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MP A R
Munich Personal RePEc Archive

A critical analysis of Mudarabah & a new approach to equity financing in Islamic finance
Shaikh, Salman Ahmed International Association of Islamic Banks

01. July 2011

Online at http://mpra.ub.uni-muenchen.de/19697/ MPRA Paper No. 19697, posted 19. September 2011 / 12:03

A Critical Analysis of Mudarabah & A New Approach to Equity Financing in Islamic Finance Journal of Islamic Banking & Finance, ISSN 1814-8042 By Salman Ahmed Shaikh Project Director, Islamic Economics Project islamiceconomicsproject@gmail.com www.islamiceconomics.viviti.com
Abstract Financial intermediation serves a valuable purpose, but it can also be structured using equity modes of financing. This can relieve the financee and increase diversity of entrepreneurial undertakings as in debt based commercial financing, there is little room for diversity with obligatory and stipulated servicing of debt. Using Islamic equity modes of financing poses the challenge of the agency problem and moral hazard. The extent of this agency problem in Mudarabah and its impact on economic payoffs between counterparties is analyzed in this study with a simulation model. Based on review of alternate solutions proposed, the author presents two possible covenants which could make Mudarabah mode of financing more acceptable and widely usable in financial intermediation. This would also further the egalitarian objectives of an Islamic economic order. Keywords: Interest free economy, Islamic Economic System, Mudarabah, Agency Problem, Moral Hazard, Adverse Selection. 1. Introduction

Riba in Islamic Shariah refers to ‘Anything paid/charged over and above the principal amount on a loan’. Allah in Quran said “Do not do wrong nor be wronged” (Al Baqarah: 279). It means that interest either results in injustice to the borrower or sometimes, it could result in injustice to the...

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