Interest in Islamic Finance?

Our recent research on Islamic finance suggests that murabahah instruments have been more frequently used than other Islamic financial instruments. Other researchers who have examined the practice of Islamic finance in different countries have also documented similar observation.

The use of traditionally promoted profit and loss/risk sharing instruments such as musharakah or mudarabah may expose financiers to greater moral hazard of borrowers (i.e. business owners). These instruments have an equity financing feature whereby financiers will share the upside potentials of the underlying business but will not be entitled to priority of claims in the case of bankruptcy. It can be expected that an entrepreneur or borrower with very little financial stakes in the underlying business may have greater tendency for moral hazard (e.g., misallocating business resources for private benefits, investing in riskier projects more than safer projects with a view to produce higher short-term return). Some have argued that the tendency of banks to avoid such moral hazard as one of the plausible reasons to explain the uptake in murabahah.

Murabahah instruments in practice are substantially identical to debt instruments that promise banks fixed return in the form of prescribed profit margin or mark-up. Although the preference over murabahah can be seen as a contentious solution to deal with the potential moral hazard among borrowers, the fixed return on these instruments seems to have helped fuelling interest amongst financiers to offer Islamic financing. The nature of these instruments that mimics conventional debt instruments has made it acceptable to the conventional financiers who are seemingly risk averse, hence will prefer fixed return more than volatile return from their lending businesses.

The spirit of risk-sharing promoted through Sharia may not materialise without the willingness of banks to become residual claimants by way of sharing both the profit and loss arising from the underlying business in finance. Although one may argue that practitioners in general may have compromised a fundamental principle in their efforts to expand the Islamic financial markets, taking a wider perspective on the reality of the financial world perhaps useful to rationalize the emerging nature of Islamic finance practice.

Reference:

Minhat, M. and Dzolkarnaini, N. (2017) Which firms use Islamic financing?” Economics Letters, 150, pp. 15-17. (with N Dzolkarnaini) Available for download: http://dx.doi.org/10.1016/j.econlet.2016.10.036

Minhat, M. and Dzolkarnaini, N. (2016) Islamic corporate financing: does it promote profit and loss sharing? Business Ethics: A European Review, 25(4), pp. 482-497.