Why the lack of profit/loss sharing?

Gassner's picture

Well, repeatedly we read and hear about the lack of profit/loss sharing (equity finance) in Islamic finance. Here my five cents about it:

1) Islamic commercial law, Fiqh Muamalat, per se has no preference of either permissible mode of finance, be it musharaka, ijara or murabaha whatsoever. All is halal. However, the call for modesty of debt in many hadith and the seriousness of being indebted upon death (withholding of death prayer) shows a call for a solid equity portion in business; let's call it a technical preference.

2) If we look up all debt financing modes (e.g.Murabaha, Ijara) there are remaining difficulties to finance wages, rents and installments on fresh debt. This is a true indicator for a required minimum amount of equity in a company.

3) Point 1) and 2) leads us to demand a sound debt/equity ratio.

4) Moral hazard is often claimed as reason why Islamic banks do not offer substantially equity finance. However, there is moral hazard in debt finance, too: Equity finance has a moral hazard that profits may be underreported in order to share less, debt finance has a moral hazard in reporting too much profits in order to maximise debt finance and thus return on equity. If anything, banks should give both forms of finance. A conclusion built into an economic model by Professor Wahrenburg in Frankfurt (Wahrenburg, M.: Financial Contracting with Adverse Selection and Moral Hazard, see: http://libra.msra.cn/Publication/4890621/financial-contracting-with-adve...).

5) What else is the driver for the lack of PLS? Point 4) would suggest that even non Islamic banks should have an incentive to offer equity finance! Well, how is the regulatory impact of capital weigth under Basle II? If a bank gives debt finance out 100 $ then it needs 8 $ equity, if however the bank gives out a Musharaka(equity) finance, the capital requirement would 32 $ for a direct investment or 16 $ for a diversified investment. In other words to earn the same - without risk premium - equity finance would need to deliver double or quadruple the return without extra income for the bank in this simple model.

6) Interest is deductible as cost for a company, while profits are paid out after corporate tax is being paid. The optimum rate of debt in a firm is therefore 100 % debt anyway. Read the call: "TIME FOR A LEVEL PLAYING FIELD BETWEEN DEBT AND EQUITY" at http://www.efb-geef.eu/documents/docs/policy%20papers/Debt%20vs%20Equity... for examples and solutions.

In short, we are pricing equity finance out of the financial markets for regulatory and tax reasons. This is why Islamic banks fail to offer profit/loss sharing in my opinion. This is also a main driver for the financial crisis we are in.

Inshallah, some states will reconsider the above points and put it into a general policy to find better ways to regulate the markets, while protecting depositors without the harmful side effects of the "medicine" capital weight.

Best regards,

Michael Gassner