Presentation Mudarabah And Agency Costs


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Presentation Mudarabah And Agency Costs

  1. 1. Islamic Banking and Finance 17 February 2009 Mudarabah and Agency Costs Group Presentation of Francesco Grosso & Christine Reuther
  2. 2. Mudarabah Contract and Musharakah Contract in Comparison <ul><li>Investment comes from all partners </li></ul>Musharakah Contract (profit & loss sharing) <ul><li>Investment is the sole responsibility of </li></ul><ul><li>the rabb ul-mal </li></ul>Mudarabah Contract (profit sharing) Source of Investment Profit/ Loss Sharing Management <ul><li>All partners can participate in the </li></ul><ul><li>managament of the business </li></ul><ul><li>Management is carried out by the </li></ul><ul><li>mudarib only </li></ul><ul><li>All assets of the musharakah is jointly </li></ul><ul><li>owned by all partners according </li></ul><ul><li>to the proportion of their respective </li></ul><ul><li>investment </li></ul><ul><li>All partners share the losses to the </li></ul><ul><li>extent of the ratio of their investment </li></ul><ul><li>Financial losses are suffered by the </li></ul><ul><li>rabb ul-mal only. </li></ul><ul><li>Losses of mudarib restricted to the fact </li></ul><ul><li>that his labour has gone in vain. </li></ul><ul><li>All assets or goods purchased by the </li></ul><ul><li>mudarib are solely owned by the rabb </li></ul><ul><li>ul-mal </li></ul>Ownership 1 2 3 4 1 2 3 4
  3. 3. Principal-Agent Problem Hires as manager Performs business activity Self-interest: Profit maximisation Self-interest: Consumption of perquisites, personal benefits Main features of the principal –agent problem <ul><li>Ex-post asymmetric information : after the contract has been completed, one party is better informed than the other </li></ul><ul><li>Separation of ownership and management : principal = owner  agent = manager </li></ul><ul><li>Bounded rationality of principal and opportunistic behaviour of agent lead to Pareto-suboptimal result (“agency loss“) </li></ul><ul><li>First-best solution only feasible if principal can monitor the agent‘s actions perfectly or set incentives that cause </li></ul><ul><li>the agent to conform his interests to the interests of the principal </li></ul>Contract Principal Agent
  4. 4. Mudarabah contract and pricipal-agent problem: What is the link? <ul><li>If shirking by the agent can be fully detected: “reward as a linear function of the outcome” </li></ul><ul><li>But complete monitoring of agent impossible </li></ul><ul><li>Problem: agent enjoys utility gains from shirking (“concave utility function”) </li></ul>Lack of linearity between reward and performance <ul><li>Bank depends solely on the reported profit of the entrepreneur </li></ul><ul><li>Profit depends entirely on the agent’s investment decision </li></ul><ul><li>Problem: Incentive for agent to report less profit and/ or put in little effort </li></ul>Idiosyncratic uncertainty <ul><li>Agent has full discretion over assets without bearing the risk of financial losses </li></ul><ul><li>Restrictive, non-participatory role of bank in the management of mudarabah contracts (“sleeping partnership”) </li></ul><ul><li>Problem: Incentive for agent to act in self-interest </li></ul>Discretionary power of the agent Mudarabah contracts inherently vulnerable to principal-agency problems 1 2 3 Islamic Bank (principal) Entrepreneur (agent) Contract U O U O
  5. 5. Mudarabah contract and agency problem (continued): testing three hypotheses Islamic bank will accept or reject mudarabah contracts ex ante depending on the specific attributes of the project. Islamic bank will accept or reject mudarabah contracts ex ante depending on the specific attributes of the entrepreneur. Islamic bank will accept or reject mudarabah contracts ex ante depending on the compliance with shari‘ah considerations. Hypothesis 1 Hypothesis 2 Hypothesis 3 Rational <ul><li>Classical agency theory implies a positive relationship between the level of agency problems and the </li></ul><ul><li>magnitude of asymmetric information </li></ul><ul><li>Asymmetric information is inherent in mudarabah contracts: </li></ul><ul><li> Adverse selection (ex ante): hidden characteristics of the agent‘s skills and the project </li></ul><ul><li> Moral Hazard (ex post): hidden information about the agent‘s activities and decisions </li></ul><ul><li>Increase in opportunistic behaviour of the agent. </li></ul>Rational <ul><li>Adherence to the religious codes of the shari‘ah may reduce agency problems: </li></ul><ul><li> Voluntary adoption of self-constraint by the agent </li></ul><ul><li> Avoidance of opportunistic behaviour of the agent </li></ul>1 2 3
  6. 6. Mudarabah contract and agency problem (continued): dataset and methodology of the survey <ul><li>Assessment of the impact of agency problems on the accounting and auditing process of mudarabah contracts. </li></ul>Objective of the survey <ul><li>Primary data collected by means of a structured questionnaire submitted to 52 Islamic banks. </li></ul><ul><li>The satisfactory rate was around 44%. </li></ul>Dataset Methodology (hypothetico-deductive method) H 0 H 0 H 0 In accepting or rejecting a Mudaraba ex ante: H 1 -Islamic bank gives high rank to project attributes H 2 -Islamic bank gives high rank to entrepreneur’s attributes H 3 -Islamic bank gives high rank to Shari' a compliance Key variables: construction and pricing, restrictiveness, agency incidence, monitoring
  7. 7. Mudarabah contract and agency problem (continued): Methodology used <ul><li>Univariate analysis: </li></ul><ul><li> Testing each variable separately </li></ul><ul><li> Analysing the frequency & trend of each variable </li></ul><ul><li>Bi-variate analysis: </li></ul><ul><li> Testing and analysing the strength & direction </li></ul><ul><li>of relationship between a dependent variable </li></ul><ul><li>and a set of independent variables </li></ul><ul><li> Using method of </li></ul><ul><li>‘ linear regression’: </li></ul><ul><li>Correlation matrix: </li></ul><ul><li>Keeping the incidence of agency problems as fixed variable in the auditing and accounting process in a mudarabah financing the authors analyse the contingency of all the other variables in shaping the contract. </li></ul><ul><li>The propensity shown by the variables has a </li></ul><ul><li>very low significance in the H 0  H 1/2/3 are true! </li></ul>Statistical analysis (Combination of univariate and bi-variate analysis) Linear regression in the correlation matrix: explaining the chi-square significance test Y= β 0 + β 1 X 1 ± ε H 1/2/3 Key variables (nominal & ordinal variables) H 0
  8. 8. Main reasons that prevent Islamic banks from entering mudarabah contracts (range from 0 to 1) Reasons preventing Islamic banks from entering mudarabah contracts (range from 0 to1) Problem of Moral Hazard in Mudarabah Contract The combination of unilateral risk bearing and asymmetric information on the side of the Islamic bank provide the agent with the incentive to conceal actions taken and underreport profits made after the contract has been Completed. Level of the agent’s effort and his investment decisions determine the outcome of the investment; however, both may be unobservable to the Islamic bank.
  9. 9. Restrictions imposed on the agent‘s decisions by the Islamic bank (range from 0 to 1) By tightening the discretionary power of the agent the Islamic bank can increase its rate of return/ reduce its cost of capital. Restrictions imposed on the agent’s decisions by the Islamic bank (range from 0 to1) <ul><li>Unrestricted Mudarabah Contract ( Mudarabah al-mutlaqah): </li></ul><ul><li> Mudarib has free hand in investment </li></ul><ul><li>decision and management. </li></ul><ul><li> No restrictions on the mudarib concerning </li></ul><ul><li>the type of commodity, trading partner, </li></ul><ul><li>period of time or place. </li></ul><ul><li>Restricted Mudarabah Contract </li></ul><ul><li>( Mudarabah al-muqayyadah): </li></ul><ul><li> Rabb al-mal specifies the business in </li></ul><ul><li>which the mudarib shall invest. </li></ul><ul><li> Restrictions on the mudarib concerning </li></ul><ul><li>the type of commodity, trading partner, </li></ul><ul><li>period of time or place. </li></ul>Types of Shari' a compatible mudarabah contracts
  10. 10. Main results of the bi-variate analysis Structure of bi-variate analysis (correlation matrix) <ul><li>The bank’s concern about misreporting is associated with its perception of shirking by the agent. </li></ul><ul><li>The bank’s lack of control rights increases the incentive of the agent to pursue his self-interest. </li></ul><ul><li>Monitoring costs will increase with expectations of perquisite consumption, resulting in high agency costs. </li></ul><ul><li>No significant correlation between the disadvantage in access to information and incidence of agency problem (significance indicator: > 0.05) (?) </li></ul>Interpretation of results Risk of misreporting by the agent Lack of bank’s control rights High costs required for monitoring Disadvantage in access to information Independent Variables Dependent Variable Incidence of agency problem ((1) underinvestment, (2) overinvestment, (3) personal benefit, (4) reduction of effort, (5) perks consumption) 1 2 3 4 Project attributes and entrepreneur attributes (creditworthiness & previous track records) are the most decisive factors for Islamic banks when entering and constructing mudarabah contracts.
  11. 11. Can shari´ah compliance reduce agency problems? Hypothesis (H 3 ) of the survey Assessment of the H 3 - hypothesis “ The adherence of the agent to Shari' a norms plays a significant role for the Islamic bank in accepting or rejecting mudarabah contract decisions ex ante.” <ul><li>Obedience to the religious codes of the </li></ul><ul><li>Shari' a induces the agent to adopt </li></ul><ul><li>self-constraints voluntarily. </li></ul><ul><li>This help avoid of opportunistic </li></ul><ul><li>behaviour, such as dishonesty and other </li></ul><ul><li>activities, that take advantage of moral </li></ul><ul><li>hazard imperfections. </li></ul>The structured variables used to assess this H 3 cannot be measured quantitatively since the agent’s adherence to religion is an abstract concept. Hypothesis Rational A correlation matrix based on highly disputable variables, such as religion and ethics parameters, cannot be declared valid at all, even if the significance of the regression (p=0.0000) was the minimum obtainable. Argumentation Consequence
  12. 12. Mudarabah contracts in practice: case study of Bank Islam Malaysia Berhard (2005) Customer deposits by type of contract 3.Q 2005 (in USD) Performing financing by type of contract 3.Q 2005 (in USD) Performing financing by type of contract 3.Q 2005 (in %) Customer deposits by type of contract 3.Q 2005 (in %) Non-Mudarabah contract Mudarabah contract 43% 57% 70% 15% Bai’ Bithaman Ajil Murabahah Qard al-Hasan Musharakah: 0.5% Mudarabah: 0.1% Others: 0.4% Ijarah Bai al-Inah 9% 3% 2%
  13. 13. Case study of Bank Islam Malaysia Berhard (continued): Performing Financing by sector of investment 3.Q 2005 (in USD)
  14. 14. <ul><li>Bank Islam Malaysia Berhard (2005): “Condensed Financial Statements: Unaudited Balance Sheet as at 30 September 2005“, accessed on 16 February from: </li></ul><ul><li>Haque N.U. & A. Mirakhor (1986): “Optimal Profit-Sharing Contracts and Investment in an Interest-Free Islamic Economy “, Working Paper, WP/86/12, International Monetary Fund , pp. 1-19. </li></ul><ul><li>Khalil A.A.A. & C. Rickwood & V. Murinde (2002): “Evidence on Agency-Contractual Problems in Mudarabah Financing Operations by Islamic Banks“, In: Iqbal M. & D.T. Llewellyn (eds.): Islamic Banking and Finance: New Perspective on Profit-Sharing and Risk , United Kingdom: Edward Elgar, pp.57-92. </li></ul><ul><li>Saleh A.S. & R. Zeitun (2002): “Islamic Banking Performance in the Middle East: A Case Study of Jordan“, Working Paper of the University of Wollongong and University of Western Sidney, pp. 1-17. </li></ul><ul><li>Sarker M.A.A. (1999): “Islamic Bunsiness Contracts, Agency Problem and the Theory of the Islamic Firm“, International Journal of Islamic Financial Services, Vol.1, No.2, pp. 12-28. </li></ul><ul><li>Usmani M.M.T. (1998): “An Introduction to Islamic Finance“, Working Paper, pp. 1-169. </li></ul>References