Assessing Moral Hazard Problem

in Murabahah Financing1
Rifki Ismal2
Abstract
Murabahah is a dominant financing instrument in most Islamic banks all over the world.
However, price volatility of the good being financed opens a chance for entrepreneurs to gain
profit by pretending to be default (moral hazard). Assessment on condition triggering such
moral hazard and probability of entrepreneurs to take risk of pretending to be default are
being analyzed. Finally, Islamic bank can mitigate it through appropriate banks
investigation and charging some cost as well as penalty.

.
Keywords: Murabahah, Moral Hazard, Price Risk, Penalty

1. Introduction
Islamic banking theory recognizes financing allocation into three types which are: (a)
Equity based financing; (b) Debt based financing and; (c) Benevolent loan and
services3. Islamic equity-based financing is an Islamic investment engaging at least
two parties to do business together under sharia principles3. Examples of this are
Mudarabah (trustee partnership), Musharakah (joint venture), Muzaraah (Harvest
Yield Profit Sharing) and Musaqot (Plantation Management Fee Based on Certain
Portion of Yield) (Antonio, 1999:143-155).
Meanwhile, debt based financing is a trade based financing engaging related parties
with buying and selling of good under sharia principles. This financing consists of
Murabahah (cost-plus sale), Ijarah (leasing), Bay Salam (deferred delivery sale), and
Bay Istishna (manufacture-sale). Lastly like its counterpart, Islamic banks also
provide a range of banking services such as Wakalah, (opening of letter of credit),
Kafalah (letter of guarantee) and Hiwala (debt transfer) (Obaidullah, 2005:113-115).

1
2
3

The author acknowledges his debt to Dr. Abbas Mirakhor for his extensive and helpful
guidance and comments on this paper
The author address: School of Government and International Affairs, Al Qasimi Building,
Elvet Hill Road, Durham University, Durham (DH1 3TU), United Kingdom (UK).
Fee based and fund based services

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102

Amongst all kinds of financing, debt based financing is the most favorite one in
particular Murabahah financing. Islamic banks use it is because (a) Murabahah rate of
return is predetermined, fixed and continues (b) Trade financing does not require
much efforts to monitor, cooperate or evaluate like investment based financing and
(c) Risk of default is relatively low. Whilst for the entrepreneurs, Murabahah is
preferable due to its (i) Fixed rate of return along payment period (ii) No charge for
late payment/default (iii) Treating an asset being purchased as collateral, etc (Roosly,
2005).
Nevertheless, Murabahah financing in sharia point of view contains several risk to be
anticipated by the banks. Such risks are price risk, default risk, commodity risk and
market risk. Focus of this paper is to price risk, which is the volatility of a commodity
price along its financing period (Iqbal and Mirakhor, 2007:233). Banks clients in this
case might potentially earn monetary benefit when the price of a good being financed
through Murabahah is going up more than its beginning price when Murabahah
contract was signed. Hence, there comes up three options for him to do. First is to
continue Murabahah contract until end of the period and realize the gain from the
price margin assuming future price of the good is still high. Or, second option is to
immediately terminate Murabahah contract by pretending to be default and earn
monetary benefit when price of the good has reached its highest level. Lastly is to
fully pay the total Murabahah contract on the spot with/without a hope for price
rebate as some scholar prohibits it.
Focus of this paper is to that second option because it can be classified as a moral
hazard problem in Murabahah contract. In sharia point of view, if the entrepreneur is
really in a default situation, there are only limited actions that can be pursued by
bank; (a) Extending Murabahah payment period until entrepreneur has financial
ability to continue it (Holy Quran 2:280) (b) Ending the contract with an obligation
to the entrepreneur to fulfill all of his payments (c) Selling the asset in the market as it
functions as a collateral in the contract and using the income to settle the rest of the
payment. Nonetheless, those actions only apply to an honest default. If the
entrepreneur pretends to be default it is intolerable and Islamic bank might suffer
some problems because of it, such as:

Interrupting banks predetermined cash flow in asset side, which has been
planned and adjusted with its liability side.

Disrupting banks predetermined profit calculated along Murabahah contract

(from the beginning until ending of the contract period).

Selling an asset in the market causes extra cost.

Assessing Moral Hazard Problem in Murabahah Financing

103

It requires sudden investigation (I) by bank to check the real condition of the
Entrepreneur with the cost borne by bank itself if entrepreneur is in honestly
default.

Considering those problems, it is important to prevent entrepreneur to do such a

moral hazard by finding what condition that can trigger it to happen, how big the
probability is and how Islamic bank can discourage it. Inspired by Dr. Habib
Ahmeds paper (2000), this paper explores moral hazard in Murabahah financing
contract by modifying and extending Dr. Ahmeds works combined with applied
finance/mathematical theory to model such moral hazard and find out appropriate
ways to mitigate it.

2. Murabahah Financing
2. 1. Model Selection Criteria
This part elaborates Islamic banking selection criteria in advancing Murabahah
financing to its business partners. It is going to be a starting point to know what kind
of condition that can trigger moral hazard to appear. But before that, several
assumptions below are used as the basis of the analysis.

Entrepreneur proposes Murabahah financing to Islamic bank for an asset

valued as V in time period t = 0. It also functions as collateral in Murabahah
contract.

To acquire such asset, entrepreneur proposes the bank to finance major part
of asset value or L at time t = 0. L is the residual value of the asset after down
payment (Dp) made by entrepreneur to the vendor. Down payment is counted
as Dp = DpV. Hence L = (V DpV) and L<V.

Bank is risk neutral.

Mark up (rm) is set by bank after purchasing an asset and signed bilateral
Murabahah contract with the entrepreneur. rm is assumed to be composed of
(i) rate of profit (m) and (ii) administrative cost (Ca). Thus, rm = m + Ca.
Therefore, L(1 + rm) is the total Murabahah contract to be paid from t1 until tn
(end of Murabahah contract).

Bank conducts Murabahah investigation regularly or upon demanded. During

Murabahah contract, investigation is done to monitor the entrepreneurs
financial ability while in case of default; investigation is placed to ensure the
real condition of the entrepreneur. Cost of such investigation is borne by bank
but if the entrepreneur is proven to do moral hazard, he has to cover this cost
alone.

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Following all assumptions, regular Murabahah payment from entrepreneur to Islamic

bank is formulized as
n

t =1

t =1

L(1 + rm ) t = (V D pV )(1 + rm ) t
and roled as a regular cash inflow for the bank. Finally, Islamic bank for the sake of
this research judges three variables as criteria to select Murabahah financing proposal.
Firstly is information about entrepreneur (), normalized to unity (0< <1), leading
to adverse selection (AS) or AS = (1/). If bank only knows less information about
the entrepreneur, 0 meaning there will be adverse selection, whilst if bank has a
lot of positive information about entrepreneur, 1 meaning there will be no adverse
selection.
Second variable to be evaluated is whether entrepreneur has saving account (T) in the
bank. Assuming the same normalized unity as information variable above (0< T <1),
Murabahah financing will be given if entrepreneur is the banks own depositor (T
1) meaning he has account in the bank and no financing will be given if entrepreneur
is not banks depositor or T 0. Finally is price and expected price [E(Pv)] of the
good planned to be purchased in the market. According to the standard economic
theory, price of the good in the market is determined by market demand (D) and
Supply (S) or E(Pv) = (D,S). Thus, if E(Pv)>V0 Murabahah financing will be
extended but if E(Pv)<V0 it will not be realized thereof. This third variable is notably
the source of moral hazard in Murabahah. Particularly, when the existing price of a
good is in higher position than the first price (when firstly bought).
Based on those three set of variables, Islamic bank evaluates various Murabahah
proposals with parameter = (, T, Pv). Note that the higher the risk, the closer to
unity (0< <1) and Islamic bank will tend to release funding for Murabahah
proposal. Later on, this indicator underlies a condition that opens a chance to the
entrepreneur to do moral hazard upon receiving Murabahah financing.

2. 2. Financial Decision in Murabahah Financing

As Murabahah is remarkably a trade-based contract with a deferred payment, total
payment of Murabahah contract will be treated as opportunity cost concept related to
the present and future value of the total payment (Benninga, 2000:1-10). However,
unlike conventional way of using interest rate to calculate present and future value,
sharia adopts rate of return (rm) as a controllable tool to direct the present of future
value of payments being made. With respected to Murabahah financing, Islamic bank
will decide to release financing if the present value of the total Murabahah payment is

Assessing Moral Hazard Problem in Murabahah Financing

105

higher than (or at least the same as) total proposed Murabahah financing (L0), or
simply said PV L0.
By adjusting conventional present value formula to Islamic perspective, total present
value of Murabahah financing is derived as follows:
n

PV =
t =1

L
and because L = (V D pV ) so PV of Murabahah financing is
(1 + rm ) t

formulated as

(V D pV )

t =1

(1 + rm ) t

PV =

. Recalling Murabahah financing decision

prerequisite of PV L0, Murabahah proposal from an entrepreneur will be approved

if

(V D pV )

t =1

(1 + rm ) t

L0 while PV = L0 represents internal rate of return (IRR) which

is a breakeven point between financing being given and payments received alongside
period of Murabahah contract. In order to gain profit, Murabahahs mark up rate rm
should be determined in a higher rate than IRR or r*m rm. Then, the final Murabahah
financing decision will be

(V D pV )

t =1

(1 + rm* ) t

L0 noting that r*m is the profitable

Murabahah mark up rate for the bank.

3. Moral Hazard in Murabahah Financing

3. 1. Conditions Triggering Moral Hazard
As briefly explained above, entrepreneur, who occupied Murabahah financing
contract, can be tempted to do moral hazard whenever there is a possibility for that.
Logic behind it is monetary benefit possibly gained by pretending to be default to
terminate the contract rather than continuing it until end of Murabahah contract.
Continuing the indication of moral hazard appeared inherently with fluctuation of the
price, there are three scenarios of price risk with respected to the probability of doing
moral hazard as explained in the following:
Higher Current Market Price than the First Price Agreed in Murabahah
Contract
Current market price of a Murabahah good is higher than the first price when it was
agreed to finance or Vk > V0. Intuitively, entrepreneur might think of possibility to
gain some benefit by squaring the contract, releasing the good but receiving some
money from it especially if he also has enough saving (T) in the bank to cover the
cost upon needed. He pretends to be default although pretending itself is a kind of

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106

dishonesty and not allowable in Islamic financing principle. For entrepreneurs,

settling Murabahah contract of working capital good (machinery, operational car, etc)
when they have a better alternative is not impossible, especially if they can benefit by
doing it. Specially, it is possible when a higher current market price facilitates them to
do such execution.
What are benefits of pretending to be default to end the contract unilaterally?
Following some unwanted output faced by Islamic bank as an impact of this
unplanned termination of Murabahah contract, entrepreneur will get:

Profit margin from a higher current market price of the good than the starting
price in the contract (assuming cost of selling, etc is not significant).

A release from an obligation to continue Murabahah contract and can utilize

his money (allocated previously for payment) for other purposes.

Another alternative to replace the good especially if the Murabahah good is

not needed again or there is a better alternative other than acquiring the good
at the end of Murabahah contract.

Nevertheless, as the entrepreneur declares himself default, Islamic bank will

instantaneously arranges an investigation to find out the real situation. For this
entrepreneurs declaration, probability of arranging investigation (I) is almost 1
(assuming unity index 0< T <1) and the consequences of this sudden investigation are
definitely two (i) If bank finds and believes that entrepreneurs default is real then the
cost of investigation will be under their responsibility as it should be, but (ii) if bank
finds that it is fraud (pretended to be default), the entrepreneur should bear
investigation cost and other penalties explained later.

No Changes in Market Price of the Good

If the price of a good is relatively the same as the first price agreed in the
contract (Vt = V0), entrepreneur will less consider of pretending to be default unless
he is really default consciously. The probability of doing investigation for this case
would only be 0< I <1 as Islamic bank also realizes that entrepreneur will not try to
deceit due to zero benefit of doing it. Even, if the entrepreneur is really in default and
investigation finds it true, cost of investigation and penalties will not charge him (still
responsibility of the bank). The result of ending the Murabahah contract in this case is
under bilateral decision and consciousness meaning that any benefit or loss appears to
entrepreneur at the end contains no dishonesty.

Lower Current Price than the First Price Agreed in Murabahah Contract
Undoubtedly, this condition (Vt < V0) brings no incentive for entrepreneur to conduct
moral hazard like in the first scenario and probability of banks investigation is nearly

Assessing Moral Hazard Problem in Murabahah Financing

107

zero (I 0). Entrepreneur has to pay for investigation cost and penalties as well if he
pretends to be default and proven as cheating (moral hazard) according to banks
investigation. Even if, banks investigation fails to prove it as less probability of
doing it, ending Murabahah contract by selling the good to the market might cause
him to add more money to cover the rest of the total L(1 + rm) as the current market
price of the good is lower than the first price agreed in the contract. However, as
entrepreneurs often engage in Murabahah contract for a real and marketable capital
good, so this scenario of lower current market price than firstly agreed price rarely
happens. Whilst like the same case in the unchanged price above, if the entrepreneur
really goes bankrupt and cannot fulfill his payment obligation, any benefit or loss
appears to entrepreneur at the end of Murabahah contract contains no dishonesty.

3. 2. Consequence of Price Risk

Now, focus of the analysis is to scenario of the higher current market price of the
good as it opens the opportunity of moral hazard. When entrepreneur dares to pretend
default, what is the banks total receipt if Murabahah contract has to be ended
unscheduled? Assuming that banks investigation fails to detect entrepreneurs moral
hazard, Islamic bank will get total accumulated payment of:
k

TRb =

L(1 + r
t =1

) + sV k

* t
m

(1)

with k = termination of Murabahah contract and s = portion of asset value (after being
sold) located for bank. To see the present value of TRb, it has to be adjusted with rate
of return as explained earlier. Total cost occurs in termination date is:
TCb = I + Cs

(2)

with Cs = cost of selling such asset to the market. Thus, total profit (b) for bank of
this moral hazard practice is:

b = L0 +
t = 1

V (1 D p )
+ sV k I C s
(1 + rm* ) t

(3)

As the equation 3 above has been in form of net present value, the value of L0 is
negative representing initial financing value followed by positive revenue received
from payment of Murabahah from t = 1 into t = k.
Meanwhile, if banks investigation successfully detects this entrepreneurs moral
hazard practice, total cost will be zero assuming no other related cost except
investigation cost (I) and cost of selling the good to market (Cs). Total profit of
Islamic bank becomes:

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108

b = L0 +
t =1

V (1 D p )
+ sVk
(1 + rm* ) t

(4)

For the entrepreneur, this scenario produces total revenue of:

TRc = (1 s )Vk

(5)

because he does not have any asset left but he potentially gains income from price
margin of selling asset in the higher current market price. TRc has already counted
total entrepreneurs payment of Murabahah from t = 1 until t = k. Then, if banks
investigation fails to detect his practice, total cost (TCc) is zero ending up with total
profit (c) = TRc (equation 5).
But, if his practice is caught by bank, unfortunately he has to bear I and Cs so that his
total profit is:

c = (1 s)Vk I C s

(6)

For a comparison, lets examine a normal condition when entrepreneur continues

Murabahah constract until end of the period without any willingness to take moral
hazard consequences. In this situation, total revenue for the bank is:
TRb =

t =1

t =1

L(1 + rm* ) t = V (1 D p )(1 + rm* ) t

(7)

Total cost (TC) is only investigation cost (I), so total profit counts to be:

b = L0 +
t =1

V (1 D p )
I
(1 + rm* )

(8)

On the other hand, entrepreneur receives TR as the last market price of the asset (Vn),
but his total cost is:
n

t =1

t =1

TC c = L(1 + rm* ) t = V (1 D p )(1 + rm* ) t

(9)

without any obligation to pay both investigation cost and selling cost. Then, his total
profit in this case becomes:

V (1 D p )
* t
t =1 (1 + rm )

c = Vn

(10)

3. 3. Chance of Doing Moral Hazard

Using set of formula calculated above, entrepreneur will happily do moral hazard if
profit of doing it is bigger than not doing or (mh > co). Under two consequences of

Assessing Moral Hazard Problem in Murabahah Financing

109

being found or not found by banks investigation, every scenario is shown in the
following:
Moral hazard is not found by banks investigation:
Profit resulting from moral hazard is mh = (1 s)Vk , whilst normal profit of

V (1 D p )
so moral hazard happens if:
* t
t =1 (1 + rm )

continuing the contract is co = Vn

n V (1 D p )

(1 s )Vk Vn
* t
+
(
1
r
)
t
=
1

(11)

Moral hazard is found by banks investigation:

Profit resulting from moral hazard is mh = (1 s )Vk I C s , whilst normal profit

V (1 D p )
so moral hazard happens
* t
t =1 (1 + rm )

of continuing the contract is co = Vn

if:

n V (1 D p )

(1 s )Vk I C s Vn
* t
(
1
r
)
+
t
=
1

(12)

4. Minimizing Moral Hazard in Murabahah Financing

4. 1. Charging Penalty
Because of some negative impacts of this moral hazard practice mentioned previously
and to create trusted relationship between bank and entrepreneur, Islamic banks may
impose penalties besides assigning entrepreneur to pay for investigation cost and cost
of selling. However, such penalty should fulfill at least two prerequisites (a) It is
charged during Murabahah period and not at the end of the contract period (b) It is
charged because entrepreneur deceives the bank while in fact he is in a good financial
capability to continue Murabahah contract until the end of the period. In principle,
this penalty is set to minimize entrepreneurs total profit resulted from price margin
into the level that causes him to just continue the contract until end of the period.
Total amount of penalty borne by entrepreneur of his moral hazard is counted as
{(1-s)Vk} which is percentage of entrepreneur net profit after selling Murabahahs
asset. As a result the chance of doing moral hazard become more difficult as the profit
from moral hazard is now mh = (1 s )Vk I C s [(1 s )Vk ] or simply,

mh = (1 s)Vk [1 ] I C s

(13)

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V (1 D p )
so
* t
t =1 (1 + rm )

whilst normal profit of continuing the contract is still co = Vn

the chance of conducting hazard happens might appear if:

n V (1 D p )

(1 s )Vk [1 ] I C s Vn
* t
t =1 (1 + rm )

(14)

4. 2. Effective Investigation
After charging penalty, effective investigation plays important role to detect and
minimize the probability of doing moral hazard. The entrepreneur on the other hand
considers the probability of banks investigation (to avoid sanction), as crucial factor
to calculate cost and benefit of doing moral hazard. Thus, if probability of banks
investigation can be written as PI, the probability of moral hazard and the policy of
bank to stop it can be determined. Summarizing all profit alternatives of entrepreneur
above into table below:

Table: Profit to Continue and Do Moral Hazard

Entrepreneur

Profit to continue (c)

Found in
Investigation

co = Vn

Unfound in
Investigation

co = Vn

Profit to moral hazard (mh)

V (1 D p )
* t
t =1 (1 + rm )

mh = (1 s )Vk [1 ] I C s

V (1 D p )
* t
t =1 (1 + rm )

mh = (1 s)Vk

The probability of continuing Murabahah contract until the end of the period4 is
found as:

V (1 D p

co = PI Vn
* t

t =1 (1 + rm )

(15)

and the probability of terminating it (pretending to be default) is counted as:

4
5

Sharia principles prohibit business dealing with non halal item (pork, alcohol, etc),
speculative activities, gambling, etc.
Totaling profit gained if investigation occurs and if investigation does not occur

Assessing Moral Hazard Problem in Murabahah Financing

mh = PI {(1 s )Vk [1 ] I C s } + (1 PI )[(1 s)Vk ]

111

(16)

As entrepreneur will try to do moral hazard if mh > co therefore cut-off probability

of banks investigation (PI*) that will lead to moral hazard practice is:

PI* =

(1 s)Vk

n V (1 D p )
[
]

+
+
+

(
1
s
)
V
I
C
V

k
s
n
* t

t =1 (1 + rm )

(17)

Several important points revealed by equation 17 above regarding banks policy to

mitigate moral hazard are:

If probability of banks investigation (PI) is less than (PI*) or (PI<PI*),

entrepreneur will most likely pretend to be default (moral hazard) knowing
that the profit of doing it is higher than just continuing the contract.

Moral hazard problem will likely to take place not only when probability of
banks investigation is low but also due to a very high current market price of
the Murabahah good leading to a promising profit to square the contract prior
to its end period.

Hence, to mitigate such moral hazard, Islamic bank has to (a) Determine
probability of banks investigation (PI) so that PI = PI* and (b) Set an
appropriate percentage of entrepreneurs net profit after selling Murabahahs
asset () to reduce entrepreneurs profit of terminating the contract prior to its
end period (1-s)Vk besides charging entrepreneur to pay investigation cost (I)
and cost of selling the good (Cs).

5. Conclusion
Islamic banking financing recognizes three forms, equity based financing, debt based
financing and benevolent loan. In practice, debt based financing particularly
Murabahah is dominantly occupied by Islamic banks around the globe. However,
price risk of the good being financed opens a chance for entrepreneurs to gain profit
by pretending to be default. To mitigate such problem, Islamic bank conducts banks
investigation and charging some cost as well as penalty. Hence, entrepreneur will
hopefully keep continuing the Murabahah contract until the end of the agreed period.

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