Current Issues of Islamic Contract in Malaysia

FACULTY OF BUSINESS AND MANAGEMENT

BACHELOR OF BUSINESS ADMINISTRATION (HONS.) FINANCE (BA242)

FIN546
ISLAMIC FINANCE

OCTOBER 2021 – FEBRUARY 2022

INDIVIDUAL ASSIGNMENT
CURRENT ISSUES OF ISLAMIC CONTRACT IN MALAYSIA “CHALLENGES OF
PROFIT AND LOSS SHARING FINANCING IN MALAYSIAN

ISLAMIC BANKING”

PREPARED BY: BA242 3D

ZUR ELYA NAJWA BINTI ZUNAIDI

2021858252

PREPARED FOR :

MADAM NADIA FARLEENA MOHD AZNAN

 Current Issues of Islamic Contract in Malaysia

SUBMISSION DATE : 26 DECEMBE 2022

Table of Contents

1.0 INTRODUCTION ...............................................................................................................1

2.0 FINDINGS...........................................................................................................................2
2.1 High risk...........................................................................................................................2
2.2 Selection...........................................................................................................................3
2.3 Capital Security................................................................................................................4
3.0 CONCLUSION....................................................................................................................5
REFERENCES ..........................................................................................................................6
 Current Issues of Islamic Contract in Malaysia

1.0 INTRODUCTION

Islamic banking products are considered as an alternative to traditional banking, which is

recognised for its numerous elements of gharar (uncertainty), riba' (usury), and maisir
(gambling). The advent of Islamic banking products has allowed Muslims to directly
participate in non-shariah compliant banking.

According to Mohammad Akram Khan (1990), musharakah is a profit-making contract

between two people. Some academics define mudharabah the same way. While both
musharakah and mudharabah are founded on partnerships, there are key variations between
the two contracts. Partnership and PLS financing such as mudharabah and musharakah are
still uncommon in Malaysian Islamic banks.

Profit and loss sharing (PLS) financing in Islamic banking institutions in Malaysia is
confronted with a number of difficulties. PLS financing is consisting of mudharabah and
musharakah contracts, which are Islamic financing instruments. Before delving into the
difficulties, this paper examined the application and operating mode of mudharabah and
musharakah contracts in the context of Islamic law. Unlike the musharakah contract, which
requires both the investor and the entrepreneur to contribute capital and labour, the
mudharabah contract simply requires the investor to provide capital, with the entrepreneur
being the sole person who operates the business. If the project is musharakah, both parties
share the profit or loss according to the pre-agreed ratio; however, if the project is
mudharabah, only the capital provider takes the loss due to the fact that the entrepreneur has
already foregone his or her work for the project.
 Current Issues of Islamic Contract in Malaysia

2.0 FINDINGS

According to the article's results, there are three potential obstacles to the application of
musharakah and mudharabah financing approaches in general.

2.1 High risk

Investments in musharakah and mudharabah could be considered high-risk. The high failure
rate of these financing approaches makes them difficult to implement, for a variety of
reasons, including the entrepreneurs' lack of business expertise and experience. As a result of
the musharakah and mudharabah doctrines' profit-and-loss sharing, Islamic banks may be
wary of granting loans. Investors' money is mostly owned by depositors, who always assume
the safety of their funds. If the depositors' money is lost, the Islamic banks are required to
replace it. All risks must be thoroughly evaluated in any musharakah and mudharabah
financing in order to minimise losses. In order to lower operational costs, there are a number
of procedures that need to be implemented.

There are various types of risks that Islamic banks will face as a rabbul mal (capital provider)
or musharik (partnership) (Shodiq, n.d.) Banks favor low-risk items; the less risk involved,
the better. Musharakah and Mudarabah, on the other hand, are regarded as high-risk goods by
banks. However, three factors might have a significant impact on an Islamic bank's decision
to apply PLS in their financing such as financial risk, business risk, and rate of return risk.
Due to the nature of Mudarabah, Islamic banks do not have access to or the authority to
oversee the mudarib's decision-making and management, particularly in the event of a loss
claim. Additionally, financial risk will eventually effect company risk. A business may be
exposed to danger if there is inadequate funding to continue operating the project. Finally, but
certainly not least, is the rate of return risk, which occurs when the bank's return is unknown
due to the fact that they only know the actual amount at the conclusion of the period.

As a result, implementing both financing products is extremely complicated and risky for an
Islamic bank. Both Musharakah and Mudarabah are based on the principle of sharing both
profit and loss. As a result, Islamic banks are extremely cautious when giving financing, as
the funds will most likely come from depositors. They anticipate that their deposit money
will be secure. If anything were to happen in the future, Islamic banks would be required to
absorb the loss and replenish depositors' money. Banks are not interested in sharing losses as
they are only interested in sharing profits. In other words, they desire everything that will
reduce their losses and increase their profits.
 Current Issues of Islamic Contract in Malaysia

2.2 Selection

The selection process prevents Islamic banks from providing musharakah and mudharabah-
based funding. Because Islamic financial institutions are not altruistic organisations that
provide free wealth, they must produce profit in order to remain competitive.

Islamic banks must ensure their business partners have relevant experience and growth
potential. Selection is difficult since it involves assessing many risk factors. Islamic banks
should seek for a company with a proven track record and acceptable financial performance
before providing money to them. A corporation with a 'clean' financial and performance
background may be an excellent partner. They only choose huge firms as partners because
Islamic banks were formed to promote justice and minimise the wealth gap, this alternative
may seem out of place.

In order to secure their customers' assets, Islamic banks will only provide profit-sharing
funding to well-known enterprises. A Islamic bank that only provides musharakah credit to
major businesses in good financial standing will contradict its own purpose of preserving the
concept of justice and contributing to society in need.

The wealthy will become wealthier and the poor poorer if this issue is not addressed. To
benefit society as a whole and maintain Islamic banking's long-term viability, Islamic banks
must transform from financial intermediary to actual entrepreneur. Islamic banks can
continue to provide mudharabah and musharakah financing to small enterprises as long as the
partners or firms can demonstrate the firm's potential for joint growth.
 Current Issues of Islamic Contract in Malaysia

2.3 Capital Security

In the event of a default or other loss, the safety of the capital is critical, thus it must be
ensured. This promise is a good indicator of their sincerity and commitment to keeping the
company on the right track. For example, the guarantee could be in the form of a high-valued
asset as a type of collateral (Abdul-Rahman and Nor, 2016). There is therefore less risk of
moral hazard and fraud if collateral is used as a kind of assurance. As a result, the partner
requesting the financing may not be able to provide the guarantee required. Unfortunately,
this may be the case. As a result, it highlights the difficulty of implementing Musharakah and
Mudarabah by Islamic banks before doing so.

In any investment, the safety of the capital must be ensured. Islamic banks are reluctant to
give mudharabah or musharakah contracts to customers if there is no capital guarantee. As a
kind of collateral, high-value assets like real estate or land can be used as a form of capital
security. In the event of fraud or mismanagement by the partners, a guarantee is essential. To
show their devotion and resolve, both parties must provide a guarantee of funds.

Fraud can be less likely as a result, and the company can still be on the correct. Due to the
fact that these clients lack funds, not all partners can afford to issue capital guarantees.
Because of this, delivering finance through musharakah and mudharabah for Islamic banks is
extremely difficult if the Islamic banks' perspective is still that of financial intermediaries.
Contrary to popular belief, funding without a capital guarantee is still possible if risk
management is properly executed.

3.0 CONCLUSION

In conclusion, to achieve social and economic aims, Islamic banking instruments are not just
motivated by profit. In conventional banking, the majority of funds and capital are channelled
toward enormous industries, multinational corporations, and large firms. So because in an
interest-based economy, credit distribution relies heavily on the reputation of entrepreneurs.
A more appropriate and proper flow of finances can be secured through a profit-sharing
system based on mudharabah and musharakah. The Islamic banking market will continue to
thrive even if musharakah and mudharabah contracts face substantial challenges. That's
because Islamic banks may work together with businesses to improve the country's economy,
especially the Muslim sector, while still insuring that no Shariah-compliant activities are
being carried out.

All of the above-mentioned obstacles will be addressed in the future if Islamic banks adopt
the role of real entrepreneurs. If all of these obstacles can be solved, musharakah and
mudharabah contracts will be able to stimulate product innovation in financial research,
thereby assisting Malaysia in becoming an international Islamic financial centre. Lastly, all
parties in the Islamic banking sector must begin to generate public awareness and
understanding of the PLS concept.
 Current Issues of Islamic Contract in Malaysia

REFERENCES

Abdul-Rahman, A., & Nor, S. M. (2016). Challenges of profit-and-loss sharing financing in

Malaysian Islamic banking. Malaysian Journal of Society and Space, 12(2), 39–46.

Aulia Arifatu Diniyya. (n.d.). Issues and Challenges of the Application of Mudarabah and
Musharakah in Islamic Bank Financing Products ssues and Challenges of the Application of
Mudarabah and Musharakah in Islamic Bank Financing Products . View of issues and
challenges of the application of Mudarabah and Musharakah in Islamic Bank Financing
Products. Retrieved January 1, 2022, from
https://journals.iium.edu.my/iiibf-journal/index.php/jif/article/view/482/205

Mirakhor, A., & Zaidi, I. (n.d.). Profit-and-loss sharing contracts in Islamic Finance.
Handbook of Islamic Banking. https://doi.org/10.4337/9781847205414.00012

Musharakah & Mudarabah. IslamicMarkets.com. (n.d.). Retrieved January 1, 2022, from

https://islamicmarkets.com/education/category/musharakah-mudarabah
 Current Issues of Islamic Contract in Malaysia

APPENDIX
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Challenges of profit-and-loss sharing financing in Malaysian Islamic banking

Aisyah Abdul-Rahman1, Shifa Mohd Nor1

1
School of Management, Faculty of Economics and Management, Universiti Kebangsaan Malaysia, 43600, Bangi, Selangor

Correspondence: Aisyah Abdul-Rahman (email: eychah@ukm.edu.my)

Abstract

There are challenges faced by the profit-and-loss sharing (PLS) financing in Islamic banking institutions in
Malaysia. PLS financing is comprised of mudharabah and musharakah contracts. This study evaluated the
application and modus operandi of mudharabah and musharakah contracts before dwelling into the
challenges. While musharakah contract involves contribution of capital and labor by both the investor and the
entrepreneur, mudharabah contract allows the investor to provide the capital and only the entrepreneur
operates the business. In terms of return on investment, both partners share the profit or loss based on the
pre-agreed ratio for musharakah; but only the capital provider bears the loss for mudharabah as the
entrepreneur already forgone his or her effort for the project. In examining the challenges, we had conducted
several interview sessions with Malaysian Islamic banks that offer PLS financing. The findings showed that
there were four major obstacles to PLS financing such as high risk of investment; difficulty in selecting
appropriate partners; demand comes from low credit worthiness customers; and lack of capital security.

Keywords: capital security, challenges, Islamic banking, mudharabah, musharakah, profit and loss sharing
financing

Introduction

The Islamic banking industry has demonstrated growth and resilience in the more challenging
international financial environment. This is measured through the various developments of products
and services in the Islamic banking industry, the maturity of Islamic financial markets, development
of infrastructure and financial institutions, as well as a comprehensive framework of legal, regulatory
and Shariah. The development in the Islamic banking industry is in line with the current economic
goals of broad economic prosperity, full and optimum level of economic growth, justice in socio
economy, a balanced distribution of income and wealth, and currency stability (Setiawan, 2006).

The demand for Islamic banking products to meet the ever increasing needs of the community is
seen as an alternative to conventional banking, known for its multiple elements of gharar
(uncertainty), riba’ (usury) and maisir (gambling). The introduction of Islamic banking products has
opened the door preventing the Muslims from participating directly in the banking world that is not
shariah compliant. Various Islamic financing products in the Islamic banking industry have been
 Current Issues of Islamic Contract in Malaysia

successfully implemented and are seen to have great potential for further growth and are able to
solve the problem of gharar, riba and maisir. Among the products currently offered by the Islamic
banking are ijarah, murabaha, bai’ bitaman ajil, Istisna, tawaruq and others. However, there are still
loopholes that need to be filled by the Islamic banking; that is, by way the musharakah and
mudharabah contracts that apply the PLS concept in line with the spirit of Islamic banking system of
upholding the concept of justice, the eradication of oppression, whilst preventing capitalism to rear
its ugly head that makes the rich becoming richer and the poor becoming poorer.

Musharakah and mudharabah are partnership contracts in conducting business; based on capital and
labor contribution by the investor and entrepreneur, through PLS agreement. These concepts are
also similar to conventional venture capital principle, which is expanding in Malaysia 1. According to
Ibnu Arfa (1984), musharakah is defined as an agreement between two or more persons carrying on
a particular business in order to share profits in their investments. Meanwhile, according to
Mohammad Akram Khan (1990), musharakah is a contract between two people making a financial
business to make a profit. For mudharabah, there are scholars who also give the same definition.
Although musharakah and mudharabah are both based on partnership and collaboration, there are
differences that need to be clearly understood between the two contracts. Musharakah involves the
contribution of capital and labor by both the investor and the entrepreneur; while for mudharabah,
the investor provides the capital and only the entrepreneur conducts the business.

Financing based on partnership and PLS such as mudharabah and musharakah are still less accepted
by Islamic banking institutions in Malaysia. Although musharakah and mudharabah concepts are
presently practiced, the number and amount financed are very small compared to the overall
financing. According to Bank Negara Malaysia’s (BNM) Feb 2014 monthly statistics, the total
aggregate financing of Islamic banking system in Malaysia through musharakah and mudharabah
contributed only 6 per cent of the total aggregate financing despite their noble concepts often being
preached by Islamic economic scholars who uphold the spirit of Islamic banking in helping the
community to achieve fair and equitable distribution of profit and reduce the gap between the rich
and the poor. As such, the Islamic banking institutions should offer more financing opportunities
through the concept of mudharabah and musharakah which are based on the spirit of collaboration
that will improve the economy of the Muslims. At the same time, PLS financing portrays its critical
role in helping the alleviation of the living standard of society through business activities promoted
by Islam.
 Current Issues of Islamic Contract in Malaysia

Review of literature: Musharakah and mudharabah

Past studies revealed that there are similar characteristics between musharakah and

mudharabah in Islamic financing contracts.

In a study done by Noraziah (2010), a review was done on the parameters set by BNM through
specific definition in identifying important features; so as to understand the needs of Shariah
contract. This includes the parameters in musharakah covering capital, management, PLS and
partnership. The features identified in these parameters can help the financial services industry to
identify, understand, offer and distinguish this contract from other contracts prevalent in the
industry. Shariah parameters for musharakah and mudharabah in Islamic financial institutions will
help and contribute to the socioeconomic development, especially in helping small entrepreneurs.

According to Al-Suwailem (1998), there is a great potential in musharakah venture capital for Islamic
financial institutions to invest their funds into because this type of investment will improve the
country's growth. However, Al-Suwailem is of the opinion that it does not mean musharakah based
venture capital would not fail or be involved in activities which are deemed illicit or ‘haram’. It just
presents an attractive alternative for the financing of investment other than debt-based financing,
especially in Muslim countries.

According to Kamaruzaman (2005), the mudharabah and musharakah Islamic venture capitals do not
differ much from any conventional venture capital. 2 However, what set them apart are the
principles, implementation and operation that become the foundation of the financings granted.
Both musharakah and mudharabah contracts are seen to be in line with the spirit of venture capital
and have a positive potential to continue to grow in line with the development of the Islamic
financial system in Malaysia.

In the study done by Siti Noor Aini and Hassilah (2012) on the principle of mudharabah, the elements
of uncertainty and speculation that exist in the conventional derivatives can be avoided. According
to them, in conventional derivatives, the investors do not need to know in detail the business
involved and they only get their share of the benefits at the end of maturity period. This situation
clearly demonstrates the element of injustice because it involves gharar (uncertainty) as the
entrepreneur’s practices are questionable, i.e. whether the business is conducted in the right manner
or otherwise. Therefore, the author suggested that the principle of conventional options in
derivatives be converted to mudharabah principles. According to Erni Susana and Annisa Prasetyani
Erni (2011), the mudharabah funding by PT. Bank Muamalat Indonesia is Shariah compliant. The
guarantee provided by the bank to the entrepreneur is allowed according to the Fatwas of National
Shariah Board (DSN), Indonesian Ulama Council (MUI) 2003. In addition, the financing decision was
based on the 6Cs (character, capacity, capital, collateral, condition of economy, constraints). The
usage of mudharabah financing in all sectors of the economy can provides benefits and prohibits
business that contains non-halal elements.
Current Issues of Islamic Contract in Malaysia