Musharaka and Mudaraba in Muslim Banks Financing - Case Study Example

Musharaka and Mudaraba in Muslim Banks Financing Name: Institution: Date: Table of Contents Table of Contents 2 Executive Summary 3 1.0 Introduction 4 2.0 Literature Review 4 3.0 Discussion 6 3.1 Musharaka System 6 3.2 Mudaraba System 8 4.0 Conclusion 9 References 11 Executive Summary This report offers a summary overview of the Islamic banking industry. As such the evaluation focuses on its key strategic approaches namely the Musharaka and Mudaraba financing approaches. On one hand, the Musharaka approach, also regarded as a joint venture partnership, allows for profit and losses sharing under both the restricted and unrestricted categories. On the other hand, it establishes that the Mudaraba approach involves banks financing entire projects while the entrepreneurs offer labour and management skills. One major merit of both financing approaches is increased societal equality gains. However, a major limitation emerges in the use of trust as the only business loss hedge I the industry, exposing the banks to great loss risks. 1.0 Introduction The global market is changing with new financial regulations emerging and developing. One of the global financial industry players is the Islamic banking institutions a concept that was legalized in the 1970s for global operation. Since then, as an industry evaluation by the Australian government (2010) argued, the Islamic banks have developed and exponentially grown in the global market not only in the Islamic religion states, but also in the non Islamic religion states across the globe. Based on this review, it is imperative to evaluate the principles of operation as well as the factors behind the drastic growth and increased influence of the banking system across the globe. This report focuses on two critical aspects in Islamic financing namely Musharaka and Mudaraba respectively. In this regard, it evaluates the principles of operation for each, their implications as well as execution challenges in the current global financial market. Therefore, it develops a conclusion on the overall rating of the appropriateness and relevance of such principles and practices application. 2.0 Literature Review Hanif (2011) conducted a study evaluating the spread of the Islamic banking spread in Pakistan, one of the nations dominated by the Islamic religion. In its analysis, the evaluation established that the market has over the last five years experienced an over 70% growth of the banking sector in the market. This can be further evidenced in the figure below This scenario is not limited and restricted to the Islamic dominated nations. This has led to increased concerns on the guiding factors and principles on which the system operates under. However, as Obaidullar (2005) argued, this has faced an increased market challenge in its application. In this regard, issues and concerns have been raised on the profit sharing approach adopted and especially on instances such as unrestricted Musharaka and the high involvement risks of loss making. One of the challenges of the system is the application and management of the expected risks and mismanagement by the debtors in the market This report evaluation seeks to evaluate these factors. On one hand, the report evaluation will shed more light on the working principles of Musharaka and Mudaraba principles in the Islamic banking industry. In particular, the evaluation will discuss the concept of profit making and how the respective organisations increase their operational revenues, despite the lack of interest rates on loans. Moreover, the evaluation will evaluate how the application of the systems benefit not only the partners but also the society at large and how the banking system has an added advantage and overall societal gains over the conventional banking system. Moreover, the evaluation will focus on highlighting the potential and existing challenges in the execution of the Islamic financing system in the market. This is based on a study evaluation as conducted by Bukhari (2006) arguing that the industry despite its numerous success instances has a wide range of operational and strategic challenges in the dynamic global market. In this regard, the findings will allow for the development of an appropriate recommendation for future improvements in the industry operations. Therefore, in general the evaluation will offer a review of the operational industry principles, a virtual that minimal reviews have focused on. One major challenge on the topic literature as Amin, Isa and Fontaine (2013) stated, is religious bias. Therefore, due to its scholarship approach and the lack of religion bias, the report findings will serve as an imperative comparison tests between the Islamic financing approach and the conventional banking rule, developing a framework and benchmark from which each of the systems can improve their operations based on peer industry performances and operations. 3.0 Discussion This report evaluation examines the Musharaka and the Mudaraba operational principles in the Islamic banking systems. As such, it evaluates each of the principles individually in the market. 3.1 Musharaka System The Musharaka system is described as a joint venture partnership. In the conventional banking industry, when entrepreneurs lack enough funds, they borrow loans from the banks of which are repaid back at agreed interest rates. However, this as Dusuki (2010) argued is prohibited under the Shariah laws. Therefore, the Islamic banking industry uses a partnership approach, Instead of advancing money to the debtors in terms of capital for their respective ventures. Upon the advancement of such capital, the bank and the entrepreneur’s contract into a joint venture where the profit gains acquired from the proceeds are shared under pre-agreed ratios. On the other hand, in the event of losses, the partners share the losses on the basis of their equity contributions to the venture. This approach is beneficial to the partnership in that it increases the overall gains for the lenders as when the profits are higher; they acquire increased revenues unlike the conventional banking industry. However, dynamic market changes such as the 2008 global financial crisis led to increased losses to the Islamic banks more than the conventional banks as illustrated in the figure below Under the Musharaka lending system, the banking system has two strategic alternatives namely the restricted and the unrestricted musharaka. On one hand, the restricted Musharaka system is one in which the banks regulate and control the ventures in which the entrepreneurs invest the funds in. Under this approach, the two agree on the specific ventures and business models in which their shared funding would be channelled into. On the other hand, the unrestricted Musharaka is where the banks offer the entrepreneurs the liberty and mandate to decide the various ventures in which to channel the funds. Through this approach, the ventures have the alternative and opportunities through which to invest in multiple projects. This is a major merit and deviation from the conventional banking industry that requires a specific investment project. Through the unrestricted approach, entrepreneurs can focus on the dynamic and emerging markets that emerge and grow after the actual lending has already occurred, allowing and exponentially increasing the chances for increased gains and profitability levels for such invested funds. However, as Fahim and Porzio (2010) in an evaluation of the approach in the European market argued, one major challenge of the system is the failure by the entrepreneurs. The absolute trust offered to the entrepreneurs’ management and decision making independence exposes the banks to increased risks. Therefore, this has over the years exposed the banks to increased loss risks on their invested funds. 3.2 Mudaraba System McMillen (2008) described the Mudaraba system is an approach through which two parties enter into partnerships where one contributes the finances and the other labour and entrepreneurial skills required. Therefore, under the Mudaraba system, the various factors of production responsibilities are shared among the partners. In the Islamic banking system, there are two respective levels of the system. On the first tier, financier and investors advance their finances and funds onto the banks. On the second tier, the banks acquire applications form potential investors with viable investment projects with the potential of accruing profits in the long run. As such, the banks finance all the capital requirements while the entrepreneurs provide labour as well as the other technical services required in managing the investments. Upon the realization of profits, both the entrepreneurs and the banks share the gains. However, in the event of losses, the banks incur the whole amount. On the other hand, the entrepreneurs’ efforts and time and labour contributions go out unrewarded. As Wilson and Henry (2004) established, one major advantage of this system is the support it offers the society. In this regard, the banks extent the required funds to viable projects. This is an imperative societal development approach in that it supports social projects and ventures whose idea conceivers lack enough funds to carry out the required projects. This is an imperative and objective balance between economic development and social equality and balance development and enhancement. Nevertheless, the application system has a major challenge in that the occurrence of fiduciary risks in the market. Sundararajan and Errico (2002) argued that due to the reliance on the management skills and credibility of the Mudaraba venture on the entrepreneurs and the placing of all the oversight and responsibility at their discretion, any negligence by the entrepreneurs exposes the banks to eventual investment losses. Moreover, the practice is based on the Islamic faith values and morals such as honesty, transparency and ethical business practices. Although their application guarantees increased profits chances, these values and trust levels could be misused by the entrepreneurs in the Mudaraba leading to losses to the capital financiers. 4.0 Conclusion In summary, this evaluation report conducts an overview focus on the Islamic banking industry. In this case, the industry applies two basic and most dominant practices namely the Musharaka and the Mudaraba practices. On one hand, an evaluation of the Musharaka system establishes that it functions as joint venture partnership where the banks and the entrepreneurs share capital contribution and at times even management roles. Moreover, the acquired profit or loss gains are shared based on predetermined ratios and equity contributions respectively. Further, the approach evaluation reveals that there are two types of Musharaka. On one hand is the restricted Musharaka where funds advanced are used on specific projects while on the other hand is unrestricted Musharaka where the investors have the liberty to invest funds in any project of their choice. On the other hand, the Mudaraba system involves the contribution of all required funds in a venture by the banks, while the entrepreneurs provide the required labour and management services and practices in its operations. The adoption of this practice is classified as advantageous approach to enhancing social and societal development and equality promotion in the long run. References Amin, M., Isa, Z., & Fontaine, R. (2013). Islamic banks. The International Journal of Bank Marketing, 31(2), 79-97 Australian Government, 2010). Islamic Finance. Austrade.gov.au Bukhari, N. (2006). Islamic banking theory, practice and challenges. The Journal of Commerce, 1(1), 85. Dusuki, A. W. (2010). Do equity-based sukuk structures in Islamic capital markets manifest the objectives of shariah?? Journal of Financial Services Marketing, 15(3), 203-214 Fahim, K. M., & Porzio, M. (2010). Islamic banking and finance in the European Union: A challenge. Cheltenham, U.K: Edward Elgar. Hanif, M. (2011). Differences and similarities in Islamic and conventional banking. International Journal of Business and Social Science, 2(2), pp. 166-175 McMillen, M., (2008). Islamic law; Equity funds; Trends; Tax benefits; Real estate developments; Nominations; Legislation;Joint ventures; Group life insurance; Foreign investment; Financial instruments; Contracts; Consolidation; Civil law; Capital markets, The International Lawyer, 42(2), pp. 1-17 Obaidullar, M., (2005). Islamic Financial Services, King Abdulaziz University, Jeddah Saudi Arabia Sundararajan, V., & Errico, L. (2002). Islamic financial institutions and products in the global financial system: key issues in risk management and challenges ahead (Vol. 2). International Monetary Fund. Wilson, R., & Henry, C. M. (2004). The politics of Islamic finance. Edinburgh: Edinburgh University Press. Read More