Reconsidering Mudarabah Contracts in Islamic Finance: What is the Economic Wisdom (Hikmah) of Partnership-based Instruments?
Shinsuke Nagaoka
Abstract: In Islamic economics and finance, a broad consensus has been reached that, out of all the financial instruments, partnership-based instruments are the most preferable, which is justified by the way any risk involved is properly shared by both parties. This risk sharing is highly consistent with the general spirit of Islamic teachings. However, when the negative effects of securitization, which appears to be a risk-sharing instrument, as seen in the subprime mortgage crisis in recent years, are taken into consideration, characterizing partnership-based instruments as risk-sharing ones is not necessarily sufficient to describe their important economic implications. Therefore, this paper aims to reconsider those implications by thinking back to partnership contracts in pre-modern times and then reformulating their economic wisdom (hikmah), so that for future Islamic financial practice.
JEL Classifications: G , G , P , P , O .
I. IntroductionIn Islamic economics and finance, a broad consensus has been reached that, out of all the financial instruments, partnership-based instruments are the most preferable. This consensus is unanimously supported from the viewpoint of juristic propriety; it is also supported by an economic
, Postdoctoral Research Fellow of the Japan Society for the Promotion of Science (JSPS) at the Centre for Southeast Asian Studies, Kyoto University, Japan.
argument relating to the economic doctrine of Islam, namely that the use of partnership-based instruments is justified by the way any risk involved is properly shared by both parties. This risk sharing is highly consistent with the general spirit of Islamic teachings.
However, when the negative effects of securitization, which appears to be a risk-sharing instrument, as seen in the subprime mortgage crisis in recent years, are taken into consideration, characterizing partnership-based instruments as risk-sharing ones is not necessarily sufficient to describe their important economic implications. Therefore, this paper aims to reconsider those implications by thinking back to partnership contracts in pre-modern times and then reformulating their economic wisdom (hikmah) for future Islamic financial practice.
II. Partnership-Based Instruments in Islamic EconomicsSince the surge of academic interest and research into the Islamic economic system from the mid-twentieth century (generally referred to as ‘Islamic economics’), there appears to have been a consensus about which financial instruments should be adopted in the reconstructed Islamic economic system. Most Islamic economists encouraged the use of partnership-based financial instruments like mudarabah and musharakah contracts.
The mudarabah contract is a form of contract in which one party provides capital with which another party undertakes some business; the former is termed rabb al-mal and the latter mudarib. Any profit from the venture is distributed between the parties in a ratio agreed beforehand, while any loss is entirely borne by rabb al-mal unless mudarib has a defect (see Figure ).
Figure : Principle of Mudarabah
rabb al-mal
mudarib labour
capital
Business
distributed in a pre-determined ratio
borne by rabb al-mal
profit
loss
The musharakah contract is a form of partnership in which multiple parties invest. In Islamic finance, sharikat al-[inan is used as a variation of musharakah. Any profit is distributed between the parties in a ratio agreed
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beforehand (according to the Hanafi and Hanbali schools of Islamic law), or shared in proportion to the amount of investment (according to the Maliki and Shafi[i schools). There is consensus among the schools that any loss is distributed in proportion to the individual parties’ share in the investment. A right to participate in managing their business partnership is given to investors, but this right is entrusted to each investor (see Figure ).
Figure : Principle of Musharakah
investor
investor
labour
capital
Business
pre-determined ratio or amount of investment
borne in proportion to the amount of investment
profit
loss investor
labour/capital
One of the early Islamic economists, Qureshi, had already mentioned partnership-based banking systems in a work published in : “Islam prohibits interest but allows profits and partnership. If the banks, instead of allowing loans to the industry, become its partners, share the loss and profit with it, there is no objection against such banks in the Islamic system” (Qureshi, : - ).
Around the same time, Ahmad ( : ) also stated his preference for partnership-based systems: “The shirakat banks would lend money to industry and commerce on the basis of shirakat, that is, they would share the profit with their debtors rather than burden industry and commerce with a fixed rate of interest”.
According to an earlier overview by Siddiqi ( ) this consensus with regard to the most preferable financial instruments was widely shared both by experts in Islamic jurisprudence and scholars specializing in economics until the end of the s. For example, al-Sadr ( [ ]) formulated the partnership-based banking system as a preferable Islamic economic system; Uzair ( ) presented the core mechanism of the partnership-based banking system from the viewpoint of economics, and Siddiqi himself ( [ ]) the system in his book and developed it to suit the modern banking system under the name of ‘two-tier mudarabah’ (Siddiqi, [ ]) (see Figure ).
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Figure : ‘Two-tier Mudarabah’ for Modern Banking
rabb al-mal
mudarib
rabb al-mal
mudarib
bank liability side asset side
III. Partnership-Based Instruments in Islamic FinanceExperience through the growth of Islamic finance in the s showed that, in practice, partnership-based instruments are not necessarily suitable for most aspects of Islamic finance, particularly its asset side. The Middle East and Malaysia did not in fact adopt partnership-based instruments as core financial products, preferring mostly mudarabah contracts, which are not partnership-based.
Nevertheless, most Islamic economists and also many practitioners who deal in non-partnership-based financial operations on a daily basis firmly hold that partnership-based instruments are the ideal financial instruments for the Islamic economic system. For example, al-Ghamdi of Al-Rajhi Bank in Saudi Arabia argues (cited in Sum, : ) that, while the present emphasis on non-partnership-based financial instruments is accept-able, it should be phased out once Islamic finance grows into a much bigger and more developed system. This comment appears to imply that non-part-nership-based instruments should be replaced by better instruments, that is, partnership-based instruments. Several Islamic banks in the Gulf countries, are looking to emphasize change in their operations from non-partnership-based instruments to partnership-based ones. Warde ( : ) reports that, in response to criticism of non-partnership-based instruments, many Islamic banks started phasing out the elements of such instruments, par-ticularly murabahah contracts, which had been subject to criticism.
Thus, partnership-based instruments have maintained their status as the preferred option for Islamic economic transactions throughout the history of Islamic economics and Islamic financial practice.
IV. Economic Wisdom of Partnership Contracts in Existing LiteraturesWhat makes partnership-based instruments the ideal, preferred option? Of course, in juristic terms it can be explained easily by referring to the textual
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sources which underpin the legitimacy of partnership-based instruments. This paper mainly focuses on the economic advantage of partnership-based instruments in light of their conformity with the ideals of Islamic teachings. As mentioned above, partnership-based instruments have a particular profit-sharing and a loss-sharing procedure (Siddiqi, ): any profit from ventures based on murabah contracts is distributed between both parties on the basis of a previously agreed upon ratio, while any loss is entirely borne by the rabb al-mal (capital provider); similarly, any profit from musharakah contracts is distributed either on the basis of a ratio previously agreed by the parties or in proportion to the partners’ share of investment, while any loss is borne in proportion to the amount invested.
The essential feature of profit-loss-sharing contracts is that the contracted parties ‘share’ in the outcome of the venture. In terms of economics, any risk involved in partnership-based instruments is shared by the contracted parties, meaning that the parties’ right to access any profit resulting from the venture is based on their having carried a reasonable risk of loss. As many Islamic economists and practitioners working at Sharah divisions of Islamic banks emphasize, this sort of ‘risk-sharing’ is said to be highly consistent with one of the fundamental notions of Islamic teachings (Bendjilali, : ; Kahf and Khan, : ). Therefore, ‘risk-sharing’ has been considered as the economic wisdom of partnership contracts in existing literatures.
V. Some Criticisms of Partnership-Based ContractsPartnership-based instruments have been criticized from both theoretical and practical perspectives. Criticisms of the practical difficulties with partnership-based instruments have attracted most attention. However, I believe that several of the theoretical criticisms, which I briefly outline below, contain some arguments that are useful, and which I will pick up, to help economic wisdom of partnership contracts.
. . Marxist criticisms Haque ( : - ) in the light of Marxist economics, makes an analogy between rabb al-mal and mudarib on the one hand and, on the other, capitalists and labourers or between developed and developing countries. He argues that the rabb al-mal can derive unfair and excessive profits from partnership-based instruments. He concludes that the dyadic relationship resulting from the use of partnership-based instruments leads
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to macroeconomic inconsistencies as typified by the imbalance between developed and developing countries.
However, this argument has several flaws. First, with respect to the exploitative nature of mudarabah contracts, Haque’s critique does not necessarily hold true: for the generality of partnership-based instruments, the rule is that the profit-sharing rate is not always determined to the rabb al-mal’s advantage at the expense of the mudarib, rather, it is negotiable between the parties. Second, there is a huge jump in Haque’s reasoning to the macroeconomic effects of the dyadic relationship.
Nevertheless, it seems worthwhile to reexamine both points raised by Haque. The argument about the exploitative nature of the rabb al-mal needs to be reexamined with regard to ‘the fundamental Marxian theorem (FMT)’ formulized by two Japanese mathematical Marxist economists, Okishio ( ) and Morishima ( ) . They revealed the exploitative nature of the ordinary economic exchange of commodities premised on neo-classical economics. As to the second point, although the macroeconomic effects of partnership-based instruments have never been logically examined, it is extremely important to examine such effects when considering Islamic financial practices as part of a comprehensive Islamic economic system. We need to ascertain whether the macroeconomic effects of partnership-based instruments are indeed positive – as most Islamic economists would like to believe – or negative, as pointed out by Haque.
. . Incentive problemThe second criticism relates to the microeconomic structure of partnership-based instruments. As indicated by many studies, the use of partnership-based instruments in Islamic finance gets entangled in the incentive problem, implying that such instruments cannot result in the most efficient solution owing to the asymmetry of information between rabb al-mal and mudarib. Generally, asymmetric information leads to ‘adverse selection’ before a contract is entered into, and ‘moral hazards’ afterwards. It is rightly said that the unpopularity of partnership-based instruments in the practice of Islamic finance is due to the theoretical implication of the asymmetry of information between the parties involved being relatively larger than that in the case of parties involved non-partnership-based instruments. Further, the cost for reducing such asymmetry (for example, the monitoring cost) is higher (Khan, : ). Thus, rabb al-mal needs to bear the additional cost of monitoring a mudarib’s behaviour in order to induce him to manage capital efficiently.
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Although many studies prevent theoretical arguments promising to get round the incentive problem, both in conventional and Islamic economics, they are framed on their views on analysis of the dyadic relationship between rabb al-mal and mudarib. However, it appears to be more important to consider the kind of partnership, since the impact of asymmetry of information is dependent on that. For example, the impact of asymmetric information in the case of partnership between rabb al-mal and one mudarib would be different from that in the case of one rabb al-mal and one mudarib. The incentive problem inherent in the partnership-based instruments available to Islamic finance should be reexamined from this viewpoint.
. . Shari[ah arbitrageAlmost all instruments used in modern Islamic finance are financial prod-ucts reconstructed and recompiled on the pattern of commercial contracts used in the pre-modern Islamic world or accepted by pre-modern Islamic jurisprudence. Owing to the rapid growth and diversification of Islamic financial practice, many new financial instruments (e.g., bay[ al-dayn, bay[ al-ina, sukuk, tawarruq, Islamic derivatives, etc.) have been demanded, innovated, and welcomed in the financial practitioner’s field. Some scholars criticized the manner in which these innovations were taking place, pointing out that these innovations merely adopted the premodern heritage in terms of a commercial contractual ‘form’, lamenting that they did not succeed in capturing the ‘substance’ (economic wisdom, hikmah) of the premodern contracts. El-Gamal ( ) terms such innovation as ‘Shari[ah arbitrage’.
El-Gamal ( : - ) defines ‘Shari[ah arbitrage’ as “forbidding some transaction, and then permitting it in slightly modified form, with unaltered substance”, and in a later article El-Gamal ( ) explains more concretely: “the practical solution – which I call ‘Shari[ah arbitrage’ – is to use legal devices to restructure interest-bearing debt, collecting interest in the form of rent or price mark-up. Designing such instruments and their certification as ‘interest free’ constitutes the bulk of Islamic finance”.
El-Gamal ( ) selects several financial instruments and criticizes them as ‘Shari[ah arbitrage’ and then presents several proposals for a desirable system of Islamic finance. These proposals are based on his original analysis—conducted using the framework of modern economics—on the substantial economic meaning of economic doctrines in Islam (e.g., prohibition of riba and gharar), which provide the basic framework for the pre-modern contracts. He mentions partnership-based instruments
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and in particular criticizes the existing partnership-based deposit accounts in Islamic banks using the two-tier mudarabah and then proposes a new corporate structure for Islamic financial institutions based on mutual banking (see El-Gamal, : - and ).
In his argument on partnership-based instruments, however, El-Gamal does not sufficiently develop his thinking in accordance with the result of his own analysis of the substantial meaning of (Islamic) economic doctrines. His proposal for partnership-based instruments in present financial practice is accordingly lacking in explanatory efficacy. Therefore, the substantial meaning of partnership-based contracts needs to be examined in greater detail by thinking back to the economic wisdom (hikmah) of such contracts in pre-modern times.
VI. Two-Edged Blade of Risk-Sharing Instruments in Conventional FinanceCharacterizing partnership-based instruments in economic terms as risk-sharing does reflect the ideals of Islamic teachings to some degree. However, when the negative side of risk-sharing instruments used in conventional finance is taken into consideration (especially the negative effects of securitization, which appears to be one of the risk-sharing instruments in conventional financing, as illustrated by the recent subprime mortgages crisis), describing Islamic partnership-based instruments as risk-sharing cannot be fully appropriate. Rather, it can be argued that the economic wisdom of Islamic partnership-based contracts needs to be re-examined by taking into account some of the criticisms mentioned above so as to adequately distinguish partnership-based investments in Islamic finance from securitized instruments in conventional finance.
Prior to this reconsideration, I will briefly review the merits of risk-sharing instruments in conventional finance, before stating their negative aspects, revealed in the subprime mortgages crisis.
The common purpose of these instruments is to provide adequate liquidity to those engaged in business. They enable access to a significant amount of funds by mitigating risk, which is shared by the investors in the form of shares or securities. At the same time, these instruments also enable individual investors to join in a venture with small amount of capital. It is rightly said that such instruments, particularly the legal status and structure of joint stock companies, propelled the early transition to a capitalist econ-omy in the Western countries in the eighteenth and nineteenth centuries.
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However, the recent subprime mortgages crisis has revealed that the use of risk-sharing instruments can result in risks, including those arising from using these instruments, being scattered across different business in various sectors of the economy. Further, once the negative impacts occur not only in a particular venture but also anywhere in the chain of risk-sharing, their influence, particularly at the macroeconomic level, easily spreads to other businesses in other sectors. This kind of negative effect of risk-sharing is not confined to subprime mortgages; it is implicated in several events associated with risk-sharing instruments (e.g. international turmoil from a turndown in stock prices). As Otaki ( : ) clearly points out securitized instruments, transfer risk from banks to ordinary investors or citizens, have the potential to cause more harmful effects because this is a transfer from those who have enough knowledge to manage risk to those who do not; that can increase the extent of asymmetry of information in the system, which, in turn, results in risk-scattering. Thus, risk-sharing instruments are a sort of two-edged sword – with the risk-sharing positive effects of risk-sharing and the negative ones of risk-scattering.
VII. Reconsidering the Economic Wisdom of Partnership-Based ContractsAs we have just seen, characterizing partnership-based instruments as risk-sharing ones is not sufficient to distinguish the Islamic partnership-based instruments from conventional risk-sharing instruments. This is particularly true of the contemporary innovations in Islamic finance where such partnership-based instruments like sukuk al-mudarabah and sukuk al-musharakah are very similar to conventional risk-sharing instruments. It is accordingly difficult to counter the criticisms outlined above, for, insofar as partnership-based instruments are both risk-sharing and risk-scattering, at the same time, they do not necessarily promote positive macroeconomic effects, and in today’s world where financial liquidities are provided by more segmentalized shares or securities, the possibility of an increase in asymmetry of information has become more crucial. If the promoters of such partnership-based instruments continue to regard them as the most preferable, they need to explain if and how their potentially negative effects can be avoided.
If partnership-based instruments are indeed Islamically preferable, there must be some substantial economic wisdom behind their risk-sharing properties. I believe that by thinking back to the partnership contracts in
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pre-modern times, and clarifying the substantial wisdom in them, it will help to improve partnership-based instruments in present Islamic financial practice. Note that the following argument does not necessarily intend to deny the existing characterization of partnership-based instruments as risk-sharing. Rather, it intends to reformulate it from the macroeconomic aspect.
Many studies point out several differences between the original part-nership contracts in pre-modern times and those reconstructed in Islamic finance today as partnership-based instruments. Numerous fatawa (legal opinions) issued by Islamic financial institutions for the purpose of the reconstruction of original partnership-based instruments into forms suit-able for modern financial practice also show that there are many differences between them. Among these differences, one that merits particular attention concerns the concept of corporate persona or entity in partnership contracts. As Udovitch ( , - ) points out, in classical Islamic jurisprudence, the concept of a corporate entity (legal persona) in partnership-based instru-ments was not well developed, so that corporate structures did not become prevalent in many fields of economic activity in the pre-modern Islamic world. The historical fact that, in the pre-modern Islamic world, later gen-erations, as a rule, did not hold on to family businesses, also explains the underdevelopment of the concept of a corporate entity in classical Islamic jurisprudence (Kato, ).
Although the argument as to the existence of the concept of corporate entity in classical Islamic jurisprudence seems to be still controversial (see El-Gamal, : ) and there has not been enough research about it in relation to modern partnership-based instruments in Islamic finance, it is obvious that the underdevelopment of the concept of corporate entity has been used to explain why the pre-modern Islamic world came to be left ‘behind’ by the West (Greif, ; Kuran, ).
However, if we look at the structural character of classical partnership contracts from the macroeconomic aspect, it is seen to have another, positive implication. Indeed, the underdevelopment of the concept of corporate entity restricts the continuity and scale of the relevant business. On the other hand, it also, relatively, limits the beneficiaries of the relevant business. From the macroeconomic aspect, this feature of classical partnership contracts (which lacked the concept of corporate entity) has the consequence that other economic activities are protected: even if a business in question
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conducted by a partnership-based instrument fails, the chain of negative effects on the macro economy would be relatively moderated because those sharing the risk involved in the business are limited, in contrast to the case of securitized products, which are characterized by successive transfer of risks. Therefore, it can be said that the classical partnership contracts, which did not sufficiently develop the concept of corporate entity, have a discriminative economic feature that restrains risk-scattering. This reformulated economic wisdom derived from partnership contracts can be called as ‘risk-sharing without risk-scattering’.
VIII. Concluding Observations: Toward New Partnership-Based Instruments in Islamic FinanceHow can we implement new partnership-based instruments based on the ‘risk-sharing without risk-scattering’? Generally speaking, considering the current trend of Islamic finance, it is not realistic to introduce instruments that restrict both the spatial and time-series scale of risk-sharing because, in most fields of practice, the positive effect of risk-sharing is dominant as against to the negative effect of risk-scattering. Therefore, if such instru-ments were to replace the existing ones, there would result a liquidity crunch. Indeed, the mainstream proposal for alleviating the negative risk-scattering effect in Islamic financial practice is to enhance the ability to monitor and screen.
However, the economic wisdom of partnership contracts argued above has some usefulness in that it reminds us of the harmful aspects of the current trend in Islamic finance, which is now replicating securitized conventional finance. Furthermore, it may lead us to cast a critical eye on this current trend of Islamic finance, which is heading toward a comprehensive financial system competitive with conventional finance. Some scholars like El-Gamal and Asutay believe, if I understand them correctly, that the very scope of Islamic finance should be reconsidered. El-Gamal ( : ) proposes that Islamic finance should be confined to the fields in which the substantial eco-nomic wisdom of financial instruments is realized. This implies that fields in which ‘Shari[ah arbitrage’ is dominant should be removed from the list of fields available for Islamic financial practice. This proposal is rather radical, but surely right. However, it may be more feasible to implement Asutay’s proposal that Islamic finance should strive strongly to develop in the field of community banking and ethical investment (Asutay, : ; ). This
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paper further suggests the financing of small and medium enterprises. These suggestions as financing fields offer opportunities of a scale appropriate for introducing new partnership-based instruments based on the reformulated economic wisdom of ‘risk-sharing without risk-scattering’.
People might think that such a remodeling of Islamic finance will surrender to tough capitalism. However, the experience of overseas Chinese capital both in the past and present teaches us that a corporate structure based on a robust corporate entity is not a necessary condition for economic development – Chinese businesses have been conducted successfully using certain types of ‘risk-sharing without risk-scattering’ instruments. Moreover, these businesses are not necessarily carried on by subsequent generations of the same family (Hamilton, ). In light of this, it can be said that Islamic economics and Islamic financial practice may now be entering an era that will be free from the capitalistic way of thinking.
NOTES. Here ‘shirakat’ means contracts on the principle of musharakah.. This preference for non-partnership-based instruments can be observed almost
throughout the period beginning from the s until now. Examples are presented in Tables , and .
. The FMT showed a correspondence between the existence of exploitation and the existence of positive profit derived from equation of marginal productivity of labour and capital, which is generally formula of microeconomics.
. First work theoretically mentioning to the incentive problem in Islamic economics would be Khan ( ).
. For example, even Zuhayli’s ( ) comprehensive commentary on Islamic jurisprudence
does not have a clear explanation of the concept of corporate entity.
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Appendix
Table : Bank Islam Malaysia Berhad: Mode of Financing (% to Total Financing)
