Welcome back and I wish readers and the IFN team a very joyous, highly productive and extremely successful 2021, such that no one remembers 2020 beyond a nightmare, except of course for those who sadly lost their dear ones to the coronavirus pandemic. May God Almighty bless their souls and grant strength and patience to the bereaved families for their loss.
I hope that the most exciting aspect of Islamic financing and investment contracts where the risk mitigation is by default embedded in them has since gelled well with readers. Nevertheless, before I proceed to close the debate on Musharakah Mutanaqisah and move on to the next Islamic investment contract, which is the Wakalah Bi Istithmar or investment agency, I would like to share a reader’s question received last month through email, and my response for the benefit of the wider IFN audience.
The gentleman has studied a Bachelor’s degree program in Islamic finance in a Malaysian university and wanted to know what are the issues that can be found here to do research about risk management and risk mitigation in Mudarabah and Musharakah Mutanaqisah. Although we have discussed the subject in detail during the last few weeks, I thought of sharing with you the synopsis of my detailed response to him as follows which shall also double up as a refresher.
1. Equity investment risk and default risk in Mudarabah and Musharakah
The Musharakah and Mudarabah structures are exposed to capital impairment. How would an institution protect itself from such risks?
Risk mitigation
One way for an Islamic financial institution to mitigate the equity investment and default risks in a Musharakah transaction is to appoint the customer as the managing partner with a well-defined managerial scope.
In Mudarabah, the Mudarib is by default appointed the sole manager for the Mudarabah entity and is held responsible for any loss, unless he can prove his innocence.
Similarly, any loss to the Musharakah capital due to the managing partner’s negligence will protect the institution since as per the Shariah principles the institution’s equity will transform into a debt on the managing partner, hence the heavier equity risk shall be replaced with relatively lighter credit risk.
In the same manner, the loss to the Mudarabah equity due to the Mudarib’s negligence or willful default shall convert the Mudarabah capital into a debt on the Mudarib to the extent of the original Mudarabah capital.
As such, there is no denial to the importance of conducting thorough due diligence by the institution before entering into a Musharakah or a Mudarabah contract owing to the institution’s fiduciary responsibilities toward its depositors.
2. Market risk
An Islamic financial institution is exposed to market risk so long as it continues to remain a partner in a Musharakah or a Rab Al Maal in a Mudarabah with a client since the health of the institution’s equity would directly depend on the state of the Musharakah or Mudarabah business. How can the institution address such risk?
Risk mitigation
The institution can reduce the Musharakah market risk by way of entering into a diminishing Musharakah with the client whereby the other partner (client) would gradually purchase the institution’s equity on agreed-upon dates as per a schedule attached to the agreement. Any default in meeting with its purchase commitment by the customer at any time during the diminishing Musharakah tenure will transform the institution’s remaining unpurchased equity into a debt on the customer. Through this model, the institution will see its market risk gradually reduced as and when the other partner pays for the purchase of part equity on the agreed dates. In addition, in the event the client fails to pay any installment on time, such default shall convert the remainder equity into a debt on the client, ie the market risk shall be shifted into the credit risk.
As for Mudarabah, the Mudarabah agreement bears the clause to the effect that upon the completion of the Mudarabah term, the Mudarib is bound to return the Mudarabah capital to the Rab Al Maal together with the Rab Al Maal’s share of any unpaid Mudarabah profit. If the capital returned by the Mudarib is less than the original capital, the Mudarib will have to prove that this was due to a loss suffered by the Mudarabah, which was not attributed to his negligence.
The Rab Al Maal may also insert a clause in the agreement that should the Mudarib foresee during the Mudarabah tenure that the Mudarabah capital may suffer a loss in future due to market circumstances, it shall seek the Rab Al Maal’s advice whether to liquidate or continue with the Mudarabah investment. If the Mudarib did not consult with the Rab Al Maal in such a situation and continued with the Mudarabah investment which resulted in a loss to the Mudarabah capital, the Mudarib shall be responsible to make good the loss.
I will return next week to share the remaining three risks found in Mudarabah and Musharakah and how they can be mitigated. So, bye for now.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions of the Dubai Islamic Economy Development Centre, nor the official policy or position of the government of the UAE or any of its entities. The purpose of this article is not to hurt any religious sentiments either consciously or even unwittingly.
Sohail Zubairi is the senior advisor with the Dubai Islamic Economy Development Centre. He can be contacted at [email protected].
Next Week: Final points on Musharakah Mutanaqisah