1. University of Sarajevo
School of Economics and Business
University of Bolton
MASTER’S DISSERTATION
Agency problem in implementation of Mudaraba
Case example of Bosnia and Herzegovina market
KEMAL KEČO
SUPERVISOR: DOC. DR. VELID EFENDIĆ
Sarajevo, October 2016.
2. University of Sarajevo
School of Economics and Business
University of Bolton
MASTER’S DISSERTATION
Agency problem in implementation of Mudaraba
Case example of Bosnia and Herzegovina market
KEMAL KEČO
SUPERVISOR: DOC. DR. VELID EFENDIĆ
Abstract: Considering the fact that Islamic banks' main goal is to replace models of banking business which
are based on interest with profit-sharing modes of financing on both asset and liability side, there are some
banking products and financing models which are specific for Islamic banking business. To be more precise,
in business of Islamic banks large part of assets are financed by Mudaraba model of financing. However, due
to different types of problems the bank faced using Mudaraba financing, agency problem being one of them,
different fixed income models for financing have been developed in Islamic banks. These problems have not
been avoided by Islamic banking sector in Bosnia and Herzegovina as well, which is the reason why this
particular market will be used as case example in this research paper. Methodology used in this research is
descriptive or qualitative research. Primary data has been collected and analyzed on the market of Bosnia and
Herzegovina. Theoretical background and research showed that implementation of Mudaraba is limited
mostly by agency problems on the market. Researches and efforts done in past have not solved the agency
problems, when a model such as Mudaraba is implemented on the market.
Sarajevo, October 2016.
3. i
STATEMENT OF COPYRIGHT
The undersigned Kemal Kečo, a student at the University of Sarajevo, School of
Economics and Business (hereafter: SEBS) and University of Bolton, (hereafter: UoB),
declare that I am the author of the master’s dissertation entitled “Agency Problem in
Implementation of Mudaraba: Case Example of Bosnia and Herzegovina Market”, written
under supervision of Doc. Dr. Velid Efendić.
In accordance with the Copyright and Related Rights Act I allow the text of my master’s
dissertation to be published on the SEBS and UoB website.
I further declare:
the text of my master’s thesis to be based on the results of my own research;
the text of my master’s thesis to be language-edited and technically in adherence
with the SEBS’s and UoB's Technical Guidelines for Written Works which means
that I cited and / or quoted works and opinions of other authors in my master’s
thesis in accordance with the SEBS’s and UoB's Technical Guidelines for Written
Works;
to be aware of the fact that plagiarism (in written or graphical form) is a criminal
offence and can be prosecuted in accordance with the Copyright and Related Rights
Act
to be aware of the consequences a proven plagiarism charge based on the submitted
master’s dissertation could have for my status at the SEBS and UoB in accordance
with the relevant SEBS and UoB Rules on Master’s Thesis.
_________________
Sarajevo, October 17th
, 2016 Author: Kemal Kečo
4. ii
ACKNOWLEDGEMENTS
First and foremost, I express my deepest gratefulness to God, for the blessing of
successfully completing this project. I thank Him for endowing me with health, patience
and knowledge to complete this work.
I dedicate this master’s dissertation to my dear parents, Samir and Azbeina Kečo, and my
sister Emina. I acknowledge my sincere indebtedness and gratitude to them. I cannot find
proper words to describe my appreciation for their devotion and faith in my abilities and
attainment of my goals. Thank you for your support, prayers, love, sacrifice and patience.
You raised me to be the man I am today and you will never leave my thoughts and prayers.
I also wish to dedicate this dissertation to my wonderful wife, Selmina Kečo. Your
support, love and encouragement gave me strength and inspiration in attainment of my
goals every step of the way, since the day I met you. With you beside me I am a better
man.
I would like to express sincerest gratitude to:
My master’s dissertation supervisor and mentor Prof. Velid Efendić, for guiding me
through the process, unselfishly sharing his knowledge and experience and devoting his
time and effort. Prof. Fikret Hadžić and Prof. Sabri Muhammad for devoting their time and
effort so that I can increase quality of my work and knowledge.
All the professors and staff at the University of Sarajevo and the University of Bolton for
their support and dedication.
Bosna Bank International for supporting my master’s education.
My friends, employers, managers and colleagues for their support and efforts to make this
journey as easier for me as possible.
Kemal Kečo
Sarajevo, 2016
5. iii
TABLE OF CONTENTS
CHAPTER ONE: Introduction.......................................................................................... 1
1.1 Background.................................................................................................................. 2
1.2 Research Motivation.................................................................................................... 3
1.3 Research Objectives and Hypothesis........................................................................... 4
1.4 Research contribution .................................................................................................. 4
1.5 Research Methodology ................................................................................................ 4
1.6 Overview of Dissertation............................................................................................. 5
CHAPTER TWO: Theoretical Framework: Agency Problems in Financing............... 7
2.1 Introduction.................................................................................................................. 8
2.2 Overview of Agency Problems in Financing............................................................... 8
2.3 Agency Problems in Islamic Financing..................................................................... 10
2.4 Agency Problems in Mudaraba Financing Model ..................................................... 13
2.5 Conclusion ................................................................................................................. 15
CHAPTER THREE: Literature Review......................................................................... 16
3.1 Introduction................................................................................................................ 17
3.2 Literature on Implementation of Mudaraba............................................................... 17
3.3 Literature on Agency Problems ................................................................................. 21
3.4 Conclusion ................................................................................................................. 24
CHAPTER FOUR: Islamic Banking in Bosnia And Herzegovina ............................... 25
4.1 Introduction................................................................................................................ 26
4.2 Banking sector of Bosnia and Herzegovina............................................................... 26
4.3 Islamic Finance and Banking Development in Bosnia and Herzegovina.................. 28
4.4 Conclusion ................................................................................................................. 30
CHAPTER FIVE: Research Methodology ..................................................................... 31
5.1 Research Philosophy.................................................................................................. 32
5.2 Research Methodology .............................................................................................. 32
5.3 Research Strategy ...................................................................................................... 32
5.4 Research Design ........................................................................................................ 33
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5.5 Research Data Collection and Analysis..................................................................... 33
5.6. Sample Selection....................................................................................................... 33
5.7 Questionnaire and Interview...................................................................................... 34
5.8 Research Limitations ................................................................................................. 36
CHAPTER SIX: Research: Findings and Analysis........................................................ 37
6.1 Respondents’ Profile.................................................................................................. 38
6.2 Past and Future Financing Plans and Experiences..................................................... 40
6.3 Adverse Choice and “Ex Ante” Moral peril .............................................................. 42
6.4 Sharing of Information and Financial Data Between Company and Financier......... 44
6.5 Overseeing of Decision Making of Agent From the Side of Financier..................... 46
6.6 Ethical Standards and Place of Sharia ....................................................................... 48
6.7 Conclusions and Policy Implications......................................................................... 50
CHAPTER SEVEN: Recommendations for Future Research and Conclusion .......... 52
7.1 Recommendations for Future Research..................................................................... 53
7.2 Conclusion ................................................................................................................. 54
REFERENCES
APPENDIX
7. v
LIST OF TABLES AND GRAPHS
Table 1: Summary of B&H banking sector, 2015…………………………………………27
Table 2: Survey respondents profile…………………………………………………….....39
Table 3: Statistics of past and planned financing………………………………………….40
Table 4: Reference statement……………………………………………………………...43
Table 5: Willingness towards information sharing………………………………………..44
Table 6: Ethical standards in financing and investments………………………………….48
Graph 1: Expected form of controls in financing projects………………………………...41
Graph 2: Willingness to share information with financier regarding costs………………..46
Graph 3: Willingness to allow overseeing of decision making……………………………47
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1.1 Background
Agency theory, also called principal-agent relationship, has been defined as a theory in
which a certain person (principal) through contract, allows and engages another person (the
agent) in order for him to perform certain duties for the principal and also accept some
delegation of decision making (Bonazzi & Islam, 2007). Several things can cause problems
to arise in this type of relationship, some of the main are occurrence of different goals and
objectives between agent and principal, difficulties for principal to access precise
information and agent behavior, lack of alignment of goals and actions, conflict of
behavior, moral hazard, adverse selection with signaling and screening. These problems
transfer also to Islamic financial institutions. Irresponsible actions and decisions of agents
in using money of principal, monitoring problems, non-performance according to Sharia
laws and non-disclosure of full information are also problems faced in Islamic finance
agency contracts (Shamsuddin & Ismail, 2013).
When we take example of Mudaraba, as a financial contract which is based on principles
that project is owned by those who provide capital, managed by entrepreneur, results are
divided by the two parties, but the manager or entrepreneur has control over the
information which are tied to outcome of business activities performed on the project;
authors agree that the manager may get an incentive to report performance of project
falsely and therefore keep the larger share of profits for himself. This, however, is only one
possible scenario in which the agent (manager) can misuse his function. From the
perspective of principal (owner of capital) manager has much opportunities to misuse his
position and information over which he has control and keeps private.
On the other hand, entrepreneurs themselves have their reasons why they do not prefer
contracts such as Mudaraba. These reasons include: necessity to constantly keep and
provide for insight details records, facing hardship in expanding a business financed
through Mudaraba because of limitations in reinvesting earnings and acquiring additional
funds, the manager cannot become an owner of the project in short-term. Similarly, banks
also choose fixed return models of financing instead of models like Mudaraba since it is
not necessary to monitor them as closely, invest money in monitoring staff and procedures
and lack of information about the abilities of the entrepreneur (Iqbal & Molyneux, 2005).
10. 3
Agency problems are even greater and extend more in Islamic finance due to the fact that
interest is forbidden. Islamic principles which stand behind agency contract lead to some
specific agency relationships. Traditional agency problems in which managers try to avoid
their duty to maximize profit of shareholders is now increased by tendency of managers to
work with funds in a way which is not Sharia compliant. Agency problems faced by
Islamic financial institutions are even more complicated than those which conventional
banks face and that is why they deserve special attention and investigation. These can
extremely affect credibility of Islamic bank and may lead to loss and decreased number of
investors (Safieddine, 2009).
Islamic finance market, with emphasis on Islamic banking is developing rapidly in the
market of Bosnia and Herzegovina. Since one of the main models of financing for Islamic
bank is based on principal-agent relationship (Mudaraba), Bosna Bank International, the
only bank now working on but being unable to implement all the principles of Islamic
banking on the market of B&H, has to be aware of the common problems which arise
between managers and shareholders or investors.
1.2 Research Motivation
Motivation for this dissertation is to explore how agency problem influence
implementation of Mudaraba. Doing the survey and providing theoretical background
related to agency problems in Mudaraba, dissertation will prove the arguments vital for
process of implementation of Mudaraba, with emphasize on example of Bosnia and
Herzegovina. Purpose of the research is also to provide valuable feedback from selected
companies in B&H market, as case example market in this research, which operate in
different industries in order to see how important this issue is in implementation of pure
Mudaraba principles. Interviews with relevant personnel from BBI bank on this topic will
also be done. Aim of this dissertation is to provide valuable insights directly from the
market, and help in future development and implementation of Islamic finance products,
specifically Mudaraba.
11. 4
1.3 Research Objectives and Hypothesis
Principal objectives of this master’s dissertation are as follows:
Objective 1: Provide in depth analysis of agency problems in Mudaraba financing
Objective 2: Make an Empirical research on the market of Bosnia and Herzegovina
regarding agency problems in Mudaraba financing
Objective 3: Explore problems and issues to be considered in future
Objective 4: Provide answers, solutions and recommendations for the
implementation of Mudaraba in the market of B&H
Hypothesis of this dissertation is:
Implementation of Mudaraba is limited mostly because of agency problems.
1.4 Research Contribution
This research provides contribution both in theory and practice. Theoretical background
that dissertation provides serves as a good basis and contribution for future investigations
on this topic in the market of Bosnia and Herzegovina especially. Regarding the practical
part survey done on the market of Bosnia and Herzegovina stand as contribution in that
direction. For the first time, direct feedback from the companies on the local market has
been collected regarding topic of agency problems. Results of that research show valid
concerns and recommendations for future actions if there is a goal for implementation of
Mudarabah in Bosnia and Herzegovina. Because of previous stated reasons, this
dissertation contributes to both theoreticians and practioners in the industry of Islamic
banking, with emphasize on the local market of Bosnia and Herzegovina.
1.5 Research Methodology
Methodology used in dissertation descriptive or qualitative research. In the first part of the
research paper, theoretical research results will be provided, presenting the background of
12. 5
the problem we are exploring. Published documents, articles, papers and books will be
reviewed in order to deliver results for this part of paper.
Second part of the dissertation uses qualitative research methods, specifically survey and
interviews. Survey will be distributed to companies which operate in different sectors in
Bosnia and Herzegovina and will test the hypothesis presented in this research. Sample of
companies for this survey will be determined based on the performance of the companies
in their respective industries. Performance determinants will be based on growth tendency
of companies, their investments in development in past 5 years and plans for future
investments and development. Sample will include up to 50 different companies from
different industries.
Interviews will also be used in the process of confirmation of hypothesis stated. Interviews
will be done with key personnel from Bosnia Bank International in charge of implementing
and monitoring of financial products provided by the bank. The results and responses will
be analyzed quantitatively and statistically, and will be presented and explained in a
qualitative manner.
1.6 Overview of Dissertation
Structure of the dissertation will consist of the following. It will start with the introduction
which will give brief overview of what the research is all about and will present to a reader
what to expect from the paper ahead.
After the introduction part, first part of dissertation will present data on theory of agency
problems in financial sector. This will be a theoretical part consisting of three parts. First
part will present a general overview of agency problems in financing, providing opinions
of authors, researchers and data on agency problems in financing in general. This will be
followed by part which will put more emphasis on agency problems in Islamic finance
specifically. It will present some specific problems related to Islamic finance only and will
be followed by even more specific presentation of agency problems in Mudaraba financing
model.
Second part of the research will present overview of literature focused on two main points.
First one is implementation of Mudaraba and the second one is agency problem itself. This
13. 6
part will provide the overview and examples of putting Mudaraba model in practice,
obstacles it faces and prove that agency problem is a dominant one in implementation of
Mudaraba.
Having in mind that market of Bosnia and Herzegovina has been chosen as a case example
market for this research, third part of it will be focused on Islamic banking sector of B&H.
This part will provide overview of banking sector of B&H, followed by and overview of
development of Islamic finance in B&H and concluded with overview of Islamic banking
sector in the country.
Part of the research will also be a questionnaire and interviews. Fourth part will describe
the sample chosen for the questionnaire, the questionnaire itself and research methodology
in details. After that, the fifth part will provide results and conclusion of this research from
the market and interviews done.
The paper will be finished with overall conclusion and recommendations for future
research. References and appendix will also be added at the end of paper.
15. 8
2.1 Introduction
Agency problems are something that has been analyzed through decades, not only related
to Islamic financing, but to business concept and everyday business life overall. Problems,
changes and consequences agency problems brought to business environment are
constantly being analyzed and monitored in order to try and find the best way possible to
deal with the effects of them.
First part of dissertation will provide a theoretical framework of agency problem in general
in financing and then with focus on Islamic finance and Mudaraba. This is the topic on
which many authors have worked on and some of the main conclusions and observations
will be presented here.
2.2 Overview of Agency Problems in Financing
Industries, businesses and companies worldwide are based on various forms of structure.
Based on those structures within companies and division of work and responsibilities,
various situations are encountered on daily basis, many of which contain problems of
bigger or smaller volume. Agency, as a form of relationship in business conduct is one of
the forms which brings both benefits and problems to those involved. Since we are focused
on strictly business environment in this paper we will first define the term “agency” from
business perspective. Web Finance Inc. (2016) defines agency as „fiduciary relationship
between two parties in which one (the 'agent') is under the control of (is obligated to) the
other (the 'principal'). The agent is authorized by the principal to perform certain acts, for
and on behalf of the principal. The principal is bound by the acts of the agent, performed in
carrying out entrusted duties and within the scope of agent's authority”. Even though
defined as fiduciary (special relationship of trust and confidence), agency relationship
brings its own burdens and problems.
Agency problem is defined as a conflict between interests and goals of parties involved
within a firm. These parties are usually stockholders, bondholders and managers (agents)
themselves (Lee & Lee, 2006). Almost every contractual relationship in which one party
(agent) offers and promises some sort of performance and actions to another party
(principal) has a potential to contain agency problems (Armour, et al., 2009).
Ibrahimy and Ahmad (2012) state that primary cause of problems in agency relationship is
division of control and ownership in modern-days companies. This division of control and
16. 9
ownership is basically a division between the decision-making, risk and consequences
associated with the decisions made which brings agency problems on the surface. Ibrahimy
and Ahmad (2012) also bring observation of other authors throughout the 20th century
who also state that problems in agency relationship are key factor for existence of many
problems, arising from the view of the firm itself. In order to try and prevent agency
problems from happening, compensation rules and policies have been established by firms.
However, directors, due to different pressures they face, are not very keen to pay to the
executives amounts they require; on the other side, they are also not imposing penalties for
performance below expected. This averseness in the long run has led pay-performance
relation downward which basically isolated payment system from some key factors which
should influence it.
The problem which arises in principal-agent relations leads to agency cost, a burden which
lays on the back of shareholders. Agency costs are the costs of both perceptible and
imperceptible nature which shareholders pay because of actions and doings of managers
which are not in the interest of the company but rather self-serving. These costs can be
divided to direct and implicit. Direct costs include verifications and auditing process of
financial statements in order to determine their correctness, tracking of doings of manager
by board or independent advisors and etc. Implicit costs on the other hand may include
different types of limitations directed to limit actions of managers (e.g. votes of
shareholders for important decisions). On the bottom line, result of managerial behavior
which is characterized as self-serving and result of efforts put by shareholders to prevent or
at least limit this type of managerial behavior reduces the value of the firm overall. This
later leads to skepticism on the side of investors because they are not willing to pay money
and invest in firm which has these types of problems causing negative influence on the
firm’s value. This usually leads to rise in conflicts of interest between the parties involved
(managers, stockholders, bondholders) which add up on agency cost due to the process and
different investment necessary to solve these conflicts. At the bottom line, stockholders are
those who pay for these agency costs (Lee & Lee, 2006).
Agency problems can also be observed in lending where adverse choice and ethical risks
are two main problems faced. Adverse choice is a problem which occurs when a lender has
trouble to find quality information about potential future borrowers and due to that is
unable to divide risky from non-risky borrowers. Ethical risks on the other hand is related
to situation in which a borrower makes some unobservable choices, which may for
17. 10
example include withhold of important information, and this ethical risk can be divided to
either being ex ante or ex post (actions before or after). After the final stage of the project
there are additional problems which may occur, such as borrower (agent) not disclosing
profitability of the project or running away from the loan (Armendariz & Morduch, 2007).
Armour, et al. (2009), explain further on that due to the fact that agent has, in most cases,
much better and more relevant information regarding certain relevant facts, than principal
has; the principal cannot be completely sure that agent has performed according to what he
has promised. The agent has the opportunity here, and in many cases acts with bad faith
and diverts for himself what was supposed to belong to principal or improve the status of
the firm. This leads to conclusion that or directly or because quality of agents’ work needs
to be assured, principal has to focus on monitoring agent, which is costly process, value of
performance of agent to the principal will be decreased. If a complexity of the task done by
agent is higher, discretion and rights given to agent have to be higher which leads to bigger
agency costs and problems. Armour, et al. (2009) further on distinguish three types of
agency problems which can arise. The first problem is reflected in the conflict between the
owner of the capital or firm and managers hired; problem is in the fact that managers need
to be assured to pursue interests of capital owners rather than their own. Second problem
lies in the conflict between those owners who have majority and control firm’s interests
and non-controlling part. In the second case controlling part acts as agent and it needs to be
assured that those who have majority and control do not expropriate the minority. Third
agency problem is in relation between firm and owners of capital itself with other parties
which include employees, customers and creditors. In the third case assurance needs to be
made that owners of the capital and firm do not act opportunistically towards these other
parties.
2.3 Agency Problems in Islamic Financing
Agency problems in Islamic financing deserve separate analysis from the conventional
financing for a number of reasons. First reason is obvious and represented in the very
nature of operations of Islamic financial institutions which separates them from
conventional firms and poses widened issue of differentiation of ownership and control,
which lay in the basis of agency theory. The main source of differentiation is contained in
the fact that managers of Islamic financial institutions and other firms have a responsibility
18. 11
to achieve objectives presented to them by shareholders in a Sharia compliant manner. In
Islamic financing managers must achieve maximization in value of investments by obeying
rules of Sharia as well which poses a whole new perspective for agency behavior and
decisions (Archer, et al., 1998).
Safieddine (2009) confirms this in a research done more than decade later. He states that
while in conventional firms agency problems occur when managers (agents) fail to do their
duty and maximize capital of shareholders; in Islamic financial institutions any
misplacement of funds into investments not compliant by Sharia creates additional agency
problems source. Islamic banks also face something which goes beyond compliance with
the Sharia rule. This is prohibition of interest (Riba). Islamic banks, in contrast with
conventional financial institution, pays a return to depositor of funds based on the
profitability of the bank. Here, additional agency problem and risks arises which is
existence of space for manipulation of payouts to depositors of the funds. Based on
conducted overview of literature author concludes that in the example of Islamic financial
institutions, well-known and traditional agency problem of managers and their tendency
not to fulfill properly their duty of maximizing shareholders wealth, is increased by the risk
of managing funds in a way which is not Sharia compliant, and also division of flow of
money and control rights for depositors.
This separation of cash flow and control rights brings much higher agency costs. Following
this line it is concluded that agency and its relationships and configurations in Islamic
financing are more complex than those faced by conventional institutions, which means
that they require special analysis. The need for this exists because those mechanisms in
charge of solving agency problems in conventional financing might not be enough to
protect the interests of shareholders in Islamic financing (Bebchuk, et al., 2008).
Dar and Presley (2001) conclude that existence of agency problems and lack of balance
which exists between management and control rights is considered to be one the major
causes why PLS (profit loss sharing) models in Islamic finance are not present as much as
they should be. With the agency problems in the picture this puts PLS models of financing
in a disadvantaged position comparing to other modes of financing. Because of these facts
many Islamic financial institutions offer products which are similar to conventional
financing products, while at the same time Sharia compliant; authors conclude that higher
19. 12
complexity of Islamic financial institutions and their products and all the agency problems
lower efficiency of Islamic banks (Beck, et al., 2010).
Another important factor to be considered, which influences negatively on implementation
of profit-sharing modes of financing in Islamic financial institutions, is the moral hazard
problem. This problem is identified in changes done by entrepreneur upon receiving the
funds from financial institution. In these profit-sharing modes of financing in Islamic
financial institutions, moral hazard harms are quite parallel to the problems found in
agency relationship in conventional financing, taking form of principal-agent problems and
issues which can be recognized in equity agreements (Iqbal & Llewellyn, 2002).
Iqbal and Llewellyn (2002) further on state other problems related to agency relationship
in Islamic financing. These problems include incentive issues, which is basically a key
point which allows principal to rely on agent to fulfill actions in the best interest of
principal. However, in this case as well agent has superior information and can choose his
behavior even after the contract has been signed and agreed. Agency problem in Islamic
finance also arises because the agent cannot be monitored properly without high costs
included.
Profit-loss sharing contracts in Islamic finance, reserved strictly for business instead of
consumer financing, are structured in a manner that financiers bare all the losses from
financial perspective. This brings huge and serious agency problems in these financial
contracts and arrangements. Fact that profits will be shared between financier and agent
does not bring anything positive to the equation either because the financier cannot know
for sure, or without big difficulties, what the real profit is. Following this path of problems,
negligence done on purpose by the agent is quite difficult to prove and even though a
financier involves himself in that proves it is quite costly and time consuming. In other
types of financing, one in which financier and receiver of funds share profit and loss
(Musharakah) difficulties are in the fact that Islamic law does not permit collateral because
that would negatively influence idea of partnership (Visser, 2009).
Some other agency problems which are present in Islamic financing and are part of
conventional financing as well include: conflict of goals, conflict of behavior (principal
cannot perfectly monitor behavior of agent) and conflict of information asymmetry.
Islamic financing also includes these problems even though contracts are in terms of joint
venture and equity participation (Shamsuddin & Ismail, 2013).
20. 13
Only basic overview of agency problems in Islamic financing has been presented in this
part of the paper. Different models of financing are based on different rules and terms and
have their own problems in agency relationships. More detailed overview and explanation
will be offered in the following part with emphasis on particular financing model of
Mudaraba.
2.4 Agency Problems in Mudaraba Financing Model
Having presented agency problems in conventional and Islamic financing, we will focus
now on specific problems in agency relationship in Mudaraba model of financing.
Mudaraba as financing model of Islamic financial institutions has characteristics of both
equity and debt. In this particular financing model Sharia prohibits Rab-Ul-Mal to affect
the business operations but oblige him to absorb all the losses, it can be proved that
Mudaraba faces agency problems higher than debt and equity in conventional financing.
Agency problems of equity can be seen in the fact that profits in Mudaraba also will be
shared, and profits are calculated as revenue minus cost. That is why Mudarib (agent) will
have desire to increase the cost which add on to his benefit. On the other side, agency
problems faced by Mudaraba are higher than debt financing in conventional financing
system. This can be shown on simple example that in Mudaraba there is much higher
incentive to work on projects with higher risk than it is the case in debt financing, because
Rab-Ul-Mal takes on his account all the losses (Bacha, 1997).
Samad, et al. (2005) also quote Bacha and confirm his theory and define Mudaraba as a
hybrid model, having features of both equity and debt but it is none of those two fully. In
this model of financing Islamic bank has no direct participation in decisions of
management and it relies fully on the entrepreneur who runs the business capital is
invested in. This entrepreneur is in fact agent and because of this relationship and rules this
model of financing is subject to agency problems. Agency problems faced in Mudaraba
financing model become acute when bank has no or only a little access to accounting
information relevant to business invested in, due to different reasons such as non-existence
of standardized financial reporting and rules and procedures. Agency problems combined
in Mudaraba financing model, alongside with lack of proper financial data, complicate
implementation of this and similar forms of financing by Islamic banks and encourage debt
over equity financing. Authors state another important factor to be considered which is
privacy and confidentiality. Entrepreneurs (agents) are in general people who guard the
21. 14
information they possess jealously. Mudaraba model requires from agent to disclose all
information of business operation. This fact can create concern in minds of many
entrepreneurs who prefer to keep information to themselves and not disclose them easily.
These concerns influence the demand for Mudaraba models of financing.
Many authors argue that if agent is put into a proper incentives scheme, problems would be
avoided. This is exactly what Mudaraba financing does, allowing entrepreneurs to
participate more in a profit share and align their incentives on a higher level with those of
shareholders. However, even though a good model in theory, there is a huge challenge
faced by Islamic banks to adapt this model to a range of conflicts in interest which exist in
business world (Iqbal & Lewis, 2009).
Greuning and Iqbal (2008) state that use of Mudaraba increase moral hazard problems
financial institution faces. Islamic bank is the one who bears all the losses if the results are
negative, it cannot force mudarib (agent) in any way, to achieve outcome the bank desires.
Agents can exploit these types of situations and especcially when bank has no right to track
or participate in project management. Mudaraba model exposes Islamic bank to agency
problems in a way that mudarib (agent) increases the expenditures and increase
consumption of non-important benefits to the expense of the important one. Agent is the
one who enjoys the benefits while the banks partially bears the costs.
In their analysis of profit loss sharing contracts such as Mudaraba and agency problems
which occur in it Khalil, et al. (2002), include problems such as overconsumption of
resources by agent, false reporting of profits and avoidance of risk and lack of proper effort
by agent. Research has shown that three most important agency problems faced in
Mudaraba financing arise from attributes of project, quality of agent employed and
respecting of Sharia. Khalil, et al. (2002) further state three features of Mudaraba which
are distinctive and lead to agency problems. These three features are: risk, extreme
linearity and discretionary power. Risk is part of profit-sharing contracts and the return and
earnings of the bank depend only on reported cash flows from the activities. These
operating activities depend on decisions made by agent in everyday business. Fact that
agent is not supervised on daily basis increases risk of agency problems. Second feature,
extreme linearity, is basically sharing between compensations and results of the projects.
However, in the process of realization of the project the agent enjoys certain benefits
which bring cost to both parties but benefits only to agent. Third feature is discretionary
22. 15
power. Agent is the one who is in charge of running the project and making decision on
daily basis. This provides a full discretion over the assets to agent but the agent des not
bare losses.
We will mention some factors which are searched in the personality of agent for Mudaraba
contract to be more successful and face less agency problems. Based on the research done
by Adnan and Muhammad (2008) these factors include: agent possessing skill in related
business, knowing the market, knowledge on how to correct risk in business, business
background of the family, commitment to job, articulation of particular language, business
habits and having own business, track record, ability to predict risk in business and etc.
2.5 Conclusion
This section has presented some basic risks and agency problems faced in Mudaraba
financing. Several problems arising from agency relationship have been identified in this
section of the dissertation. Many problems are common for both conventional and Islamic
finance, while Islamic finance has its own set of problems as well such as Shariah aspect of
agent-principal relationship. Division of control and ownership, agency costs (direct and
implicit), adverse choice and ethical risk, profit-loss sharing, lack of balance between
management and control rights, moral hazard problems, conflict of goals and behaviors,
lack of proper efforts by agent and false reporting are only some of the main agency
problems identified by authors and analyzed in this part. Secondary data analysis in this
part provide structured overview on agency problems from perspective of both
conventional and Islamic finance as well as Mudaraba model of financing.
24. 17
3.1 Introduction
With the first formal establishment of Islamic banking back in 1970s it was believed that
Islamic banking will bring significant alternative to conventional banking, based especially
on the Mudaraba model of financing. Promoters of Islamic banking believed that profit-
loss sharing model of Mudaraba would bring alternative which would shift people from
using interest based banking to Islamic banking. However, a few decades later, it is visible
that some other models, e.g. Murabaha, based on fixed income and short term investment
are much more dominant in Islamic banking sector. Many different reasons have been
presented as an explanation to why the profit-loss sharing model such as Mudaraba is not
as successful as it was predicted. Most prominent and significant reasons are contained in
the agency problems which Islamic financial institutions face.
3.2 Literature on Implementation of Mudaraba
This section of the paper will put its focus on implementation of Mudaraba financing
model and problems and constraints it faces due to agency problems which occurr. We will
not go into too much details defining Mudaraba here, however we will mention a few
important characteristics of this model.
AAOIFI (2016) defines Mudaraba as a contract in business in which one party invests
capital for doing business and other party invests effort, profit is shared proportionally
based on agreement and loss is bared only by financier. However, in case of loss the
entrepreneur has no reward for his effort invested. In theory, this model is supposed to be
the basis for Islamic re-organization of commercial banking. This is only in theory, in
practice Mudaraba has not made much progress, especially on the asset side of bank’s
balance sheet. Even though it is not the most accurate translation, Mudaraba is translated in
English as profit-loss sharing contract.
Entrepreneur cannot guarantee any profits, entering into Mudaraba contract. Important fact
to mention also is that there are two types of Mudaraba contract: unrestricted Mudaraba
contract (entrepreneur has no restrictions in management of funds) and restricted
Mudaraba contract (specific restrictions are imposed on management of capital). Mudaraba
is represented both on liability and asset side of the bank. On liability side it is in form of
unrestricted Mudaraba where those who deposit their money give freedom to the bank to
invest it according to their predictions, on the asset side however, it is restricted Mudaraba
because bank finances certain project with some restrictions involved (Siddiqui, 2008).
25. 18
In theory, this model looks great, it is supposed to be basis for Islamic re-organization of
banking. However, in practice, problems occur which make this much harder than
expected. Agency problem being one of the major ones.
A number of reason exists for lack of PLS (profit loss sharing) contracts, Mudaraba being
one of them. First reason authors emphasize is agency problem. These types of contracts
are very vulnerable to agency problems, managers (agents) put in less effort but have
incentive at the same time to report profit less than it actually is, and keep as much funds to
themselves as they can (Dar & Presley, 2001).
Sarker (2015) states several, precisely agency problems, which influence implementation
of Mudaraba financing model and other PLS models as well. First problem faced by the
Islamic financial institution is to choose the investor most appropriate for investment of
funds. All the investors present their projects as if they possess the best quality for
potential investment, but hiding important inside information only they can know. This can
lead to investment of funds in high risk projects. Islamic banks, in order to avoid moral
hazard and adverse selection invests more funds in information-gathering process of
choosing investors and managers. This decreases incentives for managers and makes
Mudaraba less competitive on the market, comparing to conventional financing products.
Third problem which makes Mudaraba implementation more difficult and riskier is under-
reporting and declaring false profit amounts by managers and Islamic banks have to
include costly tracking in order to prevent this.
Businesses have certain tactics to avoid even this monitoring done by the bank. Example
from Pakistan market shows that. Many businesses there possess several books of account
which makes a difficult job for a bank to monitor and find a proper one. Because of
asymmetry in information such as this one, risks and monitoring cots of proper Mudaraba
implementation increase (Siddiqui, 2008).
Abd Razak (2006) also states that in contrast to theory there is not much true Mudaraba
practice in real-life experience. There are different explanations and reasons for this of
course but the author implies that a main reason for this are agency problems. Mudaraba
and other PLS contracts as well are sensitive and vulnerable towards agency problems.
Manager (agent) has an incentive to exclude others form sharing profit as much as he can
while at the same time he is not willing to take risk for capital invested which makes
Mudaraba less attractive for investments in practice even though maybe manager is fully
26. 19
capable to do the job and the principal would be satisfied. High costs incurred in
monitoring make this model even less attractive.
Implementation of Mudaraba is hardened even more by the fact that contract nature and
rules do not allow bank to monitor the agent appropriately or to participate in running of
the project. These things make it difficult for a bank to predict or manage financial risks of
the project invested in appropriately. Bank is not in a good position to be able to know
about doings of the manager (agent), nor in position to decide how to monitor his behavior
especially if the losses have been made. This type of risk is happening in the markets
where there is high degree of asymmetry of information and low level of disclosing of
needed financial information by manager. In case that manager’s actions are proven as
misconduct further complications arise because bank cannot recover debt by rules of
Mudaraba. Banks holds a fiduciary risk as well towards the depositors of funds. This risk
leads to the possibility that bank can be faced with legal actions against it. If the bank is
exposed negatively too much with its relations with the agent and inability to monitor his
actions properly, it faces risks from losing funds and failure to perform according to
standards connected to its fiduciary responsibility (Shodiq, 2012).
Adnan & Muhammad (2008) conducted a study after realizing that there is very low
percentage of Mudaraba financing in practice, compared to other financing products of
Islamic banks which is why many critics have been expressed on the topic of Islamic
banking operations. Among the top concern of non-implementation of Mudaraba in a way
it should be done is high potential for agency problems connected with modern
investments. This topic was raised long back by Jensen and Mechkling (1976) who also
proposed two methods to solve agency risk, one is monitoring of agent (method we
mentioned earlier along with constraints and costs it brings) and the second one is to bond
agent to a positive outcomes.
In analysis of Mudaraba, Shaikh (2011), states that agency problems are one of the main
reasons for lack of full and proper implementation of Mudaraba. He states that for the
agent, Mudaraba model is preferable, but it is completely opposite for the financier. In his
paper he quotes State Bank of Pakistan which commented on this issue in its report on
“Financial stability review for 2007/8” where it is stated that: “In fact, the agency problem
is 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.” (p. 7,
27. 20
Chapter 8). Agency problem Mudaraba has is described as a chronicle one by Rosly and
Zaini (2008), a problem which prevents Mudaraba from its full implementation in amount
it should be present.
Agency problems and problems we mentioned as a part of it such as asymmetry of
information, moral peril and adversarial selection has led to low use of ‘profit-sharing’
finance. This is exactly the reason why Mudaraba is not present as much as it should be in
portfolio of Islamic banks as other structures with fixed return models are (Durrani &
Boocock, 2006).
In an interview done with representative of Bosna Bank International (BBI), agency risks
are mentioned as one of the main reasons why the only bank in Bosnia and Herzegovina
conducting its operation by Islamic banking principles, has not yet implemented and does
not plan to implement Mudharaba anytime soon. He also confirms that for manager and
agent, Mudharaba is a preferable model of financing, however, for bank it is not at the
moment. With moral hazard agency problems included and lack of legal security in the
society overall, Mudaraba is not even planned for implementation. In his opinion,
Mudaraba can only be implemented in highly controlled surroundings which are hard to
find and establish. Risk of investment and management of funds in a way which is not in
accordance to Islam, lack of trust towards the manager/agent due to their opinion that
financier dies not have to be included fully in everyday business decisions and lack of
readiness to fully disclose and share profits with the bank are only some of the reasins why
Mudaraba is not a preferable model for investments now.
Experiences also confirm that today, in worldwide practice of Islamic banks, Mudaraba is
rarely used in its pure form, exactly due to lack of full controlled surrounding necessary for
implementation of Mudaraba. Fear from misconduct of agent and high possibility for agent
to deceive and falsely present information in financing process, is the reason why BBI
bank and many Islamic banks in the world, do not decide to implement Mudaraba
financing model in practice in its pure form.
Since the earliest theories on agency problems and its effect on Mudaraba, until present
days, one thing is clear that all authors agree upon and that is the effect of agency problems
on proper Mudaraba implementation. Review of literature has shown that agency problems
are present in markets across the world when it comes to Mudaraba implementation, even
28. 21
in those markets where other products of Islamic financing found a nurturing ground and
proved successful.
3.3 Literature on Agency Problems
Agency, in theory and definition, diagnose existence of differentiated goals between
principals and agents and when conflict between these goals arises there may arise also
motivation for agent not to act fully in interests of principal. Principal has to be ready for
such cases and ensure that there is a contract prepared which contains mechanisms to
ensure principal’s interest will be fulfilled. However, with outcome uncertainty and
unpredictable factors which influence actions and decisions of managers it is almost
impossible to construct a contract which will consider all possible outcomes. Not always is
possible also to determine who is to be blamed, agent’s decisions and actions or some
external factors. Sometimes principal, in order to protect his interests as much as possible,
may offer a contract to agent which specifies extent to which compensations are dependent
on specific behavior or outcome. This type of contract is a good option for Islamic banks
and its financing models, especially Mudaraba. As with other factors related to agency,
problems arise here as well because principal faces difficulties in specifying every
potential behavior of agent, secondly, monitoring of behavior specified is costly (Hassan &
Lewis, 2007).
Even though monitoring is a costly process there is a clear need for it due to specific
characteristic of majority of financial contracts. This special characteristic is viewed in the
fact that clear and full value of financial contract cannot be confirmed completely at time
of purchase because post-contract actions of counterparty determines the actual value of
contract. Monitoring is necessary because nature of many financial contracts is long-term
and as conditions change during the contract, information gathered at the beginning can
become unrelated to the contract. Financial contracts and manager-agent relations,
compared to other economic contracts such as purchase of goods, are specific and its value
cannot be confirmed completely at the beginning of contract. The need for monitoring
exists, as agreed by authors and researchers in this field, but it is an expensive process and
costs and benefits of it needs to be balanced and defined before the monitoring process
starts (Iqbal & Molyneux, 2005).
In his assessment of agency problems in financing, Moller (2013), emphasizes two main
agency problems in financing and those are adversative selection and moral peril. He
29. 22
mentions definition of adverse selection made by Armendariz and Morduch (2007) who
explain this term as problem which occurs when financial institutions do not have proper
and reliable information regarding future potential borrowers and because of that are not in
position to recognize risky borrowers. Adverse selection in Islamic finance occurs before
signing of contract because of the fact that borrower has more information on the project
than the bank does, according to Ahmed (2002). Need for monitoring exists wherever there
is chance for moral peril existence; this further leads to existence of asymmetric
information. To overcome these problems, performance of agents, borrowers and other
users of finance are regularly monitored and periodic reports are being submitted on this
(Iqbal & Molyneux, 2005).
Moral peril is defined as situations in which risk of bank is tightly related to choices made
by borrower of funds but which are not observed and it includes risks like avoiding and
keeping information private (Armendariz & Morduch, 2007). This moral peril can be
divided as ex ante or ex post peril, and as the terms say it is related to actions of borrower
before and after the loan has been taken. Actions made by borrower which belong to “ex
ante group” directly affect lender achieving it expected returns and these actions are
usually related to asymmetrical information on behalf of lender. Difficulties and problems
that lender face after the borrower has received and invested money belong to “ex post
group” of moral peril; risk of non-disclosure of full profitability or even running away
from loan exist here (Moller, 2013). In their article on “A Theory of Profit Sharing Ratio
under Adverse Selection” Jouaber-Snoussi and Mehri (2012) propose a solution to avoid
adversative selection problem which is in formation of profit-sharing ratio (PSR) as a part
of profit-loss sharing contract. This PSR can perform as a filter device for bank. With
assumption that manager knows his risk entering business project it is pointer of high risk
if manager would accept loan over a certain critical ratio point; this would give a clear
signal to the bank that with this manager there is a strong possibility for occurrence of
agency problems.
The biggest challenge for occurrence of moral peril risk and its biggest source in Islamic
financial transactions happens “ex post” or after a bank lends capital to manager of project
or a firm, because of conflict of interests. If there exists a conflict between interests and
goals of management and shareholders of the company, moral peril will occur immediately
when management (agent) neglects to share information with shareholders (principal)
which would serve best interest of company and principal if shared. This is commonly
30. 23
known as principal-agent problem in investment banking (Moller, 2013). Islamic financial
institutions have been obstructed in their work to increase profit-loss sharing (PLS) assets
in their own portfolios due to existence of asymmetry of information, adverse selection and
moral peril, all of which we have discussed earlier in the paper. Providers of capital have
used different types of contracts and contractual obligations to face these problems and
prevent them from happening, but in many cases unsuccessful. However, solutions based
on Islamic principles (spiritual responsibility) could provide solution to problems in
agency since it is expect that consciousness for accountability on Judgement day could
bring positive changes in behavior of agent, which yet remains to be proved in practice
(Durrani & Boocock, 2006).
Non-existence of balance between management and control rights is considered as one of
the main reasons why there is lack of Profit Loss Sharing (PLS) products of financing in
practice of Islamic financial institutions. Having in mind this lack of balance and agency
problem which happen due to it, PLS models of financing have a disadvantaged position
compared to other financing models. PLS models of financing are inherently showing
vulnerability towards agency problems because agents (managers) tend to invest less effort
in project while at the same time report less profit than it actually is. If the project financed
is large there is also large potential for conflict of interests to arise due to separation of
ownership and management which of course leads to rise in agency problems inside the
structure of organization. These factors, among other, have resulted in much less favor of
responses towards PLS contracts from the side of financial and business community
members (Dar & Presley, 2001). Due to this fact, many Islamic banks, in their everyday
business, offer products which look like conventional financing products while being
Sharia compliant at the same time. It is not clear if these products provide same structure
of incentives to all the parties involved in financing as conventional banks do or it is
maybe different. Even though there are clearly different characteristics between
conventional and Islamic banking, monitoring costs directed towards lowering agency
problems are probably of the same amount. Even though many authors state that Islamic
finance faces lower agency costs and problems, higher complexity of Islamic banks can
lead to higher agency costs and problems and to lower efficiency as well (Beck, et al.,
2010).
As noted earlier, agency problems arise because agent usually has better and superior
information and experience in conducting certain project, which is at the same time the
31. 24
reason why the agent is employed by the principal. Agent has a lot of width to act in his
own interests. He can choose his behavior after establishment of the contract, due to this he
is able to hide the outcome of the contract even from principal, and the agent cannot be in
all of these situations monitored efficiently or without high costs included. The challenge is
constantly present to create contracts which will define and align interests of principal and
agent appropriately and prevent serious loss in investments (Iqbal & Molyneux, 2005).
According to Safieddine (2009) primary issues which needs to be in focus of resolving in
Islamic financial institutions are agency problems which Investment Account Holders face.
Survey he made show that banks put priority on the rights of shareholders and customers in
front of the rights of other stakeholders. This shows that Islamic financial institutions have
conscious towards importance of rights of Investment Account Holders (IAH) and other
customers, but the survey also shows that this conscious is not put in practice properly.
Banks, for example, do not permit IAHs to be board members or to participate in decisions
of managers. Because of this IAHs have no space allowed to express their need, concerns
or track their investments (Grais & Pellegrini, 2006). They are directly exposed to agency
problems because managers have complete rights to manage their funds and take risky
investments using them, and above all, their actions are not monitored as strictly as IAH
would like that to be the case. Authors and researchers have also provided propositions to
influence and solve agency problems as effectively as possible. Since there is a number of
these proposals, some tested and failed, some not tested at all and some tested but failed to
solve the problem in full scope we will not list them here. Important fact to notice is that
no model has yet been developed which would solve agency problems in financing, both
conventional and Islamic.
3.4 Conclusion
In order for financing model such as Mudaraba to be successful and widely used problems,
risks and constraints connected with its use in everyday life have to be understood. This
thesis aims to do exactly that. Its purpose is to analyze agency problems which Islamic
financial institutions face in implementation of Mudaraba model of financing, its sources,
possible effects and potential space to prevent them from happening in future. The thesis
presents an overview of agency problems throughout the past decade, the consequences it
brought in establishment of Mudaraba financing model and includes a research on this
topic in the market of Bosnia and Herzegovina where only one Islamic bank exists.
33. 26
4.1 Introduction
Since part of the master’s dissertation is focused on case example of Bosnia and
Herzegovina market, following part of dissertation will provide analysis of banking sector
of Bosnia and Herzegovina and Islamic finance and development in the country. Economy
of the country and banking sector especially has been influenced a lot by conflict period
and war which occurred at the end of 20th
century on territory of B&H. Efforts from
founders of Bosna Bank International influenced development of Islamic finance in the
country, although that development is slowed down by laws and regulation procedures.
4.2 Banking Sector of Bosnia and Herzegovina
Report from International Monetary Fund states that banking sector dominates the
financial system of Bosnia and Herzegovina with account of 87 percent of assets in
financial system of the country which is equal to 84 percent of GDP. Non-domestic
subsidiaries comprise the banking system in majority and constitute over 80 percent of
assets in banking sector. Limited interconnectedness exist between the banks but on the
other side connection between banks and insurance sector is notifiable. Banks have a cross
border publicity on a significant level while insurance and other, non-bank, financial
institutions play a small, not much significant role (Internationl Monetary Fund, 2015).
Due to destruction of banking sector during the war (1992-1995) the need arises for
reconstruction of banking sector starting from 1996 immediately. This is why the banking
sector of B&H went through substantial changes in structure and organization. Central
Bank of B&H was established in 1997 according to “Currency board” arrangement, with
the goal of stabilizing currency and returning of trust in financial system. Starting from 21st
century confidence in banking system was returned and the system itself recorded
significant development and growth in deposits and capital amount (Efendić, 2012).
Balance sheet total of the banks in Federation of Bosnia and Herzegovina at the end of
third quarter of 2015 was 16,6 million BAM which is 3 percent more than at the end of
2014. The structure of assets has had a small change in the two key things: increasing the
share of loans from 69.2% to 69.6% and the decrease in the share of cash funds from
28.2% to 26.7%. The loans in the first three quarters of 2015 recorded a growth of 3.6%
and amounted to 11.6 million. In the structure of financing sources of banks deposits in the
amount of 12.6 million and a share of 75.5% continued to be the major source of financing
34. 27
for banks in the Federation of Bosnia and Herzegovina (Banking Agency of the Federation
of Bosnia and Herzegovina, 2015).
Based on data from Banking Agency of Republic of Srpska in 2015 there were 9 banks in
this entity, conducting their operation in 95 branches and 232 other organizations units.
Total balance level at the end of September 2015 was 7,578.6 million BAM, and is
approximately at the same level as on 31.12.2014 year (7588.3 million BAM), consisting
of balance sheet assets in the amount of 6,654.5 million BAM and off-balance sheet assets
in the amount of 924.1 million BAM. Total gross loans (4,774.1 million BAM) grew at a
rate of 1% compared to the end of 2014. The share of total non-performing loans (14.55%)
in total loans increased by 0.2 percentage points compared to the previous year. Non-
performing loans to legal entities in total loans to legal entities amounted to 16.54% (from
31.12.2014 when it amounted to 16.19%), while the share of non-performing household
loans in total loans to population amounted to 11.77% (Banking Agency of Republic of
Srpska, 2015)
Table 1: Summary of B&H banking sector, 2015
B&H F B&H RS B&H
Number of banks 26 17 9
Total assets (millions
of BAM)
24.2 16.6 7.6
Total loans (millions
of BAM)
16.4 11.6 4.8
Source: Banking agency of Federation of B&H and Banking agency of Republic of Srpska
Central Bank of Bosnia and Herzegovina in its report states that the third quarter of 2015
was marked with fairly modest lending activities of commercial banks. Deposits sustained
following the rising trend during the observed quarter. Commercial banks are still focused
on national funding sources and continue paying off accountabilities to non-residents.
Interest rates on credits and deposits did not record any noteworthy deviances compared to
the previous period. Growth of total loans has been very modest from the beginning of
2015 and ranged around the average of 2% per month. The reason behind this low level of
credit growth is inadequate demand for loans, mostly from the sector of private and public
companies, and caution of banks when it comes to credit risk. Due to such situation in the
banking sector, commercial banks largely use domestic sources to finance new loans, while
their use of funds from abroad continues to decrease. Total deposits in the banking sector
35. 28
continued rising and exceeded the amount of BAM 16 billion at the end of the third quarter
of 2015. (Central Bank of Bosnia and Herzegovina, 2015)
Here we have presented some basic, mostly statistical information regarding banking
sector of Bosnia and Herzegovina with reference on latest data available. This part is
intended to provide the reader with basic, overall picture of state of banking sector in the
country and these data provide exactly that.
4.3 Islamic Finance and Banking Development in Bosnia and Herzegovina
Development of Bosnian economy, including banking system, was significantly influenced
by historical events that occurred on the territory of B&H, especially being under the rule
of empires: Ottoman’s from 15th
to late 18th
century and Austro-Hungarian after the
Ottomans until 19th
century. Historical facts show that first examples of lending and
deposit activities in territory of B&H were found in early 15th
century and it was interest
based financing. From 16th
century and development of “waqf” institutions first examples
of interest free loans originated. This institution was used by Muslims since they were the
ones who tried to avoid interest based financing. Beginning of development of commercial
banking in Bosnia and Herzegovina is linked to 1883 and opening of branches of Union
bank from Vienna. First initiative for establishment of Islamic bank in B&H is linked to
1990 and initiative from Republic of Iran which has been stopped because of start of the
aggression on territory of B&H. “Waqf bank Sarajevo” was the second example of this
type, established in 1992, however in their business practice interest was present like with
other commercial banks, even though they stated they will work on Sharia principles. In
2000, by the initiative of Islamic Development Bank, Dubai Islamic Bank and Abu Dhabi
Islamic Bank, new Islamic bank was established, Bosna Bank International (Hadzic &
Efendic, 2012).
In Bosnia and Herzegovina the importance of Islamic banking is not recognized from
important institutions in relation to the potential that it offers. Faculty of Economics in
Sarajevo is virtually the only educational institution that deals with the study and research
of Islamic banking (Arnautalic, 2015)
Hadzic and Efendic (2012) elaborate about the difficulties for establishment and proper
function of Islamic banking. Law on banks in B&H has been made in environment where
36. 29
only conventional, interest-based banks were present and working. Because of this, current
law does not recognize and respect specifics of banking business which is interest-free.
However, current legal system is not a constraint for establishment of such banks and BBI
bank is still active and trying to work and implement Islamic banking principles since
2000.
Overall low efficiency of banks in Bosnia and Herzegovina was recorded in the only
Islamic Bank of Bosnia and Herzegovina (Efendic, 2011). The operations of Islamic banks
in Bosnia and Herzegovina due to the underdevelopment of the banking sector does not
contribute to its higher efficiency, on the contrary, by all indicators of efficiency of banks
in Bosnia and Herzegovina, Islamic bank is below the average efficiency of other banks
(Efendic, 2011).
Because of all the limitations in the legal framework, BBI has attempted to provide
Shari’ah compliant banking by accommodating the current system. The bank has also
made proposals for updates to B&H’s banking laws twice in the past. On both occasions
the amendments were blocked in the Upper House of Parliament after having passed the
Lower House. While there is no legislative framework for the development of Islamic
banking and finance, there is still a significant potential for expansion which will lead to
the establishment of a competitive Islamic finance banking sector in B&H (Efendic &
Izhar, 2014).
Governor of the Central Bank of Bosnia and Herzegovina, Mr. Kemal Kozarić, stated
during last year’s conference on Islamic Banking, held in Sarajevo, that this is a great place
and opportunity to say something and discuss about the legal framework for Islamic
banking, since it does not exist in Bosnia and Herzegovina. He recalled that in Bosnia and
Herzegovina there is only one bank operating on the principles of Islamic banking, but, as
he said, has not made sufficient promotion of the benefits of Islamic banking, and on how
to do it (Islamic Community of Bosnia and Herzegovina, 2015).
Conference on Islamic Banking held in Sarajevo in 2015 and its participants confirmed
that there is a potential, will and desire to implement Islamic finance and banking in
Bosnia and Herzegovina in full extent. This is however prevented primarily due to lack of
legal framework on state level and level of Federation of Bosnia and Herzegovina which
has not yet been implemented despite the efforts invested. There is a lot of space for
37. 30
improvement in the field of implementation of Islamic finance in Bosnia and Herzegovina
and that is something to look forward to in the future.
This is confirmed by professor from Faculty of Economics from University of Sarajevo,
prof. Hadzic. As for the limitations of Islamic banking in Bosnia and Herzegovina,
professor Hadzic, among other alleged reasons for lack of proper Islamic finance
development, stated division of the banking sector, the underdevelopment of financial
markets, lack of public awareness and highlighted the prejudices noting that Islamic
banking is not in any way designed for members of the Islamic faith only because it is
banking for all potential clients on the market. Professor Hadzic considers it is very
important to continue to work on the legislation, and the harmonization of existing
regulations that will allow equal position of Islamic banks in relation to other banks in
Bosnia and Herzegovina. This legislation is related to the tax system, the Law on Banks,
Law on VAT and the other regulations which defines or determines the operations of the
banks (Hadzic, 2014).
Kovacevic (2016) in an interview confirmed this as well. He stated that legal security of
society is the key for successful development of Islamic banking in Bosnia and
Herzegovina. With lack of legal security and support, products of Islamic banks cannot be
implemented in its pure form and as they should be. With lack of this factor and lack of
legally controlled society products of Islamic bank will not relish in their pure form as
much as they could, especially Mudaraba.
4.4 Conclusion
Territory of Bosnia and Herzegovina, current legal framework and post-conflict system
which has been established led to soil ground for opening of European banks and their
divisions. Unfortunately, current legal framework does not allow Shariah compliant
banking to be present and implemented in its pure form. Efforts, especially from founders
of BBI bank, but also from Islamic community and different parties promise expectations
that future will bring positive regulations for Islamic banking in the country.
39. 32
5.1. Research Philosophy
Research philosophy used in this dissertation is interpretivism. This approach is based on
data collected from interviews, questionnaires (such as in this dissertation) as well as
secondary data collected during the research process of writing the master’s dissertation
(Dudovskiy, 2016). Effort was invested to study the phenomena of agency problems in
natural environment without any interference, using questionnaire and interviews, and
combining the findings with the secondary data available. Another factor of interpretivism
in research philosophy of this dissertation is the fact that data presented is influenced by
human element, researcher interpreting information acquired throughout the study process
(Saunders, et al., 2009).
5.2 Research Methodology
Methodology used in this research is descriptive or qualitative. In the first part of the
research paper, theoretical research results from secondary data is elaborated, presenting
the background of the problem being explored. Published documents, articles, papers and
books have been analyzed and reviewed in order to deliver results for this part of paper.
Second part of the dissertation used qualitative research methods, specifically survey and
interviews (Nyame-Asiamah & Patel, 2009). Survey was distributed to companies which
operate in different sectors in Bosnia and Herzegovina. Interviews with Bosna Bank
International personnel have also been used in the process of confirmation of hypothesis
stated.
5.3 Research Strategy
Starting from wider theoretical picture and elaborating on agency problem in financing and
narrowing it down to only Mudaraba and market of Bosnia and Herzegovina shows
deductive nature of the research (Robson, 2002). Information relevant to the topic have
been collected and analyzed, choosing the most suitable and relevant elements for the topic
and hypothesis being investigated. However, elements of inductive research can be found
as well, especially in start of gathering data from market of Bosnia and Herzegovina,
leaving space for further analysis and investigations of the problem on the market as well
as finding a potential solution (Saunders, et al., 2009).
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5.4 Research Design
This master’s dissertation includes overview and theoretical analysis of the problem as
well as survey, interviews and their analysis. It is primarily exploratory research which
provides insight into agency problems in Mudaraba financing model and develops the
overall picture of the state of that problem in market of Bosnia and Herzegovina through
the survey undertaken. Research findings show present issues, areas for potential growth
and prioritizes areas which require further research (Kothari & C.R., 2004).
5.5 Research Data Collection and Analysis
Data used in the process of writing master’s thesis have been collected through qualitative
methods. Wide range of potential useful data has been collected, analyzed and processed
for further use. Interview and survey results have been combined with secondary data to
deliver proper conclusion and recommendation for future research.
Data analysis was carried out by use of descriptive statistics and latent level of analysis.
Descriptive account of the data is presented followed by a more interpreted analysis
concerned with the response of research participants and what has been inferred or implied
within that response (Saunders, et al., 2009). Important findings in research analysis have
been connected with findings in literature review to have a better and clearer picture of the
results of research. The questionnaire was divided in three main parts. However, due to
relation of the findings with the agency problem presented in literature review, analysis
will be provided from a couple of main aspects, after the initial description of research
respondents and their profile.
5.6. Sample Selection
After the theoretical part and literature review presented in the paper, on the topic of
agency problems in Mudaraba financing, taking a case of Bosnia and Herzegovina as an
example considered in the research, aim was also to do a survey on the sample of
companies operating in the market of Bosnia and Herzegovina. Sample of the companies
taken into account for the research was not limited to certain industries or any other
restrictive factors which would for any reason exclude some and include some other
companies into a research. It was rather decided that companies from all kinds of industries
41. 34
and regardless of the size, since the companies themselves possess high potential for taking
a loan, are eligible to participate in the research.
This is the very first time that survey has been done on this topic in Bosnia and
Herzegovina. This is one of the reasons why we included companies from different
industries into survey. Part of companies, larger ones, were also selected based on the
information on their investments and future investment plans. Smaller companies were
chosen so that we could be able to conclude whether their opinions differs in any way from
bigger ones. Several key industries for B&H economy were selected and we have looked
for companies from those industries to participate in research. Representatives of each
company answered web based survey and the software used made sure that each company
representative could fill the survey only once.
However, constraint has been made on the person which is going to fill out the survey and
whose opinion will be taken into account. This has been restricted to directors of the
companies, managers in decision making positions and managers of projects which
companies operates on and invest in, since they are the group of people with most
influence on business and investment politics of the company as well as the flow of
important information as a result of investment.
The plan prior to the start of the research was to collect around 50 responses from the same
number of companies while at the same time keeping in mind to have approximately
similar number of responses from different companies regarding their size and financial
capabilities. Non-probability sampling has been used in the research since we approached
companies which were closest and most accessible while trying to accommodate goals of
research.
This sample will provide and insight into the opinion of companies which invest or
planning to invest funds, on the questions related to agency problems and acceptance of
Mudaraba financing model.
5.7 Questionnaire and Interview
The questionnaire applied during the research consisted of 3 main parts and 22 questions.
Main reason for conducting survey was to check directly with different companies
potential for existence of agency problems in financing. Goal of the questionnaire was to
42. 35
ensure anonymity and allow respondents to answer questions honestly without hesitation.
Questionnaire was made and distributed because these information asked could be
considered as sensitive and if asked in other ways responses could be reliable like they are
now. The goal was also to collect answers from different companies and industries,
analyze them and compare to each other so that additional conclusions could be made.
First part of the questionnaire contains questions which are related to general information
regarding companies whose representatives filled out the research. General information
such as the industry in which company operates, size of the company in terms of number
of employees, yearly revenue and financial value of assets of the company. The ownership
structure and amount of time that company is active and operational has also been
questioned. This was all done with a purpose to be able to divide companies based on
different factors and check whether the responses on key questions are different in any
way.
Second part of the questionnaire is related to the financing conditions on which the
company would agree or choose. These financing conditions questioned in the survey are
related directly to condition faced in Mudaraba financing. Purpose of this part of
questionnaire was to see the response of companies in choosing some of the conditions are
facing some of the requests in financing which is not usual to face in conventional
financing. This part will provide an insight into the consciousness of companies and
potential investors on the existence of something like Mudaraba and an insight for
researchers on the potential for implementations of Mudaraba. However, main goal of this
part was to provide an insight into the potential for development of agency problems in
taking financing from the financial institution.
Main focus of the third part of questionnaire were ethical standards in financing, since the
literature review showed that moral hazard and ethical misconducts are one of the main
agency problems. Goal of this part was to see if there is a potential for ethical misconduct
on the market and where can it be expected, starting from investment into forbidden
products and services, to some more subtle moral hazards but on the same scale of peril.
Interview was conducted with Head of Retail banking of BBI bank, Mr. Amel Kovačević.
Interview was done because of current position he holds in the bank and considering that
he has all the information regarding doing business with clients of BBI bank in the country.
Considering the main topic of the paper, interview questions were focused on getting
43. 36
information regarding current state of Mudaraba offer of BBI bank, plans for future and
reasons why Mudaraba is not offered by the bank at the moment.
5.8 Research Limitations
Research limitations include mainly factor of biased participants. Participants in the survey
were directly related to their company and their own actions in the past and potential
actions in the future. This leaves space for non-objective attitude to be expressed more than
we would like it to be. Limitation of resources, expertise and time to analyze the subject
even more are also factors to be mentioned here. Future analysis with more involvement
from Bosna Bank International, as the only bank working on principals of Islamic finance,
as well as other academicians and experts in the field would be extremely valuable and
would provide much more information and more detailed analysis.
45. 38
6.1 Respondents’ Profile
Survey which has been conducted on the market of Bosnia and Herzegovina recorded 50
responses from companies of different size, revenue, ownership structure and working in
many different industries.
First part of the research contained questions related to general information about
companies in order to differentiate them by size, industry and other different factors.
As it can be seen from the table below survey was filled by companies from different
industries: construction, tourism, consulting services, telecommunications, accounting
firms, commerce, dealerships, textile, advocacy, digital marketing, food industry, energy,
oil, distribution, transport and manufacturing. Size of the companies based on number of
employees also varied, starting from up to 20 employees to more than 500 employees per
company.
Variety of companies participated in the survey. This has been chosen as approach in order
to be able to draw conclusion while comparing many different factors and company
profiles. All of these companies which participated in survey have either used some
financing before or planning to use it in future. Based on their answers and such varieties
of profiles we will be able to extract different conclusions. No company was disregarded,
many different industries, sizes ownership structures and age of companies were included
in research.
Annual turnover of the company was also one of the questions of the surveys. Categories
of offered answers were up to 1 million of KM, from 1-3 million KM and more than 3
million KM. 40% of surveyed companies stated that their annual turnover is higher than 3
million KM, 32% of companies have annual turnover between 1-3 million KM and 28%
with turnover of less than 1 million KM per year. Value of assets of the companies were
also measured. Specific data can be found in the Table 1.
In 64% of the companies the ownership structure was ltd., while other companies were
structured as joint stock companies and trades. Out of the companies surveyed, 52% were
running business form more than 10 years, and 38% between 5-10 years, 0which is enough
time in which companies gained experience with taking loans from financiers.
46. 39
Table 2: Survey respondents’ profile
Source: Author
Category Frequency Percentage (%)
Sector of core business
Trade and commerce 8 16%
Tourism 4 8%
Construction 14 34%
Transportation 1 2%
Energy 3 4%
Telecommunications 2 6%
Other 18 30%
Size of company
1-20 employees 22 44%
21-50 employees 6 12%
51-100 employees 8 16%
101-500 employees 7 14%
Over 500 employees 7 14%
Annual turnover
Up to 1 million KM 14 28%
1-3 million KM 16 32%
More than 3 million KM 20 40%
Value of assets
Up to 500 000 KM 16 32%
500 000 – 1 million KM 7 14%
1-5 million KM 14 28%
5-10 million KM 6 12%
More than 10 million KM 7 14%
Ownership structure
Joint stock company 12 24%
Ltd company 32 64%
Craft / trade 6 12%
Age of company
Less than 5 years 5 10%
5-10 years 19 38%
More than 10 years 26 52%
Capital ownership
Domestic 31 62%
Foreign 11 22%
Mostly domestic 4 8%
Mostly foreign 4 8%
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6.2 Past and Future Financing Plans and Experiences
Since the main topic is related to a financing model of Islamic banks, part of research was
also focused to explore past and future financing plans and experiences of companies.
Responses showed that almost 60% of research participants have applied for financing
so far, while at the same time more than 80% of them are planning to apply for
financing in the future. Out of 29 companies which applied for financing in past, only 3
of them are not planning to do the same in the future.
Table 3: Statistics of past and planned financing
Category Frequency
(out of 50)
Percentage
Applied for financing in past 29 58 %
Never applied for financing 21 42 %
Planning to apply for financing in future 42 84 %
Will not apply for financing in future 8 16 %
Source: Author
When comparing capital ownership structure and financing experiences from the past it is
visible that companies which have domestic capital ownership structure (completely or
mostly) have applied more for financing, 63% of them, than companies with foreign
capital ownership structure, 47% of them.
Scale from 1-5 has also been presented in order to measure satisfaction of companies with
current offers of financing on the market, with value 1 representing the lowest satisfaction
and value 5 for highest satisfaction. Most of the companies, 58%, are mildly satisfied,
choosing the value 3, while 32% of the companies have chosen value 2 showing their
unsatisfaction with current financing conditions on the market.
These data show that future will bring high demand for financing from companies of
different size and experience, both domestic and foreign capital ownership, who are at the
moment mostly mildly satisfied with what the market has to offer in terms of financing.
This data standing alone may present chance for new financing products, such as
Mudaraba to try and find its place on the market, bringing refreshment and new option in
financing. However, responses presented in the following part of this analysis will show
that this will not be accomplished easily and many factors should be considered in deciding
whether to introduce it to the market or not.
48. 41
Having in mind that Mudaraba financing model requires constant overseeing of the project
from the financier side and even potential interfering into some decisions made by
managers of project, it is essential that users of finance allow the bank to have insight into
project details on daily basis.
Graph 1: Expected form of controls in financing projects
Source: Author
Responses show that companies are not willing to allow the financier to have desired
insight and excess control over project in the desired ratio. Very small percentage of
companies (14%) would allow financier to have insight into all details and decisions made
on project. On the other side most of the companies (86%) would not allow financier at all
or would allow partial interference and insight into project details. Regardless of the
industry, size of the companies, ownership structure and all other factors, most of the
companies are not willing to share information and allow financier to have insight and
excess any control in daily activities of project company works on.
This particular statistic presents a problem and obstacle for future potential implementation
of Mudaraba. Mindset of managers who are in charge of companies and projects invested
in has to be changed so that more benefit can be expected for companies as well as
financiers. Managers need to understand that inclusion of financier and giving him full
insight of project activities will not lead to project being stolen from them but rather
project being improved. Welcoming new experiences and opinions can highly benefit
companies and projects.
49. 42
6.3 Adverse Choice and “Ex Ante” Moral Peril
A problem which lenders face in distribution of financing is adverse choice, inability to
find quality information about potential future borrowers and because of that failure to
divide risky from non-risky borrowers (Armendariz & Morduch, 2007).
This is precisely one of the agency risks in Mudaraba financing as well. Companies
allegedly apply for financing in Mudaraba only with projects with low risk, which has been
proven as wrong. After the approval of financing projects proved to bear much higher rate
of risk than it was reported and real risk was covered by the company applying for
financing.
Moller, 2013, has also identified these problems and defined them as “ex ante” moral peril.
Actions which belong to this group are those made by borrower which directly affect
lender to achieve expected return and this is usually related to asymmetrical information on
behalf of lender.
With a ration from 1-5, where 1 represented lowest risk and 5 the highest, 52% of the
companies stated that risk of project with which they would apply for financing is on level
2, while 30% stated that it is on level 3. This is precisely what literature reviews and
research of previous authors stated. Companies declare low risk in project when applying
for finance, however, the risk of project is higher than declared by the companies.
This is one of the first problems which banks face in approving of financing, choosing the
investor most appropriate for investment of funds. All the investors present their projects
as if the possess the best quality for potential investments, but at the same time hiding
important inside information only they can know. This leads to higher costs involved in
information gathering process while choosing investor (Sarker, 2015).
Part of these problems could be solved if companies applying for finance would deliver a
full reference list of their previous experiences on projects. This list would include both
positive and negative references, if they exist. Based on these data financier would have an
easier job in determining riskiness of allowing finance to the particular company.
However, companies themselves are not so keen to deliver full list of references if they
include negative things and past experiences. Only 52% (26) of the companies researched
believe that it is important to deliver both positive and negative references to financier
when applying for financing (see table 3 for detailed response summary). At the same time,
50. 43
48% (24) of the companies believe that only positive references are important and should
be presented to financier.
Table 4: Reference statement
Category Frequency Ratio
Capital ownership
Domestic 15 of 35 43%
Foreign 11 of 15 73%
Previous financing application
Applied for financing in the past 13 of 29 45%
Never applied for financing 13 of 21 62%
Planning to apply for financing in the future 22 of 42 52%
Will not apply for financing in future 4 of 8 50%
Source: Author
Interesting pattern is visible here and shown in Table number 4. Companies with foreign
ownership of capital are the ones who mostly believe that both positive and negative
references should be stated in application for financing. At the same time it is interesting to
note that less than 50% of the companies who applied for financing so far believe they
should present all references. A percentage that creates concern is that only 52% of the
companies planning to apply in future for financing believes that both positive and
negative references has to be provided to the financier.
These data give an insight that companies with foreign capital ownership can be trusted
much more in the data they provide compared to domestic companies. Results show that
73% of foreign owned companies would report both positive and negative references
compared to only 43% of domestic companies. This may be attributed to different
mentalities, habits and laws which govern foreign owned companies to deliver these
information but the truth is they are appearing to be much more trustworthy.
Being honest and acting in good faith is a huge benefit in the entire financing process. Data
that only 45% of companies who applied for financing so far say they have stated both
positive and negative references in application process shows how much risk there is in
application review process. Each application for financing has to be reviewed with great
attention to details and not only review what has been filed but also to investigate the
overall status and references of the companies. Dedicating time to analyze companies more
51. 44
closely is a must, they are keen to hide things which are not in their favor and attention has
to be directed in screening process of each financing applicant.
6.4 Sharing of Information and Financial Data Between Company and Financier
One of the main problems in relationship between agent and principal, which we examine
here through relation between financier and company using the finance, is the sharing of
information and financial data. Authors state that due to the fact the agent has, in most
cases, much better and more relevant information regarding certain relevant facts, than
principal has; the principal cannot be completely sure that agent has performed according
to what he has promised. Agent has the opportunity here and in many cases acts with bad
faith to gain more revenue and benefits or get better status based on information acquired
(Armour, et al., 2009; Lee & Lee, 2006; Sarker, 2015; Kovacevic, 2016).
Entrepreneurs (agents) are in general people who guard information they possess jealously.
Mudaraba model requires from agent to disclose all information of business operation
(Samad, et al., 2005).
Since the company is running the project which is financed by the bank and makes
decisions related to it on daily basis, one of the goals of the research was to explore
opinions of companies on sharing of information upon receiving the financing. Two things
were examined: to which extent the company would be willing to share information
regarding project with the financier after they receive financing and do the companies
consider it necessary to notify financier if certain changes occur which influence entire
project they are working on.
Table 5: Willingness towards information sharing
Category Frequency Ratio
Willingness to share information regarding progress and
details related to project with financier, after the financing
has been approved
This kind of request from financier is not expected 10 20%
We are not ready to share details even if we do not
get financing because of that
1 2%
We are ready to partially share information 27 54%
We are ready to completely share information 12 24%
