partnership equity islamic finance.pdf

8/11/2019 Partnership Equity Islamic Finance.pdf

1/22Electronic copy available at: http://ssrn.com/abstract=1415239Electronic copy available at: http://ssrn.com/abstract=1415239Electronic copy available at: http://ssrn.com/abstract=1415239

Review of Islamic Economics, Vol. , Special Issue,

Partnership, Equity-Financingand Islamic Finance: WhitherProt-Loss Sharing?

Mohammad Omar Farooq

Abstract: Proponents of Islamic nancial institutions (IFIs) regard their conventionalcounterparts as Islamically unacceptable, because the latter are interest-based, notbased on fair prot-loss sharing (PLS) and risk sharing. Idealization of the PLSmode is questionable as it is not explicitly mandated in Islams primary texts. Thepreference for PLS is based on juristic interpretation that evolved in response to theprohibition of rib a, commonly equated with interest. Contrary to theory, IFIs inpractice have marginalized PLS modes and instead adopted mark-up type, interest-substituting, risk-avoiding modes of nance. In this paper it is argued that despitethe theoretical idealization, IFIs as businesses are rational in avoiding PLS modes.Partnership is the least common form of business organization for practical reasons.In this context these reasons also cover equity-nancing. IFIs are organized as banks,but rather than being nancial intermediaries, they are primarily merchant banks.Accordingly, this paper contends that legally restricting or religiously idealizing PLSmodes is untenable. The conclusion is that, while paying lip service to PLS modes todene themselves as interest-free aka Islamic entities, IFIs continue to marginalizePLS, packaging conventional banking products under Islamic labels.

I. IntroductionThe Islamic Banking and Finance (IBF) movement has become a rapidly

expanding phenomenon in the Muslim world. It is also drawing attentionand serious involvement of major Western nancial powerhouses. The cruxof the IBF movement is the Islamic prohibition of rib a, which orthodoxyequates with interest in general. To avoid interest completely as its central

M O F , Associate Professor of Economics and Finance, Upper IowaUniversity, Fayette, Iowa, USA.

,

Review of Islamic Economics , Vol. , Special Issue, , pp. .


2/22Electronic copy available at: http://ssrn.com/abstract=1415239Electronic copy available at: http://ssrn.com/abstract=1415239Electronic copy available at: http://ssrn.com/abstract=1415239


allocation tool, IBF has developed an impressive array of transactionsmodes claimed to be based primarily on prot-loss-sharing (PLS) modes.

Since rib a was dened as interest, Islamic banking became synonymouswith interest-free banking. The prevailing belief was that interest-basedbanking would be primarily replaced by prot-and-loss sharing (PLS)schemes (Warde, : ).

PLS modes seek to avoid debt-nancing and use partnership andequity-nancing, similar to venture capitalism. Paradoxically, while thepertinent literature continues to emphasize PLS as the main modes,in practice Islamic nancial institutions (IFIs) have deliberately andsystematically avoided them. PLS modes are often presented as variant forms

of partnership nancing. This paper contends that there is a serious problemwith the partnership framework, in which equity-nancing is considered.The problem stems from the very nature of partnership as a legal form ofbusiness organization. It is further argued that without modifying variouscontractual aspects of equity-nancing, it is economically rational for IFIsto use predominantly debt-like instruments, while claiming Islamicity onthe basis of almost non-existent PLS modes.

II. Idealization of the PLS Mode in Islamic Finance

One key precept of Islamic nance is that under conventional systems basedon interest, neither prot and loss nor risk is shared by the contractingparties. This is evidenced in the following statements:

[T]he instrument of interest has a constant tendency in favour ofthe rich and against the interests of the common people. The richindustrialists, by borrowing huge amounts from the bank, utilizethe money of the depositors in their huge protable projects. Afterthey earn prots, they do not let the depositors share these protsexcept to the extent of a meagre rate of interest, and this is also taken

back by them by adding it to the cost of their products. Therefore,looked at from macro level, they pay nothing to the depositors.While in the extreme cases of losses which lead to their bankruptcyand the consequent bankruptcy of the bank itself, the whole loss issuffered by the depositors. This is how interest creates inequity andimbalance in the distribution of wealth. (Usmani, : )

Prot Loss Sharing (PLS) dominates the theoretical literature onIslamic nance. Broadly, PLS is a contractual arrangement betweentwo or more transacting parties, which allows them to pool theirresources to invest in a project to share in prot and loss. Most


3/22


4/22


subject of Islamic modes of financing and it is normally restrictedto a particular type of shirkah , that is, the shirkat al-amw al ,

where two or more persons invest some of their capital in a jointcommercial venture. However, sometimes it includes shirkat al-a [mal also where partnership takes place in the business of services.(Usmani, : )

III. Praxis of Islamic Financial Institutions (IFIs): Rhetoric vs. Reality Even though PLS modes are idealized in Islamic nance, in reality they areseriously marginalized in IFIs.

Almost all theoretical models of Islamic banking are either based on

Mu da rabah or Mush arakah or both, but to-date actual practice ofIslamic banking is far from these models. Nearly all Islamic banks,investment companies, and investment funds offer trade and projectnance on mark-up, commissioned manufacturing, or on leasingbases. PLS features marginally in the practice of Islamic bankingand nance.

Whatever is the degree of success of individual Islamic banks, theyhave so far failed in adopting PLS-based modes of nancing in theirbusiness. Even specialised Islamic rms, like Mu da rabah Companies... in Pakistan, which are supposed to be functioning purely on aPLS basis, have a negligible proportion of their funds invested ona Mu da rabah or Mush arakah basis. According to the InternationalAssociation of Islamic Banks, PLS covered less than percentof investments made by Islamic banks world-wide ( gures).Likewise, the Islamic Development Bank (IDB) has so far not usedPLS in its nancial business except in a few small projects. (Dar andPresley, : )

Instead, IFI have turned predominantly to Mur abahah , a mode thatensures maximum risk avoidance and a relatively high return. Mu da rabah and Mush arakah have been found to be inoperable in the modern context(see, Saeed, : ; Aggarwal and Yousef, : ; Vogel and Hayes, :). Vogel and Hayes ( : ) observe: While the distinction from a mere

loan is compelling in theory, in practice Islamic banks often employ variousstratagems to reduce their risks in mur aba hah almost to zero, particularly ininternational trade. Thus, the banks have quietly disengaged from the PLS/risk-sharing modes and embraced Mur aba hah , which is described by manyas mur aba hah syndrome: the strong and consistent tendency of Islamic


5/22


banks and nancial institutions to utilize debt-like instruments particularlyin external nancing (Yousef, : ). Saeed ( : ) further explains:

Mur aba hah , which is the dominant method of investment of fundsin Islamic banking is, for all practical purposes, a virtually risk-freemode of investment, providing the bank with a predetermined returnon its capital. As the Council of Islamic Ideology Report recognizes,in mur aba hah there is the possibility of some prot for the bankswithout the risk of having to share in the possible losses, except inthe case of bankruptcy or default on the part of the buyer.

Interestingly, Siddiqi, a leading proponent and expert on Islamic

economics and banking, asserted in his earlier writings in the s: For allpractical purposes this [the mark-up system or Mur aba hah ] will be as goodfor the bank as lending on a xed rate of interest (Siddiqi, : ). Notingsome international and national statistics that illustrate the seriously skeweddistribution of wealth, Sufyan Ismail writes: Any neutral observer can seethe problems the above [capitalist banking] system causes on a macro basisin any economy. Islamic nance operates a system called Mush arakah whichensures that the above inequalities do not occur... Mush arakah lies at theheart of the Islamic Financing philosophy, where the notion of sharing in

risk and return between investors and entrepreneurs nds its natural home(Ismail, n.d.: , ) The same viewpoint was clearly echoed in The Text ofthe Historic Judgment on Interest by the Supreme Court of Pakistan (SeeSection , Mark-up and Interest): The Council has in fact suggested thatthe true alternative to the interest is prot and loss sharing (PLS) based onMush arakah and Mu da rabah .

Siddiqi ( : ) went much further to warn the Islamic nanceindustry:

... we cannot claim, for an interest-free alternative not based on

sharing, the superiority which could be claimed on the basis ofprot-sharing. What is worse, if the alternative in practice is builtaround predetermined rates of return to investible funds, it wouldbe exposed to the same criticism which was directed at interest asa xed charge on capital. It so happens that the returns to nanceprovided in the modes of nance based on mur aba hah , bay [ salam (a forward sale, whereby payment is made at time of contract anditem is delivered at later), leasing and lending with a service charge,are all predetermined as in the case of interest. Some of these modesof nance are said to contain some elements of risk, but all these


6/22


risks are insurable and are actually insured against. The uncertaintyor risk to which the business being so nanced is exposed is fully

passed over to the other party. A nancial system built solelyaround these modes of nancing can hardly claim superiority overan interest-based system on grounds of equity, efciency, stabilityand growth.

Nevertheless, criticism of mur aba hah may have been overstatedbecause, as the proponents of IBF argue, mark-up or cost-plus typetransactions are permissible in Islam. Yet, permissible mur aba hah is insales, not in nancing transactions. In vogue only since the s (Siddiqi,

), modern mur aba hah combines sales and nancing as part of onetransaction. Can Muslims still not deviate from classical Islamic law? Ofcourse, they can. And, indeed, much of modern Islamic banking is basedon signicant reformulation of classical laws. Islamically there is nothingwrong with mur aba hah , but there is nothing especially Islamic about it,either. Mark-up or cost-plus pricing is a common business transactionworldwide. Banking primarily based on this type of transactions robs IFIsof distinctively Islamic characteristics. Furthermore, as Islamic bankingwas designed for greater economic development of Muslims, the currentpredominance of mur aba hah is unhelpful in that regard.

With such idealization of PLS modes and categorical emphasis onpartnership-type nancing, mu da rabah and mush arakah , what happenedto bring about the present situation? Why have the PLS modes beenmarginalized and mur aba hah and other mark-up type, interest-substitutemodes became predominant? Is it that the people running or owning theIFIs are not devoutly committed to Islam, or are they irrational?

IV. Why is the PLS Model being shunned by IFIs?Businessmen generally are rational. They have reasons not to be deeplyenamoured with PLS modes. According to Iqbal and Molyneux ( : ):

There are many reasons why businessmen do not prefer PLScontracts. These include, among others: (i) the need to keep andreveal detailed records; (ii) it is difcult to expand a businessnanced through mu da rabah , because of limited opportunities tore-invest retained earnings and/or raising additional funds; (iii)the entrepreneur cannot become the sole owner of the projectexcept through diminishing mush arakah , which may take a longtime. Similarly, there are some practical reasons for banks to prefer

xed-return modes, including the fact that due to moral hazard and


7/22


adverse selection problems in all agent-principal contracts such asmu da rabah , there is a need for closer monitoring of the project.

This requires project monitoring staff and mechanisms, whichincrease the costs of these contracts. Moreover, on the liabilities side,the structure of deposits of Islamic banks is not sufciently longterm, and therefore they do not want to get involved in long-termprojects. Third, PLS contracts require a lot of information aboutthe entrepreneurial abilities of the customer. This may not be easilyavailable.

At the same time, contrary to popular perception of many credulousadherents among Muslims, mur aba hah in practice may not be quite as

Shar i[ah -compliant as generally claimed. It is also heavily criticized orrepudiated by many Islamic scholars and even some Islamic nancialinstitutions.

A number of scholars have recently cast doubts upon the acceptabilityof one of the most widely used forms of Islamic nance: the type ofMur aba hah trade nancing practiced in London. These investorsand well-known multinationals are seeking lowest-cost workingcapital loans. Although these multi-billion-dollar contracts havebeen popular for many years, many doubt the banks truly assumepossession, even constructively, of inventory, a key condition ofa religiously acceptable mur aba hah . Without possession, thesearrangements are condemned as nothing more than short-termconventional loans with a predetermined interest rate incorporatedin the price at which the borrower repurchases the inventory. Thesesynthetic mur aba hah transactions are unacceptable to the devoutMuslim, and accordingly there is now a movement away frommur aba hah investments of all types. Al-Rajhi Bank, al-Baraka, andthe Government of Sudan are among the institutions that havevowed to phase out mur aba hah deals. This development createsdifculty: as Islamic banking now operates, mur aba hah tradenancing is an indispensable tool. (Vogel and Hayes, : )

Despite such criticisms, cost-plus nancing or mur aba hah (mostlydebt-like instruments) continue to be the mainstay of Islamic banking. Inthe chapter The Performance of the Islamic Banks - A Realistic Evaluation,Usmani, a quintessential Shar i[ah expert in the eld of Islamic banking andnance, laments (Usmani; : ):

This [ i.e . Islamic] philosophy cannot be translated into realityunless the use of mush arakah is expanded by the Islamic banks. It


8/22


is true that there are practical problems in using the mush arakah as a mode of nancing, especially in the present atmosphere where

the Islamic banks are working in isolation, and mostly without thesupport of their respective governments. The fact, however, remainsthat the Islamic banks should have advanced towards mush arakah in gradual phases and should have increased the size of mush arakah nancing. Unfortunately, the Islamic banks have overlooked thisbasic requirement of Islamic banking and there are no visible efforts to progress towards this transaction even in a gradual manner, even on aselective basis . ... [T]he basic philosophy of Islamic banking seems tobe totally neglected. (Emphasis added)

Thus there is a basic contradiction. The PLS/risk-sharing modehas been virtually abandoned in practice, yet Prot Loss Sharing (PLS)dominates the theoretical literature on Islamic nance (Dar and Presley,

: ). There are several explanations identied in the literature forIFIs entrenched tendency to avoid PLS modes and overwhelmingly usemur aba hah and other non-PLS modes. Dar and Presley ( : )enumerate several such explanations:

(i) PLS contracts are inherently vulnerable to agency problems asentrepreneurs have disincentives to put in effort and have incentives toreport less prot as compared to the self-nancing owner-manager. ...

(ii) PLS contracts require well-dened property rights to function efciently.As in most Muslim countries property rights are not properly denedor protected, PLS contracts are deemed to be less attractive or to fail ifused. ...

(iii) Islamic banks and investment companies have to offer relatively lessrisky modes of nancing as compared to Mu da rabah or Mush arakah in the wake of severe competition from conventional banks and othernancial institutions, which are already established and hence morecompetitive. ...

(iv) The restrictive role of shareholders (investors) in managementand, hence, the dichotomous nancial structure of PLS contractsmake them non-participatory in nature, which allows a sleepingpartnership. ...

(v) Equity nancing is not feasible for funding short-term projects due tothe ensuing high degree of risk (i.e., the time diversication effect ofequity). This makes Islamic banks and other nancial institutions rely


9/22


on some other debt-like modes, especially mark-up to ensure a certaindegree of liquidity...

(vi) Unfair treatment in taxation is also considered to be a major obstaclein the use of PLS. While prot is taxed, interest is exempted on thegrounds that it constitutes a cost item. This legal discrimination andits associated problem, tax evasion, make PLS less reliable as a tool forreward sharing...

(vii) Secondary markets for trading in Islamic nancial instruments,particularly Mu da rabah and Mush arakah , are non-existent.Consequently, they have so far failed to effectively mobilise nancialresources.

Each of these explanations has merit. Indeed, the starting point of anysuch critical evaluation of the gap between rhetoric and reality might bethat the Islamic nance discourse simply has exaggerated the usefulnessand relevance of PLS modes (Dar and Presley, : ), which may alsohave stemmed from a fundamental problem with the notion that rib a and interest are equivalent and that since rib a is prohibited in Islam, so isinterest (Farooq, ).

V. Why is Partnership the Least Common form of Business Organization?Business organizations usually take three broad forms: sole proprietorship,partnership and corporation. Islamic nance, at the level of rhetoric,embraces various forms of partnership or equity-sharing. Three such formsthat can take various sharing modes are:(i) Partnership: least common type of business organization;(ii) Equity-financing: corporate structure; few publicly traded corporations;

private corporations are greater risk (iii) Venture capital partnership: entrepreneurial finance; risky; small

portion

None of these forms is predominant or common in the portfolio of IFIs.It has already been explained why IFIs might not nd PLS modes attractiveand practical. However, the issue can be approached from another angle.Which of these three forms of business organization sole proprietorship,partnership and corporation is the least common? For example, in thecontext of the United States (and it is not much different in many developedcountries), the least common is partnership, as depicted in Table .


10/22


Table : Distribution of Businesses by Legal Types in USA

Number Revenue Prots

Sole Proprietorship % % %

Partnership % % %

Corporation % % %

Source: Statistical Abstracts of the United States,

As a legal form of business organization, partnership is the least popular,for well-established reasons. Some of these are: split/divided authority; hardto nd suitable/compatible partners; conict between partners, etc. An

Inc. magazine poll in USA on Are partners bad for business? is revealing(Caggiano, ), which is depicted in table .

Table : Responses to PLS Financing Related Issues

Yes No

Is partnership a bad way to run a business? % %

Why is partnership bad? Response Rate

Personal conicts outweigh the benets %

Partners never live up to one anothers expectations %

Companies function better with one clear leader %

Source: Caggiano ( )

The survey also indicated some positive aspects that the participantsappreciated. However, of those who characterized partnerships asgood, the majority ( %) said they were or are involved in equalpartnerships. This notion of equal partnership might explain why PLSmodels appear unattractive both to businesses and IFIs simply because most

associations involving IFIs and their clients are not interested in such equalpartnerships.

Another Inc. magazine study of partnership businesses concludedthat partners in each of those businesses knew one another long beforeworking together. An illuminating article titled Partners are from Marsexplains through partners experience why prior closer acquaintance isimportant (Sherman, ). While Shermans work sheds light on individualpartners, some essential issues of compatibility and conict are morecommon to partnership than to other forms of business organization.


11/22


In a competitive setting, where IFIs have to offer their services andbusinesses have to utilize IFIs services, such partnership or equity-sharing

models simply are not compellingly attractive to either side. These problemsare not limited to just partnerships (general or limited), but also to allequity-sharing modes, including corporations and venture capitalists.

Such considerations are further complicated by some restrictiveelements of classical parameters of Islamic contracts and business structures,which are not necessarily derived from either the Qur a n or Sunnah. Theyare primarily interpretative, speculative derivations by jurists.

Here are some examples: Imam Malik and Hanbali jurists are ofthe view that the liquidity of capital is not a condition for the validity

of mush arakah (Usmani, : ). Equity-sharing modes can run intoproblems often, when partners bring illiquid capital to the business: ImamAbu Hanifah and Imam Ahmad are of the view that no contribution in kindis acceptable in a mush arakah (Usmani, : ).

On the other hand, some classical schools restrict in-kind contributionto Mush arakah . Thus the anomalies among various schools are notable,which is explained by the fact that there is nothing direct and specic inthe Qur a n and Sunnah, from which to derive the above rules. Why notlet businesses work out these matters? Perhaps Islamic legal thinking has

tended at times toward over-denition or excessive prescriptiveness: expertguidance that the jurists and scholars could have offered was turned intomatters of law.

According to Usmani, the rules of nancing in both mush arakah andmu da rabah are similar (Usmani, : ). Let us take a further look atsome of the basic principles of mush arakah and mu da rabah .

(i) Financing through mush arakah and mu da rabah does never mean theadvancing of money. It means participation in the business and in thecase of mush arakah , sharing in the assets of the business to the extentof the ratio of nancing (Usmani, : ).

Clients of IFIs cannot be expected to like this limitation. It is justthat simple. One can contend that client businesses are supposed to actaccording to Islam and, regardless of any other factor, simply seek out PLSmodes. After all, rib a is prohibited and so is interest as the argumentgoes. Unfortunately, the problem may lie right there. Although rib a iscategorically prohibited, interest on loans for mutual benets and mutually

agreed, without any exploitative aspects, may not be prohibited (Farooq,


12/22


). Thus, devising of business modes and practices for compatibility withthe presumed scope of prohibition may be Islamically untenable.

(ii) An investor/nancier must share the loss incurred by the business tothe extent of his nancing (Usmani, : ).

In theory it sounds good. However, as businesses IFIs do not careto enter into undertakings that would expose them to indeterminate loss.Rational businesses generally try to maximize prot (subject to otherparameters) and thus also try to minimize loss and risk. IFIs cannotarticially alter the commonsense human response. While businesses may

not like IFIs to get closely involved in partnerships, IFIs themselves deem asunattractive their role as passive equity-investor.

Since the use of risk-sharing modes, considered to be the hallmarkof Islamic banking, is rather limited, clients do not notice anysignicant operational departure from the previous practices basedon xed rate nancing. (Iqbal and Molyneux, : )

Thus, while IFIs keep their transactions presumably interest-free byavoiding debt instruments, in practice they mimic conventional nancial

institutions and conne themselves to contracts that are debt-like, such asmark-up type transactions ( mur aba hah, ij arah, salam , etc .).

(iii) The partners are at liberty to determine, with mutual consent, the ratioof prot allocated to each one of them, which may differ from theratio of investment. However, the partner who has expressly excludedhimself from the responsibility of work for the business cannot claimmore than the ratio of his investment (Usmani, : ).

This is obviously related to issues of agency. Having banks/lendersas active partners is not liked by the businesses. Without being activemanagement partners, which is not possible for nancial institutions, IFIsincur both agency problems, asymmetric information and moral hazard.Client businesses may hold back accurate information about prot and loss:prot could be understated; and loss could be overstated or understateddepending on particular advantages potentially sought by the partnerbusinesses.


13/22


As for moral hazard,

[I]t arises when a contract or nancial arrangement creates incentivesfor parties to behave against the interest of others. It is generallybelieved that moral hazard problems are much more serious in prot-sharing contracts than in interest-based contracts, which is one of thereasons for their lack of popularity in Islamic banks. One problem,for example, is the incentive the borrower may have in concealingthe true level of prots, or absorbing some of the prots throughunauthorized perquisites. (Iqbal and Molyneux, : )

However, Iqbal and Molyneux ( : ) do concede that the problemof moral hazard in this context may have been overstated:

While there may be a grain of truth in this argument, we believethe matter has been exaggerated. For one thing, these problems arenot unique to prot-sharing contracts; they are similar to those thatarise in any equity contract in conventional systems. For another, theproblem of moral hazard also exists in interest-based contracts.

In the economics literature, there are contrasting positions about therelative efciency of sharing arrangements. A widely held perception amongeconomists is that sharing arrangements are less efcient compared to rst-

choice solutions. Stiglitz and Weiss ( ), for example, write:In general, revenue sharing arrangements such as equity nancing,or sharecropping are inefcient. Under those schemes the managersof a rm or the tenant will equate their marginal disutility ofeffort with their share of their marginal product rather than withtheir total marginal product. Therefore, too little effort will beforthcoming from agents.

The same problem arises in corporate management (Iqbal and

Molyneux, : ). Iqbal and Molyneux then present counter-argumentsfrom the economics literature. However, if the trendline for PLS contractsin IFIs portfolio is any indication, there is no appreciable change in favourof PLS to conrm that the problem is overstated.

Based on primary survey data, Khalil et al. ( ) investigated threemain questions:(i) What are the aims of the monitoring system in mu da rabah contracts?(ii) What are the main areas of activity to be monitored?(iii) What are the main devices which agents use in monitoring the

mu da rabah contract?


14/22


The authors clarify:

In general, a number of distinctive features can be attributed to theMu da rabah contract to reect its nature and the inherent magnitudeof agency-contractual problems. We identify three main features;namely, idiosyncratic uncertainty (risk), extreme linearity anddiscretionary power. ... [I]diosyncratic uncertainty, particularly forthe bank, is embodied in prot-sharing contracts. This uncertaintyhas many sources: the banks return is assumed to depend solely onthe reported future cash ows resulting from operating protability,which in turn depends entirely on the corporate investmentdecisions that are made by the agent. Moreover, the agent is notfully supervised, and has a measure of independence. Given that the

agents level of effort may be regarded as unobservable, it cannotbe contracted. Moreover, the uncertainty is exacerbated by lackof security over assets. ... Accordingly, uncertainty will be severeand the bank bears very signicant risks, particularly in the caseof occurrence of losses. This may give rise to high incidence ofadverse selection and moral hazard problems, which are facilitatedby the ability of entrepreneur, in such contracts to hide informationregarding his abilities and background before contracting and toconceal actions taken after the contract is put in place. In addition,the outcome may not be reported truthfully by the agent...

Monitoring costs may be incurred in all stages of the contract to ensurecompliance with the terms of the contract, and to convey veriableand informative signals about the entrepreneurs behavior...

Mu da rabah contract ... provides the entrepreneur with full discretionover assets, similar to that assigned to sole owner-manager projects,without bearing the risk of nancial losses. By contrast with equity,there are no automatic rights to make appointments to the boardof directors using associated voting power, which would give thenancier some scope of intrusive oversight of operating activity.(Khalil et al., : )

It is worth emphasizing that the entrepreneur under a mu da rabah hasfull discretion over the assets and operation, without bearing the risk ofnancial loss. Usmani (n.d.) explains:(i) in mu da rabah , investment is the sole responsibility of the rabb al-m al

[i.e . the nancing partner](ii) in the mu da rabah , the rabb al-m al has no right to participate in the

management which is carried out by the mu da rib [i.e . entrepreneur] only.


15/22


(iii) in mu da rabah the loss, if any, is suffered by the rabb al-m al only,because the mu da rib does not invest anything. His loss is restricted to

the fact that his labour has gone in vain and his work has not broughtany fruit to him.

These distinctive characteristics of mu da rabah , as specied byclassical Islamic jurisprudence, illustrate the underlying reasons why sucharrangements are not compellingly attractive to rational nanciers on aPLS basis. Thus, in the context of bank participation in a project, all thenancing would come from the bank with the entrepreneur making nonancial contribution to it. The risk of nancial loss would be borne by

the bank the nancing partner while the entrepreneurs loss would belimited to his labour. Could a rational investor or nancier nd such anarrangement attractive?

While there is a compelling case for the impracticality of classicalmu da rabah , what about mush arakah ? Here are some of the salient featuresof mush arakah , as articulated by Usmani (n.d.).(i) The investment in mush arakah comes from all the partners.(ii) In mush arakah , all the partners can participate in the management of

the business and can work for it.

(iii) In mush arakah all the partners share the loss to the extent of the ratioof their investment.

(iv) The liability of the partners in mush arakah is normally unlimited.Therefore, if the liabilities of the business exceed its assets and thebusiness goes into liquidation, all the exceeding liabilities shall beborne pro rata by all the partners. However, if all the partners haveagreed that no partner shall incur any debt during the course ofbusiness, then the exceeding liabilities shall be borne by that partneralone who has incurred a debt on the business in violation of theaforesaid condition.

(v) In mush arakah , as soon as the partners mix their capital in a joint pool,all the assets of the mush arakah become jointly owned by all of themaccording to the proportion of their respective investment. Therefore,each one of them can benefit from the appreciation in the value of theassets, even if profit has not accrued through sales.

The conditions of mush arakah are more practical for enlisting partnerparticipation or equity-nancing. So, why is mush arakah not more common


16/22


in IFIs portfolio? The very nature of banks may help explain this fact. Banksare generally specialized for nancial intermediation, not for participation

in businesses as partners or on the basis of equity-nancing. IFIs arelike merchant banks, not banks in the conventional sense. Historically,merchant banks, now so called, are in fact the original banks. Thesewere invented in the Middle Ages by Italian grain merchants (Wikipedia,Merchant Banking). There were good economic and nancial reasons formerchant banking to become widespread.

Merchant banks rst arose in the Italian states in the Middle Ages,when Italian merchant houses generally small, family-ownedimport-export and commodity trading businesses began to usetheir excess capital to nance foreign trade in return for a share ofthe prots. This trade generally consisted of lengthy sea voyages.Thus, the investments were very high risk: war, bad weather, andpiracy were constant threats, and by their nature the voyages werelong-term and illiquid. (Craig, )

In the banking industry, merchant bank is another name for investmentbank. In the wake of the crash in the US, commercial banking wasgradually but completely separated from investment banking. And parallelto commercial banks a private equity market, to be served by investmentbanking, developed into a special and signicant niche.

Although not dened in U.S. federal banking and securities laws,the term merchant banking is generally understood to meannegotiated private equity investment by nancial institutions in theunregistered securities of either privately or publicly held companies .Both investment banks and commercial banks engage in merchantbanking, and the type of security in which they most commonlyinvest is common stock. They also invest in securities with an equityparticipation feature; these may be convertible preferred stock or

subordinated debt with conversion privileges or warrants. Otherinvestment bank services raising capital from outside sources,advising on mergers and acquisitions, and providing bridge loanswhile bond nancing is being raised in a leveraged buyout (LBO) are also typically offered by nancial institutions engaged inmerchant banking. (Craig, ; emphasis added).

Compared to merchant banking, investment banking became furtherdened:


17/22


Investment banks assist public and private corporations in raisingfunds in the capital markets (both equity and debt), as well as in

providing strategic advisory services for mergers, acquisitions andother types of nancial transactions. They also act as intermediariesin trading for clients. (Wikipedia, Investment)

Quite common in Europe is another banking practice universalbanking. This covers the entire range of nancial services, including thetraditional products offered by commercial banks as well as holding claimson rms (including equity and debt), and participating directly in thecorporate governance of rms that rely on the banks for funding or asinsurance underwriters (Calomiris, ). Developed countries, especiallyin Europe, are experiencing more universal banking.

Continental European banks are engaged in deposit trading, realestate and other forms of lending, foreign exchange trading, as wellas underwriting, securities trading, and portfolio management. Inthe Anglo-Saxon countries and in Japan, by contrast, commercialand investment banking tend to be separated. In recent years,though, most of these countries have lowered the barriers betweencommercial and investment banking... (Rich and Walter, : )

But even in countries where universal banking is common, such as inGermany, equity-nancing generally averages one-quarter of their portfolioas of (Rich and Walter, : ). Notably, it is neither mandated by thegovernment, nor is any particular pattern observable. Indeed, many of thesebanks choose to specialize, albeit operating as universal banks.

The issue of universal banking is relevant since Islamic banking isattempting to function as a full service nancial institution whereas, based ontheir learning curves, the nancial institutions have evolved to be specializedwhile keeping available the full range of choices. Some more recent workprovides empirical support for the view that equity participation of banksin business nancing can have positive impact.

Equity participation by banks can help overcome a well-documentedagency problem, namely the ability of banks to extract rents fromtheir captive borrowers. Reducing this problem creates value forrms, their banks, and the economy as a whole by improving therms investment incentives. (Mahrt-Smith, )


18/22


The same author also points out that, while equity participation bybanks can be a negative incentive to their prot extraction, this can be

overcome: The negative effect of bank prot extraction can be signicantlyreduced when the bank holds a mix of debt and equity as opposed to puredebt.

No empirical work is available to support the position that banksequity participation in businesses seeking nance has a positive impact,when the participation is exclusively equity-based ( i.e ., without combiningwith debt-nancing). This is incompatible with Islamic banking, as IFIs wantto serve as nancial intermediaries and as merchant-cum-investment banks,with the parameters that their services are supposed to be primarily (or,

even exclusively) based on PLS mode and there is no room for conventionaldebt-nancing.

Under such conditions can mu da rabah or PLS contracts be modied?The answer is yes, although it would need to be signicantly delinked fromclassical Islamic jurisprudence, which is the foundation of Islamic nance.There is a palpable need for new nancial engineering.

Financial markets are becoming more and more sophisticated,and competitive. In order to exploit the fast changing marketenvironment and face increasing competition, nancial engineering

and innovation is imperative.Until now, the Islamic nancial tools have essentially been limitedto classical instruments developed centuries ago and their variants.Those instruments were developed to meet the needs of thosesocieties. While they may serve as useful guidelines for Islamiccontracts, there is no reason to be restricted only to them. (Iqbal etal ., : )

The rst issue may well be with the way the prohibition of rib a hasbeen overextended in classical Islamic jurisprudence and then, through therib ainterest equation, has remained an overstretched carryover to moderntimes due to strict legalistic approach. The evidence of IFI behaviour is quiteclear that, even though they aim to be interest-free and thus avoid monetarydebt contracts, in reality they have landed on hiyal (ruse; legal stratagems)by following the prohibition in form, while circumventing it in substance.

Indeed, the fascination with PLS-only as the ideal Islamic mode is acarryover from classical Islamic jurisprudence, which the so-called homoIslamicus is nding insurmountably difcult to implement. Naqvi, a notable

authority in the eld, has made some revealing comments:


19/22


The most widely held view is that Islamic banks should deemphasizeuse of the xed rate of return instruments, and that, reversing present

trends, they should be run exclusively on the basis of the prot andloss sharing (PLS) principle to become truly Islamic. It is arguedthat any attempt to dilute the importance of the PLS principle inIslamic banking theory or practice by the use of even the Shar i[ah -compatible xed rate of return instruments will make Islamic bankingless efcient and less equitable because this is the one principle mostrecommended by the Shar i[ah (i.e., the Islamic Law) ( e.g ., Siddiqui,

a; Chapra, ; and Usmani, ). From this point of view, itdoes not matter if the PLS instruments have lost out in the processof natural selection, practically vanishing from the Islamic banksportfolios. The almost universal recommendation still is that thePLS principle be observed faithfully, even exclusively, because itis hoped that presumably by some variant of Says Law anample supply of such instruments will create their own demand.But this argument comes dangerously close to circular reasoning: itmakes the desired efciency and equity outcomes of Islamic bankingcontingent on the adoption of the PLS principle, which is prejudgedas the only one which is Islamically just! The possibility that the PLSprinciple, if implemented universally and without any safeguards,may itself lead to inefciency and inequity is totally alien to thisantiseptically consequence-insensitive procedural way of thinking.

(Naqvi, : )

VI. ConclusionIFIs proclaim that the conventional nancing based on interest is unjustsince there is no fair sharing of prot-loss and risk. However, the IFIsthemselves do not utilize PLS modes substantively in their portfolios. Abulk of the problem stems from the parameters for the PLS modes inclassical Islamic laws. The problems facing the IFIs can be addressed withinnovations, but the solutions then become less-anchored in the traditional

Islamic legal discourse. Many suggested innovations, as well as many currentpractices, make the IFIs resemble conventional nance. Islamic discourseignores the underlying reality that partnership is the least common businessorganization due to certain inherent problems associated with it. Thoseproblems are real and human behaviour in such business organizationalcontexts, in avoiding the PLS and risk-sharing modes, is being rational.

The preoccupation with PLS modes stems from the presumed prohibitionof interest and dislike of debt instruments in business. Notwithstanding thatthis prohibition may suffer problems of interpretation and overly expanded


20/22


scope, nevertheless, the IFIs make up ruses ( hiyal ) to manufacture productsand services that are only legally Islamic or Shar i[ah -compliant. But there

isnt much difference in substance between IFIs and conventional nancialinstitutions. This being the case it is no wonder that conventional nancialinstitutions are aggressively grabbing their share of this niche market as theycan easily adapt the form of their operations. Yet in reality they have less riskin the Islamic market, while earning prot that is comparable to or betterthan that which they earn in their conventional market.

R EFERENCES

Aggarwal, Rajesh and Yousef, Tarik ( ). Islamic Banks and Investment Financing, Journal of Money, Credit and Banking, ( ), pp. - .

Caggiano, Christopher. ( ). Are Partners Bad for Business? FaxPoll Results on Questionsabout Partnership, Inc. Magazine , February. Available at: , Access Date: th April .

Calomiris, Charles W. ( ). Universal Banking and the Financing of Industrial Development .Policy Research Working Papers, World Bank. Available at: , Access Date: th March .

Craig, Valentine V. ( ). Merchant Banking: Past and Present, FDIC Banking Review ,( ), September. Available at: , Access Date: th March .

Dar, Humayun and Presley, John ( ). Lack of Prot Loss Sharing in Islamic Banking:Management and Control Imbalances, International Journal of Islamic Financial Services, ( ), pp. - .

Farooq, Mohammad O. ( ). The Riba -Interest Equation and Islam: Reexamination ofthe Traditional Arguments, Global Journal of Finance and Economics (forthcoming).

Henry, Clement and Wilson, Rodney Wilson (eds.) ( ). The Politics of Islamic Finance. Edinburgh: Edinburgh University Press.

Inc. ( ). Snapshot: Partners. The partners in each of these Inc. businesses knewone another long before working together, October. Available at: , Access Date: th March .

Iqbal, Munawar; Ahmad, Ausaf and Khan, Tariqullah ( ). Challenges Facing IslamicBanking . Islamic Research and Training Institute Occasional Paper, No. . Jeddah: IslamicDevelopment Bank.

Iqbal, Munawar and Llewellyn, David T. (eds.) ( ). Islamic Banking and Finance: NewPerspective on Prot-Sharing and Risk. Cheltenham: Edward Elgar.

Iqbal, Munawar and Molyneux, Philip ( ). Thirty Years of Islamic Banking: History,Performance and Prospects. New York: Palgrave MacMillan.


21/22


Ismail, Sufyan (n.d.). Why Islam has Prohibited Interest and Islamic Alternatives for Financing .Available at: , Access Date:April , .

Khalil, Abdel-Fattah A. A.; Rickwood, Colin, and Murinde, Victor ( ). Evidence onAgency-Contractual Problems in Mudaraba Financing Operations by Islamic Banks, inMunawar Iqbal and David T. Llewellyn (eds.), Islamic Banking and Finance: New Perspectiveon Profit-Sharing and Risk . Cheltenham: Edward Elgar.

Mahrt-Smith, Jan ( ). Should Banks Own Equity Stakes in their Borrowers?A Contractual Solution to Hold-Up Problems, Journal of Banking & Finance , ( ),pp. - .

Naqvi, Syed Nawab Haider ( ). Islamic Banking: An Evaluation, IIUM Journal ofEconomics and Management , ( ), pp. - .

Rich, Georg and Walter, Christian ( ). The Future of Universal Banking, Cato Journal ,( ), pp. - .

Saeed, Abdullah ( ). Islamic Banking and Interest: A Study of the Prohibition of Riba andits Contemporary Interpretation. Leiden: E. J. Brill.

Sherman, Aliza ( ). Partners are from Mars: Advice for Choosing a Business Partner .Available at: , Access Date: rd February .

Siddiqi, Mohammad Nejatullah ( ). Issues in Islamic Banking , Leicester: The IslamicFoundation.

Siddiqi, Mohammad Nejatullah ( ). Lecture Series on Islamic Bank and Finance . UCLAInternational Institute, Available at: , Access Date: th February .

Stiglitz, Joseph E. and Weiss, Andrew ( ). Credit Rationing in Markets with ImperfectInformation, American Economic Review , ( ) June, pp. - .

Supreme Court of Pakistan ( ). The Text of the Historic Judgment on Interest . Availableat: , Access Date: May , .

Usmani, Muhammad Taqi ( ). An Introduction to Islamic Finance. The Hague, Kluwer

Law International.Usmani, Muhammad Taqi (n.d.). Musharaka h & Mudaraba h. Available at: , Access Date: th May

.

Vogel, Frank and Hayes, Samuel ( ). Islamic Law and Finance: Religion, Risk and Return. The Hague: Kluwer Law International.

Warde, Ibrahim ( ). Islamic Finance in the Global Economy , Edinburgh: EdinburghUniversity Press.


22/22


Wikipedia. Merchant Banking . Available at: , Access Date: th March .

Wikipedia. Investment . Available at: ,Access Date: th May .

Yousef, Tarik ( ). The Murabaha Syndrome in Islamic Finance: Laws, Institutionsand Politics, in Clement Henry and Rodney Wilson (eds.), The Politics of Islamic Finance. Edinburgh: Edinburgh University Press.

partnership equity islamic finance.pdf

Documents