"The ideal mode of financing according to sharia is mudaraba or musharaka"- Sheikh Muhammad Taqi Usmani, Chairman, Accounting and Auditing Organisation for Islamic Financial Institutions.

The global financial crisis has prompted debate about the use of excessive debt and speculation to fuel growth. It has also renewed calls for Islamic finance to use more equity-based structures such as musharaka and mudaraba and reduce reliance on debt funding.

In light of the current debate on the role of debt to finance growth, Reuters asked industry experts if Islamic finance needs to use more equity instruments and why.

Also, what would be the implications for the Islamic finance industry if there is use of more equity and less debt and would this affect the profitability of Islamic banks?.

Would a shift towards more equity financing make Islamic finance more or less attractive to investors?

Mohamad Akram Laldin is sharia adviser to Malaysia's central bank and executive director of International Shari'ah Research Academy for Islamic Finance (ISRA). Edib Smolo is researcher at ISRA. Both are based in Malaysia.

 

By Mohamad Akram Laldin and Edib Smolo

 

KUALA LUMPUR, April 27 (Reuters) - Since its inception, pioneers of Islamic finance promoted the idea of Islamic finance based on equity and a profit-and-loss sharing (PLS) model. As one of the basic principles of Islamic finance is "no risk, no gain," it implies that anyone who wishes to gain a profit must bear a risk as well.

It is for this reason that some Muslim scholars insist on promoting equity-based modes of financing, such as mudaraba and musharaka.

In the case of mudaraba, the capital provider (rabb al-mal) is solely responsible for the material losses and the manager (mudarib) will bear the loss of the cost of his effort in undertaking the mudharabah venture. The profits are shared according to agreed ratio between the capital provider and manager.

On the other hand, under musharaka, both partners (i.e. financier and borrower) share profit according to agreed ratio, while losses are to be shared according to capital invested by each partner.

If we were to examine some of the major crises in the international financial world, including the current global crisis, we will find that some of the major causes behind them are easy availability of credit and imprudent growth of debt, especially short-term debt.

The current financial system is predominantly interest-based and debt-driven where risk transfer rather than risk sharing takes place.

 

Currently, the use of equity and PLS modes within Islamic finance industry is insignificant. In fact, it is dominated by debt-creating instruments through sales- and/or lease-based modes.

Learning from the experience of conventional financial system and current financial crisis, a shift to more equity-based financial system - where risk-sharing takes place - is the only viable solution. The shift will bring about a balance between Wall Street and Main Street.

Introducing more PLS instruments in the financial system will make both financial institutions and entrepreneurs (borrowers) more responsible as they will assess the risks more carefully and efficiently. As a result, this will bring about stability and justice in the market.

This shift may not be an easy solution right now, and looking from a short-term perspective it may not be profitable and attractive to the investors. However, if we look at this as a long-term solution, then we will be faced with a more stable and just financial system.

This would be a system where the risk-sharing, justice, fairness and stability would prevail. In the long-run, the real investors would be better off, with the overall economy benefiting as well, while the effects of unproductive speculation and gambling would be reduced.

It is important to note that from the sharia perspective, it has allowed both debt and equity modes of financing and there is no indication showing that one is preferred over the other.

 

It all depends on the need of the market to determine which mode is to be utilised. Having said that, there are general principles in the sharia which state that harm shall be prevented and if the over usage of one mode might adversely affect the market or the society at large, than certain control mechanisms must be put in place in order to prevent the harm.

As for the utilisation of debt-based instruments, at the moment, there is no clear indication showing that it definitely leads to harm. However, further studies are needed to ascertain this fact.

It is good to balance between the two as each has its own role to play in the current financial system. If any shift is to be proposed in order to balance them, it should be done gradually as the drastic change might affect the market and the industry adversely.

 

27 Apr 2010