Debt vs Equity in Islamic Banking

Debt Vs. Equity- A critical analysis from both

sharia and economic point of view.

July’2011 Submitted by:

Bashir uj Jaman

Markfield Institute of Higher Education,Leicestershire, UK

Equity

Some Scholars claim that equity

financing schemes such as

Musharakah and Mudarabah are

more Islamic than other debt

financing schemes. Do you agree

to this claim? Analyse this issue,

either from the perspective of

economics or Islamic

Jurisprudence.

Though using debt based instruments such as

Mura’baha and Sa’lam is permissible by Sha’ria

but Maq’sad al sha’ria expects that Islamic

banking should maintain a balance between debt

and equity. As because, equity instruments such

as Muda’raba and Musha’raka brings justice to

the whole economy.

Debt Vs. Equity, A critical analysis from both sharia and economic point of view

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Bashir Uj Jaman MA (top up), Sep’2010 session

Noble Prize winner, father of microcredit, Professor Dr. Muhammad Yunus in a lecture to

students of economics said ‘’ Sometime knowing nothing is better than knowing something’’.

He explained, at the inception of microcredit system, he was able to take his innovative

structure of developing microcredit system with poor people, only because he knew nothing

about conventional banking system. Conventional banks does not lend to poor people

because they do not have any collateral or guarantor. Professor Yunus did everything

opposite of conventional bank. Conventional banks do not lend without collateral, Grameen

bank established by him lend without it. Conventional bank lend to man, Grameen bank lend

to woman. He criticized conventional bankers that because of their educational background in

banking or for their previous work experiences in banks, they were not able to think out of

the box which grameen bank did. Innovation and working against the wave of conventional

banks with a philosophy of reaching poor was the main reason behind Grameen bank’s

success.

Islamic banks with an aim of bringing revolution to the economy with interest free ethical

banking should be able to invent product out of the box with different structures. That was

the dream of first generation Islamic economists to free the economy from the burden of

fixed rate interest and from the debt based economy leading to credit crunch. Foundation of

Islamic banking was drawn from the principle of sharia Al gunum-bil Gurum- no risk, no

profit. That is why, most of the Islamic scholars in their literature talked about designing a

banking system based on profit and loss sharing (PLS) which brings equity and justice to the

society. Debt based products such as Murabaha was allowed to practice only in exceptional

circumstances. But in the course of time, permission of exception has turned into norms and

core activities of Islamic banking practice nowadays. Therefore, question arises, is Islamic

banking moving away from the principles laid out by sharia? Is it becoming like other

capitalist, profit oriented banks with the fabrication of Sharia engineering? Or, is this the only

option and reality that must be followed by Islamic banks as a financial intermediary?

Islamic banking came into existence with an aspiration to save Muslims from the sin of

involving into interest based banking. At the very beginning when Islamic scholars were

shaping layout of Islamic banking, they were actually thinking of finding an alternative of

fixed interest rate banking. Criticism about conventional banking came from different angles

but the most common one was that influences of fixed rate interest makes rich, richer and

poor, poorer (Usmani, 2002). Because, depositor with surplus money are guaranteed fixed


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interest rate return but entrepreneur who has expertise but is in need of money is burdened

with fixed rate interest, no matter how the real economy performs. Therefore, at the inception

of Islamic banking prevailing belief was that Islamic banking will remove ‘‘fixed rate

return’’ interest with ‘‘profit and loss sharing (equity)’’ interest free scheme (Warde, 2000,

75-76). On the other hand, Islamic bankers who got their first hand training and experiences

from conventional banking were searching for Sharia compliant fixed rate return products

because of less risky nature of it. When they have found Murabaha to be used with deferred

payment basis, they have started using it excessively. Hence, it is necessary to analyse

whether moving away from equity (profit loss sharing) to debt based financing is taking

Islamic banks away from the spirit of Sharia (Maq’sad al Sharia).

Equity is ownership in business which gives right to participate in earnings while debt is the

right to be repaid with a set rate of return (Walter, W. Robert, 2004). In conventional banking

practice of equity is known either in the form of venture capital or by the term private equity

(Abu Umar, 2010). Different forms of equities are used in capital market as either preference

shares or equity shares. Preference share holder gets the right to receive profit prior to equity

share holders at a fixed rate basis (Bhattacharyya, 2005). According to principle of Islamic

Sharia of ‘’profit comes with risk’’, preference shares is not Islamic. Because, it is invested in

fixed rate return basis and it gives priority over equity shareholders though both equity and

preference shareholders suffers same risks. On the other hand, Islamic equity based on

Musha’raka and Muda’raba, all the shareholders shares same risk and benefit by their

investment or human labour.

Conventional banking system creates debt by lending money in interest basis. Islamic banks

create debt with sale of assets in bai’ muajjal (deferred payment), Salam or isti’sna basis.

Critiques argues, does it make any difference whether debt is created either by lending money

or by selling goods with same interest rate benchmarking? But Islamic sharia does not have

any restriction on amount of profit if the mechanism of earning profit is sharia compliant.

Therefore, it is necessary to understand arguments of Islamic economists about use of both

equity (Profit and loss sharing) and debt financing.

Gafoor (1995) has cited most of Islamic economists who felt alternative Islamic banking

system based on profit and loss sharing instead of conventional interest based banking.

Among them are Anwar Qureshi (1946), Naiem Siddiqi (1948) and Mahmud Ahmad (1952)


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in the late forties, followed by a more elaborate exposition by Mawdudi in 1950

(1961). Muhammad Hamidullah’s 1944, 1955, 1957 and 1962, Muhammad Uzair (1955).

Abdullah al-Araby (1967), Nejatullah Siddiqi (1961, 1969), al-Najjar (1971) and Baqir al-

Sadr (1961, 1974) were the main contributors to the literature of Islamic economics. They

have all recognised the need for commercial banks and the evil of interest in that enterprise,

and have proposed a banking system based on the concept of Mudarabha - profit and loss

sharing.

Dususki (2007) has categorizes two different views based on Islamic banking structure and

objectives; Chapra’s model and Ismail’s model. Chapra’s model favours PLS and places

greater social welfare responsibilities and religious commitments upon Islamic banks in order

to achieve the Islamic economic objectives, including social justice, equitable distribution of

income and wealth, and promoting economic development. Although they do not fully

negate the use of other Sharia permissible debt-based contracts alongside the equity-based

contracts, they do assert that the socio-economic objectives including social justice, economic

growth, efficiency and stability that Islamic economics seeks to achieve are better served by

resorting primarily to equity-based contracts.

An alternative vision for Islamic banking is proposed by Ismail’s framework. According to

this view, an Islamic bank should act as a normal commercial entity that aims at maximizing

profits so long as it is done in a manner consistent with Islamic law. Hence, the

overemphasis placed on PLS modes of financing is argued to be inappropriate and unfounded

in any Qur’anic text and even incompatible with the methodology of Shariah.

On the contrary, Wahbah Al-Zuhayli believes that as what stated in his famous book ‘’Al-

Fiqh Al-Islami wa-Adillatuh’’, Islamic banks must be sensitive to the needs of the society

since its primary goal is not profit making but rather to endorse social goals of socio-

economic development and alleviate poverty. This could be achieved if Islamic banking able

to handle macroeconomic shocks by reliance on equity rather than debt.


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Therefore, the most widely held view is that Islamic banks should deemphasize use of the

fixed rate of return instruments, and that, reversing present trends, they should be run

exclusively on the basis of the profit and loss sharing (PLS) principle to become truly Islamic

(Farooq,2006).

Interest has been prohibited because it brings unethical risk free gain to depositors. Vogel and

Hays reveals: "While the distinction from a mere loan is compelling in theory, in practice

Islamic banks often employ various stratagems to reduce their risks in murabaha almost to

zero, particularly in international trade." Thus, quietly they have disengaged from the

PLS/risk-sharing modes and embraced Murabaha, which is described by many as "murabaha

syndrome.

In an interview with Menachem Wecker, Dr. Askari said, “What you see today isn‟t Islamic

finance,” he says. “Most of the banks do not have that risk-sharing component. Investors

want a bond, and banks create something that looks like a bond but they say it is not a

bond, so that it is Sharia compliant.” According to Dr. Askari, Islamic bonds named sukuks

make as much sense as transparent hijabs because of its fixed return nature.

Ibn Yusof (2009) argues that Many Muslims are reluctant to put their faith in Islamic banking

as they see that it is very similar to conventional banking, and only boasts of a difference in

form not in substance. In order for Muslims to wholly embrace Islamic finance it is very

important that the substance of the contracts change and we begin to use our own unique

equity contracts such as Mudharabah and Musharakah. Only then operation of islamic bank

will be in line with Maqasid Al-Shari’ah.

With all these arguments in favour of PLS based investment mode, still 85% of investments

in Islamic banks are based in Mura’baha. There exist some challenging obstacles in

implementing PLS based Mudaraba and Musharaka, which has taken away practice of

Islamic banking from theory. Due to moral hazard and adverse selection problems in all

agent-principal contracts such as mudaraba, there is a need for closer monitoring of the

project. This requires project monitoring staff and mechanisms, which increase the costs of

these contracts. Moreover, on the liabilities side, the structure of deposits of Islamic banks is

not sufficiently long term, and therefore they do not want to get involved in long-term

projects. PLS contracts require a lot of information about the entrepreneurial abilities of the


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customer. This may not be easily available. Muhammad Abdurrahman Sadique (2010)

pointed out that,

„‟Tax structures are regarded unfavourable to equity formats. While interest payments

are deductible expenses and result in reducing the tax burden, adopting equity financing

thus claiming a share in profits could increase tax liabilities for the entrepreneur‟‟.

Rajesh Aggarwal and Tarik Yousef (1996) has found in their analysis that although Islamic

banks are or should be based on the profit and loss sharing principle, given the economic

environments in which they operate, this type of financing may not be possible. Both adverse

selection and moral hazard suggest the need for some sort of debt-like instrument. The

markup principle embodied in murabahah contracts is a rational response to informational

problems. Therefore, debt based fixed return mode is more preferable by bankers. History

shows that even cash waqf method called Istiglal, a sort of sale/lease-back transaction, was

established to generate fixed income rather than the Mudaraba already recommended by

Imam Zufar at the time (Murat Cizakca, Date Unavailable ).

On the contrary, David F. Swensen, who manages probably the most successful endowment

fund in modern times, writes that he does not like to invest in debt instruments because of the

moral hazard and prefers equity. This is the exact opposite view of the prevailing one and is

clearly food for thought. Mr. Swensen rightly claims that the debtor always tries to increase

his debt level to leverage his equity position.

Though creating debt is permissible by sharia but it is not encouraged by Islam. Prophet

(pbuh) has even declined to pray Jana’za (Funeral prayer) of Sahaba who had debt.

Therefore, there must be a balance between use of equity and debt in Islamic banking. But in

reality, use of equity is declining day by day in Islamic banking.

Dr. Mehmet Asutay (2008) mentioned, „‟Malaysian IBF case depicts that the percentage

share of musharakah declined from 1.4 per cent in 2000 to 0.2 per cent in 2006, while

major modes of Islamic financing remain to be bai bithaman ajil and ijara wa iqtina

(leasing and subsequent purchase) with 55.9 per cent and 25.2 per cent respectively in

2006‟‟.


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Whatever is the degree of success of individual Islamic banks, they have so far failed in

adopting PLS-based modes of financing in their business. Even specialized Islamic firms, like

Mudaraba Companies in Pakistan, which are supposed to be functioning purely on a PLS

basis, have a negligible proportion of their funds invested on a Mudaraba or Musharaka basis.

This clearly shows that Islamic banks are clearly following conventional banks and are not

behaving in a responsible way. Thus dream of a banking system based on equity and justice

will remain unfulfilled. Use of excessive Mura’baha with deferred payment is subject to same

consequences of credit crunch of conventional banking system. Gassner (Date Unavailable)

says that, ‘‟Wealth gets created by productive investments. Hoarding is meaningless and

fixed income unattractive‟‟. Mohammed Akacem and Lyndie Gilliam (2002) have examined

effectiveness of three models, pure equity finance, pure debt finance and a combination of

two. They have argued that equity model is better able to handle macroeconomic shocks

because of its reliance on equity rather than debt. Islamic banking based on profit and loss

sharing (PLS) transfer some risks to depositors. Hence both depositors as well as bankers

remain cautious and responsible about its investment. Therefore, PLS based Islamic banking

system is capable of saving Islamic banking from financial shocks in world economy.

From the above discussions, it is being clearly found that PLS based equity investment such

as Muda’raba and Musha’raka are better than debt based instruments such as Mura’baha and

Sa’lam from both sharia and economics perspectives. It is being already 40 years since

Islamic banks has started its journey. They have relied on Mura’baha excessively with an

excuse of competing with their conventional counterparts. Sharia scholars remained silent

because, maturity of pure Islamic finance should be given some time. As even prohibition of

alcohol came in three stages, it was not commanded all on a sudden. But most of Islamic

scholars now feel that it is the right time to move back to have some self criticism in industry

level and structure Islamic investment based on pure PLS system. Otherwise, Islamic finance

will lose its confidence from different stakeholders at the long run.


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Documents

Debt vs Equity in Islamic Banking