Equity-Based Financing PDF

ECON 3430 - Islamic Banking and Finance Equity–Based Financing Outline Mudarabah Musharakah Mudarabah / Musharakah Financing Role of Equity-based Financing in Islamic Economics Possible Reasons for Lack of Equity-based Financing Implementation Addressing Apprehension Towards Equi...

ECON 3430 - Islamic Banking and Finance Equity–Based Financing Outline Mudarabah Musharakah Mudarabah / Musharakah Financing Role of Equity-based Financing in Islamic Economics Possible Reasons for Lack of Equity-based Financing Implementation Addressing Apprehension Towards Equity-Based Financing Mudarabah An arrangement whereby the owner of some property (rabbal mal) gives a specified amount of capital to another person (mudarib) who is to act as the entrepreneur to trade with the capital Profit of the venture will be shared between the two parties according to a mutually agreed ratio – Profit sharing cannot be a fixed amount or a fixed percentage of capital contribution – Profit sharing must be a percentage of the profit Mudarib cannot claim salary or fee other than daily expenses of food Losses will be borne by the rabbal mal as the financier – The mudarib bears the frustration of fruitless effort – Exception – if mudarib negligent or dishonest he has to bear (financial) losses Types of mudarabah – Unlimited mandate (mudarabah mutlaqah) {capital can be used for any buss activities} – Limited mandate (mudarabah muqayyadah) {capital to be used for spec activiti specified by rabbul mal} Rabbal-mal cannot participate in management of the business [general opinion of jurists] – Exception [Hanbali] : rabbal-mal can participate Is a stakeholder in the business Might have valuable contribution that is mutually beneficial Musharakah An arrangement whereby two or more persons contribute to the capital with their property for the purpose of trading with the joint capital, the profit of which, shall be shared among the partners Salient features of musharakah – Profit to be shared according to mutually agreed ratio – Losses to be borne strictly according to ratio of capital contribution – All partners have the right to participate in the management of the business or trade – Difference of opinion amongst fiqh schools on what constitutes acceptable capital Money, physical commodities, intangible assets (talent?), creditworthiness Mudarabah & Musharakah Financing Basic principles – Cannot entail mere advancing of money (loan) Must involve equity (mudarabah) or participation (musharakah) in the business – Financier must share in any losses incurred by the business, according to proportion of capital investment – Profits can be distributed in any mutually agreed ratio Some applications – Project financing Financing from inception of the business – Single transaction financing Export or import financing Replace functionality of conventional letter of credit (LC) – Working capital (current asset minus liabilities) financing Profit determination on the basis of constructive liquidation, with the aid of accounting methods – Asset financing For e.g., musharakah mutanaqisah Some Issues in Mudarabah and Musharakah Financing Securitization of mudarabah & musharakah – Mudarabah / musharakah certificate represents proportionate ownership in assets of the business concern / partnership, and can be a negotiable instrument – Issue – when mudarabah / musharakah assets are substantially in liquid form (cash or receivables), can the certificate be traded? Sharing of gross profit only – When mudarabah / musharakah financing affects only part of a business concern – Fixed assets, indirect expenses and overheads not exclusively attributable to the mudarabah / musharakah venture – Provide higher percentage of profit to compensate Role of Equity-based Financing in Islamic Economics Mudarabah and musharakah as financing instruments are the earliest to be proposed in literature on Islamic banking Some scholars argue that mudarabah and musharakah are the principal alternatives for replacing interest-bearing transactions – That murabahah, ijarah and BBA are derivatives (offshoots) and complements of the primary instruments (mudarabah and musharakah) – These instruments should be restricted to cases where mudarabah and musharakah are not applicable Use of equity-based financing instruments can promote distributive justice – To alleviate concentration of wealth and income disparities via equitable reallocation of productive resources – Islamic concept of development includes moral, spiritual and material aspects Money and property are social tools to achieve social good Bank’s objective should be maximization of social benefit not purely profit maximization Implementation of Equity-based financing vis-à-vis other Islamic financing products - BIMB 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Bai Bithaman Ajil 59 60 69 65 64 61 52.8 53.4 50.6 50.1 43.7 Murabahah 25 24 20 19 14 12 17.7 15.7 9.1 9 7 Ijarah 5 3 2 3 3 35 2.6 3 2.8 2.2 1.2 Mudarabah.5.5.4.2.2.01.1.1.1.1 0 Musharakah 3 3.5.5.5.50 0 0 0 0 0 Qard al-Hassanah 7 7 7 0 0 0 0 0 0 0 0 Al-Inah.3 2 1 10 12 17 21.9 21.1 13.6 10.2 8.7 Istisna’ (no salam 0 0 0 2 6 6 4.9 5.1 2.9 1.7 1.2 financing) Ar ahnu 0 0 0 0 0 0 0 0 0 0.4 At Tawarruq 0 0 0 0 0 0 0 1.6 20.9 26.7 37.8 Percentage of Total Financing Source : BIMB Annual Reports  Possible Reasons for Lack of Equity-based Financing Implementation 1. Risk Mismatch with Sources of Funds – Two-tier mudarabah remains a theoretical model First-tier mudarabah (deposits) Rabbal-mal Mudarib Mudarabah Bank Customer investment Bank (Entrepreneur) account holder Rabbal-mal Mudarib Second-tier mudarabah (financing) Due to the following two factors, mudarabah deposits are relatively much less risky when compared to mudarabah financing (risky part, bank therefore is reluctant to give financing using mudarabah) – Third party guarantee of deposits (BNM / PIDM) – Expectations of depositors  Possible Reasons for Lack of Equity-based Financing Implementation (2) 2. Focus on credit risk – General risk (market risk / systematic risk) Uncontrollable, cannot be avoided (e.g. structural changes in the economy, changes in consumer spending preferences) – Specific risk (issuer risk / non-systematic risk / credit risk) Can be eliminated via risk management methods, tools and instruments – Majority of financing products are fixed return arrangements Sale contracts without ownership risk on the part of the bank Bank only exposed to specific risk (credit risk) – Because contemporary Islamic banking is credit-driven, focus on risk management issues will always revolve around mitigating credit and default risk – Products prone to market risks (such as mudarabah, musharakah) will be deemed not viable to the banking business – In addition, skills, knowledge and experience of banking personnel and management In the area of credit risk management, not market risk management Possible Reasons for Lack of Equity-based Financing Implementation (3) 3. Lack of political will – Leadership or authorities fail to appreciate, understand and/or accept the role of equity-based financing in an Islamic economy – Concentration of wealth arguably leads to accumulation of political power and influence – One of the roles of equity-based instruments such as mudarabah is to reduce wealth disparities – As such, it would be in the best interest of the affluent to resist widespread mudarabah financing via wielding its political influence – As banking and finance is a function of the economy that a government typically regulates, political will is required 4. “Bankers will think like bankers” – No precedence of Islamic banks – Current ‘Islamic’ bankers falling back on years of conventional banking practice and experience – Perhaps a different pool of people required in the development and implementation of banking required E.g. venture capitalists (willing to take risk) Possible Reasons for Lack of Equity-based Financing Implementation (4) 5. Moral hazard – Actions of mudarib (if knows he is not liable for losess would behave to max his utility rather than max profit) reflecting inherent conflict of interest Luxurious ‘business’ expenditures Related party transactions Non- or under- declaration of profits – Lack of honest and trustworthy entrepreneurs Mudarabah is a trust-based relationship – Lack of capable entrepreneurs – Information asymmetry (there are info about the business that bank does not know) Possible Reasons for Lack of Equity-based Financing Implementation (5) 6. Shortcomings in Infrastructure and Support Systems – Banking IT systems designed for conventional banking Transaction processing systems (TPS), customer relationship management (CRM) systems, enterprise resource planning (ERP) systems, data mining and warehousing software – Accounting and auditing Lack of standards Lack of qualified accountants and auditors – Lack of legal framework and environment Arbitration and resolve of disputes Practical difficulties in objectively identifying negligence on the part of the mudarib – Lack of equal tax treatment for equity-based financing Equity financing at competitive disadvantage vis-à-vis conventional debt financing alternative – Lack of exit mechanisms Addressing Apprehension (anxiety, worry) Towards Equity-Based Financing 1. Risk of Loss Argument Financiers will bear losses which will be passed on to depositors Depositors will withdraw deposits from banks Suggested approach Prudent and diligent (careful) analysis of business to which equity financing is made Diversification of equity financing portfolio (give financing in different sectors) Promotion of paradigm shift That legitimate profit-taking is only with the undertaking of risk Islamic financial institution cannot merely deal with money exchanges No complete separation between financing sector and the trade and industry sector Addressing Apprehension Towards Equity-Based Financing (2) 2. Dishonesty Argument Dishonest entrepreneurs will exploit equity-based instruments by under-declaring profits Suggested approach Proper controls, monitoring and auditing Punitive measures against transgressors legislated to deter dishonesty Physical and monetary penalties Defamation and denial of further financing facility Addressing Apprehension Towards Equity-Based Financing (3) 3. Trade or business secrets Argument Entrepreneur or business operator has to disclose business secrets, which form the business’s competitive advantage, to the bank Suggested approach Confidentiality agreement between the entrepreneur and the bank Severe penalties in the event of breach of that contract to maintain secrecy Addressing Apprehension Towards Equity-Based Financing (4) 4. Unwillingness to Share Profits Argument Profitability dilemma Profitable or capable entrepreneurs not willing to share profits with bank, prefer conventional loans because returns to entrepreneur would be higher Less competent entrepreneurs more than willing to share business with bank because downside risk minimized Hence banks will end up financing unprofitable ventures run by less competent entrepreneurs Suggested approach Moral persuasion – that riba-based financing is sinful (should be a move to) Gradual but eventual phasing out of interest-based lending Making (risk-sharing) equity financing the only way to obtain financing