MUSHARAKAH AND MUDARABAH – TOWARDS RATIONALISATION
FARID SCOON
During the earlier stages of the development of Islamic banking it used to be commonly accepted that the ideal financing instruments of Islamic banks would be Musharakah and Mudarabah, sometimes referred to as examples of investment modes of finance. It was thought that the use of Murabahah and later Ijara by Islamic banks was a temporary phenomenon forced on them by the exigencies of the formative period of Islamic banking. This idealism was oftentimes enshrined in the charters and other policy documents of Islamic banks. The Articles of Agreement of the Islamic Development Bank, for example, provided for the maintenance by the bank of a ratio in favour of equity between its equity and loan-financing portfolios. As a matter of fact, its ordinary operations were apparently listed in order of importance as follows:
1). Equity participation in projects/enterprises
2). Investment in economic and social infrastructural projects
3). Loans for public sector projects, enterprises and programmes; and
4). Loans for private sector projects, enterprises and programmes.
Very early in its operational phases the IDB developed a policy document intended to be an operational blueprint as well as an invitation to member governments and prospective co-financiers to submit proposals for project financing along the lines outlined in the blueprint. One of the stipulations of the policy document was that the bank would seek participation in projects/enterprises having a high financial rate of return in the region of at least 20%. In addition to loans and equity participation, the policy document clearly envisaged the financing of projects on the basis of profit-sharing. It was stated in the policy document that to ensure adequate income to the bank, the net income earned by a project would be shared on a pro-rata basis, taking into account the quantum of investment by the bank.
The charter of the Jordan Islamic Bank (JIB) also biases this bank’s financing and investment activities in favour of equity participation and profit-and-loss-sharing, though it recognises Murabahah as a typically halal mode of financing. See Chapter 2, Section 7(c) of the Jordan Islamic Bank for Finance and Investment Law, No. 13. of 1978.
Notwithstanding the charters and policy documents of the above-mentioned and other Islamic banks, equity and profit participation are among the least used financial instruments by these banks. In the case of the Islamic Development Bank, instalment-sale and lease financing, which were not even mentioned in the Articles of Agreement or the policy document of the IDB referred to above, have come to occupy the highest importance among the various financing operations undertaken by the bank. Further, leasing and instalment-sale hold the promise of becoming even more important in the future. In the case of the JIB, its 1993 Annual Report shows that it distributed about 29,000.000 JD to the combined agriculture and industrial and mining sectors versus 87,000,000 to the general trade sector. In other words, close to two thirds of the bank’s financing operations was of the short-term, Murabahah and Ijara varieties.
It is clear that Murabahah, Ijara and other short-term financing vehicles are now established as an integral part of Islamic banking and are not merely some to-be-phased-out precursors to the to ideal Islamic banking operations of equity participation and profit-and-loss-sharing. Th e truer perspective is that Islamic banking is a wide phenomenon that caters to every aspect of the market. Relatively short-term instruments such as Murabahah and Ijara more efficiently service certain sectors of the market; while Musharakah and Mudarabah more efficiently service other sectors. Neither mode is more Islamic than the other. Either a particular mode of financing is halal or it is not. It cannot be halal for a particular time or during a particular phase of development, to be eventually replaced by a more halal instrument. The halal and haram of Muhammad are respectively halal and haram until the day of judgement. Moreover, it is incorrect to state that Murabahah and Ijara ai-e only for use as short-term financing instruments. Both of these instruments may, and have been used with some regularity to, finance medium-to-long-term capital acquisitions, including big-ticket items such as ships, aircraft and housing.
Nevertheless, it is also clear that the under-utilisation of the Musharakah and Mudarabah instruments of financing is a major issue facing Islamic banks and financial institutions, for which a solution must be found. It is futile to discuss whether investment modes of financing contribute more to real development than do trade modes. They both have their part to play in overall economic development. What is pertinent is that Islamic banks have been able to rationalise procedures for trade modes of financing, but have had much less success entering into the areas of equity participation and profit-and-loss sharing. Likewise, non-Muslim institutions with Islamic windows are almost exclusively occupied in trade modes of Islamic financing, which are generally safer modes.
The non-rationalisation of Mudarabah and Musharakah modes of financing means that Islamic banks are conceding a major market share to Riba-based institutions and in particular are underservicing critical sectors of the market, including private and public sector infrastructure development projects and capital-intensive, high-technology enterprises. Most Islamic banks are therefore still hardly involved in the primary stages of capital formation in Islamic societies, or in non-Islamic societies where they operate for that matter One result is that there are few if any Islamic financial institutions that have high-yielding and imaginative investment portfolios despite their otherwise proven ability to increasingly attract substantial deposits relative to investments – the perennial excess liquidity problem.
The solution to these problems is by no means to advocate the wholesale conversion of the portfolios of existing Islamic banks. Rather, on the one hand, some measure of balance sheet diversification is recommended, so that some minimum percentage of assets may be allocated to capital-formation and profit-and-loss investment vehicles. Perhaps the two-thirds to one-third ratio in favour of trade financing achieved by the JIB in 1993 is appropriate. It is really a question for the various governors and directors of Islamic banks to set and achieve a performance ratio.
On the other hand, some Islamic banks are perhaps well-suited to specialise as investment banks dedicating the majority of their portfolios to investment activity. The problem is that in either case, investment banking in the Islamic system is in many ways radically different from conventional investment banking. The fundamental factors that underpin these differences are a different legal regime and a different set of historical precedents. Moreover, because the development of Islamic banking was severely truncated during the last phases of the Ottoman caliphate and the period of European colonisation, it is as much a question of reconnecting with the foundational historical vehicles of Islamic investment financing as it is rationalising a set of already existing vehicles. It is to a further examination of these legal and historical issues that attention is now turned.
The respective legal regimes within which they operate to a great extent determine the operations of conventional and Islamic banks. The most fundamental difference between Islamic and conventional banking, the question of interest excepted, may be the legal status of the deposit in the hands of the respective banking systems. Deposits are accepted either within a “trust deposit framework” or a “loan deposit framework”. The deposit of a client in the hands of a conventional Riba-based bank is a debt. The true relationship between the parties, that is the Riba-based bank and its depositors, was described by Lord Cottenham in the English case of Foley v. Hill, 1848. It can safely be said that the statement of Lord Cottenham still represents the English common-law position on the subject and will therefore apply certainly in all countries that follow that tradition and probably in every country that allows the practice of Riba-based or conventional banking.
“Money”, said Lord Cottenham, “when paid into a bank, ceases altogether to be the money of the principal; it is then the money of the banker, who is bound to return an equivalent by paying a similar sum to that deposited with him when he is asked for it. The money paid in the bankers is money known by the principal to be placed there for the purpose of being under the control of the banker, it is then the banker’s money; he is known to deal with it as his own; he makes what profit he can, which profit he retains to himself, paying back only the principal, according to the custom of bankers in some places, or the principal and a small rate or interest according to the custom of bankers in other places… That being established to be the relative situations of banker and customer, the banker is not an agent or factor, but he is a debtor”
What then is the nature of a deposit in a debt-based bank? Firstly, it is not a deposit per se, but a loan by the customer or depositor to the bank. Secondly, the bank does not hold the money, in the great majority of cases anyway, as a trustee and the depositor is not in any way a trustor. Thirdly, it is clear that under the debt-based system the bank has complete autonomy to use its customer’s deposits to invest, loan or allocate the money in whatever manner it thinks fit or use it as a reserve. Fourthly, and very importantly, the bank in many cases obligates itself to give the depositor/creditor, some specified increase over and above the amount deposited or loaned.
When we enter into discussions about the legal status of a deposit in an Islamic bank, we surface in a sea of confusion and a woeful lack of standardised practice. That a deposit in the hands of an Islamic banker may be classified as a loan to the banker is not impugned from a Shari’ah point of view. While we are not able to express an authoritative view, this seems to be precisely the case of deposits under the Malaysian Islamic Banking Act, 1983, as an example. The situation under the Usury-Free Banking Law of Iran appears to be that the deposits in the Islamic bank, and perhaps also the other assets the bank, belong to the depositors with the bank acting with the funds in its capacity as attorney and trustee of the people. Between these two extremes lies the Jordanian model, which seems to divide deposits into trust deposits and investment deposits, according trust deposits the legal status similar as under the Law of Interest-Free Banking of the Islamic Republic of Iran and investment deposits similar as under the law of the Islamic Banking Act of Malaysia. The legal regimes under which Islamic banks operate are as varied as the examples here given and vary as well according to the perceptions of the banking regulators in the different jurisdictions. We can’t change the legal framework within which Islamic banks operate, but at least the Islamic banking practitioners must recognise the complexity and intricacies of the environments within which they operate and the possible ramifications of these on their policy decisions and plans.
Whether a deposit is accepted under the trust or loan deposit framework may have implications for how bankers perceive their role and functions vis-a-vis their depositors and their client-users of funds. Perhaps Islamic bankers need to examine whether under the trust deposit framework there is a little too much inclination for bankers to emphasise their role of merchants and commercial partners on behalf of their depositors, which has resulted in precisely the oft-criticised overemphasis on instalment sales and Ijara which we observe in most Islamic banks. One effect of the historical truncation alluded to earlier is that while Muslims can claim credit for the invention of various primitive instruments that have now developed and become commonplace in modern commercial practice, including the cheque, promissory note, bill and mortgage, the concept of the bank itself is a uniquely European institution. In law, at least in the English common law of banking, and in practice, a bank has the character of being an “intermediary for funds” and can only inefficiently indulge in commercial and trade activities, which ought properly to be left to the client-users of the bank’s funds. Is the ratio of trade vs. investment financing in Islamic banks reflective of this historical truncation? It would be revealing to survey commercial institutions that have availed themselves of Islamic trade financing to determine what percentage of these institutions also avail themselves of Riba-based institutions to finance their other requirements, and if they do, whether this is because of some inherent inability of the Islamic banking system to cater for all financing needs, or whether this inability is not in fact related to overemphasis and overdependence on easy trade financing by Islamic bankers.
The historical truncation in the development of a uniquely Islamic banking system also sets the stage for an impeding acceptance of Mudarabah and Musharakah, whether within the trust or loan deposit framework. The choice of assets of a conventional commercial bank is largely determined by the bank’s ability to liquefy its assets. The bank, in accepting deposits (loans) from its depositors, obligates itself, as we have seen, to repay the deposit with interest on demand. The success of a conventional commercial bank is almost entirely dependent on the confidence of the public in the bank’s ability to pay on demand. The profitability of the bank is dependent on the bank’s ability to convert its debts (deposits) into assets that yield a higher rate of interest than that it pays its depositors. The conventional bank, therefore, prefers to convert its debts into assets that are themselves easy to liquidate, so that it will always be in a position to satisfy the demands of its depositors whenever called upon to do so. The choice of assets of a conventional commercial bank, therefore, tends to be a multitude of small-to-medium collateralised, short-term advances or overdrafts. Conventional commercial banks are therefore not disposed to permanently financing the fixed capital of industry.
Other economic institutions, including specialised investment banks and the stock and securities markets, have generally performed the role of capitalisation of industry. In the United States, England and on the Continent, legislative action has compelled banks to separate their work as deposit banks from their work as providers of capital, even though the rationale for the legislative action may have preceded from different historical circumstances unique to each of these systems. It is into this climate that the historically truncated Islamic bank is interposed. It must now subject its legal framework to ijtihadic review in order to reassociate and reharmonise that framework with the economic structures, such as Mudarabah and Musharakah, that had long fallen into disuse. This is the challenge of rationalisation.
Within this loan-deposit and trust-deposit polarity, the Islamic bank has perhaps to devise new and different trends towards balancing collateral requirements and towards asset preferences. The majority of Islamic banks appear firmly to prefer the classical English commercial banking model, albeit substituting trade financing vehicles for interest-based products. Provided that regulators are not averse to such developments. Islamic bankers would perhaps only need to overhaul some of their internal systems to ready themselves for Mudarabah and Musharakah.
In the first place, legally (according to the Shari’ah) and practically there ought not to not be an extra-transactional collateralisation requirement in Musharakah and Mudarabah contracts. The true position is that a party undertaking work on the basis of a Mudarabah contract does so as a trustee. He cannot be held responsible for any loss of, or damage to, the property entrusted to him, until and unless the same is found to have arisen due to any excess or neglect on his part. Any responsibility for guaranteeing against trading losses does not devolve on him. Trading losses are borne by the capital-owner as part of the risks undertaken by him. As such, the capital-owner cannot require collateral as a condition of the contract. The character of these investment vehicles is such that the bank, enjoying the ownership of the subject property of the transaction, has sufficient valuable assets to cover its own resources in the resource allocation. Perhaps there is a greater risk, but this is in the very nature of the transaction. It is not risk-free banking; it is profit-and-loss-sharing banking.
In the second place. Islamic banks concerned about minimising risks will, in common with conventional banks when they make a risk assessment on the lending of money, look to several factors, including very importantly the viability of the project for or in which the money is being invested. Extra-transactional collateralisation, as we have seen, is a comfort factor not open to the Islamic banker. The alternative open to the Islamic banker, it has been suggested, is a new and different involvement and relationship between banker and entrepreneur. Th e Islamic bank will have to develop mechanisms for more closely monitoring investment projects and this monitoring cannot just be limited to balance-sheet monitoring. Perhaps the Islamic bankers will have to be cross-trained with the expertise not just in financial services but, collectively speaking, in a host of other disciplines in addition.
At the same time, it is not being suggested that Islamic banks become directly involved with the management or directorates of companies with which they are investing, though in some cases this may be appropriate. After all, the primary function of the bank is still a fund intermediary. But shorn of extra-collateralisation requirements within the loan-deposit framework and encumbered with the extra-fiduciary requirements within the trust-deposit framework, and for his own peace of mind and profitability, the Islamic banker requires a system where he can be proactively involved in the processes for which the funds under his control have been invested.
If Islamic banks make a start today, perhaps in the second quarter of a century of Islamic banking a new breed of qualified Islamic bankers will be able to take charge of Islamic banks. Only then can one say that Islamic banking has taken root.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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