Debt or equity? Shariah allows both

By Rusni Hassan /Kuala Lumpur

It could be observed that the widespread use of fixed return techniques of debt financing transactions would have been necessary during the initial implementation of interest-free banking.

This is because the entrenched conventional mindset in the interest-based system that has existed for hundreds of years would need its own gestation period to be uprooted, even among Muslims themselves.

Debt financing, which is more palatable to the risk appetite of the bank’s commercial interests, was and is still seen as an ideal alternative financing pool to conventional interest-based banking.

But after over 40 years since the inception of Islamic banking, perhaps the time has come for banks to adopt a more equitable and a more acceptable mode of financing in the eyes of Shariah: that is equity/profit and loss-sharing/investment-based funding, exemplifying the business activities conducted by the Prophet and thus being more acquiescent to the spirit of the Shariah.

On the Shariah legal perspective, there is nothing objectionable to this form of transactions as they are permissible (mubah) contracts.

However, reservations from the aspect of “debt versus equity financing” are that the roles of Islamic banks are similar to conventional banks as they are also in the same business of taking deposits and extending credits.

Islamic banks are said to manipulate the trading modes in ways that retained their identity as “lenders” rather than traders.

The Shariah does approve of both debt-based transactions and profit-and-loss sharing which is equity based, and there is no question of whether one or the other is less compliant or less Islamic.

But they are meant for different segments of people. Whilst debt-based financing can cater to the needs of lower-income groups, equity-based activities could be a better fit for more affluent investors.

As for the Islamic banking operations and instruments, a balance should be struck between debt-based and equity-based mechanisms.

Islamic banks should develop balanced and competitive products based on both forms of activities that would accommodate the needs of public customers, traders and industrialists in the ever changing and complex world.

The problem faced by the industry is that its equity portfolio is less than its debt portfolio, and that the industry is so much influenced by the conventional financial system which is debt based.

The Islamic finance industry, being a follower to the conventional system, was initially set up on the same basis which is debt based operations.

A swift change of focus from debt to equity would have an unfavorable effect on the industry, impinging on its development due to its inability to manage the risks, which are distinctive from what it is familiar with.

Another challenge is to develop a whole new set of industry infrastructure, market framework and regulations to meet the new features of equity-based finance practices. Ultimately, educating the industry players and all the stakeholders will be the utmost challenge of all.

From one perspective, the shift toward equity financing would be more attractive to investors as it provides more stability to an investment.

However, in absence of a proper framework for such a practice, investors will be wary that such an investment could carry unknown risks.

Eventually, investors will be looking for an investment mechanism that has minimum risks and greater return. Prior to the establishment of a comprehensive framework, the equity investment mechanism will not be attractive to both investors and financiers. – Reuters

Rusni Hassan is Shariah adviser to HSBC Amanah Malaysia and an associate professor in Islamic law at International Islamic University Malaysia.