Hanafi scholar al-Sarakhsi, in the case of several entrepreneurs (mu

daribs), the mudaribs can

only act in accordance with mutual agreement and approval of the investor. If one of the entrepreneur (mudarib) act

independently without his colleagues’ or investors’ permission, he becomes liable to the investor for any losses due

to the independent and the unauthorised action (Borhan, 2004).

However, the Shafie jurists have different views on multi-tier mudar

abah (profit sharing). Most Shafie scholars

prohibit the use of mudarabah (profit sharing) contract with several entrepreneur (mudarib) regardless of any

permission given by the capital provider. Such contract is regarded as void if it is implemented. Yet, a few Shafie

urists such as al-Shirazi allow the implementation of this contract (Borhan and Sa’ari, 2007).

354 Noraina Mazuin Sapuan / Procedia Economics and Finance 35 ( 2016 ) 349 – 358

Many new contracts have emerged in the contemporary period. Basically, modern PLS instruments are formed

based on studies by the classical Islamic scholars; however, new developments are introduced to fulfil the

requirements and demands of modern industries. According to Al-Zuhayli (2007), among the contracts currently

availab

le that use the mudarabah (profit sharing) concept are; simple partnership (s

harikat al-tawsiyah al-basitah),

particular partnership (sharikat muhassah), joint stock companies (sharikat musahamah) and hybrid limited

partnership (sharikat al-tawsiyah bi-l-ashum).

Figure 1: Financing Process under Mudarabah (profit sharing) Contract

Contemporary scholars agree that capital can be in the form of monetary or non-monetary assets. Nevertheless,

debts or loans cannot be accepted as capital. Mudarabah (profit sharing) contracts can be either single-tier or multi-

tiered. In a single-tier contract, the fund provider (

rabbulmal) deals directly with the entrepreneur (mudarib),

meanwhile in two-tier contracts (Refer to Figure 1), fund provider (

rabbulmal) entrust their funds to an agent, who

acts as an intermediary and who later deals with the entrepreneurs chosen to execu

te the projects. The entrepreneur

(mudarib) o

f a mudarabah (profit sharing) contract may assign the capital to another entrepreneur (mudarib) in

another mudarabah (profit sharing) contract with the permission of the primary capital provider. The profit gain

from the investment will be shared between the fund provider (rabbulmal) and the first entrepreneur (mu

darib)

based on the pre-determined ratio between them and the balance w

ill then be shared with the other mudaribs.

However, in the case of losses, it will be borne solely by the rabbul maal except if the loss was due to the

egligence of the mudarib. The application of unrestrictive mudarabah (profit sharing) i.e. al-mudarabah al-

mutalaqah is considered the most suitable contract to be impleme

nted in the modern investment structure whereby it

would allow the entrepreneur (mudarib) more innovation and creativity in executing the business venture.

3.1.2 Capital Guaranteed

Contemporary scholars also approve on the idea

of giving a third party guarantee (al-kafala) to the mudarabah

(profit sharing) capital as it would be able to mitigate risk exposures and secure the return of the capital. The

guarantee can protect investors (rabbul maal) from misconduct or fraud, but not from market risk. According to

Dalla Albaraka, giving a guarantee to the entrepreneur (mu

darib) in mudarabah (profit sharing) capital is prohibited.

Yet, if the guarantee is given by the government, then it is allowed (Rosly, 2005). Currently, third party guarantees

can

be obtained from the government or from private entities.

In June 2002, the Shariah Advisory Committee of Bank Neg

ara Malaysia ruled that third party guarantee is

permissible for Islamic deposits. This guarantee scheme is based on the concept of mutual guarantee (al-kafala)

mong Islamic financial institutions as participants of the scheme. This scheme does not violate the Shariah

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Noraina Mazuin Sapuan / Procedia Economics and Finance 35 ( 2016 ) 349 – 358

principles since its objective is to protect the public interest (maslahah), especially the depositors and the banking

industry. However, Islamic banking institutions need to ensure that the funds gained from Islamic deposit insurance

schemes are invested in Shariah-compliant instruments. In line with this, the government of Malaysia has introduced

erbadanan Insurans Deposit Malaysia (PIDM) or the Malaysia Deposit Insurance Corporation (MDIC), a fully

guaranteed government agency as a third party to offer insurance coverage on deposits based on Shariah principles.

Furthermore, in 2005, Bank Negara Malaysia (BNM) app

roved Credit Guarantee Corporation Berhad (CGC) as

a third party-guarantor for business ventures with the implemen

tation of Islamic Direct Access Guarantee Scheme

(DAGS-i). In this scheme, the guarantor will charge fees f

or the guarantee services given exclusively to Islamic

financing products offered by Islamic financial institutions to their customers (BNM, 2008).

3.1.3 Establishment of Pr

ofit Equalization Reserve

In year 2004, the Malaysian Islamic banks have introduced a new mechanism in distributing profits for the

mudar

abah (profit sharing) investments. The new mechanism is known as Profit Equalisation Reserve (PER). The

profit equalisation reserve is the amount appropriated by the Islamic bank (rabbul maal) out of the their gross profit

such as from mudarabah (profit sharing) profit, before allocating it as an entrepreneur (mudarib) share, in order to

maintain a certain level of return on investment for the Investment Account Holders (IAH) and to increase owners’

equity (ISRA, 2011).

According to Shaharuddin (2010), in the real banking busin

ess, the monthly rate of return recorded by the

Islamic bank (rabbul maal) throughout a year is inconsistent due to the flux of bad debt profit, provisioning and total

deposit. Thus, in order to mitigate the fluctuation of the rate of return, the Central Bank of Malaysia has demanded

all the Islamic bank (r

abbul maal) in this country to implement the PER mechanism.

This provision/reserve will be u

sed whenever Islamic bank (rabbul maal) record a low profit. As such PER is

viewed as a reserve that is built up in good times to cater for the need in a bad times (Ismail and Shahimi, 2006).

his reserve is created with the purpose of covering the potential losses or as a face of fluctuations in return for the

transaction conducted (Che Arshad and Ismail, 2011). It is also to ensure that Islamic banks have a fixed and

competitive returns to the Investment Account Holders (IAH). Therefore, indirectly profit equalisation reserve

similarly performs as a guaranteed (daman) on mudarabah (profit sharing) capital taken from the mu

darib’s profit.

Although the purpose of PER is undeniably important, its i

mplementation, however causes more confusion. The

Islamic banks may argue that they obtain the depositor’s permission based on the standard form signed at the

beginning of the contract. But, the level of transparency pertaining to this matter is very low. The acceptance of the

PER method in the Malaysian Islamic banking practices indicates the flexible approach adopted by their

pervisory Shariah Board members in modifying the Islamic commercial contracts (Shaharuddin, 2010).

4. Asymmetric Information Problem in Mudarabah (Profit Sharing) Contract

Generally, Islamic financial institutions prefer to u

se debt financing instruments such as murabahah (short term

debt) or bai’ bithaman ajil (long term debt) in their business activities as compared

to equity financing tools.

Adverse selection and moral hazard problems are the reasons why equity financing, especially mudarabah (profit

haring) is a less popular choice as a financing method in Islamic financial institutions.

In reality, investments using mudar

abah (profit sharing) are very risky as the entrepreneur (mudarib), often has

more information about the proposed project and its profitability which the Islamic bank does not usually have

access to. Hence, it leads to imperfect information between the contracting parties (Siddiqui, 2008). Meanwhile,

Ismail and Tohirin (2008) and Khalil, Rickwood and Murinde (2002) discovered mudarabah venture can become

unproductive when Islamic banks fail to embark effective screening process in

the selection of suitable entrepreneur

to manage a business venture before contracting and at the same time failed to monitor the entrepreneur’s actions

ter the contract is implemented. This generally related to the ability of entrepreneur to conceal information

regarding his background and capabilities before contracting and his disguise actions after the contract is

implemented.

Sarker (2000) also revealed that the asymmetric information in mudar

abah contract also cause by the untruthful

behaviour of entrepreneur that failed to report the outcome accurately. Meanwhile, Iqbal and Lewis (2009)

disco

vered that entrepreneurs with below average profit favour equity contract after debt contract in order to

minimize losses in case of failure. In contrast, managers with above average earning prefer to use debt financing in

356 Noraina Mazuin Sapuan / Procedia Economics and Finance 35 ( 2016 ) 349 – 358

order to maximize their gains in case of success. This is in line with the finding from Allen and Gale (1992) where

better quality firms use debt financing as a signal of their superior quality. The problem becomes more serious as the

existence of restriction of using collateral for these assets by the regulator. Investment using mudarabah contract is

also very risky as there is no certainty on returns.

Adverse selection is the true risk of the entrepreneur (mu

darib) before the investment is executed. Meanwhile,

the problem of moral hazard arises when the mudarib is not motivated to fulfil the interests of the project other than

or his benefit. It is also related to the risk that the entrepreneur would conceal information concerning his abilities

and background before the contract and that he would perform independently after the contract is executed (Ismail

and Tohirin, 2008). Furthermore, according to Dar and Presley (2000), such problems can also exist when the

entrepreneur dishonestly under-reports or reduces the declared profits.

4.1 Remedial Action to Reduce Asymmetric Information in Mudarabah (Profit Sharing) Contract

Since the Islamic financial system runs on the principle of risk-sharing, disclosure of information between

parties is v

ery critical. Information regarding the possible combination on how the capital is used, the objective of

the rabbulmal and performance of the venture, among others, must be transparent. A

ccording to Siddiqui (2008),

risk and equity sharing contracts are related to various investment risks such as credit, market and operating risks

which are the results of information imbalance, leading to a problem of adverse selection and moral hazard. Ismail

d Tohirin (2008) reveal that the reason behind unsuccessful mudarabah (profit sharing) business ventures in

Islamic banking is lack of expertise in monitoring the entrepreneur’s operations. Investments using mudarabah

(profit sharing) contract are also very ris

ky as there is no certainty on returns.

4.1.1 Incentive Compatible Contract

Presley and Sessions (1994) and Ahmed (2002) recommended the implementation of incentive-compatible

ntracts to allow more efficient disclosure of information between

the contracting parties. The agency theory states

that the agent may not always act in the best interests of the financier. Therefore, the investor needs to set

appropriate incentives for the agent to earn higher return for the project.

4.1.2 Screening and Monitoring Process

Abalkhail and Presley (2002) emphasized on the use of screening process to overcome the problem of

complete contract that create an adverse selection and moral hazard problems. Sarker (2000) and Ismail and

Ahm

ad (2006) suggested the usage of screening as well as monitoring process to supervise the actions of the

trepreneur in the financing and investment activities. According to Jensen and Meckling (1976), monitoring

expenditure is an agency cost that is directly related to the financier’s monitoring of the agent’s behavior. Effective

monitoring will reduces the a

gency costs even if the agent’s information and actions cannot be fully monitored.

Various benefits can be shared by both principal (capital provider) and agent (entrep

reneur) when the agency costs

been minimize. Ahmed (2002) stated that asymmetric inform

ation can be resolved if the rabbul maal can gather

more information on the operations of the firm especially through the monitoring process. Rabbul maal should

evaluate and monitor the mudarib’s visions, objectives, market strategy, financial strategy and production process

hen the contract being executed. Recent studies by Muda and Ismail (2010) and Wan Kamaruddin and Ismail

(2013) had proved that Mudharabah contract can achieve optimality and mitigate asymmetric problem as well as

minimise transaction cost.

4.1.3 Muslims’ Behavior

From the Islamic perspective, risk and uncertainty can be mitigated through good behavior, as recommended by

Isla

mic teachings. The al-Quran instructs trustworthiness (amanah) (A

l.Baraqah, 282) and insists on fairness and

justice in economic activities. Allah (S.W.T) commands such behaviour to generate harmony among mankind to

ach

ieve Maqasid as Shariah. As mentioned by Metwally (1997), the objective of an Islamic firm is not profit

357

Noraina Mazuin Sapuan / Procedia Economics and Finance 35 ( 2016 ) 349 – 358

maximization; nevertheless, Islamic firms aim to achieve reasonable (fair) profit since Islam instructs Muslims to be

moderate in pursuit of profit and wealth.

4.1.4 Corporate Governance in the Management of Contract

Basically, corporate governance is related to the internal in

tegrity of a corporation that promotes a corporate

fairness, transparency and accountability in the management. Meanwhile, Islamic corporate governance is

establis

hed from the epistemological aspect of Tawhid, embedded the Shari’ah rules and emphasize on the principle

of consultation (shura) bet

ween every stakeholder that involved in the investment activities.

Currently, many Islamic scholars try to emphasize on the role of

Islamic corporate governance to mitigate

agency problems in Islamic financing instruments especially in mudarabah (profit sharing) contract. The special

criterion that is highlighted in Islamic corporate governance is the role of sharia (the latter will be known as s

huratic

process in the decision making process.

In the contemporary practice, s

hura have been suggested as one of the monitoring mechanism to attain

accountability, fairness and transparency in the governance of Islamic corporations (Abdul Rahman, 1998; Iqbal and

Mirakhor, 2004; and Hasan, 2009).

The member of s

hura will comprises of Islamic banks, shareholders, employees and the managers of firms.

Through shura, every party involved will participate in the discussion and will open the door for information to be

disclo

sed and delivered efficiently from the manager to the stakeholders, thus this will narrow down the asymmetric

information in the venture. This is consistent with the spirit of Islam that emphasis on the importance of

trustworthiness and cooperative among Muslim. At the same time, it is to ensure that every activity and decision on

the business venture, especially that based on mudarabah (profit sharing) contract are mutually agreed by all parties

volved before the realization of the contract as the capital provider cannot participate in the management activities.

5. Conclusion

Mudarabah (pr

ofit sharing) has through various evolutionary changes and modernizations since its practice in

the pre-Islamic era. The improvement on existing mudarabah (profit sharing) conditions in modern mudar

abah

(profit sharing) is acceptable prov

ided that it does not contradict with the provisions in the al-Quran and Sunnah.

The intention of this development is to fulfil the needs of the modern communities and the fast-growing Islamic

inancial market. However, in reality, mudarabah (profit sharing) is less preferab

le compared to Islamic debt

financing instruments. This is due to the existence of imperfect information that is inherent in mudarabah (profit

aring) contracts and creates problem of adverse selection and moral hazard, also kn

own as agency problems. As a

result, mudarabah (profit sharing) has declined in importance as a financing vehicle.

In order to overcome the agency problem, screen

ing, monitoring and supervision of the mudarib (entrepreneur)

by the capital provider have been suggested as the best tool

to mitigate this problem. Meanwhile, from the Islamic

perspective, the principle of a

manah (trusteeship), fairness and shura (mutual consultation) have also been pointed

out as part of reliable solutions to reduce the agency problem in mudarabah (p

rofit sharing) contracts. As a faithful

Muslim, the entrepreneur needs to work in a trustworthy manner and carry out his responsibility truthfully with the

intention of obtaining Allah’s blessings and not for his self-interest.

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