Debunking the Myths of Murabaha in Islamic Banking - Understanding the Misconceptions in Islamic Finance

Dive deeper into the Murabaha mode of Islamic finance and learn about the misconceptions surrounding this widely-used method in Islamic banking. Explore the reality of risk sharing and its impact on the industry. Discover the truth behind the criticisms of Islamic finance.

Debunking the Myths of Murabaha in Islamic Banking - Understanding the Misconceptions in Islamic Finance
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Islamic banking has faced a lot of criticism in recent years, with many critics arguing that the excessive use of the Murabaha mode of financing is problematic. However, a research paper by Mohammad Dulal Miah and Yasushi Suzuki aims to clear up these misconceptions and provide a deeper understanding of the Murabaha mode of financing in Islamic banking. The paper, titled "Murabaha Syndrome of Islamic Banks: A Paradox or Product of the System?" takes a closer look at the role of Murabaha in Islamic banking and examines the myths surrounding it. This blog post will summarize and explain the key findings of this paper, in order to help readers gain a better understanding of the Murabaha mode of financing and the misconceptions surrounding it. The research paper provides a much-needed insight into the current state of Islamic banking and debunks the myths that have been circulating about it.

Debunking the Myths: The Misunderstood Murabaha Mode of Islamic Finance

On point
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"Are Murabaha criticisms missing the mark? Dive into the reality of the concentration of this mode of financing in Islamic banking and the misconceptions surrounding it."

Islamic banking and finance have received a significant amount of criticism in recent years due to the excessive concentration on the use of the Murabaha mode of finance. Critics argue that this concentration is problematic, but fail to provide specific reasons for their criticism or offer thorough analyses of potential remedies.

One criticism of Islamic financing is that it lacks a solid theological foundation. Some argue that the question of Islamic financing is not about whether it can increase productivity or economic performance, but rather about Muslim attempts to adopt an Islamic financial model in their economic lives as a means of protecting their cultural identity and underlying moral sentiment. Some critics go as far as to argue that Islamic finance is a costly alternative to conventional banking.

However, the historical roots of Islamic finance may not be enough to sustain this argument. Over the years, Islamic financial institutions have come out of the oral tradition and successfully competed in terms of productivity and performance with conventional banks. The rapid expansion of Islamic banking and finance does not support the idea that clients and customers of Islamic banks are driven solely by moral sentiment rather than economic rationales.

The productivity and financial stability of Islamic banks have been widely documented in the existing literature. However, it can be argued that the embedded benefits of efficiency and stability are offset by the cost disadvantage of the Shari'ah-compliance model. The repetitive transactions required for a single contract as it is currently practised may be a cause of this disadvantage.

Another criticism is that the changes in the interest rate of Islamic banks closely follow the changes in the interest rate of conventional banks, leading to the conclusion that Islamic deposits are not interest-free but are closely pegged to conventional deposits. This conclusion is flawed. The fact that the Islamic deposit rate follows the conventional rate does not invalidate the proposition that Islamic deposit is based on profit and loss sharing.

Although there may be a non-stationary pattern of the Islamic deposit rate, there are strategies to neutralize the fluctuation. For example, Islamic banks offer 'hidah' rate for wadi'ah yad-dhomanah (saving account) holders, and an 'indicative profit rate' for mudaraba saving account holders. These rates are quoted by Islamic banks but are not legally committed to being paid.

The Complexities of Participatory Finance/Risk Sharing and Islamic Banks' Risk Exposure

Explore the reasons behind Islamic banks' reluctance to engage in equity-like financing and the potential consequences of encouraging high risk-taking in the industry.

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Islamic banks have been criticized for not actively participating in equity-like financing, but the reason behind this may not be as simple as it seems. Suggesting banks to take on more risk associated with participatory finance goes against the long-standing practice of the banking industry.

Regulatory agencies cannot simply encourage high risk appetite of financial institutions because the bankruptcy of a single bank can lead to an overall bank run, which in turn, through its ripple effect, may trigger a financial and economic crisis. In the case of bankruptcy of a depositary corporation, it is usually the depositors who lose their deposited amount, which leads to a loss of confidence in the financial system and disintermediation of financial resources resulting in economic slowdown.

The failure of financial institutions results in macroeconomic instability and bail out cost. Due to the huge social cost involved with the bankruptcy of depository corporations, tight regulations are put in place to prevent banks from undertaking excess credit risks.

One might argue that banks' limited liability and the existence of "quasi" flat rate deposit insurance could encourage banks to assume more risk, which is termed in the literature as "moral hazard". However, there is confusion in this story between the rescue of a bank and the rescue of the owners or managers who are responsible for the creation of the situation which creates the need for a rescue. "To the manager, it is not much of a consolation that his/her firm is saved by the government if the rescue operation involves the termination of his/her contract" (Chang 2000:782).

Even if governments do not provide explicit deposit insurance, they almost always bail out because the government cannot take its hands off in a circumstance where a large and significant number of depositors have their money at risk. In the incentive approach, solvency regulations are modeled as solutions to principal-agent problems between a public insurance system and private banks.

Given the potential financial catastrophe and loss of depositors' confidence in the financial system, it is rational to ask Islamic banks to keep away from dealing with high risk and fundamental uncertainty involved with participatory financing.

Unlocking the Potential of Participatory Finance/Risk Sharing: A Look at Division of Work and Specialization in Islamic Banks

Islamic finance has been criticized for not actively participating in equity-like financing, but the reason behind this may not be as simple as it seems. Suggesting banks to take on more risk associated with participatory finance goes against the long-standing practice of the banking industry.

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It is important to note that the agency problem embedded with musharaka and mudaraba are different, musharaka is partnership contract where agency problem is evident, whereas in mudaraba is a trust-based contract which does not involve with agency risk. The literature has not differentiated these two contracts, and it is suggested that Islamic banks should keep away from trust-based financing, as they are responsible for paying the best effort to protect the welfare of their depositors.

In a mudaraba contract, financiers 'trust' the entrepreneurs in regard to their sincerity and dedication to the project's success as well as honesty in dealing with financial information that affects the contract. However, these attributes are unobservable and require continuous monitoring.

One of the main challenges for newly established firms is their difficulty in accessing capital markets for their necessary financing. In the context of Islamic financing, they may prefer participatory financing without conditions of collateral. However, Islamic banks tend to be very conservative in engaging with young and small enterprises due to their own business strategies in terms of risk-appetite and profitability.

Islamic venture capital (VC) firms are often established by Islamic banks as their venture capital wing dedicated to venture capital financing. However, this should be modeled after special purpose entity (SPE) so that the depositors of mainstream Islamic banking operations remain unaffected by the economic outcome of the SPE. Independent VC firms are expected to become the effective vehicle to bring the risk-neutral investors into Islamic financial systems.

Furthermore, Islamic banks are facing difficulty in sharing risk and uncertainty embedded in microfinance towards marginal clients. Microfinance institutions (MFIs) such as Grameen Bank have widespread coverage in empowering the poor and are successful due to their ability to raise concessional fund from the development agencies.

In conclusion, the participatory finance and bank's risk exposure is a complex issue, and it is essential to consider the different types of contracts and the unique challenges that each poses, in order to find the right solutions.

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In conclusion, Islamic banks have been heavily criticized for their concentration on debt-like financing such as murabaha and ijara, rather than participating in more equity-like financing through musharaka and mudaraba. However, this paper argues that this is not a problem that can be easily solved through regulatory changes, as it may lead to increased risk-taking and potential financial catastrophe. Instead, the solution lies in the division of work and specialization within the Islamic banking industry. Mainstream Islamic banks should continue to focus on mark-up financing in order to protect the welfare of depositors, while independent venture capital firms and microfinance institutions can focus on equity financing and financing for marginal clients respectively. By doing so, Islamic banks can uphold the true spirit of Islamic finance through increased participatory finance without compromising the safety and stability of the banking system.

by Fatih Yürür
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