Variants of Participatory Financing for Risk Assessment and Mitigation in Islamic Banking

Abstract

The participatory modes of Islamic financing including Musharakah and Mudarabah are widely accepted as the ideal modes of financing among the jurists of Islamic banking and finance. However, paradoxically, these are not the most popular modes of financing in practice. The practice of the participatory financing in Islamic banking is constrained by several factors. Therefore, Islamic banks are applying the adapted variants of Musharakah. The present study aims to explore the prevailing variants of participatory financing in the Islamic banking industry of Pakistan using multiple case studies strategy. Findings suggest that Islamic banks adapt the participatory financing to make these fit for SME financing, corporate financing, consumer financing, and commodity operations financing within the embedded contractual variants of Musharakah namely diminishing Musharakah and running Musharakah, while pure Musharakah and Mudarabah are not applied in practice. The study also provide insights into the design of participatory financing arrangements and the procedures adopted by Islamic banks for assessing and mitigating the underlying risks associated to the participatory financing, particularly the risk induced by asymmetric information including adverse selection, and moral hazards.