A Critical Analysis of Mudarabah & a New Approach to Equity Financing in Islamic Finance

Journal of Islamic Banking & Finance, Forthcoming

10 Pages Posted: 19 Sep 2011

Date Written: September 19, 2011

Abstract

Financial intermediation serves a valuable purpose, but it can also be structured using equity modes of financing. This can relieve the financee and increase diversity of entrepreneurial undertakings as in debt based commercial financing, there is little room for diversity with obligatory and stipulated servicing of debt. Using Islamic equity modes of financing poses the challenge of the agency problem and moral hazard. The extent of this agency problem in Mudarabah and its impact on economic payoffs between counterparties is analyzed in this study with a simulation model. Based on review of alternate solutions proposed, the author presents two possible covenants which could make Mudarabah mode of financing more acceptable and widely usable in financial intermediation. This would also further the egalitarian objectives of an Islamic economic order.

Keywords: interest free economy, Islamic economic system, Mudarabah, agency problem, moral hazard, adverse selection

JEL Classification: L38, I31, O10

Suggested Citation

Shaikh, Salman Ahmed, A Critical Analysis of Mudarabah & a New Approach to Equity Financing in Islamic Finance (September 19, 2011). Journal of Islamic Banking & Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1930173

Salman Ahmed Shaikh (Contact Author)

Islamic Economics Project ( email )

Karachi, Sindh
Pakistan

HOME PAGE: http://www.islamiceconomicsproject.com

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