research paper 56 ifikr

8/18/2019 Research Paper 56 Ifikr

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No. 56/2013

ISRA Research Paper

Challenges in the Application of MuÌÉrabah and MushÉrakah Concepts in the Islamic FinanceIndustry in Malaysia


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Research Team

Assoc. Prof. Dr. Ahmad Zafarullah Abdul Jalil

Associate Professor

Universiti Utara Malaysia (UUM)

[email protected]

Dr. Zairani Zainol

Assoc. Prof. Dr. Nuarrual Hilal Md Dahlan Dr. Selamah Maamor

Assoc. Prof. Dr. Asmadi Mohamed Naim

Assoc. Prof. Dr. Abdullah Hj. Abdul Ghani

Assoc. Prof. Dr. Muhammad Nasri Md Hussain

Ab Malek Foad Ab Bakar

Universiti Utara Malaysia (UUM)


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C h a l l en g e s i n t h eA p pl i c a t i on of M u ḍ

ā r a b a h a n d M u s h ā r a k a h C on c e p t s

i n t h

eI s l a mi c F i n a n c eI n d u s t r y i nM a l a y s i a

ExecutiveSummary

The Islamic finance and banking industry has growntremendously during the past few years from an alternativeform of financial intermediation for Muslims to a complete,competitive and integral component of the mainstreamglobal financial system that serves both Muslims and non-Muslims. According to Ernst & Young’s World IslamicBanking Competitiveness Report 2013, global Islamic banking assets have grown annually by 19 percent onaverage, and are set to cross US 1.8 trillion (RM5.56trillion) in 2013.

Most Islamic finance and banking scholars subscribe tothe view that a banking system constructed to promoterisk-sharing, co-operation and mutual assistance wouldreflect the principle of profit-loss sharing (PLS) that isembodied in muÌÉrabah and mushÉrakah; hence, theseshould ideally be the cornerstone of Islamic banking. Itis believed that Islamic banks need to achieve socio-economic objectives through the use of muÌÉrabah andmushÉrakah contracts. Despite the quasi-unanimity ofIslamic finance and banking scholars on the importanceof muÌÉrabah and mushÉrakah in the Islamic bankingsystem and the dominance of the concept of PLS in thetheoretical literature, the allocation of most Islamic fundsis confined to short-term and low-risk investments with aslim profit margin (Dar & Presley, 2000). MuÌÉrabah andmushÉrakah only constitute a negligible portion of boththe assets and liabilities of Islamic banks. In Malaysia,even though the development of products and servicesin the Islamic banking system is very encouraging,financing products based on the principles of muÌÉrabah and mushÉrakah are almost non-existent. The assets andfinancing activities of Islamic banks in Malaysia appearto be concentrated more on debt-based contracts such asbayÑ bi thaman Éjil (BBA), murÉbaÍah and ijÉrah. The

concentration on non-PLS modes of financing also raisesthe question of whether Islamic finance and bankingoperations in general are totally Islamic or whether thename is merely used as a “veil” by conventional banks toattract funds from Muslim investors.

Given the above scenario, this study has been conducted tofind the reasons behind the paradoxical differences betweenwhat is being idealized and what is being practiced in theindustry. The study examined the issues within the scopeof the Malaysian Islamic finance and banking industry.The findings of this study were based on primary data

gathered through interviews with selected Islamic financialinstitutions (IFIs) as well as secondary data obtained fromreports published by Bank Negara Malaysia (BNM) andIFIs. The study also conducted a detailed analysis of the

following statutes insofar as muÌÉrabah and mushÉrakah are concerned: the Partnership Act 1961 (Act 135) (‘PA’),the Civil Law Act 1956 (Revised 1972) (Act 67) (‘CLA’)and the Islamic Financial Services Act 2013 (Act 759)(‘IFSA’).

This study found that in Malaysia, muÌÉrabah- andmushÉrakah-based products constitute a very small portionof IFI assets. There are a number of reasons why IFIs seemto be reluctant to operate or implement muÌÉrabah and

mushÉrakah. These include high risk levels, the familiarrole of the bank as a fund provider rather than a partner orinvestor, inadequate demand from customers, complexityin implementing the products, stringent regulations andlack of expertise and skilled staff. The Capital AdequacyFramework for Islamic Banks adopted in 2012 by BNMis also found to have a negative impact on the IFIs if theywere to adopt muÌÉrabah-based and mushÉrakah-based products. This may further discourage IFIs from offeringmuÌÉrabah- and mushÉrakah-based transactions.

From the legal perspective, our analysis shows that thereare some provisions in the PA which cannot accommodatethe concept and practice of muÌÉrabah and mushÉrakah.The provisions are section 3, which states that the partners’relationship in a partnership venture is to carry on businesstogether with a view to profit; section 6, which requiresestablishment of a firm; and section 47(2), which requiresthat the number of the partners in the partnership must not be more than twenty persons. Thus, it is of paramountimportant that these provisions in the PA be amendedto allow muÌÉrabah and mushÉrakah products to berecognized under the PA and thus become enforceable.Alternatively, the researchers suggest that Parliament passa special law to deal specifically with muÌÉrabah and

mushÉrakah products.

Analysis reveals that there is no law that unequivocallygoverns muÌÉrabah and mushÉrakah. The question is:what is the governing law for muÌÉrabah and mushÉrakah?Is it the CLA or PA or SharÊÑah as prescribed by the IFSAor the Central Bank of Malaysia Act 2009 (CBA)? One canargue that the governing law is the SharÊÑah, but there is nodetailed SharÊÑah-based written law passed by Parliamentfor muÌÉrabah and mushÉrakah so far. It is submitted that,due to the absence of SharÊÑah-based written law governingmuÌÉrabah and mushÉrakah, the baseless presumption

that the governing law is the SharÊÑah, as prescribed underthe IFSA and the CBA, can cause fatal legal problems tothe practice of muÌÉrabah and mushÉrakah products inMalaysia.

Challenges in the Application of MuÌÉrabah and MushÉrakah

Concepts in the Islamic Finance Industry in Malaysia


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Further, there are no exemption provisions under the CLAand the PA to exempt muÌÉrabah and mushÉrakah fromtheir operations. Thus, the governing law for muÌÉrabah and mushÉrakah, it is submitted, is not clear. In addition,if the SharÊÑah is the governing law, then which madhhabwill be the prevalent law? Will it be the ×anafÊ or ×anbalÊor ShÉfiÑÊ or MÉlikÊ School, or opinions or guidelines

provided by the SAC or the SharÊÑah Committee? Theseissues have not been clearly resolved by the IFSA and theCBA.

Based on the findings of this study, several recommendationsthat can be implemented in order to encourage widerapplication of muÌÉrabah and mushÉrakah contracts bythe IFIs have been suggested. Among the recommendationsare:

• The roles of existing third-party guarantors suchas Syarikat Jaminan Kredit Perumahan and CreditGuarantee Corporation (CGC) should be enhanced

so that they can also cover risks from muÌÉrabah-and mushÉrakah-based products. In this matter, therelevant authorities should streamline the legislationregarding the roles and responsibilities of third- party guarantors in the context of muÌÉrabah andmushÉrakah financing.

• The IFIs should establish subsidiaries that will playroles similar to those of a venture capitalist. It is thesesubsidiaries that will focus on looking for potential projects and providing them with financing based onmuÌÉrabah and mushÉrakah contracts. The financing

model used by KFH for its Pavilion Project, or byAffin Islamic Bank to provide financing for a high-end residential development in Penang in 2008 withMutiara Goodyear, or more recently to developVERVE Suites KL South with Albatha Bukit KiaraHoldings could be used as examples. The IFI shouldensure that its subsidiary is staffed with an adequatenumber of people who have a good understanding ofmuÌÉrabah and mushÉrakah contracts and who areaware of the risks involved. It is also important thatthis subsidiary be given an exemption or a grace periodfrom being subjected to the Basel III requirements.The local Institutes of Higher Learning (IHLs) also

have roles to play in providing the human capitalneeded by the IFIs. As such, a closer collaborationshould be forged between the IFIs and the IHLs inidentifying the types of training and courses thatshould be offered to produce specialists in muÌÉrabah and mushÉrakah contracts.

• Some sections in the PA and the National Land Code(NLC) need to be revised and certain amendments be made so as to make muÌÉrabah and mushÉrakah IFIs products harmonious with the existing legal andregulatory framework besides being in compliance

with the Islamic law requirements.

• The relevant authorities should also look into theissue of negligence, especially the burden of proofregarding the existence of negligence, to mitigate the

Keywords:

MuÌÉrabah, MushÉrakah, Profit-Loss Sharing,Islamic Financial Institutions, SharÊÑah

risks of muÌÉrabah or mushÉrakah contracts from being lopsided to the detriment of the IFIs.

• In the selection of a potential muÌÉrib, only thosewho are capable of bringing in some capital should begiven priority. By requiring the potential muÌÉrib to provide part of the capital, the problem of asymmetricinformation could be reduced.

• The IFIs could also be encouraged to offermuÌÉrabah- and mushÉrakah-based product by providing special tax treatment such as tax waiversand tax neutralization for all proceeds obtained fromfinancing projects using muÌÉrabah and mushÉrakah contracts. The special tax treatment given can be justified on the grounds of the higher level of risksthat IFIs need to assume in providing these products.In order to encourage more entrepreneurs to usemuÌÉrabah and mushÉrakah contracts, they couldalso be given special tax treatment on any proceeds

obtained from projects financed using these contracts.

• The government should intervene more directlyin order to increase the use of muÌÉrabah andmushÉrakah contracts. It is suggested that thegovernment and the government-linked companies be encouraged to use muÌÉrabah and mushÉrakah contracts in financing their development projects.

• The government should use muÌÉrabah andmushÉrakah contracts for its various financing schemesoffered through agencies such as the SME Bank, the

Agrobank or the Malaysian Industrial DevelopmentBoard (MIDF). Currently, the government has almost100 types of funds or financing schemes for SMEs.Therefore, there is clearly a lot of room for thegovernment to experiment with the application of themuÌÉrabah and mushÉrakah contracts.

• The IFIs should have a paradigm shift in the waythey view their role as Islamic banks and theirunderstanding of the philosophy underlying Islamic banking activities. IFIs should also re-examine theirrole as fund providers and transform themselves into becoming service providers. It is suggested that IFIs

be focused on their role as service providers (trustees)and delegate their investment activities to separateentities; i.e., their subsidiaries.

• The IFIs as well as relevant authorities shouldincrease the public’s awareness of muÌÉrabah andmushÉrakah contracts and their importance, especiallyin terms of the economic development of the Ummah.This can be achieved through extensive and effective promotions through various platforms such as publicforums, conferences and electronic media.


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Introduction

Most scholars of Islamic banking and finance subscribeto the view that financial instruments based on profit-loss sharing (PLS), such as muÌÉrabah and mushÉrakah,represent the true spirit of the Islamic banking system(Qureshi 1945; Ahmad 1947; Siddiqi, 1983; Khan &Mirakhor, 1987; Chapra, 1992; Ahmad, 1994; Hassan,1999; Haron, 2000; Ahmad, 2000; Warde, 2000; Siddiqui,2001; Rosly & Bakar, 2003; Usmani, 2004; Choudhury& Hussain, 2005). These authors place greater social andreligious responsibilities upon Islamic banks. The authors believe that, contrary to conventional banks, Islamic banksneed to achieve socio-economic objectives such as social

justice, economic growth, efficiency and stability; andthese objectives can be better served through the use ofthese PLS contracts; i.e., muÌÉrabah and mushÉrakah.

MuÌÉrabah1 is a form of contract in which one party (therabb al-mÉl ) provides capital while another party (themuÌÉrib) undertakes a commercial enterprise. Any profitfrom the venture is distributed between the parties basedon a ratio agreed beforehand while any loss is entirely borne by the rabb al-mÉl .

According to Ibn ManÐËr (n.d), the linguistic meaning ofmuÌÉrabah is derived from the expression Ìarb fÊ al-arÌ ,

which means ‘making a journey’. It is mentioned in theQur’Én in SËrah 73 (Al-Muzzammil), verse 20:

ه ل � غن رض بن ون خ و

“...and others travelling throughout the landseeking of the bounty of Allah.”

According to Shaharuddin (2010), the contract is calledmuÌÉrabah because the contract normally requires theagent manager to travel and transport merchandise from

one place to another.

Another term for the same contract is qirÉÌ , which isderived from the verb qaraÌa, ‘to cut’. A related word ismuqÉraÌah, which carries the connotation of balancedreciprocity. QirÉÌ is derived from qaraÌa because theinvestor severs the invested capital from the rest of hiswealth. Its relationship with muqÉraÌah is because the twocontracting parties will share the proceeds in a balancedmanner (Shaharuddin, 2010).

As for mushÉrakah, it can be defined as a joint enterpriseformed for conducting some business in which two or

more partners share the profit according to a specificagreed ratio while loss is shared according to the ratio oftheir capital contributions (Usmani, 2004). The linguisticroot words of mushÉrakah are shirkah or shirk , which both

mean partnership. MushÉrakah literally means sharingand/or mingling (Farooq & Ahmed, 2013). Accordingto Al-Harran (1993), mushÉrakah can take the form ofa partnership with unlimited liability or a company withlimited liability. In the context of Islamic finance, thecustomer will apply for financing to share the capital,management and returns of a project. If the bank, afterreviewing all the required information it has requestedof the customer, decides the project is feasible, it mightconsider sharing in its financing.

Despite the quasi-unanimity of Islamic economics andfinance scholars on the importance of muÌÉrabah and

mushÉrakah in the Islamic banking system and thedominance of the concept of PLS in the theoreticalliterature, the allocation of most Islamic funds is confinedto short-term and low-risk investments with a slim profitmargin (Dar & Presley, 2000). MuÌÉrabah and mushÉrakah constitute a negligible portion of both the assets andliabilities of Islamic banks. In Malaysia, even thoughthe development of products and services in the Islamic banking system is very encouraging, financing products based on the principles of muÌÉrabah and mushÉrakah arealmost non-existent. The assets and financing activitiesof Islamic banks in Malaysia appear to be concentrated

instead on debt-based contracts such as bayÑ bi thamanÉjil (BBA), murÉbaÍah and ijÉrah. It seems that Islamic banks prefer to operate according to the principles of thefee-based category owing to its simplicity, lower risk and predetermined fixed rate of returns, even though somemay deem such facilities to open a back door to interest(Haron, 2004).

Problem Statement

Nowadays, Islamic finance and banking have become areality that cannot be ignored. In 2012, there were more

than 600 Islamic financial institutions (IFIs) operating inat least 75 countries worldwide (Securities Commission,2012). The industry has evolved rapidly during the past fewyears from an alternative form of financial intermediation

Section 1

Islamic banks need to achieve

socio-economic objectives such as

social justice, economic growth,

efficiency and stability; and these

objectives can be better served

through the use of these PLS

contracts; i.e., muÌÉrabah and

mushÉrakah

“

”


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for Muslims to a complete, competitive and integralcomponent of the mainstream global financial system thatserves both Muslims and non-Muslims worldwide.

According to Ernst & Young’s World Islamic BankingCompetitiveness Report 2013, over the last four years,global Islamic banking assets have grown annually by

19 percent on average, and they are set to cross US$1.8trillion (RM5.56 trillion) in 2013, up from the US$1.3trillion of assets held in 2011. In Malaysia, during thefirst seven months of 2012, Islamic banking total assetshave increased by 20.6 percent to reach RM469.5 billion,representing 24.2 percent of the assets of the country’s banking system (Ministry of Finance, 2013).

As mentioned earlier, it is accepted by most scholarsin Islamic Banking and finance that a banking systemconstructed to promote risk-sharing, co-operation andmutual assistance would manifest the principle of PLS,and that this should be the cornerstone of Islamic banking.

As stated by Warde (2000), the principle of PLS

...is at once the most “authentic” form of Islamic

finance since it replicates trans¬actions that were

common in the early days of Islam, the one that

is most con¬sistent with the value system and the

moral economy of Islam and the most “modern”

one. Thus, it is believed that Islamic banks are

supposed to offer instruments consistent with the

religious beliefs and cultural characteristics of

Muslim societies (Warde, 2000, p. 5).

The preferability of muÌÉrabah was also stressed byKhan and Mirakhor (1987): “Even though in practicethe role of profit-sharing and partnership is very small at

present, they continue to dominate the theory of' Islamic

banking. They are regarded as the norms towards which

practice should and would eventually gravitate” (Khan &Mirakhor, 1987, pp.185-199).

The International Association of Islamic Banks (1995, pp.3-4) enumerated some of the economic rationales for thesuperiority of the PLS contract:

If interest is replaced by profit sharing, someimbalances are expected to be reduced. First,

the return on capital will depend on productivity.

Allocation of investable funds will be guided by

the soundness of the project. This will in effect

improve the efficiency of capital allocation.

Second, the creation of money by expanding

credit will be created only when there is a

strong likelihood of a corresponding increase

in the supply of goods and services. In case the

enterprise suffers losses, repayment of capital to

the bank is diminished by the amount of loss. Thus

in the profit-sharing system, the supply of moneyis not allowed to overstep the supply of goods and

services. This will eventually curb inflationary

pressures in the economy.

In Malaysia, even though the

development of products and

services in the Islamic banking

system is very encouraging,

financing products based on the

principles of muÌÉrabah andmushÉrakah are almost non-

existent

“

” Third, the shift to profit-sharing may increase

the volume of investments that translates into job

creation. This is because the interest mechanism

makes feasible only those projects whose expected

profits are sufficiently high to cover the interest

rate plus added income. This filters out projects

which otherwise would be accepted in the profit-

sharing system.

Fourth, the new system will also ensure more

equitable distribution of wealth. Wealth would

bring more wealth to its owners only when

its use has actually resulted in the creation of

additional wealth. This would in time reduce the

unjust distribution of wealth, which continued for

decades during the interest regime.

Fifth, the abolition of interest, together with the

restriction of forward transaction, as prescribed

by SharÊÑah, will curtail speculations measurably.

But still, there will be a secondary market trading

common stocks and investment certificates based

on profit-sharing principles. This will bring sanity

back to the market and allow raising of funds

for enterprises and liquidity to equity holders”

(International Association of Islamic Banks,

1995, pp.3-4).

However, what is being practised by the IFIs is farfrom these idealized models. Only very small portionsof their funds are invested using the muÌÉrabah andmushÉrakah contracts. Several studies have pointed outthat muÌÉrabah and mushÉrakah financing have declinedto almost negligible proportions (Aggarwal & Yousef,2000; Lewis & Algaud, 2001; Kuran, 2004; Yousef, 2004;Iqbal & Molyneux, 2005; Wajdi, 2006). For example,the International Association of Islamic Banks (IAIB)estimated that PLS comprised less than 20 percent ofinvestments made by Islamic banks worldwide in 1996.Lewis and Algaud (2001) found that less than five percentof the assets of Islamic banks are in the form of financinginstruments based on genuine PLS. Wajdi (2007) observedthat the ideal structure of Islamic banks, which is supposedto be based on PLS, has proved to be a mirage as very fewIslamic banking assets are based upon such contracts.

This trend is observed in all countries, including Malaysia,which offer Islamic finance and banking services. A study by Hassan (2005) indicates that in Malaysia, the shareof mushÉrakah declined from 1.4 percent in 2000 to 0.5


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percent in 2003. Another study by Samad et al. (2005)shows that in 2002, muÌÉrabah and mushÉrakah of BankIslam Malaysia Berhad, accounts for only 0.66 percent and3.53 percent respectively of the total financing.

Meanwhile, muÌÉrabah and mushÉrakah constituted 9.33 percent and 2.16 percent of Bahrain Islamic Bank’s total

financing respectively (Samad et al. 2005). Similarly Darand Presley (2003) revealed that in 1998 Dubai IslamicBank allocated only 10 per cent of its total funds for PLScontracts, while Jordan Islamic Bank and Qatar IslamicBank allocated three percent and four percent respectively.The authors also show that, apart from a few small projects,the Islamic Development Bank (IDB) has so far not usedPLS in its financial businesses. Furthermore, accordingto Dar and Presley (2003), even specialized Islamic firmssuch as muÌÉrabah companies (MCos) in Pakistan, whichare supposed to function purely on a PLS basis, invest onlya negligible proportion of their funds in the muÌÉrabah and mushÉrakah systems.

The lack of muÌÉrabah and mushÉrakah financing products is due to IFIs’ preference for more profitableand less risky debt-financing products such as murÉbaÍah (Mehmet, 2007). Indeed, nearly all Islamic banks,investment companies and investment funds offer tradeand project finances based on a mark-up, commissionedmanufacturing or leasing (Dar & Presley, 2003). Yousef(2004) described this phenomenon of IFIs’ over-relianceon debt-based financing as the MurÉbaÍah Syndrome.

This circumstance raises the question of whether the

essence of risk-taking and value addition, which areindispensable social imperatives and hence indicators ofIslamicity, have been lost (Rosly & Abu Bakar, 2003).Apart from the prohibition of elements such as ribÉ , ghararand maysir, other distinctive features of Islamic bankingand finance are their religious and social responsibilities,which are supposed to be reflected in their commercialdealings and other activities. The introduction of Islamic banking to the financial system is part of a vision to movefrom a debt-based financial intermediary to an equity- based and risk-sharing arrangement (Wajdi, 2007). Anideal Islamic banking model would be reflected in its balance sheet structure, which would be dominated by

PLS in terms of both assets and liabilities. Theoretically,Islamic banking is deemed to be a good alternative to the

conventional system due to its robustness and the potentialstability that the system may provide (Khan & Mirakhor,1987; Siddiqui, 2001).

The concentration on non-PLS modes of financing alsoraises the question of whether Islamic banking and financeoperations in general are totally Islamic or whether the

name is used as a ‘mask’ placed on a conventional bank toattract funds from Muslim investors. It has been suggestedthat Islamic banks should diversify as a matter of urgency by promoting ethical banking via arrangements such asthe trustee partnership (muÌÉrabah) and the joint venture(mushÉrakah) (Rosly & Abu Bakar, 2003). According toAggarwal and Yousef (2000), Islamic banks are supposedto serve the function of allocating investment funds tolong-term productive projects. Thus, Islamic banks areexpected to favour small entrepreneurs who do not haveaccess to credit in the conventional banking system andto extend their links to rural regions that are often cut offfrom formal access to urban financial markets.

It is believed that in this way Islamic banking can generatethe much-needed economy of scale and scope to increase profitability in addition to having a positive influence onthe well-being of society (Rosly & Abu Bakar, 2003). Inaddition, Islamic banks are not only intermediaries andtrustees of other people’s money but also incorporate both profit and morality into their objec-tives; they share profits and losses with their depositors, thereby givingtheir depositors some ownership rights (Rosly & AbuBakar, 2003). Wahbah Al-Zuhayli, in his famous book al-

Fiqh al-IslÉmÊ wa Adillatuh (Islamic Jurisprudence and

its Evidence), asserted that Islamic banks must rely onequity instead of debt since their primary goal is not tomake profits but, rather, to endorse social goals of socio-economic development and alleviate poverty.

Given this scenario, there is clearly a need to study thereasons behind this paradoxical difference between whatis being idealized by Islamic economists and SharÊÑahscholars and what is being practised in the industry. Eventhough quite a substantial number of studies have beenconducted to elucidate the reasons behind this trend, theytend to be too general in context and some of them are not based on empirical data or information. The majority of

them are mostly theoretical in nature and deal mostly withthe rules of muÌÉrabah and mushÉrakah contracts as wellas justifications why they should be preferable in Islamic banks (Qureshi, 1945; Ahmad, 1947; Siddiqi, 1983; Khan& Mirakhor, 1987; Chapra, 1992; Ahmad, 1994; Hassan,1999; Haron, 2000; Ahmad, 2000; Warde, 2000; Siddiqui,2001; Usmani, 2004; Choudhury & Hussain, 2005). Therehave also been some empirical studies that looked intothe performance and practicality of implementing themuÌÉrabah and mushÉrakah contracts, including studiesconducted by Rosly & Bakar (2003), Dar & Presley,(2003), Sundarajan & Errico (2002) and Shaharuddin

(2010). However, these studies are mostly based onsecondary data and not on primary information obtainedfrom in-depth interviews with industrial practitioners.

Apart from the prohibition of

elements such as ribÉ, gharar

and maysir, other distinctive

features of Islamic banking and

finance are their religious and

social responsibilities, which are

supposed to be reflected in theircommercial dealings and other

activities

“

”


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This study will be more specific in nature by examiningthe issues within the scope of the Malaysian Islamicfinance and banking industry. In this study, we will baseour analysis on data gathered from face-to-face interviewswith representatives from selected IFIs who are directlyinvolved in dealing with muÌÉrabah and mushÉrakah – based products. We will also examine this issue froma legal perspective by analysing the following statutesinsofar as muÌÉrabah and mushÉrakah are concerned: the

Partnership Act 1961 (Act 135), the Civil Law Act 1956(Revised 1972) (Act 67) (‘CLA’), the Islamic FinancialServices Act 2013 (Act 759) (‘IFSA’) and the CentralBank of Malaysia Act 2009 (Act 701) (‘CBA’).

Objectives of the Study

The following are the objectives of the study:

1. to examine the current practice and preference ofMalaysian IFIs in terms of their financing modes;

2. to analyse the attitude of Malaysian IFIs towards themuÌÉrabah and mushÉrakah contracts;

3. to investigate the challenges and constraints faced by Malaysian IFIs in applying the muÌÉrabah andmushÉrakah concepts; and

4. to propose measures and policies that would encouragea wider adoption of the muÌÉrabah and mushÉrakah contracts by Malaysian IFIs.

Research Questions

The following are the research questions of the study:-

1. What are the current practice and preference of theMalaysian IFIs in terms of their financing modes?

2. What are the attitudes of the Malaysian IFIs towardsthe muÌÉrabah and mushÉrakah contracts?

3. What are the challenges and constraints faced bythe Malaysian IFIs in applying the muÌÉrabah andmushÉrakah concepts?

4. What are the measures and policies that can beimplemented by the relevant authorities in order toencourage a wider adoption of the muÌÉrabah andmushÉrakah contracts by the Malaysian IFIs?

Significance of the Study

This study will contribute towards understanding whyIslamic banks seem to be reluctant to offer muÌÉrabah and mushÉrakah-based products from the perspective ofthe IFIs themselves. As this study is based on in-depthinterviews with representatives from the IFIs, it provides

an insight into the views of practitioners on the practicalityof implementing muÌÉrabah and mushÉrakah conceptsin today’s world. This study will also help to clarify thechallenges faced by the practitioners of Islamic banking inapplying the muÌÉrabah and mushÉrakah concepts. Thisin turn will enable us to identify the types of measures thatcan be implemented in order to resolve these challengesso that there will be a wider application of the muÌÉrabah and mushÉrakah concepts by the IFIs in Malaysia.

Methodology

At present there are 25 financial institutions (22 banksand three development financial institutions) in Malaysiawhich offer Islamic financial products and services (Table1). For the purpose of this study, we have selected eightof these institutions for interviews. The eight institutionscomprise one full-fledged local Islamic bank, two full-fledged international Islamic banks, three Islamic bankingsubsidiaries of local banks and two financial developmentinstitutions.

Islamic banks must rely on equity

instead of debt since their primary

goal is not to make profits but,

rather, to endorse social goals of

socio-economic development and

alleviate poverty

“

”

Table 1: List of IFIs in Malaysia

No IFI

1. Bank Islam Malaysia2. Bank Muamalat

3. Maybank Islamic

4. Al-Rajhi Bank

5. Kuwait Finance House

6. CIMB Islamic

7. Hong Leong Islamic

8. Affin Islamic

9. AmIslamic Bank

10. RHB Islamic

11. Public Islamic Bank

12. HSBC Amanah Malaysia13. OCBC Al-Amin

14. Standard Chartered Saadiq

15. Bank Muamalat Indonesia

16. Asian Finance Bank

17. Alkhair International Islamic Bank

18. Elaf Bank B.S.C (c)

19. CITI Malaysia

20 Bank of Tokyo-Mitsubishi UFJ Malaysia

21. Deutsche Bank AG, IIB

22. Bank Rakyat

23. Bank Simpanan Nasional

24. SME Bank

25. Agrobank


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Limitation of the Study

The findings of this study are based on the data gatheredfrom interviews and discussion with eight IFIs only.This is mainly due to the lack of cooperation from IFIs,which did not appear to be very interested in the issue.The analysis could have been improved if more IFIs

had participated in this study. However, as we managedto get at least one representative from each type of IFI, particularly the major players of the industry, to partake inthis research, the findings of this study may still representthe general view of the industry on the issue of muÌÉrabah and mushÉrakah.

Organization of the Study

The report is divided into four sections. In section 1, we provide a general overview of muÌÉrabah and mushÉrakah.Section 2 provides a synthesized review of articles that

address the issue of muÌÉrabah and/or mushÉrakah. Thefindings from the data analysis are discussed in section3. Finally, section 4 summarizes the research findingsand provides some policy recommendations on how toencourage wider adoption of muÌÉrabah and mushÉrakah contracts by Malaysian IFIs.

Data was gathered through guided interviews as wellas from financial reports of the institutions involved.The researchers interviewed officers who were directlyinvolved in dealing with muÌÉrabah and mushÉrakah – based products, i.e., the officers/persons in charge in theProduct Development Department, Credit Department,Legal Department, SharÊÑah Department and Risk

Management Department.

The primary data was complemented with secondary datacollected from relevant reports and publications by BNMand IFIs.

The questionnaire used in the interviews was designed toachieve various objectives of the research, including thecurrent practice of IFIs, their preferences, their attitudestowards muÌÉrabah and mushÉrakah, and the challengesthey face in the implementation of muÌÉrabah- andmushÉrakah-based products. The questionnaire, whichwas semi-structured in nature, serves as a guideline for

the researcher to interview the bank officers or persons incharge in the Product Development Department, CreditDepartment, Legal Department, SharÊÑah Department andRisk Management Department.

The questionnaire is divided into six parts:-

• Part A: Background of the Organization,

• Part B: Asset and Liability Portfolio,

• Part C: MuÌÉrabah,

• Part D: MushÉrakah,

• Part E: Islamic Bank Tribunal/Arbitration, and

• Part F: Opinion.

In Part A, the information elicited include year ofestablishment, number of staff, branches, total assets and profits. In Part B, the questions are related to assets andliability portfolio, business focus, preferences, target clientsand credit control. In Parts C and D, we developed questions

focusing on muÌÉrabah and mushÉrakah respectivelyin terms of the understanding, planning, opportunitiesand problems faced in offering the products from the perspective of bank officers. To achieve the researchobjectives, we included questions regarding changesneeded by the IFIs in terms of the legal infrastructure, taxincentives, support from the government and insurance(takÉful ) in order to offer both types of products. Inaddition, we sought the opinions of the banks on what theycould do to reduce/mitigate the risks associated with bothtypes of products. Questions pertaining to actions takenin cases of default and negligence were also raised in

this part of the questionnaire. Part E covers informationon IB tribunals or arbitration as well as the PartnershipAct, in particular, the need for an Islamic Partnership Act.Finally, Part F requests respondents’ overall opinions onmuÌÉrabah and mushÉrakah -based products.


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Section 2

Literature Review

In this section we will first provide a brief analysis ofthe historical evolution of these two concepts. We willthen discuss the issues related to the implementation ofmuÌÉrabah and mushÉrakah, followed by a discussionof the criticisms against the implementation of these twoconcepts. Finally, we will review some of the suggestionsand recommendations on how to implement muÌÉrabah and mushÉrakah.

The Historical Evolution of MuÌÉrabah and

MushÉrakah

MuÌÉrabah as a form of financing contract existed even before the arrival of Islam. Trade was the main activityof the population in pre-Islamic Makkah. Since there wasno banking system or financial inter ¬mediation in pre-Islamic Makkan society, two methods of financing wereemployed: partnership (muÌÉrabah) and lending basedupon usury (El-Ashker, 1987). The former was the mainfeature of business at that time. However, the demand foran entrepreneur’s services depended upon his/her skilland ability to make profits or avoid losses and on his/her reputation among fellow traders. On the other hand,lending based upon usury was commonly practised among

the Arabs and between the Arabs and the Jews.

After the emergence of the Islamic state in 610 CE, partnership or business on a PLS basis was the only pre-Islamic method of financing business that continuedto survive (El-Ashker, 1987). According to El Ashker,although the principles—the sharing of risk and returns between the partners concerned—remained the same, thescale of business activities financed using this conceptexpanded to a larger number of suppliers of funds as wellas entrepreneurs. The capital was divided into small sharesand the degree of risk and returns was small comparedwith the earlier system of partnership during the pre-Islamic period. This method of financing also helpedinvestors to invest within their financial capability. ElAshker asserts that with the expansion of the state and itseconomic activities, partnership came to resemble a joint-stock enterprise and there was perhaps an over-the-counterfinancial market, although there is no data to confirm itssize or even its existence.

After the emergence of the

Islamic state in 610 CE,

partnership or business on a

PLS basis was the only pre- Islamic method of financing

business that continued to

survive

“

”

Chapra and Khan (2000) state that during the medievalIslamic period the PLS modes of financing, along withdeferred-payment or delayed-delivery trading and interest-free loans (qarÌ Íasan), were used for raising money tofinance production. During this period, interest-bearingloans and other overtly usurious practices were not incommon use. The practice of muÌÉrabah in the westwardtrade between Egypt and Tunisia, and mushÉrakah in thenorth-south trade between Egypt and Syria as well as between Egypt and Jeddah during the eleventh century has been documented by Goitein (Cizakca, 1995). Udovitch(1979) states that activities such as agriculture, crafts,manufacturing and long-distance trade of not only theMuslims but also the Jews and Christians during this period were supported by these modes of financing.

Haque (1992) remarks that in pre-capitalist medievalMuslim society the two common dominant modes ofcommercial capital were the business organizations ofmuÌÉrabah and mushÉrakah. He says that the commercialcapital was the product of the specific economic conditionsof the times because of the explicit ban on interest-bearingcapital. Furthermore, according to Haque, the existenceof muÌÉrabah was due to the lack of modern banking,financial and corporate institutions; there were no other

categories of capital where people could invest theirwealth; and this system underwent an evolution.

Udovitch (1979) also highlighted that, in the thirteenthcentury CE, techniques similar to those that had been practised in the Muslim world from the earliest medieval period were adopted in Europe. In addition, in Asia at theend of the fifteenth century CE, shipping in the IndianOcean was organized according to the muÌÉrabah contract.Under this arrangement, each member of the crew wasa muÌÉrib who had a share in the profits. The investors provided the capital and shared the profits according to a pre-determined ratio (Meilink-Roelofsz, 1970).

Issues in the Implementation of MuÌÉrabah

and MushÉrakah Contracts

Numerous studies have been conducted regarding thelack of PLS contracts in the Islamic banking and financialsystem. Khan and Ahmed (2001) conducted a survey on perceptions of risks of different types of SharÊÑah principlesin IFIs in 28 countries. They found that mushÉrakah,mushÉrakah mutanÉqiÎah and muÌÉrabah were amongthe riskiest principles compared to the other principles

( salam, istiÎnÉÑ, ijÉrah and murÉbaÍah). According to thisstudy, credit risk was noted to be highest in mushÉrakah (3.69 out of a score of 5.00) followed by muÌÉrabah (3.25). Together, the findings of this study highlighted that bankers perceived the PLS modes to have higher credit


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risks. Ahmad (2011) conducted a study on MalaysianIslamic banks and found that only three banks reportedexposure to muÌÉrabah and mushÉrakah contracts. Thesetwo contracts are less popular among other banks becausethe PLS arrangement poses higher risks (capital risk,counterparty risk, performance risk and reputational risk)

to the Islamic banks which provide the financing.

According to Van Greuning and Iqbal (2009), a holisticapproach to understanding the risk of Islamic bankingshould start with a rigorous analysis of the risk profile ofthe different financial contracts on each side of the balancesheet. Elgari (2003) agrees, stating that studies on riskunderlying the Islamic mode of finance are very important because the Islamic mode of finance carries higher risksthan interest-based loans.

Shamshad Akhtar, Governor of The State Bank of

Pakistan and the former Director-General of the AsianDevelopment Bank, stated in the foreword of a book byVan Greuning and Iqbal (2008), “The risk profiles ofassets of Islamic banks depend on the structure of Islamic

financial instruments and contracts and their functionality

and maturity profile. On the liability side, equity risks are

recognized to differ for depositors and investment account

holders” (Van Greuning & Iqbal, 2008, p. xvi).

This shows that Islamic banks face different kinds ofrisks at different stages of an Islamic contract. Lack ofunderstanding of the nature of the inherent contract maylead to serious implications.

The types of risks are not only different due to differentfinancing contracts (Kahf, 2006), but new risks couldalso develop in the different stages of financing orinvestment. For example, a financing product which isSharÊÑah compliant at the start of the transaction could beaborted when elements or activities that are not SharÊÑahcompliant are detected at the later stage of the project.The documentation of these risks at the initial stages offinancing or investment activity will provide a strongerwarning system for risk managers. Sundarajan and Errico(2002) opine that while the PLS modes may shift the direct

credit risk of Islamic banks to their investment depositors,they may also increase the overall degree of risk of theasset part of banks’ balance sheet since the assets underthis mode are uncollateralised.

Meor (2008) outlines the different types of risk at eachstage of the mushÉrakah contract. At the contract stage, anumber of risks are present. Capital recovery due to creditrisk is one of them. The mushÉrakah capital may not berecovered as it ranks lower than debt instruments uponliquidation. Meanwhile, counterparty risk is identifiedwhen a partner to a mushÉrakah does not pay the profit

that the financing institution is entitled to. A loss-makingoperation that requires additional capital injection exposesthe financial institution to the risk of capital impairment andthe opportunity to reinvest in other types of investments.

Meor (2008) also identified another form of counterpartyrisk in that a partner can at any time withdraw from the partnership by giving notice to this effect. Moreover, thewithdrawing partner may owe money to the financinginstitution. The financing institution may have to resort to buying the withdrawing partner’s share or to find a new partner to takeover. There is also price risk, whereby thefinancing institution as the buying partner is exposed to

fluctuations in the share price (low investment value). The parties should also be mindful that the sales and purchasesare affected in a separate agreement and the acquisition price of the equity is not fixed at the original or face value(as it can be construed as a price guarantee and, therefore,non-recognition of income). This is a SharÊÑah compliancerisk.

In addition, regulatory risk has also been identified as oneof the major risks faced by the Malaysian Islamic banks.The reason is that the practitioners find it very difficult toimplement SharÊÑah-based transactions while existing laws

and regulations are mostly based on civil law. InadequateIslamic regulatory frameworks remain a major constraintin addressing legal issues relating to Islamic bankingtransactions.

Another major problem with the PLS contracts that isfrequently mentioned in the literature is the agency problemthat is said to be inherent within these types of contracts(Kazarian, 1993; Khalil, Rickwood & Murinde, 1996; Dar& Presley, 2000; Iqbal & Molyneus, 2005). In the words ofthe State Bank of Pakistan (2008): “[T]he agency problemis one of the major factors for the reluctance on the part

of banks to undertake equity based modes of financing, as

it gives entrepreneurs the incentive to under-state profits”

(State Bank of Pakistan, 2008, p. 7).

The agency problem is also related to the problems of moralhazard and asymmetric information that seem to plaguePLS contracts. Together, all these problems would lead toa situation whereby the entrepreneurs have the perverseincentive to behave against the interest of the bank by, for

Inadequate Islamic regulatory

frameworks remain a major

constraint in addressing legalissues relating to Islamic

banking transactions

“

”

These two contracts are less

popular among other banks

because the PLS arrangement

poses higher risks (capital

risk, counterparty risk,

performance risk andreputational risk) to the

Islamic banks which provide

the financing

“

”


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example, concealing the true level of profits, absorbingsome of the profits through unauthorized perquisites orshirking effort. In order to avoid these problems, the bankwould have to incur extra costs for monitoring purposes.Because banks normally do not want to incur these extracosts, the best option for them would be to simply limit theoffering of these types of products.

Other than these problems of agency, moral hazard andasymmetric information, the PLS contracts are alsoassociated with a host of other challenges that render themrather unattractive to the IFIs. The following are some ofthe challenges identified by Dar and Presley (2000):

• In order for the PLS contracts to function properly, itwould require properly defined property rights, whichare missing in most Muslim countries.

• Faced with stiff competition from more experiencedand established banks and other financial institutions,

the IFIs would have to offer modes of financing thatare less risky and more profitable in order to sustaintheir survival.

• The restrictive role of shareholders (investors) inmanagement and, hence, the dichotomous financialstructure of the PLS contracts makes them non- participatory in nature, which allows a sleeping partnership.

• Equity financing is not feasible for funding short-term projects due to the ensuing high degree of risk (i.e.,

the time diversification effect of equity). This makesIslamic banks and other financial institutions rely onsome other debt-like modes, such as a mark-up toensure a certain degree of liquidity.

• While profit is taxed, interest is exempted on thegrounds that it constitutes a cost item. This legaldiscrimination and its associated problem, tax evasion,make PLS less reliable as a tool for reward sharing.

Besides high risk and moral hazard, Bakar (2002) alsolisted a number of other reasons for the reluctance of the

modern Islamic financial system to use equity financing:

(1) The banks lack suitable and qualified staff with themanagement skills to undertake this task.

(2) Most Islamic banks are very new and cannot affordto undertake equity financing until they are moresecurely established.

(3) There are structural and other regulatory issues relatedto the implementation of these two concepts.

In a more recent study, Farooq and Ahmed (2013) found

that most respondents attributed the slow growth ofmushÉrakah financing to the lack of expertise on bothsides—bank management and customers—and lack ofinterest by the bank management in promoting mushÉrakah

as a mode of finance. According to these authors, thereare a number of factors that explain why Islamic banks donot have any interest in promoting this mode of financing.These include (i) the majority of the existing staff of theIslamic banking industry have no knowledge of Islamic banking and finance, (ii) the PLS modes of financingrequire additional monitoring by the staff and mechanisms

which increase the costs of these modes of finance;therefore, they do not want to get involved in these typesof projects, and (iii) muÌÉrabah and mushÉrakah modesof financing also require a lot of information about theabilities and capabilities of the entrepreneurs, which maynot be so readily available.

Criticism of the Application of MuÌÉrabah

and MushÉrakah in the Islamic Finance and

Banking System

Although most contemporary Islamic scholars considerPLS as the most valid and favourable form of Islamiccontracts, its application to the Islamic finance and banking system has received some criticisms. Other than practical difficulties in implementing the muÌÉrabah andmushÉrakah contracts, some authors have also outlinedcriticisms against these contracts from the theoretical perspective.

Naqvi (1981) argues that, although it is true that the systemof PLS (muÌÉrabah) is lawful according to the SharÊÑah,it does not necessarily mean that it is the best principleon which an Islamic economy should be based. He also

maintains that, since muÌÉrabah is based on the custom ofthe pre-Islamic Arabs and not on the Qur’Én or the Sunnah,there is nothing sacred about the system. He suggests thatthe system should be tested on an economy-wide basis before any possible significant evaluation of it can bemade:

It will require all the savers to become risk-takers,

something that does not happen when this system

is one of the many possibilities open to investors,

the option to invest in interest-bearing deposits

being not ruled out. The risk-takers may take this

form of investment, while the risk-averters will

not opt for it. In that case, the preference structure

of the investors remains intact while it does not

when the system is adopted on an economy-wide

basis (Naqvi, 1981, p.136).

most respondents attributed the

slow growth of mushÉrakah

financing to the lack of expertise

on both sides—bank management

and customers—and lack of

interest by the bank managementin promoting mushÉrakah as a

mode of finance

“

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Siddiqi (1983) suggested that the Islamic banking modelshould be based on muÌÉrabah and shirkah (now termedas mushÉrakah). However, Siddiqi believed that an Islamic banking system would be successful only in a countrywhere the SharÊÑah was enforced, meaning that usurywould be prohibited and anyone indulging in activities based on usury would be punished.

Based on the theory of Marxist economics, Haque (1985)argued that the relationship between rabb al-mÉl andmuÌÉrib is similar to the one between capitalists andlabourers or between developed and developing countries.According to him, muÌÉrabah can lead to an exploitivesituation whereby the rabb al-mÉl may be able to obtainunfair and excessive profits.

Another criticism is that most of the instruments usedin modern Islamic finance are based on the commercialcontracts used in the pre-modern Islamic world or accepted by pre-modern Islamic jurisprudence. As the industry

grows, there is a need for new financial instruments to bedeveloped. Some scholars have criticized the way theseinstruments have been developed as they believe that theseinnovations merely adopted the form of the pre-moderncontracts but failed to capture their ‘substance’ (economicwisdom, Íikmah). This type of innovation is termed‘SharÊÑah arbitrage’ by El-Gamal (2006). According to El-Gamal (2006), there are three steps involved in the practiceof SharÊÑah arbitrage:

1. Identification of a financial product that

is generally deemed contrary to the precepts of

Islamic Law (Sha’ria).

2. Construction of an “Islamic analog” to that

financial product. Examples include Islamic home

(mortgage) or auto-financing – commonly using

the Arabic-nominate contracts murabaha or ijara,

as well as Islamic bonds or certificates commonly

marketed under Arabic names like sukuk al-

ijara or sukuk al-salam. In fact, an important

step in executing Shari’a arbitrage is finding an

appropriate Arabic name for the Islamic analog

product, preferably one that was extensively used

in classical Islamic legal texts. Differences in

contract forms and language thus justify and lend

credibility to the “Islamic” brand name.

3. In the meantime, an Islamic financial

structure marketed under an Arabic name must be

sufficiently similar to the conventional structure

that it aims to replace. Sufficient similarity would

ensure that the Islamic structure is consistent with

secular legal and regulatory frameworks in target

and origin countries (El-Gamal, 2006, pp. 20-21).

He criticized the use of the two-tier muÌÉrabah depositaccounts currently being practised by Islamic banks and

proposed replacing it with a new corporate structure forIFIs based on mutual banking.

a muÌÉrabah contract in which

the agent is not held liable for

the loss of people’s investments

would cause serious difficulties

to the investors, for the

business demands a high levelof responsibility, honesty and

integrity

“

”

Haque (1992) rejects the adoption of muÌÉrabah as aninstrument for modern banking and finance for severalreasons. In his view, the muÌÉrabah contract is very riskyand dangerous, for the success of the system dependssolely on the trustworthy conduct of the agent. He arguesthat muÌÉrabah as explained in the classical fiqh texts

was a simple muÌÉrabah, which would only be suitablefor social structures that existed in the past, such as inMadinah, where people knew each other very well. One ofthe key factors that underlie the success of a muÌÉrabah venture is trustworthiness. It was relatively easy to identifythe trustworthiness of a business partner in a small andclose-knit society. However, trustworthiness is moredifficult to identify in a modern society, especially indealing with large-scale companies. Thus, a muÌÉrabah contract in which the agent is not held liable for the lossof people’s investments would cause serious difficultiesto the investors, for the business demands a high level of

responsibility, honesty and integrity. In fact, the Prophet(peace be upon him) was well known as al AmÊn (thetrustworthy person) for his management of the commenda2 caravan journeys, for which he used KhadÊjah’s capital, before his call to Prophethood (Borhan, 1997).

Borhan (1997) points out that the theoretical concept ofIslamic banking based on PLS was originally developedfrom the explicit assumption of a general prohibition ofinterest. Among other objections to the application ofthese concepts is that a medieval-style contract may notnecessarily be suitable for modern economic realities, forit could lead to one party taking advan¬tage of the other as

well as creating difficulties in management and regulation.

Ismail (2002) has proposed an alternative for the Islamic banking model that differs from Chapra’s model,which favours PLS and places greater social welfareresponsibilities and religious commitments upon Islamic banks in order to achieve the Islamic economic objectives.According to Ismail’s model, an Islamic bank should actas a normal commercial entity that aims at maximizing profits as long as it is done in a manner consistent withIslamic law (Ismail, 2002). Ismail (2002) states thatthe overemphasis on the PLS modes of financing is

inappropriate, is not founded in any Quranic text, and iseven incompatible with the methodology of the SharÊÑah.


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More recently, Shaharuddin (2010) concluded thatmuÌÉrabah banking products in Islamic banks in Malaysiahave deviated from the original theory as the muÌÉrabah contract is not predominant in daily Islamic bankingtransactions. He further added that the Malaysian SharÊÑahscholars adopted an incoherent legal methodology inmodifying the muÌÉrabah classical doctrine to suit modern banking practices. Shaharuddin affirms that SharÊÑahscholars in Malaysia are much more liberal than ×anafÊscholars as they justify certain actions of Islamic banks based on an unregulated definition of maÎlaÍah.

Suggestions for the Implementation of

MuÌÉrabah and MushÉrakah

Several authors have come up with a number of solutions inorder to make PLS contracts more appealing to IFIs. Bacha(1997) suggested that the muÌÉrib should ‘reimburse’ therabb al-mÉl in the event of certain outcomes. Karim (2000)recommended that the muÌÉrib contribute some capital or

collateral to the project. Adnan and Muhammad (2008)argued that while cases of muÌÉrib negligence leadingto losses are taken care of in muÌÉrabah, proper systemsshould evolve to establish such negligence and ascribe thelosses to the muÌÉrib. Khan (2003) suggested that banksguarantee investment deposits by tabarruÑ to minimize theagency problem. Orhan Astrom (2011) proposed a negativeincentive scheme as a solution to reduce the problem ofasymmetric information inherent in PLS contracts such asmuÌÉrabah and mushÉrakah.

Sundararajan and Errico (2002) state that theadministration of the PLS modes is more complex thanconventional financing. However, they accept that thestructure and balance sheet of Islamic banks and the use ofthe PLS modes mean that Islamic banks are better placedthan conventional banks to absorb external shocks. Theauthors add, “In the event of operational losses, unlikeconventional banks, Islamic banks have the ability to

reduce the nominal value of a portion of their liabilities.

As a result, solvency risks that may result from an asset–

liability mismatch are typically lower in Islamic banks

than in conventional banks” (Sundararajan & Errico,

2002, p.4).

Elgari (2003) also rebuts the assertion that Islamic banksface more risks than their conventional counterparts,since dealing in loans—as conventional banks do—doesnot lead to a reduction in banking risks. Therefore, the

cause of a higher level of risk for Islamic banks is theresult of relying on non-PLS modes of financing such asmurÉbaÍah. The reason for this situation is that financialassets generated from murÉbaÍah assets resemble thosewhich are generated by conventional bank loans. Chapra(1985) stressed that the non-PLS modes of financing suchas bayÑ mu’ajjal and murÉbaÍah could degenerate into

pure financing agreements with an agreed profit marginand would thus be no more than a mask for interest.

In his study, Nagaoka (2010) concluded that it is notrealistic in Islamic finance to introduce profit-sharinginstruments on a large scale as doing so would result ina liquidity crunch. He further states that it is feasible todevelop community and ethical investment, focusing onfinancing of small and medium enterprises. He states thatthis financing sphere offers opportunities on a large scalesuitable for introducing new partnership-based instrumentson the reformulated economic wisdom of ‘risk-sharingwithout risk-scattering’. Experiences based on Chinese

businesses has proved that robust corporate entity is nota necessary condition for the economic development, asthey have been conducted successfully using certain typesof ‘risk-sharing without risk-scattering ’ instruments(Nagaoka, 2010).

financing sphere offers

opportunities on a large scale

suitable for introducing new

partnership-based instruments

on the reformulated economic

wisdom of ‘risk-sharing withoutrisk-scattering’

“

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Section 3

Findings and Analysis

The findings of this research were based on secondarydata obtained from reports published by BNM and IFIs aswell as on primary data gathered through interviews withselected IFIs. We have also conducted a detailed analysisof the Partnership Act 1961 (Act 135), the Civil LawAct 1956 (Revised 1972) (Act 67) (‘CLA’), the IslamicFinancial Services Act 2013 (Act 759) (‘IFSA’) and theCentral Bank of Malaysia Act 2009 (Act 701) (‘CBA’).

We will first provide an overview of the muÌÉrabah andmushÉrakah practices among IFIs in Malaysia using thefindings from the secondary data before analysing the

findings from the interview sessions. This will then befollowed by a legal analysis of the aforementioned itemsof legislation.

MuÌÉrabah and MushÉrakah Practices in the

Malaysian Context

Table 2 shows the total amount of muÌÉrabah deposits by IFI for 2010 and 2011 3. In 2010, the total amount ofmuÌÉrabah deposits in the 21 IFIs stood at RM176 billion(two IFIs, however, did not have any deposits: SME Bankand Al-Khair). Bank Rakyat had the highest amount of

muÌÉrabah deposits with RM48 billion, followed byMaybank Islamic with RM26 billion, CIMB Islamicwith RM21 billion, and RHB Islamic with RM14 billion.Meanwhile, Bank Islam and Bank Muamalat, the two full-fledged Islamic banks in Malaysia, collected RM12 billionand RM11 billion of muÌÉrabah deposits respectively.Together, the six above-mentioned IFIs held more than 70 percent of the muÌÉrabah deposits of IFIs in 2010.

In 2011, the amount of muÌÉrabah deposits in IFIsincreased by 12 percent to reach RM200 billion. Thegrowth was contributed to, among other factors, by thesharp increase in the amount of muÌÉrabah depositscollected by RHB Islamic, which has seen its muÌÉrabah deposits increase by 63 percent to reach RM13 billionin 2011. Bank Rakyat remained the IFI with the largestamount of muÌÉrabah deposits with RM58 billion or 28 percent of the total muÌÉrabah deposits.

The share of muÌÉrabah deposits as a percentage of totaldeposits is shown in Figure 1. In 2010, the muÌÉrabah

deposit share of the total deposits for all 19 IFIs stood at61 percent. As for Bank Rakyat, Bank Simpanan Nasional,Bank Muamalat, AmIslamic, Affin Islamic and StandardChartered Saadiq, their muÌÉrabah deposits constitutedmore than 70 percent of their total deposits. In 2011,there was a slight drop in the muÌÉrabah deposit shareof total deposits to 60 percent. Most IFIs except KuwaitFinance House, Bank Muamalat, Affin Islamic, OCBC AlAmin, Bank Rakyat, Bank Simpanan Nasional and AgroBank experienced a decline in their share of muÌÉrabah deposits. Only Agro Bank and OCBC Al Amin saw asignificant increase in their muÌÉrabah deposits, from46.26 percent in 2010 to 60.81 percent in 2011 for AgroBank, and from 41.92 percent to 54.87 in 2011 in the caseof OCBC Al Amin. On the other hand, Maybank Islamic,Al-Rajhi and HSCB Amanah were the three banks thatexperienced the biggest drop in the share of muÌÉrabah deposits as compared to total deposits. For example, themuÌÉrabah deposit share of the total deposits in Al-Rajhidropped from 46.22 percent in 2010 to only 11.11 percentin 2011, while for HSBC Amanah the ratio dropped from68.05 percent in 2010 to 42.58 percent in 2011.

Table 2: MuÌÉrabah Deposits by IFI in 2010 and 2011 (RM’000)

and Their Percentage Share*2010 2011

IFIs MuÌÉrabah Deposits % MuÌÉrabah Deposits %

1. Citibank 37,772 0.02 36,054 0.02

2. Al-Rajhi 2,371,131 1.35 593,646 0.29

3. Kuwait Finance House 370,369 0.21 916,686 0.45

4. Asia Finance Bank 1,204,670 0.68 1,125,165 0.56

5. AgroBank 1,810,945 1.03 2,322,463 1.15

6. OCBC AlAmin 1,559,575 0.89 2,772,881 1.37

7. HSBC Amanah 3,992,875 2.27 3,740,525 1.85

8. SC Saadiq 2,597,531 1.47 4,651,357 2.3


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2010 2011

IFIs MuÌÉrabah Deposits % MuÌÉrabah Deposits %

9. Bank Simpanan Nasional 4,828,738 2.74 6,792,101 3.36

10. Hong Leong Islamic 5,788,177 3.29 7,093,974 3.51

11. Affin Islamic 5,223,417 2.97 7,428,130 3.68

12. Public Bank Islamic 8,226,144 4.67 9,706,072 4.81

13. Muamalat 10,513,819 5.97 11,484,501 5.69

14. Bank Islam 11,670,335 6.62 11,923,848 5.91

15. AmIslamic 11,772,288 6.68 13,086,278 6.48

16. RHB Islamic 8,253,416 4.69 13,488,256 6.68

17. CIMB Islamic 21,550,298 12.23 22,441,205 11.12

18. Maybank Islamic 26,363,389 14.97 24,896,241 12.33

19. Bank Rakyat 48,029,136 27.26 57,350,930 28.41

TOTAL 176,166,035 100 199,826,685 100

* Exluding Al-Khair and SME Bank which have no muÌÉrabah deposits.

Source: Financial Statements and Yearly Report of Various Banks, 2010 and 2011

Figures 2 and 3 show the types of financing by contracts by 21 IFIs in Malaysia for 2010 and 2011. As can beseen, there are four main contracts offered by these IFIsin their financing products: BBA, bayÑ al-ÑÊnah, ijÉrah and murÉbaÍah. The figures also show the relatively low proportion of both muÌÉrabah and mushÉrakah financing products.

In 2010, the total financing of the IFIs in Malaysiaamounted to RM204 billion. Of this, BBA constituted 28 percent (RM57 billion), bayÑ al-ÑÊnah 28 percent (RM57 billion), ijÉrah 23 percent (RM46 billion) and murÉbaÍah 11 percent (RM23 billion). Only two percent of the totalfinancing in 2010 consisted of mushÉrakah-based products(RM3.6 billion), while muÌÉrabah represented only 0.06 percent of the total financing.

The amount of financing increased to RM249 billion in2011. BayÑ al-ÑÊnah contracts amounted to RM69 billion,which constituted 27 percent of the total financing ofIFIs. BBA contracts represented 27 percent of the amount(RM68 billion), ijÉrah 22 percent (RM34 billion), andmurÉbaÍah 13 percent (RM31 billion). MushÉrakah stillremained at 2 percent of the total amount with RM5.7 billion while the proportion of muÌÉrabah dropped to 0.04 percent with RM93 million.

If we look at the amount of financing by banks (Table 3for 2010 and Table 4 for 2011), Bank Rakyat, MaybankIslamic and CIMB Islamic represented more than 50 percent of the total amount of financing. In 2011, the totalamount of financing offered by Bank Rakyat was RM51 billion or 20 percent of the total financing, Maybank

Islamic RM47 billion (19 percent), and CIMB IslamicRM29 billion (13 percent). However, of these three biggest Islamic financiers, only Bank Rakyat and MaybankIslamic offered mushÉrakah financing products. In 2011,Maybank Islamic had RM1.6 billion in mushÉrakah financing while the amount disbursed by Bank Rakyatwas RM70 million. Other banks that offered mushÉrakah financing to their customers were HSBC Islamic (RM1.7 billion), RHB Islamic (RM1.6 billion), Kuwait FinanceHouse (RM397 million), OCBC Al-Amin (RM173million), Bank Muamalat (RM41 million) and AmIslamic(RM0.6 million). Nevertheless, except for HSBC Islamicand RHB Islamic, mushÉrakah financing constituted onlya small portion of the total financing of these banks.

As for muÌÉrabah, there were only two banks that offeredtheir customers this type of financing: Bank Islam (M)

Berhad and Kuwait Finance House. In 2010, Bank Islamhad RM6 million in muÌÉrabah financing, and the amountremained the same in 2011. Meanwhile, the amount ofmuÌÉrabah financing in Kuwait Finance House wasRM117 million in 2010. The amount decreased slightly toRM87 million in 2011.


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Figure 2: Financing by Contracts, 2010 (%)

BBA (28%)

IjÉrah (23%)bayÑ al-ÑÊnah

(23%)

MurÉbaÍah

(11%)

Tawarruq (2%)

Istisna (1%)

MuÌÉrabah (0.06%) MushÉrakah (2%)

Others (5%)

Source: Financial Statements and Yearly Report

of Various Banks, 2010

Figure 3: Financing by Contracts, 2011 (%)

BBA (27%)

IjÉrah (22%)bayÑ al-ÑÊnah

(28%)

MurÉbaÍah

(13%)

Tawarruq (2%)

Istisna (3%)

MuÌÉrabah (0.5%)

Others (5%)

Source: Financial Statements and Yearly Report

of Various Banks, 2011

Figure 1: MuÌÉrabah Deposit of Total Deposit by IFIs, 2010 and 2011 (%)

* Exluding Al-Khair and SME Bank which have no muÌÉrabah deposits.

Source: Financial Statements and Yearly Report of Various Banks, 2010 and 2011

0 10 20 30 40 50 60 70 80 90 100

KFH

Citibank

Al-Rajhi

Public Bank I

Bank Islam

HSBC Amanah

Maybank Islamic

CIMB Islamic

OCBC AlAmin

AFB

Agrobank

RHB Islamic

Hong Leong I

SC Saddiq

Muamalat

Affin islamic

Ambank I

BSN

Bank Rakyat

2010

2011

MushÉrakah (0.04%)


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6

R es e

ar ch

P aper N o

5 6 / 2 0 1 3

T a b l e 3 : F i n a n c i n g b y C o n

t r a c t s a n d b y I F I s , 2

0 1 0 ( R M ’ 0 0

0 )

N o

I F I s

B B A

I j É r a

h

B a y Ñ a l -

Ñ Ô n a h

M u r É b a Í a h

T a w a r r u q

I s t i Î n É Ñ

M u Ì É r a b a h

M u s h É r a k a h

O t h e

r s

T o t a l

1 .

B I M

B

6 , 2

0 9 , 4

1 9

3 4 5 , 7

6 3

1 , 6

7 5 , 2

2 9

1 , 1

2 0 , 3 8 0

2 , 5

7 3 , 3

2 8

3 5 3 , 1

2 5

6 , 0

0 0

1 , 4

8 9

1 2 , 2 8 4 , 7 3 3

2 .

B . M

u a m a l a t

2 , 1

9 2 , 5

0 8

1 , 4 6

5 , 7

7 2

6 6 4 , 5

8 7

6 5 5 , 2 6 0

8 7 3 , 5

6 0

4 2 7 , 3

6 7

2 2 , 6

4 7

7 3

5 , 4

2 5

7 , 0 3 7 , 1 2 6

3 .

M a y b a n k I

1 3 , 7

1 2 , 1

3 3

1 2 , 4 7

0 , 4

8 0

6 , 9

3 8 , 7 7 3

1 , 2

5 5 , 6

8 8

1 9

9 , 7

8 3

3 4 , 5 7 6 , 8 5 7

4 .

A l - R a j h i

4 , 2

6 7 , 6

8 9

1

2 , 6

2 5

4 , 2 8 0 , 3 1 4

5 .

K F H

2 , 0 5

5 , 6

1 8

3 , 9

2 7 , 7 8 1

1 7 , 5

9 8

1 1 7 , 8

8 7

4 5 1 , 8

5 8

3

2 , 5

3 0

6 , 6 0 3 , 2 7 2

6 .

C I M

B I

1 0 , 3

2 0 , 3

4 1

5 , 9 7

9 , 8

5 4

5 , 8

2 7 , 6

7 1

1 , 1

4 7 , 2 8 9

4 1

8 , 7

3 0

2 3 , 6 9 3 , 8 8 5

7 .

H o n g L e o n g I

1 , 9

4 1 , 0

2 6

2 , 1 8

3 , 5

8 8

1 0 3 , 1 3 5

4 , 2 2 7 , 7 4 9

8 .

A f f i n I s l a m i c

1 , 9

3 0 , 7

8 0

1 , 0 6

1 , 1

6 6

9 7 , 8 8 2

5 5

4 , 3

9 0

3 , 6 4 4 , 2 1 8

9 .

A m

I s l a m i c

1 , 2

6 0 , 6

6 4

6 , 2 7

1 , 7

4 7

1 , 0

3 3 , 0 4 7

3 , 4 4

2 , 8

0 7

1 2 , 0 0 8 , 2 6 5

1 0 .

R H B I s l a m i c

1 , 6

9 7 , 8

7 4

2 , 4 7

8 , 8

5 1

1 , 5

2 4 , 4

3 1

1 , 5

3 4 , 7 8 2

5 3 0 , 2

7 5

1 , 1

7 2 , 7

3 3

9

7 , 0

8 3

9 , 0 3 6 , 0 2 9

1 1 .

P u b

l i c B a n k I

4 , 6

5 6 , 7

6 7

8 , 7 3

4 , 8

8 4

3 , 1

8 7 , 8

7 7

1

0 , 0

0 0

1 6 , 5 8 9 , 5 2 8

1 2 .

H S B C A

7 6 2 , 9

6 7

1 6 1 , 9

0 8

1 , 2

3 4 , 1

9 8

1 , 4

1 0 , 1 6 9

5 5 2 , 9

5 8

6 2

6 , 5

8 9

4 , 7 4 8 , 7 8 9

1 3 .

O C B C A l

7 1 7 , 5

8 6

9 8 9 , 4

1 2

3 3 1 , 8

6 5

9 4 , 3

6 5

4 2

2 , 5

0 5

2 , 5 5 5 , 7 3 3

1 4 .

S C

S a d d i q

3 9 5 , 0

1 0

4 3 7 , 8

5 8

1 , 3

0 9 , 6

0 6

1 9 2 , 5 0 2

5

0 , 8

2 4

2 , 3 8 5 , 8 0 0

1 5 .

A F B

4 6 , 6

1 9

1 4 8 , 4 4 5

4 5 6 , 1

9 2

1 1 6 , 5

1 6

6 2 7

7 6 8 , 3 9 9

1 6 .

A l k

h a i r

1 8 1 , 0 8 6

1 8 1 , 0 8 6

1 7 .

B . R

a k y a t

3 , 6

4 1 , 3

6 9

1 , 0 1

7 , 6

3 1

3 5 , 5

4 3 , 6

6 5

4 , 9

0 0 , 3 0 5

2 6 3 , 5

7 1

6 4 , 3

0 2

1 , 1 8

2 , 2

4 7

4 6 , 6 1 3 , 0 9 0

1 8 .

B S N

9 8 1 , 8

8 4

3 , 8

3 5 , 6

0 6

3 , 5 8 4

6 0

4 , 8 2 1 , 1 3 4

1 9 .

S M

E B a n k

9 3 4 , 4

4 4

6 0 2 , 5

3 6

8 9

8 , 4 5 4

1 5 7 , 6

9 5

1 9

5 , 3

7 5

1 , 8 9 8 , 5 9 3

2 0 .

A g r o B a n k

1 , 4

3 6 , 4

2 5

2 , 2

8 9 , 6

1 3

1 , 4 5

3 , 3

7 6

5 , 1 7 9 , 4 1 4

2 1 .

C i t i b a n k

4 2 , 1

0 1

6 , 0

9 5

4 6 2 , 3

1 4

5 1 0 , 5 1 0

T o t a l

5 7 , 1 0 0 , 9 8 7

4 6 , 3 0

9 , 7 8 2

5 7 , 4 2 4 , 4 3 7

2 3 , 4 0 2 , 8 7 4

4 , 1 6 6 , 6 5 1

1 , 6 0 2 , 5 7 6

1 2 3 , 8 8 7

4 , 0 7 6 , 8 6 5

9 , 4 3 6 , 4 6 5

2 0 3 , 6 4 4 , 5 2 4

S o u r

c e : F i n a n c i a l S t a t e m e n t s a n d Y e a r l y R e p o r t o f V a r i o u s B a n k s , 2 0 1 0


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i n t h


T a b l e 4 : F i n a n c i n g b y C o n

t r a c t s a n d b y I F I s , 2

0 1 1 ( R M ’ 0 0 0 )

N o

I F I s

B B A

I j É r a

h

B a y Ñ a l -

Ñ Ô n a h

M u r É b a Í a h

T a w a r r u q

I s t i Î n É Ñ

M �

research paper 56 ifikr

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