Using Mudharabah: Advantages and Disadvantages Essay

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Introduction

Reeling from the consequences of numerous financial meltdowns and confronted by a mob of despairing small businessmen unable to break free from the grip of a flawed capitalistic banking system ignited the need for a holistic, humane, and practical banking policy. The clamor for a better system calls for the creation of a line of credit for aspiring entrepreneurs, while at the same time ensuring the sustainability of the banking sector. As a result, the Muslim world invented a new banking methodology, and one of the primary components is a financing model known as the mudharabah or profit-sharing. The following pages will examine the advantages and disadvantages of using the mudharabah financing system.

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The Context of the Emergence of the Mudharabah System

From a contentious point of view, the conventional form of banking, comprising a system that utilizes depositor’s money in order to transform it into capital, this method leaves much to be desired. Conventional banking practices are inherently flawed due to the one-sided business transaction between the banker and the person taking out a loan. In an ideal situation, the bank lends money with interests. This process covers the risk taken by the financial institution in the case of non-payment. If the money that was used as a form of a credit to support a fledgling business went to the right person with a successful business model, both parties are going to benefit from a substantial financial windfall.

The idealistic appreciation of the conventional banking paradigm does not eliminate the fact that most business start-ups end in failure. It does not require the skills of an economist or a seasoned finance expert in order to understand the pitfalls in starting a commercial enterprise. It is easy to empathize with the misfortune of friends, neighbors, and acquaintances who tasted the bitter effects of bankruptcies or the failure to keep their businesses afloat. At first glance, the conventional banking model seemed to offer a fair deal to businessmen needing to take out a loan. However, a closer examination reveals that in most cases, the loan agreement has been structured in such a way that it favors the banker and not the one taking out the proceeds of a business loan (Aziz et al. 2013). For example, a large loan usually requires collateral, which is significantly more valuable than the money involved in a typical loan agreement. In contrast, the mudharabah is a Muslim-inspired financial framework characterized by a “profit-sharing scheme” (Farid 2012). The core component of the alternative way of getting loans for a business start-up was established for the purpose of eliminating the problems normally associated with the conventional method of taking out loans. However, one can also see the advantages and disadvantages of applying the said scheme in a real-world setting.

The Advantages of Using the Mudharabah System: Applying it to the Durrat Khaleej Al-Bahrain Project

There are three major advantages of using the mudharabah system. These advantages are listed as follows: the system was designed to eliminate the adversarial form of banking that exists between bankers and those needing cash to build a business or finance a project; the system was created to eliminate the parasitic or predatory effect on the business relationship between lender and borrower, and the system was established with an eye towards positive community development (Meutia 2016). With regard to the first potential advantage of the mudharabah, it eliminates the adversarial nature of conventional banking systems.

Consider, for instance, the typical process that an entrepreneur has to go through in order to acquire a bank loan. The banker demands a form of collateral before he or she begins to process the request. The banker analyzes the loan request with the bank’s shareholders or investors’ interest in mind and not the one applying for a line of credit. Applying the principle to the Durrat Khaleej Al-Bahrain project, the bank fosters financial inclusion and reduce the impact of harmful products and practices (Mudharabah n.d.). This is manifested in the way the “Rab-ul-Maal” or the financier exerts great effort to help the “Mudarib”, the term used to describe the borrower or the businessmen seeking a line of credit. The financier works to help the people behind the project to succeed, and not being mindful only of his ability to earn money from such transactions.

With regard to the second advantage, the mudharabah model was created to eliminate the parasitic or predatory nature of the conventional banking model. Consider, for instance, a loan agreement or the application of a credit line that does not involve the use of collateral or any form of downpayment. When misfortune strikes the hapless entrepreneur or borrower of funds, the bank quickly asserts itself to protect the interest of the investors and its corresponding executives. When applied to the Durrat Khaleej Al-Bahrain project, the “Rab-ul-Maal” will not attempt to create a one-sided deal with the “Mudarib” or the entity desiring to build a business venture or a project (Mudharabah n.d.). In other words, there is an incentive for the lending institution to consider the long-term success of the “Mudarib” and not just the financial institution’s short-term profits.

With regard to the third potential advantage of the mudharabah system, it is imperative to understand the core principles embedded in the so-called “profit-sharing” scheme. In a book entitled Risk Management for Islamic Banks, the authors provided an alternative view of money not as a commodity but as a storage of wealth and a medium for exchange (Wahyudi et al. 2015). In a technical sense, it is forbidden under Muslim laws to sell money for a profit. It is easier to appreciate this concept when applied to the issue of burgeoning credit card debts or the financial crisis that affected millions of lives in 2008. The said financial fiasco was preceded by bankers lending money to insolvent families (Sinai 2013).

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The problem was not rooted in the failure to collect money from the borrowers, but in the inherently flawed system that expected borrowers to produce more funds using the amount given to them, without considering the fact if the borrower has the capacity to generate wealth. When these principles are applied to the Durrat Khaleej Al-Bahrain project the mudharabah system of financing encourages the creation of a mutually beneficial partnership between the “Rab-ul-Maal” and the person desiring to acquire money to start a business or initiate a worthwhile project. In this context, the banker does not force the borrower to multiply his or her funds without considering the avenues available for wealth creation. This mindset was expressed in the due diligence that was applied at the beginning of the multi-billion dollar business venture. For example, some of the financiers, like the Kuwait Finance House invested in feasibility studies that revealed the high demand for real estate properties in the Gulf (Mudharabah n.d.). It was not only a lucrative undertaking, but the project had the potential to create high-quality products that are not beyond the reach of the consumers. Here is an example of a successful collaboration between bankers and businessmen seeking to acquire a dependable line of credit.

The Disadvantages of Using the Mudharabah System: Applying it to the Durrat Khaleej Al-Bahrain Project

There at least two major disadvantages in using the mudharabah system. The said disadvantages are listed as follows: the system cannot handle the type of risk inherent in a complicated business venture and it is difficult to expand the business using the aforementioned financing framework. The need to underwrite a multi-billion dollar business proposal like the Durrat Khaleej Al-Bahrain project exposes financial institutions to tremendous levels of risk. With regard to the first potential disadvantage, one has to acknowledge the imbalance between the so-called partnership between the lending institution and the one requesting to acquire loans for business purposes. The relationship is unequal in terms of responsibilities, access to information, and financial exposure (Sapuan 2016). For example, the banker provides finances, but he does not have full access to the business operation. In addition, it is possible for an unscrupulous businessman to manipulate the financial data in order to report a loss or not declare the full amount of profits that were collected in a given time period.

With regard to the second potential disadvantage of the said alternative system, it is critically important to understand that the process requires strict adherence to rules based on Islamic laws (Mudharabah n.d.). In other words, the need to come up with hundreds of billions of dollars in loans is a problematic process if the bank promises not to charge interest. Thus, if a bank executive in Bahrain reaches out to a potential investor in Europe and explains the unique financing framework, it is going to be a challenge persuading the said investor to commit huge sums of money without any guarantee in the form of earning money through the conventional method. Therefore, it will take a very long time to raise up billions of dollars in investment funds. The mudharabah system promises to eliminate the problems created by the conventional banking system. However, it is a fragile system that requires a great deal of monitoring and due diligence of the bankers in order to prevent massive financial losses. In addition, it is a financing scheme suited to less complicated business ventures.

Conclusion

The mudharabah system is an enticing alternative to the conventional banking model utilized all over the world. One of the most endearing features of the said the alternative system is the potential to eliminate the predatory or adversarial nature of the modern banking system. In the conventional method, the banker has no need to consider the wealth-generating capability of the borrower as long the lending institution has done its due diligence to set-up a process of collecting money that was owed to the bankers. The mudharabah system places a great deal of value in helping the borrower to succeed, and the inherent principle is geared towards positive community development and not just a system to enrich the banks and their corresponding executives. However, the mudharabah system is a risky banking model. When applied to the Durrat Khaleej Al-Bahrain project, it is difficult to manage the risk of such a large business venture. It is also difficult to raise the needed capital due to certain restrictions.

Reference List

Aziz, F, Anjam, M, Fahim, S & Saleem, F 2013, ‘Mudharabah in Islamic finance: a critical analysis of interpretation and implications’, International Journal of Asian Social Science, vol. 3, no. 5, pp. 1236-1243.

Farid, F 2012, Shari’ah compliant private equity and Islamic venture capital, Edinburgh University Press, Edinburgh.

Meutia, I 2016, ‘Empirical research on rate of return, interest rate and mudharabah deposit’, International Journal of Accounting Research, vol. 5, no. 1, pp. 1-5.

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Mudharabah n.d., Powerpoint slides.

Sapuan, N 2016, “An evolution of mudharabah contract: a viewpoint form classical and contemporary islamic scholars’, Procedia Economics and Finance, vol. 35, no. 1, pp. 349-358.

Sinai, T 2013, ‘House price moments in boom-bust cycles’, in E Glaser & T Sinai (eds), Housing and the financial crisis, University of Chicago Press, Chicago, IL, pp. 19-68.

Wahyudi, I, Rosmanita, F, Prasetyo, M & Putri, N 2015, Risk management for Islamic banks: recent developments from Asia and the Middle East, John Wiley & Sons, Hoboken, NJ.

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IvyPanda. 2020. "Using Mudharabah: Advantages and Disadvantages." October 22, 2020. https://ivypanda.com/essays/using-mudharabah-advantages-and-disadvantages/.

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