New Direction for Islamic Financial
System
So far, Islamic
financial system has been concentrated on debt-financing neglecting
equity-financing which is more appealing for the development of Islamic financial
system as the conventional banks may be likely unwilling or unable to undertake
this type of financing. Equity financing is best represent by both mudarabah
and musharakah contracts of partnership. The reluctance of modern Islamic
financial system is likely caused by a few reasons which are interrelated and
subsequently render the Islamic financing based on equity financing less
popular. The first reason, undoubtedly, is due to the high risk to which both
mudarabah and musharakah are exposed.
As both mudarabah and
musharakah financing operate on a profit and loss sharing basis, they are
considered as high risk tools because:
i.
Returns
to the banks are more uncertain as they depend on the performance of the
business.
ii.
In
conventional financing, banks only assume credit risk but in these two Islamic
tools of project financing, the banks must also undertake the business risk.
Needless to say that
banks are conservative and risk averse by nature as they are responsible not to
their shareholders but also to their depositors. As their depositors comprise
both small and large depositors, banks look upon themselves as trustees for
these funds. As trustees they are bound to protect these funds and their
depositors to ensure that the banking system is fair, sound and most
importantly safe. This can only be assured if the banks use less risky
financing products.
The second obvious
reason behind this reluctance is the question of moral hazard. Naturally, both
mudarabah and musharakah require substantial trust between the banks and their
customers. If a bank acts only as a capital provider as in mudarabah or leaves
all aspects of management to the customer in terms of honesty, integrity,
management and business skills. Equally problematic is the aspect of monitoring
and supervision. Musharakah in particular requires more commitment and effort
from the banks compared to other forms of financing as the bank assumes
business as well as credit risks. Given the fact that both mudharabah and
musharakah are equity financing in character, collateral is not a prerequisite.
This inability to
secure a lien on the (partner's) assets of the business would require more
careful evaluation of the prospects of the business and hence more precaution
in extending financing. Sharing of business risks also entails more diligence
in terms of market research on the company, the business, competitors,
industry, etc by the banks. And, should the bank decide to participate actively
in the management of the businesses, the bank must have qualified personnel who
have the management skills undertake such tasks. Most bankers are generally
trained to do credit analyses, thus lacking in these management skills which
are necessary to protect the banks' interest in musharakah financing.
In addition to these
problems, perhaps the issue of matching of funds would be relevant to our
discussion. The bulk of a bank's source of fund is from depositors in the
saving or current accounts. The nature of such deposits is that withdrawals are
on demand. The average tenure for a general investment accounts is 24 months,
which is not very long. In mudarabah and musharakah financing, banks are
committing their fund in medium to long term ventures and as resulting in
mismatch of the tenures of sources and uses of fund Most Islamic banks, being
very 'new' and 'young' cannot afford to undertake musharakah as they have not
built up their equity and shareholders fund sources vet. Related to this is
longer period taken to realize the returns from mudharabah and musharakah
financing Islamic banks, being business entities, are primarily concerned with
profit maximization especially at this stage of development. Social obligations
are secondary until they could put themselves in a more stable financial
position and establish themselves as better alternatives to the conventional
banks.
Also relevant to the
point of discussion is that most Islamic bankers were initially trained as
conventional bankers. It will take some time for them to adapt their way of
viewing financing from conventional perspectives to Islamic perspectives. The
issues of collateral, guarantee, fixed and certain returns, creditworthiness,
etc., are still of paramount importance to Islamic bankers Islamic bankers find
it difficult to break away from comparing the return received from Islamic
financing to conventional financing direct comparison is more straight-forward
and easily done in murabahah and bay' bi thanam ajil than in mudarabah and
musharakah.
One problem which is
worthy of discussion is the structural issues pertaining to equity financing.
Structural issues are issues related to the existing bank regulations, tax
structure and other regulatory issues. Even though the Islamic Banking Act 1983
gives more flexibility to Islamic Bank in terms of financing products, other
aspects are very similar to conventional banks, flexibility is not elaborated
and in practice, the Interest-Free Banking Scheme (SPTF) guidelines issued by
Bank Negara also do not clearly provide the guidelines for mudharabah and
musharakah financing. Also, there is a limit of 10% shareholding by a bank in a
particular company under the Banking and Financial Institutions Act 1989. This
amount is also insignificant that the entrepreneur has to approach several
investors to take off a new venture. Most banks are still unsure on what they
can or cannot do, whether mudharabah and musharakah financing will affect their
capital adequacy ratio, what are the relevant accounting treatment and the
like. Confirmation on any issues requires clarification from Bank Negara or
other regulatory agencies and this could delay a financing exercise. This
eventually could lead to banks taking the easy way out and resorting to other
more convenient tools of financing such as murabahah and bay' bi thaman ajil.
Last but not least, the
above reluctant is probably due to the customer or potential partner's
perspective. If they have good projects or business, customers generally would
not want the banks to share the profits and therefore would prefer to borrow.
On the other hand, if a project is not financially attractive and the customer
wants the bank to participate in the equity, the project may be likely rejected
by the bank for being not feasible. Also, most businesses do not want to
relinquish management control of their business which may happen if they enter
into musharakah financing contract with a bank.
The above list of
problems which seems to discourage the role of equity financing requires a
comprehensive response and solutions to overcome some, if not all, of the said
problems. In this context, the bankers must be creative enough, with the
assistance of Shari'ah experts, to be able to undertake the above challenges
positively and constructively and this, surely, will require the restructuring
of the concept and modus operandi of Islamic equity financing to make it more
feasible and attractive. Otherwise, the problems will render the Islamic equity
financing unpopular and impractical from the modern banking perspective.
With regard to the
issue of moral hazard and its relation to the question of collateral, it is
respectfully submitted that a few perspective from Islamic law point of view is
deemed necessary. The writer is of the view that collateral could be brought in
the agreement of the project financing particularly to secure the interest of
the investor but this practice is meant only for compensating any negligence
committed by the entrepreneur. The collateral however, cannot be used under any
circumstances to redeem the loss due to 'genuine' reasons it is for this
reason, it is respectfully submitted, that the classical jurists disapproved
the practice of taking collateral (rahn) in partnership enterprise. The
classical jurists were silent on the use of the collateral to compensate the
loss caused by negligence and improper practices of the entrepreneur.
Therefore, it seems to the writer that the issue is ijtihadi in nature and
hence, it is open for alteration and modification especially to suit the needs
of the modern requirement and above all to protect the interest of the parties
involved in a partnership contract. Perhaps, this newly proposed practice of
taking collateral upfront differs from the classical practice in the sense that
the collateral will be ready for any compensation even before the negligence is
committed but it is refundable should there be no negligence.
The above line of
restructuring one aspect of equity financing would be helpful to overcome the
reluctance of some of the financiers to take up equity financing. However, this
may not in favor of the prospective entrepreneurs. They may now be reluctant to
come forward to participate in equity financing since they have to furnish the
collateral from the very beginning and this may put unnecessary burden on them.
In this context, perhaps we have to examine thoroughly both the principle and
institution of rahn in Islamic commercial law so as to contribute in giving
some encouragement to the entrepreneurs. Otherwise, equity financing will
remain unpopular.
It may be suggested
that the party who shall provide the collateral would be a third party who is
not related to either of the parties in a particular project financing. As
Islamic commercial law allows the third party to be the guarantor as well as to
furnish the collateral on behalf of the entrepreneur on the basis of wakalah,
it follows that this third party might be another financial institution which
is willing to take the liability which might arise from both mudarabah and
musharakah. In this context, more research should be undertaken to examine
whether the Islamic bankers could follow the practice of Credit Guarantee
Corporation (M) Berhad which was established since 1972 whose shareholders,
among others, were commercial banks, finance companies and Bank Negara of
Malaysia. As the banking and financing sectors have their Islamic windows, the
same would be equally applicable to Credit Guarantee Corporation. This Islamic
Guarantee Window will manage a separate pool of funds solely for the purpose of
meeting the liability of guaranteeing financing granted under the Islamic
Banking concept irrespective of whether the facility is a debt or equity
financing. Or perhaps an Islamic Guarantee Window is to be created
independently from the Credit Guarantee Corporation but to be participated by
all financial institutions offering the interest free banking facilities so
that a bigger pool of funds can be created for this programme. This will be
similar to the idea and practice of Islamic Inter-Bank Money Market facilities.
Under this proposed structure, all participating interest-free financial
institutions will be investing under the principle of mudarabah to meet the
liability of the failure of equity financing due to willful negligence or
misappropriation or misuse of funds on the part of the entrepreneur. Profits
arising from this investment will be set aside and accumulated as reserves to
meet any liability in respect of financing facilities guaranteed under this
arrangement. In the event this scheme ceased to operate, this fund may be
refunded to all participating institutions provided that all guarantee covers
have been terminated and the Window's liability under this scheme has been
completely relinquished.
The establishment of an
Islamic Guarantee Window or even Corporation would be useful and workable
provided it is governed by a detailed legal framework so as to establish
negligence or otherwise on the part of the entrepreneur. The failure to have
the legal support would create many tensions not only between the investor and
entrepreneur on the one hand but also between all participating financial
institutions in the above scheme of Islamic Guarantee Corporation on the other.
A committee of experts of both Civil law and Shari'ah law is to be formed to
look at the common principles of establishing the act of negligence in both
legal traditions.
As mentioned elsewhere,
in the modern application, the banks can screen the client, the prospective
entrepreneur, appraise the project, monitor implementation and, if necessary,
take part in actual management in order to ensure the anticipated results are
achieved. These are issues which need proper and serious attention from all
financial institutions participating in interest-free banking scheme. These
issues, relatively speaking, are everlasting. For this reason, it is suggested
that all financial institutions ought to contribute to fund and establish a
central research body which will undertake the research pertaining to the above
issues. The emphasis of the research body would be more on equity-based
products and their implementation. The research team will include bankers
legal, tax and shari'ah experts. It will be a cost rather than profit centre
and contributing members will be required to share in the cost of each product
and its application. On the other hand, it is hoped in the near future, that
the Islamic banks are able to have their own yardstick to screen and evaluate
the potential entrepreneurs, to asses the project proposed not only in terms of
profitability and feasibility but also, most importantly, in terms of enhancing
the Islamic world-view in economic and commercial developments be it in
manufacturing sector, service sector, agriculture sector, trading sector,
construction sector, etc.
As far as the tax issue
is concerned, it has been observed that the current practice that is dividends
are distributed from the profits only after the payment of taxes has two major
implications:
i.
Dividend
to a bank is one component of income and will be subject to taxes. This leads
to the double tax deduction of dividend income; first at the business' level
and later at the bank's level, which result in lower profit to the bank.
ii.
As
dividends are declared after and not before the payment of taxes, a lower
return will be received by the bank.
Therefore, from the
company's point of view, interest is an expense while dividend is not. As
dividends cannot be used to reduce tax liability, a company would be more
receptive to enter into as interest-based financing to equity financing. To
encourage more equity financing by banks, dividends paid to the banks should be
made from profits before payment of taxes, just like interest. This would
address the current imbalance which is more favorable towards interest. Another
approach could be to treat interest just like dividends so that equal tax
treatment could be accorded to these two items. A more radical approach could
be to "penalize" interest expenses or income so as to make dividend
payments and income more attractive from the taxation point of view, thus
encouraging more equity financing by the banks.
In the context of
Islamic banking, the tax reform is deemed necessary whereby the tax rate should
be commensurate the risk taken. Therefore, it is respectfully submitted that as
murabahah is the least risky of the Islamic financial instruments, the profit
it generated should be taxed most heavily and in contrast, mudarabah which is
the most risky of all should not be taxed at all. It should be pointed out that
this proposal does not mean that there will be a loss in revenue for the
country because the loss can be more than compensated for the tax potential of
the newly created firms financed by musharakah and the individuals who are
employed under these firms.
As for the high risk
that both mudarabah and musharakah would assume, it may be pointed out that
some projects can be quite "safe" if for example the nature of the
profit sharing is to cater for government contracts or established and
reputable companies. For open market projects where the risk is higher, the
returns can be negotiated to reflect the higher risks. For projects of this
nature will "force" the banks to be "more professional" and
more "business minded" rather than just be bankers.
Above all, it is worth
mentioning that musharakah, in particular, is a very flexible financing tool
and the Islamic banks must exploit this aspect. In other words, it can be
implemented in various ways for example through equity partnership, joint
ventures, co-financing and venture capital. As venture capital funds are common
in conventional banking and operations of such funds by Islamic banks will be
quite similar, this will be easily accepted by most Islamic banks. The main
difference is that the projects or businesses to be financed must be lawful
from the Shari'ah perspective. Also, depositors of these funds must know from
the outset that investment would be more long term in nature, returns are
uncertain, irregular, and may be delayed. The potential for equity financing
particularly musharakah in project or infrastructure financing is unlimited and
Islamic financial institutions should be always encouraged to step out from
their conventional banking mentality and conservative stance. Regulatory and
tax incentives are always strong impetus for change. Research should be
accelerated so that products are more marketable to both bankers and customers.
Training is another key area to ensure the availability of a pool of
well-trained Islamic bankers who are less resistant towards the Islamisation of
the financial industry.
Conclusion
The foregoing
explanation has illustrated that the Islamic financial system has been closely
attached to various forms of transactions available in Islamic commercial law.
It also explains that the system has been working quite well in the past 14
years as it has been able to meet various needs of the customers, both the
depositors and fund users. However, it is respectfully submitted that more
emphasis should be equally given to equity financing particularly in the are of
project financing which constitutes the current need of the nation
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