Thursday, February 12, 2009

Islamic Finance: Debt Vs. Equity Financing in the Light of Maqasid al-Shari'ah

Islamic banking is an investment and financing system which expands globally. The Islamic banks have only been established for some 30 years but the banking system is based on long-going traditions within Islamic finance. The system is founded on ethical values and emphasizes the well-being of society as a whole.

A bank that uses its functions and operating modes based on Shari’ah principle is obviously difference than manmade principles. Islamic banks are meant to become finance institutions to help Muslims avoiding riba and other prohibited elements present in commercial and banking transactions. All other Islamic banks, the Islamic Development Bank (IDB) and also the General Secretariat for the Organization of Islamic Conference (OIC) has accepted the definition of Islamic banking as a financial institution whose statutes, rules and procedures expressly state its commitment to the principles of Islamic Shari’ah and forbids of the receipt and payment of interest on any of its transaction.

However, its main purpose may not merely focus to what stated above. As what stated in his famous book Al-Fiqh Al-Islami wa-Adillatuh, Wahbah Al-Zuhayli believes that 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.

Current practice

But what happens today is the other way round, Islamic banks only deals with clients that deserve doing transaction with them while poor people are neglected. The necessities of Islamic banks helping the poor people should be the main focus since 291 million or 24% of the total OIC-LDCs population suffer from human poverty (SESRTCIC, p.41). Thus questions arise from the light of justice and the “maqasid al-Shari’ah”, should the help come in terms of debt or equity? Evidence on current practice by Islamic banks worldwide suggests that the majorities of financing operations are not based on equity but rather takes the form of debt-like instruments (Aggarwal and Yousef 2000; Asyraf and Nurdianawati 2006; Mehmet 2007). This is because according to Mehmet (2007), Islamic banks and financial institutions have opted for profitable Islamic financing such as murabahah instead of musharakah (musharakah is equity-finance oriented and murabahah is debt-financing).

This is proven when Mehmet (2007) quoting Hasan’s recent data while studying the Malaysian case as stated:
The percentage share of musharakah declined from 1.4% in 2000 to 0.5% in 2003. Evidently, it seems that the major modes of Islamic financing are in the form of bay bi thaman al-ajil and ijarah thumma al-bay with 47.4% and 27.9% respectively in 2003 (p.5).

In contrast, an ideal Islamic banking model is reflected through its balance sheet structure that is dominated by profit and loss sharing (PLS) on both assets and liabilities sides. That is why most of the Islamic economics writers believe that PLS is the only principle representing a true spirit of Islamic banking system which departs significantly from the interest-based system (Asyraf and Nurdianawati 2006).

Given the emphasis on equity rather than debt, Akacem and Gilliam (2002) quoting Iqbal and Mirakhor when they argued that an interest-free banking (IFB) model would lead to:
More varied and numerous investment projects for which financing is sought; more cautious, selective and perhaps more efficient project selection by the suppliers of funds; and greater involvement of the public in investment and entrepreneurial activities, particularly as private equity markets develop, than in the traditional fixed interest-based system (p.126).

Islam very much encourage profit that come from trade and productive investment, while fixed predetermined payment is prohibited since it is not a function of the profits and losses incurred in a venture (Akacem and Gilliam 2002). This is among the reason why many scholars hold the views that unless Islamic banking institutions resolve to PLS financing instruments, the socio-economic justice as envisioned by the Islamic banking system would never happen.

The equity based system helps to create more value added in the economy and indeed contribute to economic growth. Therefore, since equity and profit sharing financing is considered to be superior compared to debt-like financial instruments in Islamic economics, the evidence of current practice indicates that the Islamic banks have deviated from the aspirational stand of Islamic economics (Mehmet 2007).

Misgiving on profit and loss sharing (PLS)
The most common arguments against theoretical and empirical issues regarding profit and loss sharing (PLS) are discussed by Iqbal and Molyneux (2006) when some economists such as Stiglist and Weiss (1981) held perception that sharing arrangement such as profit and loss sharing are less efficient. A system that emphasis on partnership becomes an equity-based system with no debt and when the depositors become shareholders is deem to be risky. Among the arguments that being highlighted are such as problem of asymmetric information and the cost involved in reducing it, the problems of moral hazard, adverse selection problem, the agency costs and the need for monitoring the counterparties' behavior.

Some of the Islamic banks have these kind of perceptions towards the sharing arrangement such as profit and loss sharing may argue that agency problem could not be avoided under the behavioral assumption of self interest. This is because the agent may not spent their best effort since they are not using their own money but others, therefore it is very risky.

However, whilst this position has it supporters, their arguments are untenable because in examining the argument that PLS financing is too risky for banks to adopt, Iqbal and Molyneux (2006) found two fallacies in this line of arguments. First, the variability in the rate of return is not the only risk involved in financial contracts. Second, the so called 'fixed return' contracts, like interest based contracts may not in fact yield a fixed return.

Besides, many writers such as Siddiqi, Obaidullah, Chapra, Khan, Ahmed, Dar and Presley come to agreement that Islamic banks exposed to greater risks if the variation of the rate of ultimate return to the banks of their investments is greater and resulted from large scale resorting to PLS instruments could pose much more serious risk and hazards (Asyraf and Nurdianawati 2006).

Moreover, Akacem and Gilliam (2002) and Mehmet (2007) thinks that profit sharing concept may approach to market solution because it requires direct involvement of civil society, managerial skills and expertise in overseeing different investment projects from the banks. The banks need to have a correct perception in considering the superiority of equity financing compared to debt-like instrument.

Therefore, they concluded that the argument that PLS contracts are too risky for Islamic banks to adopt is not convincing. Thus they think further research and discussion is needed in order to provide continued support to the practice of PLS.

Banking from Maqasid Shariah Perspective

Siddiqi (2004) and Mehmet (2007) holds the same view that the Islamic finance should take into consideration the systemic and dynamic understanding of “maqasid al-Shari’ah” (objective of the Shari’ah). Furthermore, they emphasized that the understanding of “maqasid al-Shari’ah” not only covers on individual oriented objectives but also include broader measures ensuring welfare in order to achieve justice and equity. Thus objective of Islam as a whole and “Maqasid al-Shari’ah” (objective of the Shari’ah) should be differentiate clearly because objective of Islam involves aspects of personality and society that the latter does not cover (Mehmet 2007 p.9).

By quoting Siddiqi’s opinion, Mehmet (2007) share the same views that banks should plays its role by serving social objective, not only an individual objective. The noble vision to promote social-welfare of the society is in need to develop a welfare economics oriented paradigm, and he also believes that the social justice and ethical norms can be exercised. Despite that, Asyraf and Nurdianawati (2006) also think that Islamic banks are equally expected to play a leading role in promoting social-welfare. Their opinion are supported by the majority of the Muslim economists who posit that Islamic banking is much more than offering Shari`ah compliant products. It is a system which aims at making a positive contribution to the fulfillment of the socio-economic objectives of the community at large (Asyraf and Nurdianawati 2006).

Mehmet (2007) in his paper stress the importance of Islamic economics aims in creating homoislamicus individuals since it is also the aims of Islam. By introducing new paradigm and changing the behavioral norms of individuals, this could avoid the individuals from becoming homoeconomicus.

A so called ‘social bank’ that suggested by him focus more on the social outcome and effects of the distribution of the products. This is because he thinks it is not difficult for Islamic banks to adopt to become social banking since it did not contrary with the maslahah objective (Mehmet, 2007, p.13). Social banks and Islamic banks to him complement with each other because maslahah provides the moral standard for social good and Shariah requires justice and benevolence. In addition, Islamic banks should correct their failure in introducing robust social justice oriented principle as what done by the social banks (Mehmet, 2007 p.15).

Mehmet (2007) proposed Islamic social banking as the solution in achieving justice and equality by adopting profit and loss sharing in banks operation, it will as well meet not only the “maqasid al-Shari’ah” (objective of the Shari’ah), but objective of Islam as a whole since it reflects “new identity based on substantive and ethical religious tenets” as what mentioned by El-Gamal.
Having said that, this paper has deliberated on the challenges encountered by Islamic banking and finance in meeting justice and equality outlined in objective of shari’ah. These challenges emerge from the current practice of Islamic banking and finance flooded by debt based financing contract in the name of “efficiency” without acknowledging the shari’ah requirement in the contracts. This deviation of shari’ah requirements has tremendous impact to the individuals in the society which leads into deterioration of performance overall economy in which it is clearly against the spirit of Islam, particularly objective of shari’ah. Therefore, for realization of justice and equality for meeting Maqasid Al-Shari’ah can be achieved by shari’ah compliant products which emphasize on equity financing.

After a deep deliberation on foregoing arguments, in order for there to be justice and equality in our economic endeavors it is essential that the poor are given access to funds based on equity, if this is done then it will develop a society and economy of stability, one in which the Maqasid Shariah can be realized in its fullest sense. A society in which there exist gross inequalities can never be stable. This can be seen in many countries of the world today in which due to there being a lack of justice and equality in financing, there has been erosion of Maqasid. Loss of life is a daily occurrence as people struggle to survive and some resort to violence in order to meet there daily expenses. In other parts of the world property is destroyed as people riot due to their dismal state and this is the complete opposite of what the Maqasid adovocates. Hence in order for Maqasid to be achieved it is essential that equity contracts are introduced.

In order for Islamic banking to establish itself as being an effective alternative it is vital that there is actually a difference in substance not only in form as currently witnessed. 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.

Actually, now is the right time for Islamic Banking and Finance having a paradigm shift in the way we view financing and we should all urge for the stronger implementation of equity PLS sharing contracts to be implemented on a mass scale. This clearly will benefit poor peoples particularly farmers will have access to funds hence our productivity and output will increase, our problems of poverty can be eliminated, and society will become more stable these are just some of the benefits that the global economy can experience if there is a full implementation of Equity financing.

As part of that, the arena of micro-financing has emerged as a new alternative for Islamic financial institutions to exploit in order to expand the horizons of their operations. This mode of financing is projected to be to have the capacity to compliment the socio-economic developmental objectives of Shariah since it targets potential entrepreneurs who are relatively economically or financial deprived and handicapped. This mode of financing seeks to induce commercial innovation, entrepreneurship and risk sharing among aspiring entrepreneurs that are not endowed with the financial resources to realize their commercial potentials. Importantly, this mode of financing would immune scale entrepreneur from the exploitation of conventional financial institutions. In the same vein, it would also encourage the channeling of funds to entrepreneurs who otherwise would face upheaval task in their quest to access funds to realize their commercial or entrepreneurial aspirations.

In a nutshell, for resolving the current financial debacle faced by many countries surfaces as a result of reckless risk taking and lack of financial discipline that the whole spectrum of shariah frown upon, the Islamic banks have to be far away from debt based financing because it is such a tool that lead economy into deep crisis. Thus with the proliferation of Islamic financial instruments done by Islamic banks, the objectives of shariah would be universally realized. Thus the central objective of asset based as professed by Islamic financial industry is geared to eradicate “riba” or interest and established the norms of socio-economic justice and equality that conventional financial industry is greatly lacking. At the end of the day, if Islamic banking and finance put serious effort to counter what conventional financial industry is greatly lacking, we believe that Islamic banking and finance can be institutions epitomizing the objective of shari’ah in the whole economy.


Al-Zuhayli, D. W. (2003). Al-Fiqh Al-Islami wa Adillatuh (Fiqh dan Perundangan Islam). translated by Dr. Ahamd Shahbari Salamon. Kuala Lumpur, Dewan Bahasa dan Pustaka.
Asyraf Wajdi, and Nurdianawati Irwani Abdullah. (2006). The Ideal Of Islamic Banking: Chasing A Mirage? Retrieved January 16, 2009, from
Mehmet Asutay. (2007). Conceptualisation of the second best solution in overcoming the social failure of Islamic finance: Examining the overpowering of homoislamicus by homoeconomicus. IIUM Journal of Economics and Management 2007, 15, 1-17.
Mohammed Akacem, and Gilliam, Lynde. (2002). Principles Of Islamic Banking: Debt Versus Equity Financing, Middle East Policy, 9 (1), p124-138.
Munawar Iqbal, and Molyneux, P. (2005). Thirty Years of Islamic Banking: History, Performance and Prospects. London: Palgrave Macmillan.
Ibn Yusof
13 February 2009
11.20 a.m

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