Presentation Mudarabah And Agency Costs

Islamic Banking and Finance 17 February 2009 Mudarabah and Agency Costs Group Presentation of Francesco Grosso & Christine Reuther

Mudarabah Contract and Musharakah Contract in Comparison ,[object Object],Musharakah Contract (profit & loss sharing) ,[object Object],[object Object],Mudarabah Contract (profit sharing) Source of Investment Profit/ Loss Sharing Management ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],Ownership 1 2 3 4 1 2 3 4

Principal-Agent Problem Hires as manager Performs business activity Self-interest: Profit maximisation Self-interest: Consumption of perquisites, personal benefits Main features of the principal –agent problem ,[object Object],[object Object],[object Object],[object Object],[object Object],Contract Principal Agent

Mudarabah contract and pricipal-agent problem: What is the link? ,[object Object],[object Object],[object Object],Lack of linearity between reward and performance ,[object Object],[object Object],[object Object],Idiosyncratic uncertainty ,[object Object],[object Object],[object Object],Discretionary power of the agent Mudarabah contracts inherently vulnerable to principal-agency problems 1 2 3 Islamic Bank (principal) Entrepreneur (agent) Contract U O U O

Mudarabah contract and agency problem (continued): testing three hypotheses Islamic bank will accept or reject mudarabah contracts ex ante depending on the specific attributes of the project. Islamic bank will accept or reject mudarabah contracts ex ante depending on the specific attributes of the entrepreneur. Islamic bank will accept or reject mudarabah contracts ex ante depending on the compliance with shari‘ah considerations. Hypothesis 1 Hypothesis 2 Hypothesis 3 Rational ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],Rational ,[object Object],[object Object],[object Object],1 2 3

Mudarabah contract and agency problem (continued): dataset and methodology of the survey ,[object Object],Objective of the survey ,[object Object],[object Object],Dataset Methodology (hypothetico-deductive method) H 0 H 0 H 0 In accepting or rejecting a Mudaraba ex ante: H 1 -Islamic bank gives high rank to project attributes H 2 -Islamic bank gives high rank to entrepreneur’s attributes H 3 -Islamic bank gives high rank to Shari' a compliance Key variables: construction and pricing, restrictiveness, agency incidence, monitoring

Mudarabah contract and agency problem (continued): Methodology used ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],Statistical analysis (Combination of univariate and bi-variate analysis) Linear regression in the correlation matrix: explaining the chi-square significance test Y= β 0 + β 1 X 1 ± ε H 1/2/3 Key variables (nominal & ordinal variables) H 0

Main reasons that prevent Islamic banks from entering mudarabah contracts (range from 0 to 1) Reasons preventing Islamic banks from entering mudarabah contracts (range from 0 to1) Problem of Moral Hazard in Mudarabah Contract The combination of unilateral risk bearing and asymmetric information on the side of the Islamic bank provide the agent with the incentive to conceal actions taken and underreport profits made after the contract has been Completed. Level of the agent’s effort and his investment decisions determine the outcome of the investment; however, both may be unobservable to the Islamic bank.

Restrictions imposed on the agent‘s decisions by the Islamic bank (range from 0 to 1) By tightening the discretionary power of the agent the Islamic bank can increase its rate of return/ reduce its cost of capital. Restrictions imposed on the agent’s decisions by the Islamic bank (range from 0 to1) ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],Types of Shari' a compatible mudarabah contracts

Main results of the bi-variate analysis Structure of bi-variate analysis (correlation matrix) ,[object Object],[object Object],[object Object],[object Object],Interpretation of results Risk of misreporting by the agent Lack of bank’s control rights High costs required for monitoring Disadvantage in access to information Independent Variables Dependent Variable Incidence of agency problem ((1) underinvestment, (2) overinvestment, (3) personal benefit, (4) reduction of effort, (5) perks consumption) 1 2 3 4 Project attributes and entrepreneur attributes (creditworthiness & previous track records) are the most decisive factors for Islamic banks when entering and constructing mudarabah contracts.

Can shari´ah compliance reduce agency problems? Hypothesis (H 3 ) of the survey Assessment of the H 3 - hypothesis “ The adherence of the agent to Shari' a norms plays a significant role for the Islamic bank in accepting or rejecting mudarabah contract decisions ex ante.” ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],The structured variables used to assess this H 3 cannot be measured quantitatively since the agent’s adherence to religion is an abstract concept. Hypothesis Rational A correlation matrix based on highly disputable variables, such as religion and ethics parameters, cannot be declared valid at all, even if the significance of the regression (p=0.0000) was the minimum obtainable. Argumentation Consequence

Mudarabah contracts in practice: case study of Bank Islam Malaysia Berhard (2005) Customer deposits by type of contract 3.Q 2005 (in USD) Performing financing by type of contract 3.Q 2005 (in USD) Performing financing by type of contract 3.Q 2005 (in %) Customer deposits by type of contract 3.Q 2005 (in %) Non-Mudarabah contract Mudarabah contract 43% 57% 70% 15% Bai’ Bithaman Ajil Murabahah Qard al-Hasan Musharakah: 0.5% Mudarabah: 0.1% Others: 0.4% Ijarah Bai al-Inah 9% 3% 2%

Case study of Bank Islam Malaysia Berhard (continued): Performing Financing by sector of investment 3.Q 2005 (in USD)

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