TWO-TIER MUDARABAH' TO A FIXED RETURNS MODEL

8/19/2019 'TWO-TIER MUDARABAH' TO A FIXED RETURNS MODEL

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ISLAMIC BANKING FROM THE IDEAL ‘TWO-TIER MUDARABAH’ TO A FIXED

RETURNS MODEL – RATIONALIZING THE BLATANT DIVERGENCE.

M UHAMMAD A RSALAN

C HEVENING S CHOLAR AT DURHAM C ENTRE OF I SLAMIC E CONOMICS AND F INANCE

[email protected]

The four decades old Islamic Banking Industry (IBI), despite of its double digit growth,

efficiency and resilience, has attracted a lot of censure from scholars owing to its departure

from the utopia of profit and loss sharing (PLS) and an equitable social-oriented institution,

turning in to a profit maximizing debt based financial intermediary. We find plethora of

research, anguished with sarcastic phrases like Shariah Arbritrage (Elgamal 2006), old-wine

in new bottle, marriage of Convenience’ (Samers M., 2015) broadly due to its divergence

from initially conceived two-tier Mudaraba structure to a fixed return asset and liability of an

IB(Khan F. 2010). This paper takes a pragmatist approach to contextualize and rationalize this

deviation by highlighting the key internal and external challenges and anomalies that IBs are

dealing with, and sets out the way forward to address them.

Estimated around USD 1.3 Trillion, Islamic Banking Industry has come a long way from a

humble initiative of Mit Ghamr (1963) in Egypt and Dubai Islamic Bank (1975) to the present

day where we see 430 Islamic Financial Institutions (IFIs), 191 Islamic Banking Windows

spread across 78 countries. The table below depicts a historical growth of the IBI.

mailto:[email protected]:[email protected]:[email protected]


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Islamic Banks at the Cross Roads – What is Pulling it Back?

A better understanding of the digression of IBs towards pseudo-debt products warrants a critical

appraisal of the Islamic Banking model, its externalities and the market dynamics. The figure

below present the two-tier Mudarabah model idealized for IBs with PLS modes on either side of

Balance sheet of an Islamic Bank

:

Nevertheless, the present day asset side of IBs depict a contrary picture, with a heavy tilt towards

trade/debt based products especially Murabaha. The table below presents the distribution of assets

of IBs:


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The blatant divergence between the theory and practice has been charged to many factors

originating from the unique risk profile due to contractual arrangements, coexistence with its

conventional counterpart, regulatory pressures, governance mechanisms, customer segments and

expectations etc.

IBs dwell in a conventional system, wherein not only the market, but even the regulator

operates on ex-ante fixed terms. Even the effective pricing of sovereign debt is pegged to some

conventional benchmark, making it a fixed rate at-source proposition. Moreover, to wither the

Withdrawal risk, IBs are expected to offer their Investment Account Holders (IAH)

market competitive payoff, giving birth to the infamous Displaced Commercial Risk (DCR)

(Sundararajan V, 2007). DCR effectively reflects the tension between IAH and equity

shareholders, wherein market competitive returns are offered to IAH, at the expense of

shareholders equity holders – effectively keeping the IAH remote to the rate of return

risk . A schematic representation is as follows:


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The DCR is managed through prudential reserves such as PER and IRR , which subsequently brings

in the sophisticated debate of agency problem and stakeholder corporate governance. A

schematic representation of the overall profit distribution framework and prudential reserves is

illustrated in the following diagram.

The pursuit to offer smoothened, market tracking returns to the IAH has implication on the

overall risk appetite, product and tenor of the financing assets on the books of an IB -

justifying IBs logical preference for short term, debt based and blue-chip lending to manage

the asset liability mismatch and the subsequent liquidity risk . The challenge here is that of

the overall Asset-liability management and rate of return risk, wherein it is a fixed term and

fixed returns asset side funded by on-demand PLS deposit base offering a market tracking

varying returns. This situation is further exacerbated by the lack of liquidity instruments,

inter-banks and Lender of last resort facilities which burdens the efficiency of the IBs. The

table below elaborates the risk issues and concerns pertinent to IAH deposits.


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On the other hand Capital adequacy regulations (CAR), which has direct implication on the

asset composition and the risk appetite, by means of high risk weightages assigned to equity

modes as compared to the debt based. Despite of IFSB regulations to incorporate PLS natureof the IAH liability in to the CAR of IBs, it is recognized as capital protected fixed return

deposit in majority of jurisdiction with an exception of few.

On top of it, the contractual nature of financing arrangements, wherein banks effectively bear

the market risk of the inventory on its balance sheet adds on to the pressure on expensive

capital of the IBs. Needless to mention, the interrelated and unique risk such as operational

risk, shariah non-compliance, reputational and fiduciary risk facing an IB. Moreover the

jurisdictional heterogeneity in terms, legal system, Banking laws and regulatory

framework, makes it further strenuous for IBs to manage the workout procedure, arbitration

and dispute resolution in lending transaction. This weaves a knotty situation for IBs, leading

it to maintain a conservative risk profile based on fixed return debt based products. The table

below summarizes the risk management consideration


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Moreover, in the wake of the fact that most of the human resource being trained in conventional

setting have unfavourable risk perceptions and lack the capability as well as the will to advent

in to equity.

Who Would Bell the Cat: Shariah Supervisory Board or Board of Directors?

Besides the structural problems, another contentious issue is on the role of SSB in defining the

social character (i.e. through equity modes) of IBs, wherein IBs presumably are enterprises

serving economic, legal, ethical and social goals. Researchers like Elgamal (2006) asserts it to

SSB up to the extent of calling them as ‘Rent seeking shariah arbitrageurs’, whereas

Ahmed.H (2011) pursues a rational approach limiting the SSBs to shariah compliance,

commissioning the maqasid based goals to be addressed by the board of directors in coherence

with corporate strategy and target market segments. The table below endorses the IBs

insistence on shariah compliance and performance driven market orientation for product

development with least consideration for Islamic values.


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Market Appetite of PLS modes

Khan T. 1995 provides an interesting explanation on the demand of PLS modes. On the asset side,

i.e. the relationship between the supply (bank) and demand (borrower) of funds, mature companies

tend to have a preference for Mark-up modes, to augment profit retention and re-investmentin growth; on the contrary entrepreneurial growth oriented companies are attracted towards PLS

modes. Given the dual pressure on their risk profile and CAR, IBs can only viably extend PLS mode

to mature companies. This mismatch contributes to overall lack of equity modes on the asset

side. Moreover the lack of information infrastructure leads to information asymmetry, which also

curbs sectoral and geographical diversity in IBs assets (Dar & Presley 2000).

PLS Modes in Real World – Agency Theoretic PerspectiveDar and Presley (2000) and Ahmed H. 2002 elaborating on the agency theoretic analysis of the PLS

based modes, asserted the need of for the balance of incentive, management and controls to

mitigate agency conflict and the risk of moral hazard and information asymmetry , given the

disincentive to perform and under report profits. While Ahmed H. 2002 viewing it from a different

angle, insisted on the collateralization of PLS financing to address moral hazards. Dar & Presley

2000 further asserts that the incentive compatibility should be crafted, in a way that both the

counterparties stick to the terms of the contract – an idea that resonates with the popular metaphor of

‘Skin-in-the-Game’ (Taleb N. et al 2012).

The table above highlights the significantly less incentive compatibility of the PLS modes which

may rationalize the reluctance of IBs towards them.


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IBs Resilience in Global Financial Crisis: Give the devils its due

Despite of all the criticism, IBI stayed relatively immune to the contagion toxic effects of financial

crisis given its embeddedness in the real economy, when the world’s derivative assets were valued

around ten folds of the GDP of the world. Hence, the limitations IB model due to ShariahCompliance turned in to a blessing in disguise by shielding it from speculative leverage, derivatives,

cross-investments and debt based securities.

So What Went Wrong?

The contemporary Islamic Finance is a result of political movement of the post-colonial Muslim

world, in pursuit of an economic system in line with their faith aspirations. Such transformation

warranted Islamization of knowledge vis-à-vis economic system. A review of the impedimentsdiscussed in the previous sections, claim their origin in the transaction level which subsequently

can be mapped to the inadequacies on either cultural, organizational or institutional

formations, as framed by the New Institutional Economics (NIE) (Ahmed H. 2012)

The idea of the above discursive recourse wasn’t to present an apologetic account of IBs inability

to pursue equitable modes, but to present a critical appraisal of the complexity of the matter.

It is the Failure of Islamization of Knowledge, that lead to failure of Islamization of economy. There

exists a unanimous consensus amongst scholars (Kuran, Kahf, Siddiqui, Zarqa cited from Ahmed.H

2012) on the irrational romanticism with the historical idealistic PLS modes, in absence of the

holistic theoretical framework and scientific knowledge. IBs today, is a pragmatist co-optation of

the secular finance resulted due to non-existent Islamization of knowledge as illustrated below

(Asutay M. Lecture):


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Under the same strand of thought, Ahmed H. (2012) presents a cogent explanation of the lacklustre

ingenuity of the contemporary Islamic Finance, by attributing it to the marginal adaptation as against

intrinsic evolution, owing to stagnant knowledge creation based on Islamic ontological and

epistemological sources.

This reverse engineering approach of mechanistic determinism through the narrow

fiqhi/prohibitionist lens, coupled with limited product level commercial research to produce

Islamic analogue of conventional products can never serve the ideals of Islamic Banking.

Towards an Equitable Islamic Bank – The Way Forward

Citing Mahmood Elgamal (2006) metaphor, IBs need a shift from ‘Christian Shoe towards a fairly

priced and good shoe’. This transition necessitates a collaborative multidisciplinary effort

towards original basic and applied knowledge creation following an Innovative engineering

approach, to shape in the orientation of the culture, institutions and organization formats. Only

this can potentially would built a congenial eco-system for an IB to pursue its social and ethical goals

based on Islamic Ethos. The role and organization of SSBs (preferably that of an independent and

national level) is enormous towards the transformation from Shariah Compliant to Shariah

Based Islamic Banking. SSB has to engage in innovative ijtihadi effort following a social

good/maqasid based approach for knowledge creation - to restore the ingenuity of form andsubstance and win the confidence of the most important stakeholder i.e. Muslim client (the loyalist

as well as rational floater). Moreover, there is a need of joint ijtehad of financial economists,

academics, practitioners, jurists and shariah scholars to pursue a functional approach, instead of

product mimicry. This joint ijtehad should expand its footprint to test the viability of other

organizational format such as Non-profits, Mutual Cooperatives, Venture Capital and eventually

design Institutional arrangements for the efficient dissemination of the rewards of a just and

equitable financial Intermediation system.


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TWO-TIER MUDARABAH' TO A FIXED RETURNS MODEL