International Journal of Islamic and Middle Eastern Finance and Management Emerald Article: The entrepreneurial role of profit-and-loss sharing modes of finance: theory and practice Rasem N. Kayed
Article information: To cite this document: Rasem N. Kayed, (2012),"The entrepreneurial role of profit-and-loss sharing modes of finance: theory and practice", International Journal of Islamic and Middle Eastern Finance and Management, Vol. 5 Iss: 3 pp. 203 - 228 Permanent link to this document: http://dx.doi.org/10.1108/17538391211255205 Downloaded on: 20-08-2012 References: This document contains references to 61 other documents To copy this document:
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The entrepreneurial role of profit-and-loss sharing modes of finance: theory and practice Rasem N. Kayed
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Faculty of Administrative and Financial Sciences, Arab American University – Jenin (AAUJ), Jenin, Palestine Abstract Purpose – The purpose of this paper is to find out whether profit-and-loss-sharing (PLS) modes of finance have become viable financial alternatives for entrepreneurship and enterprise development or whether they are still merely an academic endeavour. Design/methodology/approach – The method employed in this study is a combination of extensive examination of existing literature and critical analysis of the outcomes of several relevant studies in order to establish the convergent/divergent relationship between theory and practice in Islamic finance. Findings – Based on available bank level and country level data, the paper presents evidence that the divergence between the theoretical perspective and the practical implementation of PLS modes of finance is widening to an alarming level. The paper argues that this divergence by no means can be attributed to the construct and the disposition of the PLS instruments; it is rather the product of the negative attitude and the lack of proper infrastructure of the majority of Islamic financial institutions (IFIs) – and their (reluctance) to accommodate entrepreneurship through the genuine implementation of PLS instruments. Practical implications – The findings of this study draw attention to the visible shortage in practical research pertaining to the application of the principles of PLS modes in financing entrepreneurial activities. The study suggests that the relevance, the direction and the resilience of future research undertakings should be focused on bridging the increasing gap between the prescribed role of PLS instruments and the actual performance of IFIs in promoting socio-economic development through the creation of a vibrant entrepreneurship sector. Originality/value – The paper points out that while PLS models dominate the theoretical literature on Islamic finance, and whereas the majority of mainstream Muslim scholars and financial authorities overwhelmingly judge PLS models as being compelling financial options and practical developmental tools, the reality of Islamic finance paints a different picture. The paper emphasizes the need for IFIs to conform to their own charters and assume a leading developmental role in order to realize al-Shariah objectives (maqasid al Shariah). The paper identifies key research areas that warrant the attention of keen researchers with interest in the field of Islamic finance and entrepreneurship development. Keywords Profit-and-loss sharing (PLS), Mudharabah, Musharakah, Entrepreneurship, Small to medium-sized enterprises (SMEs), Human capital, Entrepreneurialism, Finance, Islam Paper type Research paper
1. Introduction There are millions of ambitious, intelligent, and energetic Muslims who can’t get ahead for lack of capital. Give them funds, and they will work wonders Kuran (2002).
Harper (1984, p. 25) argues that small businesses are, in reality, “an extension of the personality of their owners”. So there exist as many unique small businesses as there are small business owners. Accordingly, and in such a heterogeneous small business
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environment, generalization about small firms or the challenges facing their owners becomes a difficult undertaking. Although each country is faced with an exclusive set of obstacles that hamper the development of its entrepreneurship sector, and despite the uniqueness of the problems facing individual entrepreneurs in their quest to establish their businesses, there are certain difficulties shared by the vast majority of entrepreneurs: entry into business is often hindered by the lack of financial resources, government regulations, and social attitudes that discourage risk-taking (Sage, 1993). The task of financing entrepreneurial activities continues to defy the aspirations of many potential entrepreneurs and to challenge the credibility of the vast majority of financial institutions. Kuran (2002) explains that “There are millions of ambitious, intelligent, and energetic Muslims who can’t get ahead for lack of capital” and he believes that by giving those potential entrepreneurs needed funds, “they will work wonders”. The solution as seen by Kuran (2002) rests with the world’s Islamic banks adherence to their principles as outlined by their charters. He further advocates that the attentiveness of Islamic banks to the fundamentals of Islamic banking will see these banks lending on a profit-and-loss sharing (PLS) basis to potential entrepreneurs with economically promising ideas, rather than simply to established businesses with plenty of collateral. By so doing, Islamic banks will render “a noteworthy contribution to economic development in the Islamic world and beyond” (Kuran, 2002). The emerging Islamic Financial Services Industry (IFSI) is being championed as an ideal alternative to the interest-based conventional financial system and an authentic way out of this looming impasse. Islamic financing, mainly through PLS contracts, is prescribed as a cure for the ills of the debt-based finance and an opportunity for entrepreneurs to share, rather than to bear, the risk of starting new businesses and/or expanding existing ones. It has been strongly argued that if an Islamic financial instrument can take the economy to new heights, that instrument must be based on the values of PLS contracts – namely through Musharakah (partnership financing); where the Islamic financial institution and the entrepreneur contribute capital into the business thus share the risks, as well as the rewards, associated with the entrepreneurial activity. However, the realities of the IFSI clearly indicate that commercial banking rather than investment banking dominates the practices of this infant industry (Iqbal et al., 2008; Kayed, 2007). This line of reasoning raises serious questions regarding the validity of the common perception that Islamic finance promotes entrepreneurship and encourages the creation of small and medium enterprises (SMEs). The imitation and the replication of conventional financial products and giving them Islamic names in order for them to appear Shariah compliant might be considered sufficient in meeting the technicality of Shariah compliance, but they are definitely insufficient to achieve the broader goals of Al Shariah (maqasid al Shariah) and to meet the specific objectives of the Islamic financial system, particularly the just and equitable distribution of economic wealth. The purpose of this paper is to survey a selected set of various modes of Islamic finance, particularly PLS contracts and to examine their role in promoting economic development through the enrichment of the entrepreneurial profile. Furthermore, the paper endeavors to put forward a balanced argument as to why Musharakah mode of finance has failed to realize its developmental role by failing to extend minimal support to the cause of the SMEs sector and to build meaningful partnership with existing and potential entrepreneurs.
The paper is organized into six interrelated sections including this introduction. Section 2 accentuates the need to rearranging the relationship between the borrower and the lender from being a debt-based to an equity-based relationship. Section 3 briefly presents an overview of various Islamic modes of finance with special emphasizes on the potential role of PLS instruments, particularly Musharakah, in advancing the cause of entrepreneurship and enterprise development. Section 4 explores key challenges facing the application of Musharakah contacts and debates the most frequently cited objections/criticism of Musharakah. Section 5 looks ahead and suggests some directions for future research and emphasizes the need for Musharakah to assume its entrepreneurial role. Section 6 concludes the paper. 2. Debt-based vs equity-based financing[1] The following discussion on the Islamic financial system is limited in its depth and breadth to the potential role that Islamic banking is capable of commanding in the development and promotion of a productive Islamic entrepreneurship sector. Islam prohibits all forms of interest-based financial transactions (riba) regardless of what term they might come under, and does not tolerate any attempt to justify interest-based financial activities. “Allah permits trade and forbids usury” (The Holy Qur’an, 2: 275). Hence, an alternative financial arrangement that is consistent with the religious convictions of Muslims and in harmony with their cultural characteristics, is sought to fulfill their business as well as personal financial needs. Relevant to this study is the Islamic concept of partnership financing. 2.1 Key Islamic financial themes conducive to entrepreneurship Muslims who possess financial resources are confronted with the question of how to safeguard their wealth against inflation and other changing economic circumstances while remaining faithful to principles of Islamic finance that reflect the entrepreneurial nature of Islam and its commitment to preserve the spiritual as well as the socio-economic well-being of humankind. Islam forbids money hoarding because hoarding money means preventing it from achieving its intended objectives and negates its function as a viable tool for development. Hoarding money is also prohibited on the ground that it obstructs the Muslim ummah from realizing socio-economic justice among its members, “those who hoard up gold and silver and do not spend it in the way of Allah, give them the tidings of a painful punishment” (The Holy Qur’an, 9: 43). The logical alternative to hoarding is investing and investment could be realized through a choice of opportunities. Money can be passively invested in commercial banks to earn fixed interest. This form of unproductive investment is deemed unlawful, hence condemned and prohibited in Islam. Investments could also take the form of investing in the stock market, real estate, and import/export and in many other alternatives that involve productive as well as unproductive or even destructive business activities. Islam sanctions only productive business activities, which abide by the rules of the Islamic Shariah and preserve Islamic values. The Islamic alternative to hoarding is spending in the way of the Almighty Allah; that is, to invest in business activities that are moral, productive and socially acceptable and desirable. The Muslim investor therefore is encouraged to start a business of his/her own or enter into a partnership agreement with a potential entrepreneur to create
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a new business entity. It is important to appreciate that not every individual Muslim with extra money to invest possesses the qualities, the traits and the personality to be an entrepreneur. Thus, the rationality of the Islamic financial system accommodates such situations by allowing the investor to have a share in the business venture through a partnership arrangement with the potential entrepreneur who does not have the financial resources to start his/her business. The concept of partnership is best understood within the Islamic PLS modes of finance, specifically through the arrangements of Mudharabah and Musharakah (direct partnership with the entrepreneur or through an Islamic financial institution). Such arrangements ensure that the potential entrepreneur will not start the business disadvantaged with a heavy interest burden added to the initial borrowing which has to be repaid regardless of the outcome of the business venture. 2.2 From lender-borrower relationship to productive partnership Some of the conditions imposed by lending institutions such as requesting prior business records showing profitability to guarantee the repayment of the loan are hard to fulfill, especially by new and potential entrepreneurs who do not have an established credit history or prior success profile. Commercial banks are also hesitant to take risks in financing innovations since new products lack an account of historical success and the guarantee of future performance and acceptance by the markets remains to be proven (lack of reliable information). Banks therefore require entrepreneurs to come up with substantial collateral, in most cases, to a value exceeding the value of the loan in order to protect their investment and guarantee the security of the loan. The inability of the entrepreneur to meet the tough conditions set by commercial banks means that he/she cannot count on the conventional banking system to secure needed start-up capital. This leaves the entrepreneur with the difficult task of trying to find another financing alternative – where excessive interest is often charged – or to abandon the dream of becoming an entrepreneur. Even if the potential entrepreneur was able to satisfy the requirements of the lending institution and prove his/her eligibility for the loan, the entrepreneur will then be held accountable to repay the pre-determined interest charges in addition to the borrowed principal. On the one hand, the high cost of raising capital needed to undertake the business venture imposes a heavy debt burden on the entrepreneur. The extra cost of finance places the entrepreneur in a detrimental position from the start, hence increasing the odds against the success of his/her business venture. Furthermore, the commitment to repay the loan and the associated interest is inescapable and is irrespective of the future yield of the business investment. On the other hand, interest charges on bank finance are treated as a cost item in the production process leading to increase in the prices of goods and services – thus adding to the adversity of the deprived classes of society. Viewing the delicate relationship between potential entrepreneurs and commercial banks from an Islamic perspective raises more concerns. Islam views all forms of interest-based financial transactions to be unjust; hence, they are prohibited and should not be practiced by Muslims. The alternative Islamic solution to the lack of funds for financing new business start-ups is based on the principle of PLS, through partnership agreements between the Islamic financial institutions and the entrepreneurs. An entrepreneur with an idea but lacking the financial resources to transform the
idea into business reality enters into a partnership agreement with an Islamic financial institution. The partnership agreement is an abiding contract that enables the entrepreneur to obtain Islamic (halal) financing without having to carry the burden of debt and the guilt of conducting an unethical business transaction. PLS arrangements also minimize the risk involved in any business undertaking as both parties share the risk of loss as well as the prospect of profit according to pre-determined proportions. Thus, the emphasis in these arrangements is on rearranging the relationship between the borrower and the lender from being a debt-based to an equity-based relationship. It is argued that partnership financing favors small entrepreneurs and extends long-term financing to entrepreneurs embarking on long-term productive entrepreneurial projects. Partnership financing provides protection against inflation and transforms the spirit of the relationship between the lender and the borrower to one of cooperation between two equal partners who have vested interests in the success of the business. These advantages of partnership financing are decisive factors in promoting entrepreneurship. The basic foundations of the Islamic financial system are based on the pledge of implementing an all-inclusive financial system (wealth accumulation, maintenance and distribution) that is fair, just and unbiased towards the rich minority at the expense of the poor majority. The ultimate aim is to spread socio-economic justice amongst all people regardless of their geographic landscape and/or their demographic make-up. The bank’s investment in the entrepreneurial activity (capital) actually belongs to a diverse group of local individuals and businesses. Hence, society as a whole has a stake in the success of the new entrepreneurs and in the promotion of their indigenous entrepreneurial activities. This constructive approach to partnership financing is most likely to extend much needed public backing to new business enterprises and infuse more faith in the participating financial institutions. The prohibition of riba in Islamic economics has received much attention. Many Western scholars have suggested that the prohibition of interest is anti-capitalist and an obstacle to the proper functioning of a modern economy and a detrimental factor to economic development and growth (Perkins, 2003; Pipes, 1983). On the other hand, others have argued that there is no moral or economic justification for charging or receiving interest. Charging interest, they argue is counterproductive and adds to the burdens of the entrepreneur and an interest-based economy is by no mean an economy that aspires to provide socio-economic justice. Ahmad (1996) explored the possible relationship between the banning of interest and economic development and reached these conclusions. First, money generated from “rent-seeking activity” such as charging interest creates new but artificial capital which is by no means the life-blood of the markets. Ahmad (1996, p. 4) pointed out “The essence of the market is entrepreneurship” and explained that “trade, not banking is the primary function of markets”. Interest is therefore counterproductive as it ultimately brings negative growth in the economy through a continuous process of diminishing. Even when interest is increasing wealth in numerical terms, it fails to stimulate growth in social wealth, because such synthetic wealth is neither the outcome of productive economic activity nor is the result of an increase in commodity supply. Second, the partnership arrangements between the financier and the entrepreneur eliminate the negative effect of banning interest, if any, on the markets. Mudharabah and Musharakah are two Islamic financial instruments used as alternatives to the interest-based arrangements employed by conventional banking. Mudharabah and
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Musharakah operate under the concept of “rate of return” where the financier and the entrepreneur share the risk, hence they also share the profit/loss generated by the investment according to an agreed-upon ratio. This is in contrast to the fixed pre-determined “interest rate” to be paid by the entrepreneur in addition to the borrowed principal regardless of the outcome of the business undertaking. Third, Islam prohibits paying or receiving any pre-determined fixed rate of return on borrowed/lent money. Charging interest (riba) tends to drive the poor into more poverty and create more wealth for the wealthy without doing work or sharing the risk involved in every business undertaking. Riba further creates wealth without actually being the outcome of productive economic activity or as the result of an increase in commodity supply. Islam therefore considers all interest-based financial arrangements to be unfair, unjust and morally unjustifiable and all money generated by such transactions to be unearned money, thus declares riba unlawful. Interestingly, all major religions ( Judaism, Christianity and Islam) and other ethical systems such as Buddhism and Hinduism were united in denouncing interest as unethical and immoral practice. As Robertson (1990, 1998) and Vogel and Hayes (1998) stressed the need for an interest-free economy, the work of Toutounchian’s (2009) has found interest to be unnecessary for an economy or businesses, be it conventional or Islamic. Interestingly, the majority of reserve banks in the USA, Western Europe and other developed countries such as Japan have set their lending rate to be between 0 and 0.25 percent as a measure to combat the adverse implications of the current global financial crisis and to revive the state of their economies. Chapra (1985) and more recently Mills and Presley (1999) and Warburton (1999, pp. 224-5) argued that an equity-based economy tends to outperform an economy that relies heavily on credit. Moore (1997) concluded his study on Islamic finance by suggesting that the move towards equity-based financing is set to be a global phenomenon. Wienen (1997) pointed out that debt-based financing runs the risk of forcing future generations to pay heavily to service current public borrowings. Alternatively, equity-based Islamic financing limits Muslim Governments’ borrowings to available resources hence freeing future generations from the debt burden[2]. The magnitude of the problems facing many developing countries under the rules of debt-based economies is enormous. It was reported during the G8 summit 2005 that servicing Africa’s debt is consuming all its gross domestic product (GDP). The ratio of total debt to GDP for many countries is rising rapidly; the external debts of five Arab countries (Mauritania, Egypt, Somalia, Jordan, and Syria) in 1989 for instance exceeded by far their GDP (Jiyad, 1995). 3. Islamic modes of finance In addition to their conventional role in providing interest-free financial services and investment opportunities, IFIs are under religious and moral obligations to assume a leading developmental role through the promotion of entrepreneurship and funding the creation of new enterprises. Sallah (1990, p. 128) rightly argued, “Being an Islamic institution with responsible mission, the [Islamic] bank must act with more developmental orientation”[3]. While the prevailing objective of conventional banks in a capitalist market economy is maximizing profit by charging an optimal interest rate, that of IFIs is to prove their viability as partners in development and prosperity. A view shared by the vast majority of Islamic financial scholars is that IFIs are uniquely positioned to deliver significant contributions towards the establishment
of an indigenous economic structure capable of expanding the productive base of the economies of various Islamic countries through the creation of a dynamic entrepreneurship sector. Forging partnership agreements with existing and potential entrepreneurs by means of the honest application of PLS contracts can largely facilitate the development of a dynamic entrepreneurship sector, and consequently boosts the birth rate of new SMEs.
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209 3.1 Shariah compliant financial arrangements Islamic finance offers a variety of Shariah compliant financial arrangements which Dusuki (2007) grouped into five categories: (1) voluntary altruistic contracts such as pawning (ar-rahn) contracts and al-qard al-hasan; (2) exchange modes which are best represented by cost-plus sales (Murabaha), credit sales (bay bi-thaman ajil ), and Leasing (ijarah or ıjar); (3) Islamic forwards (salam and istisna); (4) participatory PLS modes (Mudharabah and Musharakah); and (5) hybrid-modes like diminishing Musharakah (Musharakah mutanaqisah), and hire purchase (ijarah thumma al-bay). However, the most common Islamic modes of finance are Al-qard al-hassan (benevolent or good loan), Murabaha (cost plus financing), Mudharaba (silent partnership), and Musharakah (partnership financing). Following is a brief description of the first two instruments before considering Mudharaba and Musharakah in more detail, and of particular interest in the present context, Musharakah. Al-qard al-hasan is an interest-free loan in which all that is to be repaid is the amount of the borrowed principal. This form of Islamic financing does not bear interest and does not forge a business relation between the lender and the borrower. Giving interest-free loans is an activity that is most likely to take place where the lender and the borrower enjoy a form of personal relationship. Ayub (2007, p. 445) argues that “providing funds by business institutions without any return is not possible according to the rules of demand and supply [. . .] [After all], IFIs have to work as business institutions”. Therefore, he rejects the “myth” that “Islamic banks need to work as social security centers providing charity to the needy and for benevolence [. . .], [since] business and benevolence are two separate things”. Murabaha is a simple cost plus transaction which gives a fixed rate of return to the banks. Ayub (2007, p. 446) argues that “one major cause of the apparent divergence between theory and practice is the excessive use of Murabaha”, given that Murabaha is one of the most practiced[4], yet the most controversial Islamic financial products. The untenable overuse of Murabaha has been hailed as “Murabaha Syndrome” – given that the majority of banks claiming to practice Islamic financing are being censured for not adhering to the principles of Shariah when applying Murabaha contracts. Banks, in many cases, advance the funds to the client without assuming physical ownership of the goods under contract; goods are usually transferred directly to customer from seller’s warehouses (Abdul Aziz, 2009). Such practice clearly violates a fundamental pillar of Islamic financing by eliminating the element of risk which the bank, as an owner of the goods, should bear, rather than merely acts as a financer[5].
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Critics argue that Islamic banks in reality are practicing “artificial Murabaha” by extending interest-based loans to their customers. They further claim that Islamic banks are in fact charging pre-determined mark up (usually equivalent to the ongoing interest rate) under different names and pretexts to justify such questionable practices[6]. Furthermore, critics accuse Islamic banks of promoting a consumerism culture by extending their credit conveniences (through Murabaha) mainly to facilitate the purchasing of consumer goods rather than engaging in productive activities, thus working against the objectives of Shariah and negating the principles of their own charters. 3.2 Mudharabah and Musharakah contracts As noted, the primary view of Islamic financial intermediation is that risk should be shared between the lender and the borrower (investor and the financier). Mudharabah and Musharakah are the two prominent instruments with defined PLS rules designed to fulfill the risk-sharing requirement necessary for the promotion of entrepreneurship and the creation of SMEs. However, it has been strongly argued that the dominant modes of finance that are being practiced by the majority of Islamic financial institutions are risk-free financing schemes such as Murabaha, Ijara, and bay bi-thaman ajil – although these instruments, arguably, have the tendency to conceal interest under different pretexts. Islamic banking, through the Mudharabah and Musharakah instruments, is preferentially situated to play a positive role in advancing the cause of Islamic entrepreneurship, where financial capital is combined with human capital to create new business entities. Islamic banking provides current and potential entrepreneurs with needed lawful (halal ) capital to start and/or to expand their businesses. It also provides them with protection against risk and uncertainty by spreading the risk between the entrepreneur and the investor through partnership arrangements. The proficiency of the bank team under Musharakah will encourage entrepreneurs to engage in more innovative and original business undertakings. Quality entrepreneurship would also be promoted; as entrepreneurs compete to take advantage of available financial capital, financial suppliers will have the opportunity to evaluate entrepreneurs’ proposals and business plans, and to enter into partnership contracts where prospects seem promising. Key differences between the Musharakah and Mudharabah concepts from the operational perspective include: capital contribution of each partner and consequently the distribution of profit and the sharing of loss; participation of partners in managing the business; and the liability of each partner is unlimited under Musharakah while in Mudharabah the liability of rabb al-mal is limited to his/her investment. Mudharabah (silent partnership): This is a contract between two parties: the financial institution (bank) and the entrepreneur. The bank acts as financer by providing needed capital and the entrepreneur devotes his/her ideas, skills, expertise and time to investing the funds in a productive and socially accepted (halal) business venture. The agreement is based on the principles of PLS; profit when realized is shared by both parties according to pre-negotiated ratios. In the case of incurring a loss, the provider of capital (bank) bears the entire financial burden and loses all the invested money, whereas the entrepreneur’s loss is limited to his/her invested time and effort. Various research outcomes have demonstrated that banks were very cautious in their responses to potential entrepreneurs and on many occasions were not keen
on being part of such financial arrangements. Under Mudharabah, the entrepreneur assumes total management of the business, rendering the financial institution a passive partner with little or no real authority to influence the process of the business venture. The bank usually has to rely on faith, trust, and a sound confidence in the entrepreneur who is expected to abide by Islamic business ethics. In addition, the bank insists on the entrepreneur’s having a convincing argument for the economic feasibility of the proposed business undertaking. Musharakah (partnership financing): Musharakah in Arabic means “partnership”. Musharakah as well as Mudharabah are two PLS-based financial instruments that fully conform to the Islamic financial principles. Musharakah is a contract between the entrepreneur and the financial institution identical to Mudharabah except that the entrepreneur contributes to the starting capital as well as providing his/her physical and mental contributions towards the business venture. Contrary to the lending arrangements extended by conventional banking, financing through Musharakah does not mean the advancing of money to the borrower who is held accountable for the repayment of the borrowed amount plus interest regardless of the outcome of the business investment. It rather means the participation in the business and the formation of partnership between the investor and the entrepreneur where both parties share the assets of the business to the extent of the ratio of financing. The Musharakah certificate represents the direct pro rata ownership of the holder in the assets of the project. Thus, the two instruments differ in the sense that Musharakah gives both the entrepreneur and the bank the opportunity to share the finances (assets or working capital) as well as the management of the business. Consequently, the entrepreneur will be exposed to capital loss. Moreover, under the Musharakah arrangements, the bank has a say in the operation of the business and profit is shared according to pre-determined proportions such as (the partners’ percentage contribution to the start-up capital after deducting the entrepreneur’s management compensations). Losses are also borne accordingly in line with the partners’ proportion of capital contribution. Anwar (1987, p. 24) pointed out that as Muslim entrepreneurs in an interest-free economy do their utmost to maximize their returns, they end up also maximizing the earnings of their partners – through the Islamic financial institutions. This mutually beneficial relationship promotes a spirit of cooperation and partnership between the entrepreneur and his/her wider community, the local investors, and consequently advances the cause of entrepreneurship in development through participation. Musharakah is the option that is most likely to be favored by the banks because it exposes the entrepreneurs to the real risk of losing a portion of their investment hence motivates them to a adopt a more cautious approach to managing the business venture and to put forth extra effort to ensure its success. Musharakah arrangements also provide the financial institution with the opportunity to be an active participant in the entrepreneurial activity and to oversee the operation of the business. To summarize: first, Musharakah is the most authentic and least controversial PLS instrument: it is neither questionable like Murabaha, nor as risky (for the bank) as Mudharabah. Musharakah also suits entrepreneurs whom would prefer sharing rather than bearing the risk associated with new business undertakings. Second, Musharakah is a pure halal financial activity that contributes to the emergence and/or the expansion of productive business entities. It entails real economic activity – the creation of new business entity, thus is it endeavors to go beyond Al-Shariah compliance to the
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fulfillment of Al-Shariah objectives. It is expected that a substantial portion of existing and potential Muslim entrepreneurs do not wish to deal with conventional banks on religious grounds. They consider commercial banks to be unethical institutions that widen the divide between the wealthy and the needy through their immoral interest (riba)-based financial practices. Scholars surveying this topic frequently overlook this factor despite its significance and immense implications. Third, unlike interest-based conventional finance, Musharakah arrangements are fair to both the financer (presented by the financial institution) and to the entrepreneur, whether the business venture is making profit or sustaining losses. Should the venture prove to be a success and the rate of return turns to be higher than the ongoing interest rate, fixed arrangements would not then be fair to the investor. Likewise, if the business activity turns sour and ends up a failure, the entrepreneur is left to his/her fate, while the lender unfairly recovers. This practice is deemed unfair and unjust; hence it is explicitly prohibited in Islam. 3.3 The application and the performance of PLS instruments While the equity financing instruments of Mudharabah and Musharakah are unquestionably based on the principle of PLS, their overall share of banking activities is insignificant. The findings of various studies cast serious doubts on the developmental role that Islamic banking is shouldering in promoting entrepreneurship and in developing the economies of various Islamic countries. The theoretical coherence of the Islamic PLS concept remains challenging at practical level, and the promise to take the economies of Islamic countries to new levels is yet to be fulfilled (Farooq, 2007). Henry (2001) noted that less than 3 percent of the financing and investments of the Jordan Islamic Bank in 1999 consisted of Mudharabah and Musharakah[7]. A more recent study undertaken by Abdo (2011) reveals that the Jordan Islamic Bank’s investment activities by means of Musharakah have averaged 1 percent for the years (2004-2009), while financing through Mudharabah was not offered by the bank during the same period. The contribution of Islamic banking through Mudharabah and Musharakah to the developmental landscape in Algeria is as minimal as it is in the majority of other Islamic countries. Melod (2011) stated that the only investment project funded by the Algerian Barakah Bank through Musharakah did not have a happy ending. He further noted that the bank does not extend its services to include Mudharabah as a convenient PLS financial instrument. The Algerian Barakah Bank – as is the case for the majority of Islamic banks – favors Murabaha over Mudharabah and Musharakah, thus negating the developmental role that Islamic finance aims to render to Muslim communities at large. This reality led Melod (2011) to conclude that PLS modes of finance make a little, if any, input to the socio economic well-being of the country. Khalaf (2011) highlighted the scarcity of empirical statistical information regarding the application of Mudharabah and Musharakah by various Islamic financial institutions in different Islamic countries. He further explained that available indicators, although largely based on limited secondary data, reflect the relative significance of PLS modes of finance. His review of pertinent studies revealed that: . The use of Musharakah as a financing instrument by Saudi banks has dropped from 3.1 percent in the year 2000 to 1.1 percent in the year 2005. . Financing through Mudharabah did not exceed 1 percent compared to that of Murabaha in Abu Dhabi Islamic Bank during the years 2000 and 2002
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The combined share of Mudharabah and Musharakah in Qatar Islamic Bank was 1.7 percent of the Murabaha in the year 1999. There is no mention for Mudharabah in the activities of the Kuwait Finance – House during the years 2000 and 2001. Funding through Mudharabah and Musharakah represented 1 percent of total investments of International Arab Islamic Bank in Jordan. While the share of Murabaha has reached 65.3 percent of funding activities of Islamic Bank of Bangladesh, the bank did not utilize Mudharabah mode of finance in its financing activities.
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Marburg (2006) observed that: Instead of providing capital on the basis of PLS, Islamic banks acted as traders on behalf of their clients and bought and sold objects with mark-ups and mark-downs and rented or leased objects against fixed rental charges or leasing rates.
Thus, they have scored very low in their performance as socio-economic developmental institutions. Siddiqi (1991) studied Pakistan’s Islamic banking industry and found that despite tax exemption to the Mudharabah operations – provided 90 percent of profit was distributed to share or certificate holders, the Mudharabah companies performed below expectations. The commitment of Islamic banks to small entrepreneurs and to emerging enterprises has also been questioned by Harper (1997) and Yousef (1997). They – along with a host of entrepreneurs[8] – observed that access to financial facilities is generally extended to those who do not usually need them, such as large and well-established businesses. The results of a recent survey carried out jointly by the Union of Arab Banks and the World Bank show that the share of bank lending to SMEs is only eight per cent of their total lending in the Middle East and North Africa (Staff Writer, 2010). The results also reveal that the SME lending in the Gulf Council Corporation (GCC) countries stand at an exceptionally low level of 2 percent – despite the positive view that the GCC banks maintain regarding “the SMEs segment as potentially profitable”. These levels of lending remain significantly lower than in both the developing and developed countries and are below the banks’ own long range lending targets which stand at 12 percent in the GCC. The findings of an empirical research amongst Saudi entrepreneurs (Kayed, 2007) are highly consistent with the findings of other relevant studies. Data in Table I suggest that the contribution of Islamic finance through PLS instruments to the
Male (M) Personal savings Family and friends Commercial financing Islamic financing Other sources Total Source: Kayed (2007, p. 522)
47 31 4 0 7 89
Count Female (F) 2 5 1 0 0 8
Percentage Male (M) Female (F) 52.8 34.8 4.5 0 7.2 100
25.0 62.5 12.5 0 0 100
Percentage Overall (M) & (F) 51 37 5 0 7 100
Table I. Financing Saudi small business start-ups
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development and promotion of entrepreneurship in Saudi Arabia is immaterial. This is despite the fact that Islamic finance is being promoted as a viable and practical alternative to traditional finance. Although the majority of the surveyed entrepreneurs were fortunate enough to have access to financial resources to start their own businesses through their personal savings or by the help of family and friends, many more potential entrepreneurs are not so privileged. Potential entrepreneurs who do not have the financial means on their own and are restricted through limited access to capital are most likely to be denied the opportunity to turn their entrepreneurial vision into business reality and realize their dreams of becoming entrepreneurs, and to contribute to the well-being of their communities. While the combined investment of all Islamic financial institutions in the development of new and existing businesses, by means of the Musharakah arrangement, is approximately $1 billion a year, American venture capital institutions provide annually more than $25 billion in equity financing for entrepreneurial activities. This peculiar fact prompted Saleem (2005, p. 2) to claim, “In spirit and in real terms, United States financial institutions offer more Shari’ah compliant financing and investment than that provided by all the Islamic banks combined”. These disturbing readings are not to be taken lightly as they raise serious questions regarding the spirit and the validity of the Islamic financial model. Siddiqi (1991) believes that Islamic banks have resorted to Murabaha financing because of low levels of reliability and trustworthiness in the market, poor systems of auditing and accounting, and the failure of the judiciary to help financial institutions in case of default by the users of fund. It is also believed that low of moral standards in many Muslim communities restricts wide scale application of joint venture as an investment technique. Similarly, Bacha (1997) provides explanations on why the share of Mudharabah financing has been negligible in the overall financing of Bank Islam Malaysia. Applying a series of theoretical models used in the mainstream literature of finance, he elaborated that Mudharabah financing is susceptible to an acute agency problem. Comparing to conventional techniques of finance, he claims that Mudharabah contains certain features of both debt and equity financing so that their problems are thus present in Mudharabah financing. This is so, because in Mudharabah, according to Fiqh literature, the rabb al-mal should not interfere in the business and at the same time he is liable for all the losses. In this case, agency problems of Mudharabah are more severe than debt or equity. The reluctance of IFIs to be actively involved in Mudharabah contracts is somehow understandable; such arrangements are too risky for the bank, the sole financer of the business activity, the bank stands to lose its entire contribution while it has no control or influence over the business itself. This raises the issue of trust between business partners (the financial institution and the entrepreneur) and confirms the argument that the Islamic financial institution cannot afford to be “a sleeping partner because of the risk that the entrepreneur might manipulate the financial statement of the business” (Wilson, 2004, p. 104). However, the absence of Musharakah, from the IFIs’ agenda and its failure to assume its developmental role cannot be explained or justified on this ground. Under Musharakah contracts, the Islamic financial institution is a partner that shares rather than bears the risk of
incurring loss, and has the authority and the means to monitor and manage the business venture and hence to contribute to its success or failure. 4. Common objections and key challenges The apparent lack of genuine integration of PLS contracts within the IFSI has been largely attributed to the inadequate infrastructure needed for proper functioning of the Islamic banking system. This is evidenced by the severe shortage of experts in Islamic banking who are capable and keen to go beyond merely complying with Shariah rules and regulations in their financial practices to realizing the socio-economic objectives of Shariah. The achievement of such a goal requires Islamic financial institutions to assimilate both profitability and development dimensions of Islamic finance when allocating their resources. 4.1 Common objections/criticism of Musharakah As noted, the most frequently cited criticism of Islamic banking and finance is that the IFSI in reality is working within the conventional framework and that the so-called Shariah compliant Islamic products are concealed versions of the conventional. Ali (2010) argues that an impartial methodical study of Islamic finance will conclude that “it is not so Islamic after all. It is just a rehash of conventional finance”. This attitude was echoed by Dr Askari: “What you see today isn’t Islamic finance,” he says. “Most of the banks do not have that risk-sharing component. Investors want a bond, and banks create something that looks like a bond but they say it is not a bond, so that it is Shariah compliant” (Wecker, 2010). Ayub (2007) discussed the most recurrent criticisms and objections aimed at Islamic banking and made the distinction between conceptual criticism related to the philosophy and concepts of Islamic banking and finance, and practical criticism associated with the practices of the Islamic banking sector. The following discussion is focused on the divergence between theory and practice of Islamic finance relevant to namely Musharakah. Musharakah has been subjected to rigorous analysis, and several points have been made: (1) Musharakah has been censured for being an “old instrument” that is neither suitable for contemporary financial needs nor comparable with what the state-of-the-art conventional banking can offer. However, Usmani (1998, p. 29) rejected this account and explained that Musharakah as well as other instruments of finance are not static and new forms and procedures, such as diminishing Musharakah, are absolutely acceptable and encouraged as long as they operate within the broader frame of Islamic finance. (2) Usmani (1998) also noted that “risk of loss, dishonesty, secrecy of business, and clients’ unwillingness to share profits”[9] have been thought to prevent wider acceptance of Musharakah. However, he argued that these limitations are general and by no means are confined to Musharakah. (3) he decline in the number of Mudharabah and Musharakah contracts compared to those for Murabaha is largely driven by the fact that bank’s profit is assured through Murabaha and remains a prospect by means of Mudharabah and Musharakah. Furthermore, motivated by their desire to attract and retain more clients in order to compete with conventional banking, some IFIs have lost sight
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of the spirit and the objectives of Musharakah and started guaranteeing profit for their clients – thus violating the very basic principle of Islamic finance which links rewards to risk. (4) The ability of a single Islamic financial institution to be an effective partner in numerous and diverse partnership agreements has also been questioned. However, the legitimate question of whether is it practical for an Islamic bank to be an active partner in literally hundreds of assorted businesses without making far-reaching compromises is better examined in view of the relatively new Islamic diminishing Musharakah model – Musharakah Mutanaqisah Partnership (MMP). According to this concept: . a financier (Islamic bank) and (his) client participate in a joint ownership of a business; . the share of the bank is further divided into a number of units; and . the bank makes a promise to sell[10] (his) part of ownership to the client periodically and gradually leading to the entrepreneur’s total ownership of the business. Diminishing Musharakah therefore provides an authentic solution to the raised question and at the same time present the entrepreneur with the opportunity to eventually have a total ownership of his/her business. A careful analysis of the above objections confirms that the problem rests within the financial institutions and other stakeholder rather than in the construct and the spirit of Musharakah itself. 4.2 Key challenges and obstacles The reluctance of commercial lending institutions to extend their credit to (potential) entrepreneurs is largely attributed to the high risk (high failure rate and market instability) and substantial administrative costs of lending to small firms (the size of the loan is too small to be economically viable). However, lack of understanding of the nature and dynamics of SMEs, coupled with lack of qualified credit personnel to apprise feasibility studies and to evaluate and monitor small business loans, are more likely to be the real reasons behind such reluctance. Nevertheless, there are numerous occasions where Islamic banks did not behave in accordance with their basic declared principles and thus have disappointed many potential entrepreneurs and prevented them from realizing their dreams of owning their businesses and consequently from contributing to the well-being of the Muslim ummah. Yousef (1997) disputed the validity of the assumption that Islamic financing, as it is being currently practiced, leads to more entrepreneurship. He argued that the available evidence, regarding the operation of Islamic banks in the past 20 years, negates “the fundamental principles of PLS”; Islamic banks require the entrepreneur to come up with substantial security in the form of collateral before approving or even considering the loan application. This is despite the fact that such a practice goes against the essence of the PLS principle. Al-Naser (2010) tells of the agony of a young Muslim entrepreneur equipped with a well-developed idea and a number of financial studies that confirmed the feasibility of his innovative and creative project, who was rejected outright by an Islamic bank when
he sought financing. The failure to finance such a promising business initiative was justified on the ground that this project was new and therefore untested, and that the bank had no history of funding projects of this nature. In contrast, the same bank unreservedly agreed to fund traditional real estate projects under the pretext that the bank embraces a wealth of experience in similar projects. This scenario supports the argument that the shortage in the availability of skilled and creative human capital is hindering the emergence of original competitive Shariah-based financial products and services and rendering IFSI, by and large, emulating the conventional financial system – barely with an Islamic flavor (Iqbal, 1997). The following discussion suggest that lack of informed clients and competent practitioners, outdated educational systems and unsupportive state policies, individually and collectively, have played against the development and the maturity of Musharakah and prevented it from assuming its developmental role. 4.2.1 Lack of suitable clients. An acute problem facing Islamic financial institutions is the lack of suitable clients who can comprehend the nature of Islamic finance and appreciate the philosophy of Islamic financial institutions. Banking activities frequently rely on financial intermediaries. This reliance is driven by the fact that financial institutions, being Islamic or conventional, largely depend on dealing with clients as depositors and/or as fund users. However, the relationship between clients and banking systems in either case is governed by different rules and guidelines. On the one hand, conventional banks strike a lender-borrower relationship with their borrowing clients. In this relationship, banks provide loans that are to be paid back on an agreed-upon or pre-set date, with an addition of a pre-determined fixed interest rate. Banks protect their interests by acquiring adequate documents that demonstrate the ability of the borrower to repay the loan along with the stipulated interest on time – regardless of the outcome of the client’s financial venture (Ibrahim and Kayed, 2010). On the other hand, Islamic banks form partnership agreements with their clients. The partnership agreement implies that both parties share the outcome of the investment projects undertaken by the new business entity. This outcome is greatly affected by the ethics and the competence of the fund user; the more experienced and capable the client is, the greater the likelihood of achieving success in the market would be. Similarly, the more honest and trustworthy the client is, the more assured the bank will be of the safety of its investment. Some of the most important traits that are to be possessed by apposite clients include: . a comprehensive understanding of the Islamic banking model with regards to both depositing and acquiring funds; . a minimum level of Islamic morality and ethics such as loyalty, honesty, and the willingness to conduct dealings based on the law of Shari’ah (Nemer, 2005); and . awareness of the various investment opportunities available and the type of business he/she intends to venture in together with the financial institution (Abu Zaid, 1996). Needless to say, the lack of such clientele base would naturally hinder and obstruct the efforts put in by Islamic banks towards achieving financial success (Ibrahim and Kayed, 2010).
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The domination of the “riba” or interest mentality coupled with the lack of understanding of the Islamic banking model, which is deeply rooted in Islamic law or Shariah, constitute a major obstacle facing Islamic banks at the moment[11]. In addition, there seems to be no willingness to deal on the basis of PLS based on the rule linking the lawfulness of gain to risk-taking (Annadawee, 2000). In short, Islamic banks are operating in a medium that cannot be truly characterized as an Islamic. The incompatibility between a society that has no ethical framework to guide its dealings and a banking system based on the principles of Shariah that requires its clients to abide by a set of ethics and moral conduct, prevented Islamic banks from achieving their goals (Abu Zaid, 1996). The negative implications for the lack of suitable clients on Islamic banking can be summarized as follows: . The lack of understanding of the way Islamic banks operate and the domination of the usury mentality resulted in the difficulty of marketing the services offered by those banks. This convinced some of the potential clients of the inability to find suitable alternatives to conventional banking systems. This meant that Islamic banks lost some of its potential clients who could have, in due course, contributed to making them a success by providing the necessary revenues (Jaber, 1993). . The domination of the usury mentality forced Islamic banks to choose between determining fixed returns from Murabaha transactions to make such transactions similar to standard interest rates paid to the clients of conventional banks or risk losing potential clients who prefer the usury option available at conventional banks (Feruan, 2001). The usury “Riba” mindset is widespread amongst some of the clients of Islamic banks, to the extent that they are expecting profits equal to or exceeds those offered to the clients of conventional banks. This affected the performance of Islamic banks negatively due to the fact that Murabaha transactions are more risky than the traditional lending transactions practiced by conventional banks. . After experiencing the lack of integrity and ethics of some clients, Islamic banks shifted their practice from dealings that would require the client to abide by Islamic law such as Musharakah and Mudharabah, to transactions, which did not depend largely on the morality of the clients. Such transactions include Murabaha and bay bi-thaman ajil. As a result, it affected the capability of the Islamic banks, and prevented them from fulfilling their economic role. . The nature of the client’s attitude, behavior, and level of morality resulted in conventional mortgages playing a major role when deciding on the most profitable investment opportunities to the extent that some banks reversed the well-known rule that regards the client him/herself as the most important factor, and not the kinds of financial guarantees that he/she has. This greatly affected the economic role of the Islamic banks because it limited their ability to curb the problem of unemployment, by not financing a wide segment of society, which does not possess the kind of financial guarantees that the Islamic banks require. As a result, only rich clients (who can provide such guarantees) benefit from the financing of the Islamic banks[12].
Both Islamic banks and the state individually and collectively are under moral and professional obligations to address lack of suitable clients in the Islamic financial industry and take sweeping measures to overcome this obstacle. Islamic banks can act simultaneously at two different levels: (1) The intellectual level. Changing the mentality and the attitude, and subsequently the behaviour of their existing and potential clients. Islamic banks need to embark on aggressive awareness and promotional campaigns to explain and clarify the distinctive nature of the products and services they offer. In addition to promoting Islamic banks’ products and services, the organization of such campaigns should also aim at fulfilling Islamic banks’ social responsibilities towards the general populace. Creating adequate awareness of the Islamic financial industry would definitely strengthen the demand for the products and services that the industry has to offer. IFIs have no option but to embark on extensive and aggressive marketing strategies to convey and to confirm the message of the viability and distinctiveness of Islamic banking and finance in local as well as in the international marketplace. Abdul Kadir (2000) challenged IFIs to utilize technology in their marketing endeavours and precisely stated, “In an era where advancement in internet technology allows for almost zero information cost, it is hard to appreciate how the lack of awareness should persist long term”. (2) The practical level. The Islamic bank should do its best to ensure the suitability of the clients by utilizing appropriate methods to collect information about the financial history of the clients and their reputation in the market. In this regard, an Islamic bank in Palestine has established a complete unit that focuses on attracting investors and gathering information about their character and suitability[13] (Ibrahim and Kayed, 2010). Moreover, the Islamic banks should exercise caution in writing the contracts, and the practical procedures attached to them, so that the Islamic banks will ensure that their rights are protected in case the clients fail to abide by the rules and conditions of the signed contract. The state can also play a positive and constructive role in this regard by extending its support to enable the educational system to integrate Islamic economics, banking and finance into the educational curricula. 4.2.2 Lack of suitable practitioners. Banks’ personnel in many instances lack basic skills and proper training to consult clients and gain their trust – especially when applying PLS contracts. Abdallah (1999, p. 267) rightly argued, “When applying Musharakah, the bank needs more than normal conventional bankers. It needs staff with multi-dimensional knowledge and experience, who believe in the idea and dedicated to its application”. The real challenge for banks’ management therefore lies in their ability “to identify and recruit such staff”, and concluded, “Intensive training especially on the job training, would contribute to the creation of such cadre”. A great responsibility therefore falls on the financial regulators; IFIs should share the responsibilities and take adequate measures to cater to the needs of the rapidly growing Islamic banking industry. They should take the lead in training and preparing bright and motivated individuals to manage the industry’s growing demand. It is important that any proposed training program involves aspects such as: financial feasibility analysis, exposure to small business environment, ventures monitoring and
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portfolio evaluation. Furthermore, employees of commercial banks offering Islamic financial services often lack thorough knowledge and understanding of Islamic financial products and investment procedures thus fail in retaining existing clients and/or in attracting new ones. The findings of a survey conducted by the International Organization of Securities Commissions (IOSCO) “Task Force” among selected members of IOSCO as well as among external parties drew attention to “the lack of available and easily accessible data on Islamic capital market statistics and a shortage of market professionals well versed in both Islamic finance and Shariah principles” (Fact Finding Report, 2004, p. 7). Further, consumers of Islamic banking products are usually not provided with all the necessary information about their investments to determine whether their money is invested in halal businesses and in compliance with the Shariah rules and regulations. IFIs must demonstrate unwavering commitment to ensure the transparency of the Islamic financial industry, wherein clients would have complete knowledge of the nature of the Islamic banking instruments and products in order to weigh their options and make informed decisions. The challenge is also for the educational systems across the Islamic countries to assume their pivotal role in passing on the knowledge of Islamic economics amongst Muslims, and creating the awareness of the availability of Islamic financial products as alternatives to the services offered by conventional banking. This underscores the pressing need to establish diverse but parallel institutions and research centers in all Muslim countries to ensure a steady supply of skilled and keen Muslim researchers, professionals, and specialists in the various disciplines of Islamic finance. Academic institutions are urged to extend the boundaries of their curriculum to account for Islamic finance and to spread momentous education in the field of Islamic economic and law to meet the challenges of Islamic banking industry. As education and innovation are becoming the hard currency of the twenty-first century’s economy, likewise, knowledge, expertise, soft skills and positive attitude are the basic ingredients for developing a steady stock of intellectual human capital. Figure 1 maintains that formal education complemented with workplace learning and training are the basic ingredients for human capital development which in turn lead to more economic return for both people and their organizations and/or industries. In view of that, and in order to achieve sustainability in overcoming lack of suitable practitioners in the Islamic financial industry, the relationship between institutions of higher education and Islamic financial institutions should be highly synchronized and based on strategic partnership. 5. Looking forward The question as to whether the divergence between theory and practice in PLS modes of finance is the cause or the outcome of the deviation of Islamic banks from their objectives remains to be answered. In the absence of balance in investment activities of Islamic banking, one would expect such divergence and deviation to take place. The allocation of a large share of investment fund to real estate sector at the expense of other more productive sectors such as innovation and entrepreneurship helped to widen the imbalance – resulting in serious consequences that are evidenced by the steady decline in the real estate sector.
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Although Islamic banks did not feel the full impact of the current global financial crisis, prices of real estate in Dubai for instance has slumped during the last two years and lost half their values. This is a wake-up call for Islamic financial institutions to return to their roots and be true to their charters by diversifying their financing and having other options than real estate to consider as security-backed assets. 5.1 Future research directions Islamic finance is facing the challenge of reclaiming the legitimacy of its Murabaha financing. There is a pressing need to ensure, and then to reassure all stakeholders that all financial products and services offered by Islamic banks comply strictly with the Shariah rulings, and that depositors’ money is invested ethically in productive and socially accepted business activities. Furthermore, Islamic banking is also being challenged to restore the credibility of the PLS modes of finance, namely Mudharabah and Musharakah – as two powerful instruments with the potential to play an indispensable role in promoting entrepreneurship and in developing the economies of various Islamic countries. A comparative study that engages a range of Islamic countries to assimilate their experiences with Islamic banking and entrepreneurship would have two-fold objectives: on one hand, it would provide a conceptual explanation for what seems to be a conflicting account between the potentials of Islamic banking and the very limited success, if any, that it has achieved in promoting Islamic development through entrepreneurship. On the other hand, the proposed study could be linked to its practical implications for policy environment in relation to the role of Islamic financing in the promotion and development of the small business sector.
Figure 1. Overcoming lack of suitable practitioners
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Despite the wealth of theoretical research exploring the features and the potentials of Musharakah as a valid financial instrument and viable developmental tool, there is a visible gap in the empirical research regarding the application of the principles of PLS contracts in financing entrepreneurial activities. Further research is needed to: . Examine the extent of the practical implications for PLS instruments on the development of SME in various Islamic countries. . Find practical solutions to overcome the barriers preventing the application of PLS models in Islamic banking and finance. . Assess the rate of success and the level of satisfaction achieved where PLS models in general and Musharakah in particular were applied. . Appraise the contribution of Musharakah instrument (evidenced by the level of finance extended to SMEs) to the socio-economic well-being of the Muslim ummah in various Islamic countries, in terms of employment generation and poverty alleviation. 5.2 Recommendations The inclination of Islamic banks to finance traditional projects over those based on creativity has negative implication for the overall performance of Islamic financial industry and consequently prevents Islamic banks from being effective partners in the socio-economic development of their communities. This view is echoed by Al-Naser (2010) where he extended his criticism to the practices of Islamic financial institutions and pointed out that “favoring traditionalism and rejecting creativity and innovation is contrary to the nature of Islamic banking”. Islamic banks are different than their counterpart conventional banks. They differ in their philosophies and objectives, and therefore they should differ in their approaches. Being institutions with a mission that goes beyond maximizing returns, Islamic banks are expected to strive to fulfill maqasid Al Shariah (Shriah objectives) in finance which regard finance as a tool to “construct the earth”. This all-encompassing view of Islamic finance entails seeing Islamic banks diversifying their financing and investing in innovative products, infrastructure projects, the creation of entrepreneurs and new enterprises, generating employment opportunities and empowering the deprived classes of society. In order for Islamic banks to effectively carryout their socio-economic responsibilities, they must have in place proper infrastructure, where the human capital comprises the cornerstone of such an enabling environment. This can be achieved through the joint efforts of Islamic financial institutions and the institutions of higher education. The starting point would be to invest substantially in the development of a sustainable skilled, competent, and motivated human capital well-versed in Shariah as well as conventional economics in order for these banks to be faithful to their mission and to realize their intended and anticipated developmental role. The landscape of the Islamic financial industry remain highly segmented due to fact that the vast majority of the IFIs are small in size, compared with major international institutions, and collectively they account for a small proportion of the global financial market. Iqbal and Mirakhor (2007) and Fakih (2007) urged Islamic financial institutions to seriously consider taking advantage of consolidation opportunity by merging
into large financial institutions. Islamic banks need to consolidate to be able to compete and take on larger developmental projects in the areas of infrastructure, energy, and other projects that provide tangible returns for their communities. (Fakih, 2007) believes that: [. . .] consolidation within the Islamic finance industry appears inevitable, as current landscape is highly fragmented and opportunities exist for institutions to achieve scale, capture global market share and improve competitive positioning.
Reduction in overhead costs, and accessibility to diverse range of products and services are amongst the many prospective benefits of consolidation to the IFIs. 6. Concluding remarks This paper has argued that Islamic banking should return to its fundamental functions of providing innovative Shari’ah-based financial products and services that add value to the real economy and address the true financial concerns of current and potential customers. The role of financial institutions in promoting entrepreneurship is an imperative theme of any economy. Entrepreneurs across boundaries are faced with enormous obstacles before, during, and after starting their business ventures. Nevertheless, mobilizing start-up capital is considered a common problem faced by most prospective entrepreneurs regardless of their whereabouts. Critical analysis of available data from various Islamic countries indicate that the theoretical arguments for PLS modes of finance have moved far ahead of evidence. While the majority of literature on PLS modes of finance portrays Musharakah to be the missing link to prosperous economies and sustainable development through the financing of the SME sector, an objective reading into the application and the performance of these instruments tells a different story. The experiences of Islamic banking in various Muslim countries have shown that the PLS model has been marginalized, and the mainstream business is largely based on debt-creating modes to earn fixed returns as in the case of the conventional financial system. There is little, or no, evidence to suggest that Islamic banks have played any significant role in providing venture capital or financing small and micro enterprises, emerging industries, small farmers, and the agriculture sector. On the contrary, just like conventional banks, Islamic banks extended their facilities to the well-established businesses and individuals who do not really need the credit and encouraged, if not explicitly – implicitly, consumption behavior amongst typical Muslim communities at the expense of promoting productivity through the creation of vibrant SMEs sector. It is virtually impossible for a young entrepreneur, unable to meet the bank’s tough security demands, to secure a loan to start a new business or to improve an existing one. The paradox is that despite the positive attitude towards Islamic financing held by the majority of Muslim scholars and entrepreneurs; they have failed to establish a meaningful and business-productive relationship with the Islamic financial sector. Hence, they were cynical about the actual role that Islamic banking is playing in the development of local entrepreneurship.
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The findings of this study confirm that the problem rests within the financial institutions and other stakeholder rather than in the construct and the spirit of Musharakah itself. The failure of Musharakah to play a constructive role in entrepreneurship development is due to the attitude and the behavior of Islamic financial institutions and their (reluctance) to accommodate entrepreneurship through the genuine implementation of PLS contracts. This startling conclusion underscores the need to instigate further empirical and consistent research within a broader Islamic context in order to examine the expediency of the relationship between Islamic banking and entrepreneurship development in different Islamic environments. The aim is to assimilate and build-on the successful experiences of diverse Islamic countries with Islamic banking and entrepreneurship development, and subsequently to devise working policies and procedures that signify Islamic finance as a viable and accessible instrument for existing and potential entrepreneurs. Notes 1. Sections 2 and 3.2 are based on earlier work carried out by the author of this paper see Kayed (2007) and Kayed and Hassan (2011). 2. For more on the debt burden on future generations, see Democratic Staff (2004), Ferguson (1964), Holcombe et al. (1981) and Labonte and Makinen, 2003. 3. Islam rejects the theoretical as well as the practical implications of the Western definition of the term “development”. “Development” in this paper signifies the Islamic perspective of the term which roughly means “well-being” – based on the more comprehensive and inclusive concept of (tawhid ); faith in and the affirmation of the Unity/Oneness of God. 4. Muhammad (2010) stated that “about 70 percent of a typical Islamic bank’s portfolio is in the form of Murabaha”. Khalaf (2011) concluded that Murabaha constitutes between 65 percent and 90 percent of the total funding activities of Islamic financial institutions. 5. It would be interesting, in light of this claim, to embark on a research project in various Islamic countries in order to find out what proportion of Murabaha contracts is artificial. 6. Such as administrative fee, commission, and service charge. 7. As per the bank’s 21st Annual Report, p. 14. 8. Personal interviews with Saudi entrepreneurs (Kayed, 2007). 9. Refer to Usmani (1998) for more comprehensive discussion on the objection/criticism of Musharakah. 10. The opinion of Jurists is that promises in the context of commercial activities are enforceable. 11. Personal interview with the general managers of the five Palestinian Islamic Banks see Ibrahim and Kayed (2010). 12. Personal interview with the general managers of the five Palestinian Islamic Banks see Ibrahim and Kayed (2010). 13. By maintaining comprehensive database and reference checklist on the character and past performance of potential business partners to evaluate their personal and business attributes and to determine the probability of default.
References Abdallah, M. (1999), “Partnership (Musharakah): a new option for financing small enterprises?”, Arab Law Quarterly, Vol. 14 No. 3, pp. 257-67. Abdo, K.K. (2011), “Do Islamic banks in Jordan depend on Islamic investments?”, paper presented at the First International Conference on Innovative Methods of Islamic Banking and Finance, Organized by the Higher Institute for Islamic Studies, al-Bayt University, Jordan, April 5-6. Abdul Aziz, A. (2009), “Islamic banks also responsible for global financial crisis: experts”, Khaleej Times, 6 March. Abdul Kadir, A. (2000), “Selected issues on the development of Islamic financial markets”, Speech Given at the Seminar on the Rating of Islamic Financial Institutions at Bahrain, April 1. Abu Zaid, A.M. (1996), Adaur aliqtesady lelmasaref alislameyah, Alma’ahad Al’aaleme Lelfeker Alislame, Cairo. Ahmad, I. (1996), “Islam, market economy and the rule of law”, Lecture Delivered to the Second International Symposium on Liberalism in Ankara, Turkey, May 18-19, available at: www. Islamfortoday.com/mad01 (accessed July 1, 2002). Ali, L. (2010), “An electronic posting at the Islamic business and finance network” (IBF-Net, July 27 2010), available at: WWW.bfnet.com (accessed August 15). Al-Naser, L. (2010), “Islamic banking between traditionalism and innovation”, Asharq alawsat, 20 August. Annadawee, A. (2000), Jumhurat Al-Kawed Al-Fekheyah fe Al-Muamalat Al-Maleyah, 1st ed., Sharekat Al-Rajehee Al-Masrefeyah, Cairo. Anwar, M. (1987), Modelling Interest-free Economy: A Study in Macro-economics and Development, The International Institute of Islamic Thought, Herndon, VA. Ayub, M. (2007), Understanding Islamic Finance, Wiley, Chichester. Bacha, O.I. (1997), “Adapting Mudharabah financing to contemporary realities: a proposed financing structure”, The Journal of Accounting, Commerce & Finance; Islamic Perspective, Vol. 1 No. 1, pp. 26-54. Chapra, M.U. (1985), Towards Just Monetary System, The Islamic Foundation, Leicester. Democratic Staff (2004), “Why debt matters: federal debt soaring under Bush policies, threatening long-term economic security of nation”, available at: www.budget.senate.gov/ democratic/press/2004/factsheet (accessed August 21, 2005). Dusuki, A.W. (2007), “Banking for the poor: the role of Islamic banking in microfinance initiatives”, Humanomics: International Journal of Systems and Ethics, Vol. 24 No. 1, pp. 49-66. Fact Finding Report (2004), “Islamic capital market fact finding report”, Report of the Islamic Capital Market, Task Force for the International Organization of Securities Commissions, July, available at: www.sc.com.my/eng/html/resources/annual/ar2004 (accessed May 3, 2007). Fakih, R. (2007), “Consolidation in the Islamic finance market”, Opportunities and Trends, Vol. 38, January. Farooq, M.O. (2007), “Partnership, equity-financing and Islamic finance: whither profit-loss-sharing?”, Review of Islamic Economics, Vol. 11, pp. 67-88. Ferguson, J.M. (1964), Public Debt and Future Generations, The University of South Carolina Press, Chapel Hill, NC.
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Further reading Presley, J.R. and Sessions, J.G. (1994), “Islamic economics: the emergence of a new paradigm”, The Economic Journal, Vol. 104, pp. 584-96. Rosly, S.A. (2006), “Financing for Islamic banks”, Malaysian Institute of Economic Research (MIER), May 15, Malaysia Star. Wilson, R. (2007), “The west should promote islamic banking”, Islamica Magazine, available at: www.islamicamagazine.com/online-analysis/the-west-should-promote-islamic-banking (accessed June 25). Corresponding author Rasem N. Kayed can be contacted at:
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