Key Principles Enshrined in the Shariah Finance Essay

The key principles enshrined in the Shariah which shape the way Islamic finance has evolved are riba, gharrar, maisir and haram. The Quran categorically prohibits the giving or receiving of interest, regardless of the purpose for which the loan is made and regardless of the rate of interest charged. Although there is consensus among the Muslim scholars that riba is banned, some controversy exists over what the concept actually is, 

[2] and consequently what financial transactions are prohibited. 

[3] Dr Siddiqui in his book on Islamic banking attempts to resolve the issue when after examining and debating on the true nature of riba he reaches the conclusion that bank interest in all its forms and intent is riba. 

[4] In Islam, to be entitled to a permissible return, “money should be invested through the purchase and sale of tangible assets, and income streams should be derived from the economic use of those assets”. 

[5] Heavy reliance is placed upon the existence of physical assets in contracts 

[6] so as to avoid riba, as well as gharar. This prohibition of riba is the core difference between Islamic Banking and conventional banking.

Islamic banking is primarily an equity based system featuring zero based interest rates, equity participation, joint ventures, and mutual funds and leasing. The way that it differs itself from conventional banking is through the replacement of interest rate mechanisms with profit and loss sharing models i.e. mudarabah and musharaka, and other interest free instruments such murabaha, bai istisna, bai salam, ijarah. These all enhance the practical scope of Islamic finance and enable better risk management and diversification. Depositors in Islamic banks play a major role in the financing used by banks as not only do they share in the banks profits made but they also share in the losses as their deposits are not guaranteed. Profit and Loss instruments i.e. mudaraba and musharaka are contractual agreements between two or more parties based on the notion of no fixed rate of return for the borrower but rather a share in the profits of the venture or if the case may be the liability for the losses of the venture. Both PLS instruments can be used for short term, medium term and long-term projects. Mudarabah, although not based on shariah sources but rather on darrura (necessity) is a means of providing capital to entrepreneurs known who are then known as the mudarib, to go ahead with a project. It can be between the Islamic bank and an individual or a multinational corporation. It is in essence a silent partnership where the partner providing the capital is silent.

The Islamic Bank being Rab al mal (financial provider) enters a contract with the mudarib in which he forwards a sum of money to the mudarib to utilise his skills and labour, while having no involvement at all in the management of the project. The mudarabah can be restricted, which is where the Rab al Mal has the right to specify the line of business for the mudarib to work within or specific projects. An unrestricted Mudarabah is where the mudarib has the right to choose any line of business that he wishes without the interference of rab al mal.

The Rab al mal, in return for the financing provided does not receive a fixed return but a fixed share of the profits, which are agreed upon by both parties in the contract stage. The financial loss is solely incurred by the Islamic bank. The bank losses the capital invested with the Mudarib as well as the future expected cash flow from the profits gained, whereas the mudarib only loses his time and effort. The risk is therefore all the banks to bear and as a result they have to stringent in the procedure adopted to screen entrepreneurs and the measures taken to ensure a low risk and high return. Musharaka is a hybrid of sharikat and mudarabah, combining the act of investment and management. They are partnerships, where two or more people combine either their capital or labour or even reputations to form a business in which all the partners share in both the profits and the losses in predetermined ratios which reflect their share of input into the business either through the capital invested or the labour and time put in. They all also are liable for the losses in proportion to the capital they put in. Every partner has a right but not a duty to partake in the management of the business. An agreement can be reached for the partnership to be a silent partnership, with only one person managing the business and the rest taking no part in management, but still entitled to his share of the profit.

Each and every partner in the musharaka is both the agent and guarantor of the other. There is also a Diminishing musharaka which is used for large assets such as property or machinery. Diminishing musharaka involves both an ijara agreement and a musharaka agreement . The borrower along with a bank purchase a property jointly, with the share in the property reflecting the amount put forward. The borrower at the same time enters into a ijara agreement to rent the banks share of the property. So the borrower owns his share and rents the banks share. Both the amount repaid under the diminishing musharaka agreement and the amount paid under the lease agreement are amalgamated.

This is then used to calculate how much of the property owned by the bank the borrower has purchased through monthly instalments. At the end of the agreements, the bank will pass the title of ownership to the borrower after a single and last payment after which the borrower owns 100% of the property. There are two types of risk associated specifically with PLS contracts. One is the risk of the investment itself, the risk of rate of return, while the other is the risk associated with the moral conduct of the entrepreneur and his integrity. The first can be minimised through strict practices of selecting potential investments and calculating the risk and profit potential. But it cannot be fully eradicated.

The second stems from the existence of imperfect markets and asymmetric information. Islamic scholars and jurists consider PLS to be a centre pillar in Islamic financing, which it was during the early stages of the emergence of the Islamic financial markets. However, sampling from ten Islamic banks during 1994-1996, show that the percentage weight of musharakah and mudarabah in the total activities was only 7% each, with murabaha, a non-PLS method claiming 70% of the total financing 

[7] . The reason for this being that Islamic banks made considerable losses and as a result have almost completely stopped using PLS methods of financing. This is due to more than just one factor, but the most dominant are the effects of asymmetric information on the relationship between the bank and the customer and the detrimental effects that this has on the profits made by the bank. The first problem encountered by the Islamic bank, is the adverse selection problem. Islamic banks as we know do not operate with interest but instead use profit sharing schemes, where they are entitled to a specific predetermined share of a projects profit. Potential borrowers have inside information about their activities and intent and their prospective projects’ likelihood of success that the bank cannot verify easily.

Due to the nature of PLS contracts, Islamic banks will attract applicants with inside knowledge that their project is highly risky, and borrowers who will inflate their declared profit expectations in the hope of being quoted a lower profit-sharing ratio by the bank. 

[8] As a result, the rate offered by banks rather than being tailored to specific projects is averaged out to minimise losses. The low risk and high profit projects refuse to pay what in effect is a higher rate for them due to their low risk and as a result do not enter into the market at all leaving only low risk projects for the banks to invest with. Once the borrower has been transferred the funds needed for the specific project, the bank has limited control over the funds and how they are used.

With unrestricted mudaraba the mudarib has complete discretion to do with the money as he wishes. The mudarib, once given access to the funds can potentially undertake riskier projects without the banks knowledge, indulge in perquisites and mislead the bank about profits earned, leading him to have more information than the bank. This is essentially a moral hazard problem. The third and most significant problem arises as a direct result of the corporate relationship between the management of a project and owners, which is attributed as a major cause of the lack of PLS contracts being practised by Islamic banks. Once the contract has been entered into by both parties, the mudarib as manager and agent not only has no incentive to act in the banks best interest as principals but also has a disincentive to do so. This immorality and lack of integrity impose risks on the bank and their bottom line.

The agency problem, as this is, is essentially the conflict of interests that arise between the manager and the owners. The principal as owner engages the agent as a manager to act on his behalf in the day to day management and long term success of the company, and as such, expects the agent to act in the principal’s best interest as financier/owner of the company. However, the mudaraba contract as a silent partnership inherently limits the control rights of the financier, while they are exposed to the financial risk of the project. Due to the nature of the agents’ role as manager of the company, he is privy to information that the principal is not, thus has an advantage over the principal. Here, the borrower acting as the agent has the incentive to deceive the principal with regards to profits earned.

Because the principal has a predetermined fixed share (although uncertain), by manufacturing lower profits statements or even showing no profits at all the mudarib can keep 100% of the profits and offer the rab al mal nothing in return for its financing. They can also deflate the profits earned by taking excessive perks or extra leisure, empire building or resorting to accounting subterfuges to disguise the deceit. Islamic banks would have to incur costly monitoring expenses to ascertain whether the declared profits are a true reflection of the activities of the projects or not. This argument is based on the idea that parties to a business transaction will shirk if they are compensated less than their marginal contribution in the production process, and as this happens in the case of PLS, the capitalists hesitate to invest on PLS basis. 

[9] Firstly, Islamic banks lack the regulatory frameworks and tools needed in order to successfully assess the risk profile of each borrower and determine whether they are a viable investment to avoid the adverse selection problem.

Secondly, the costs that would be incurred to monitor the borrower’s activities and finances outweigh any possible gain from the project and prohibit the bank from conducting any monitoring activity. Barring any of these problems Islamic banks still face other issues such as taxation and poor accounting standards which limit the success of these banks. Any attempts to re-establish PLS methods of finance would be met with great opposition especially by the customers of the banks who would almost immediately withdraw their deposits due to the fear that the bank will lose the money through the PLS modes. To avoid the problems of asymmetric information and to subdue the worries of the depositors the Islamic banks need to utilise other permissible Islamic finance modes such as ijara and trade based financing.

Explain carefully how Islamic banks may mitigate the effects of moral hazard and agency costs in practice and compare Islamic banks’ strategies with those used by conventional banks.

Islamic banks as mentioned before have made considerable losses through the use of PLS instruments in the past mainly due to the problems associated with asymmetric information. These problems being, adverse selection before the contract is agreed upon and both moral hazard and the agency problem after the funds have been extended. Due to the impact these losses have had on the finances of the Islamic banks, they have resorted to using other less risky means of Islamic financing such as ijara contracts. In Malaysia PLS instruments only account for 0.5% of Islamic bank financing, and this is the case across many other countries in the Middle East. 

[10] Islamic banks have to some extent tried to mitigate the problems that have arisen from the PLS contracts but none the less they have not been successful in limiting the losses incurred.

Conventional Banks are prone to the same problems, although not as poignant as the Islamic banks because the musharaka contracts are mainly equity based, but regardless, they have managed to minimise the risks associated with financing in a way that the Islamic banks cannot compete with. In order to rectify the markets and attract the high profit low risk project associated with the contracts, the bank has to individualise its rates but it then faces the problem of trying to screen potential projects. This in itself is extremely difficult for a bank to do in an imperfect market where information asymmetries exist. Barring this the bank is left with the only other alternative, which is to not extend credit to anyone at all which would have a devastating effect on the banks profit. The bank can to some extent avoid this final situation by negotiating different rates with each individual potential mudarib based not only on the risk associated with the project but also additional signalling devises that low risk persons can use in order to prove to the bank that they are indeed low risk. The first problem addressed was the adverse selection problem. Being able to distinguish between the high quality low risk borrowers and low quality high risk borrowers is essential to a bank in order to eliminate the potential problems that can occur once the contract is undertaken, such as the borrowers inability to pay and the complete failure of the project. Conventional banks have successfully minimised the risks of adverse selection through techniques of initial screening and guarantees of finance.

Banks decide who to make loans to based on the borrower’s credit worthiness. They use the borrower’s financial statements and other public information they can access such as the value of the borrowers assets, as well as using the borrower’s credit rating obtained through other specialised companies.

They also use the private information they may hold if they have done business with the borrower in the past. They have established an effective and cost reducing standard screening method that applies to most cases. They also have standardised contracts and do not need to tailor each contract to the individual borrower. Restrictive covenants are also used and dictate who the funds go to specifically, when they can be used and for what.

Using all the information gained from screening they forecast and value the borrower’s probability of default and potential profitability. Alongside screening, banks also require the borrower to offer collateral for the loan. This guarantees that if the borrower defaults on the loan the bank can seize the collateral and sell it to regain the capital lost. The bank also has to do its due diligence in checking up on the borrower and valuating the project and potential cash flow stream. Islamic banks have more to lose from the problems of adverse selection than conventional banks and as a result need to put more effort into screening potential borrowers. Islamic banks initially apply a moral and ethical screen, which screens the business of the borrower and the products to make sure that they are shariah compliant which comes at a very high cost.

Once it is established that they are shariah compliant the Islamic bank can then screen the borrowers finances. Screening imposes a great cost on the firm, the cost of information, which to some extent can be lowered by implementing a more efficient and effective standard screening system which the conventional banks have done. After the preliminary screening the bank has to do its due diligence in investigating the borrowers financial plan for the proposed project to ensure that the estimates are correct, the business strategy and management are capable of producing the profits expected and that the project itself is viable. Then the bank can value the net present value of the project and calculate the rate of return needed to compensate it for the risk taken.

This is not only costly but, both the screening and the due diligence take considerable time and resources. There are 2 solutions for the moral hazard issue, monitoring and control of the borrower. Through the PLS contract itself the Islamic bank can impose penalties on the borrower for non compliance or ‘bad behaviour’ that jeopardises the banks profits. This would entail placing restrictive covenants in the contract itself to prohibit the borrower from conducting certain and to legally allow the bank to act to protect its own interests. However in order to enforce these penalties and covenants the Islamic bank has to effectively monitor the borrowers behaviour and financial actions. The cost of monitoring is high and ongoing throughout the entire length of the contract between the bank and the borrower and therefore uses a substantial amount of resources and time. For both Islamic and conventional banks, U.K. regulations for companies under the Companies Act 2006 require public companies to submit annual financial reports of the company which can be viewed by everyone.

These reports include the firms financial accounts. This enables the banks in the UK at least to have easier access to the information needed to assess the financial welfare of the borrower.

There is similar regulation in place across the European Union and U.S.A. however, countries where Islamic banks are the norm i.e the Middle East and South-East Asia have little if not any regulation for companies, which makes it even more difficult to screen and monitor borrowers. Conventional banks primarily use a combination of incentive contracts, monitoring and collateral as mechanisms to align the interests of the borrowers and the lender. However, the use of collateral in Islamic banks is limited due to the nature of Islamic instruments. PLS instruments are collateral free instruments due to the equity nature of them. Islamic banking itself also to some extent relies on the moral and ethical standards that Islam itself places on people. Professor Rodney Wilson argues that there is a higher level of trust between Islamic banks and their clients than is the case with conventional banks and hence the moral hazard risks are less. 

[11] Higher levels of trust reduce risk and uncertainty that banks face. The agency problem is the most detrimental problem that Islamic banks face with PLS contracts.

Islamic banks are affected on both the asset side and liability side. The principal-agent problem is essentially the conflict of interest of managers and shareholders, which causes the manager to shirk effort and indulge in perquisites and damage shareholder value. Therefore, a standard contract that aligns both these interests and covers all possibilities is the best way to mitigate the agency problem. Monitoring has to also be used in conjunction with the contracts to ensure that the asymmetric information is not exploited and that the terms of the contract are adhered to. Without monitoring it would be impossible to implement or enforce any contractual obligations on the borrower. Islamic banks have implemented alternative PLS contracts where the banks share of profits is altered. The borrower keeps 100% of the profit until the profit reaches a certain limit, after this the bank receives it predetermined share of profits, which essentially makes this a debit like instrument.

This has been done in Malaysia in the Bank Muamalat and has had great success. The debt contract with deterministic monitoring (in case of default) (Diamond, 1984) or stochastic monitoring (Townsend, 1979) has been shown to be optimal for financial intermediation between a large number of savers and a large number of entrepreneurs. 

[12] Although Townsend has shown that stochastic monitoring, that is monitoring and verification is done in a random way. He has shown that not only does this limit the costs associated with monitoring but also creates an incentive for honesty on the part of the borrower. 

[13] Monitoring of the borrower is an essential part of guaranteeing returns. Monitoring can be done through investigating the borrowers financial situation through financial statements and annual reports. The borrower has a contractual duty to provide the Islamic bank with financial reports.

Islamic banks can also impose a member of their bank (usually a bank manager) as a director over the borrower. This allows the bank much greater access to the borrowers financial information and enables easier and more effective monitoring and control of activities. Advocates of Islamic banking, therefore argue that a primary advantage of PLS banking is that it leads to a more efficient allocation of capital because the return on capital and its allocation depend on the productivity and viability of the project. 

[14] However, Islamic banks lack the regulatory framework and structure to be able to achieve this efficiency and are constantly being overcome by asymmetric information problems. Even if banks were to now try and adopt the PLS methods again with the solutions to counter the problems faced in the past, the depositors would almost immediately withdraw funds. The depositors do not trust banks who conduct PLS banking unless the legal framework to protect both them and the bank was implemented and regulatory and supervisory structure for companies is put in place. This is especially the case in the under developed Muslim countries were company law and regulatory bodies are few.

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