Islamic Banking and Finance: New Perspectives on Profit Sharing and Risk

  • Book Title:
 Islamic Banking And Finance New Perspectives
  • Book Author:
Munawar Iqbal
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Four key roles are performed in a financial system. First, it provides financial intermediation services, channelling funds from ultimate savers to ultimate borrowers and in the process removing budget constraints. This in turn facilitates the movement of resources between agents, over time and across space. Second, the system provides a wide range of other financial services not immediately related to financial intermediation: payments services, insurance, fund management, and so on.

Third, it creates a wide range of assets and liabilities, each of which has different characteristics with respect to, for instance, liquidity, maturity, the type of return generated, and risk-sharing. The fourth central role of any financial system is the creation of incentives for an efficient allocation of resources within an economy, and the allocation of scarce financial and real resources between competing ends. These key roles of the financial system are not specific to conventional or Islamic-based systems. It is in how these roles are performed that differences arise. This can be illustrated by giving some examples.

The function of financial intermediation requires providing mechanisms for saving and borrowing so that agents in the economy can alleviate budget constraints. This involves creating a variety of financial assets and liabilities with different characteristics that appeal to different savers and borrowers.

The conventional commercial banks provide the financial intermediation services on the basis of rate of interest on both the assets and the liabilities side. Since interest is prohibited in Islam, Islamic banks have developed several other modes through which savings are mobilized and passed on to entrepreneurs, none of which involves interest. Yasseri (Chapter 8) describes several of these modes being used in Iran. These include mu∂arabah, musharakah, muraba˙ah, muzaraºah, bayº al-salam, and so on.

 Islamic banks in other countries are also, by and large, using the same modes, though the degree of use of a particular mode may differ from one bank to another. Similarly, for performing the function of providing other financial services, such as payment services, insurance, fund management and the like, Islamic banks have developed contracts such as juºalah, takaful and musharakah. Some of these are also discussed by Yasseri.

The third and fourth common functions require creation of a wide variety of instruments and incentives for an efficient allocation of scarce financial and real resources between competing ends. An efficient allocation of resources requires an accurate assessment and efficient pricing of risk. Somehow, the price of finance needs to include an allowance for the risks involved. Similarly, the rates of return to the suppliers of finance should also reflect the risks taken.

In conventional systems a major route for this is through the rate of interest, with risks of alternative projects or loans being reflected in different risk premia incorporated in interest rates on different loans. Clearly, this route is not relevant in Islamic finance, which means that alternative mechanisms are needed.

It must be noted here that the prohibition of interest in Islam does not mean that capital is not to be rewarded nor that risk is not to be priced. The Islamic system has both fixed and variable return modes to price the capital and add risk premia according to the degree of risk involved. Islamic banks provide financing using two methods. The first is based on profit-sharing and the second involves modes which depend on fixed return (mark-up) and often end in creating indebtedness of the party seeking finance. The modes of finance used by Islamic banks are, however, unique for two reasons. First, debt associated with financing by way of mark-up modes results from real commodity sale/purchase operations, rather than the exchange of money for interest-bearing debt.

Unlike conventional debt, such debt is not marketable except at its nominal value. Second, the introduction into banking of modes that depend on profit-sharing is an innovation that brings important advantages. (See Mirakhor, 1997.)


Financial instruments, contracts, institutions and markets are needed for these functions to be performed. Risk and uncertainty are at the centre of financial contracts and the way they are constructed. If there were no uncertainty about the future, the specific contractual form in which financial markets and insti- tutions channel funds from savers to lenders would have no significance. The chapter by Suwailem (Chapter 2) discusses the problems of decision-making under uncertainty. He quotes from several authors to show that in conventional textbook presentations of decision-making under uncertainty, no distinction is made between investment and gambling.

Chance and skill are treated equally in this framework. It is not clear how gambling differs from entrepreneurship, and why taking risk in some instances is praised and in others blamed. He argues that this framework is not suitable from an Islamic perspective. Instead, he suggests that the proper starting point for the subject is causality, whereby decisions are based on proper causes to achieve the desired outcome. The most likely outcome of a certain action determines its causal value, so if an action is more likely to lead to failure than to success, it is considered as a cause of failure, regardless of the desirability of the outcome.

Because of the moral value of causes, the decision-maker shall not be deceived by the size of return when it is unlikely to materialize. Incorporating a moral value of cause, he argues that from an Islamic perspective, decision-making under uncertainty requires implementing proper causes to achieve desired outcomes. Investment differs from gambling: investment is a decision to implement appropriate causes, while gambling is to take pure chance. The former is eulogized in Islam, while the latter is condemned.

In practice, uncertainty does matter and three alternative types of contracts are available to deal with it: debt, equity and insurance contracts. In comparing conventional and Islamic financial systems, the first two of these contracts have been the focus of several chapters in this volume. Debt contracts create a defined obligation to repay irrespective of the performance of the borrower. The rate of return paid by the borrower and received by the lender is independent of performance except in the extreme case of default. Equity contracts are where the return to the holder of the contract is determined by the performance of the issuer.

 The rate of return cannot be specified in advance, but is determined by the outcome of the project. As in the conventional system, both kinds of contract exist in the Islamic financial system. Relative preferences may, however, differ. In conventional banking, debt has been found to be an efficient risk-sharing mode in the face of asymmetric information and when the costs of verifying the rate of return of a project become excessive in relation to potential benefits. At the same time, debt contracts minimize monitoring costs because the lending bank is not interested in the degree of success of the project so long as it does not fail to an extent that causes the borrower to default. Debt contracts also have lower transactions costs.

Due to these attractive features, conventional banks have a natural preference for debt contracts. However, the contract also has several undesirable features. One of these is that the bank does not share in the potential upside gain (the return is fixed even in the event that the project is extremely, and possibly unex- pectedly, successful) but does share in the extreme downside potential loss in the event of bankruptcy of the borrower.

For the financial system as a whole, it has been argued that excessive reliance on debt-financing is both inefficient and unstable. Analysing several financial crises, Chapra (Chapter 11) argues that the primary cause of these crises is inadequate market discipline resulting from debt-based borrowing and lending. He points out that:

Instead of making the depositors and the bankers share in the risks of business, it assures the depositors of the repayment of their deposits or loans with interest. This makes the depositors take little interest in the soundness of the financial institution. It also makes the banks rely on the crutches of the collateral to extend financing for practically any purpose, including speculation. The collateral cannot, however, be a substitute for a more careful evaluation of the project financed. This is because the value of the collateral can itself be impaired by the same factors that diminish the ability of the borrower to repay the loan. The ability of the market to impose the

 required discipline is thus impaired, which leads to an unhealthy expansion in the overall volume of credit, to excessive leverage, and to living beyond means. (p. 221)

He poses the question as to why a rise in debt, and particularly short-term debt, should accentuate instability. In this respect, he points out that:

One of the major reasons is the close link between easy availability of credit, macro- economic imbalances, and financial instability. The easy availability of credit makes it possible for the public sector to have a high debt profile and for the private sector to live beyond its means and to have a high leverage. If the debt is not used produc- tively, the ability to service the debt does not rise in proportion to the debt and leads to financial fragility and debt crises. The greater the reliance on short-term debt and the higher the leverage, the more severe the crises may be. This is because short-term debt is easily reversible as far as the lender is concerned, but repayment is difficult for the borrower if the amount is locked up in loss-making speculative assets or medium- and long-term investments with a long gestation period. (p. 222)

However, debt remains a useful contract both in conventional and Islamic systems. Chapra himself points out that ‘there may be nothing basically wrong in a reasonable amount of short-term debt that is used for financing the purchase and sale of real goods and services.’ The point here is that debt ought to be linked with real transactions and that it is not used for pure speculative purposes.

As compared to debt contracts, profit-sharing contracts are where the return to the holder of the contract is determined by the performance of the issuer. In contrast to a debt contract, the financier and entrepreneur share symmetrically (though not, of course, necessarily equally) in profits and losses.

There are four key differences between the debt contracts and equity or equity-type contracts: the degree and form of risk-sharing; the absence of any ownership stake in debt contracts but its presence to some degree in equity contracts; the incentives that exist for the lender to monitor the borrower’s post-contract behaviour; and the fact that default on debt contracts can trigger bankruptcy whereas poor perfor- mance on equity contracts does not trigger insolvency.

Chapra argues (Chapter 11) that more equity financing would enhance the stability charac- teristics of financial systems because, through the resultant risk-sharing contracts, financiers would have a greater incentive both to assess risks at the outset and to monitor borrowers after finance had been given.

Theoretical studies in the early 1960s, which formed the basis for the estab- lishment of Islamic banks, built their vision on profit-sharing finance. Several strong arguments in favour of profit-sharing finance over fixed return modes of finance were provided. However, in practice the modes of financing being used by most Islamic banks are dominated by fixed-return modes such as muraba˙ah and leasing (see Iqbal et al., 1998). This divergence between theory and practice needs an explanation. Several chapters in this volume address this issue.

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