In Malaysia and the Middle East, more than 70% of Islamic transactions are debt and sales-based, despite an all around acceptance among industry players that the principles of profit-loss sharing in Musharakah and Mudarabah fit perfectly within the pillars of Islamic finance.

Regulators such as Bank Negara Malaysia had introduced guidelines on Mudarabah and Musharakah financing since 2007 in an effort to boost the industry’s enthusiasm in equity-based financing, demonstrating effort but a general lack of interest among players due to a natural fear of the unknown; and in this case, the unknown factor being risk.

The following is an excerpt of Islamic finance Asia’s interview with the industry’s up and coming flyboy, Nik Norishky Thani, who had recently returned to his homeland of Kuala Lumpur after serving as executive director of Islamic Finance at the Dubai International Financial Center.

Where does the industry stand in terms of accepting equity-based financing into the mainstream?
Lately I’ve been hearing a lot of comments from the industry saying that equity-based financing is a financing method that industry players should be looking to grow. I agree, Islamic finance players should explore opportunities in equity-based financing and expand on the existing product offerings. The regulators encourage it, various guidelines were issued and I think there is a lot of merit in it.

First of all, it covers many areas such as Corporate banking— where the bank goes into a joint venture (JV) with an entrepreneur; Client-bank relationships— where the client places money in the bank, and a more innovative structure would be where the bank enters into a JV with an entrepreneur who comes up with a product, and the bank finances that product. All these transactions have their values. In the latter for example, the margin for profit should be attractive as Banks enter into the JV at the earliest chain of production. An increase in the Bank’s profits would in turn benefit the Depositors with better returns.

However we should proceed to do this carefully. We need to be realistic in terms of how ready we are for this, because firstly it may bring certain elements of risk that we have not thought of nor prepared for and secondly it is an entirely new ball game for Islamic banks and the industry as a whole.

We need more engagement with industry players and intermediaries, and we need to look at the elements that would make this type of financing workable; for example in terms of information asymmetry. The banks need to have complete information on the entrepreneurs because when you are asking a bank to enter into a joint venture with somebody, they need to know exactly what these guys can bring to the table. If not implemented properly, equity-based financing could cause uneven benefits to various stakeholders as risk-averse Clients will be crowded out of the market, letting the risk-taking individuals with better access to information to gain the most. In the long run, this may do more harm than good.

On top of this, the industry needs to be able to control the situation so that the banks and clients are well aware of what is behind this type of transactions. The plus side to this is that the technology of business management has evolved, making elements such as holding inventory more manageable these days. Yes it is high-time that the industry starts looking in this direction but we cannot be hasty, and we need to explore this further with more research and risk management tools.

Since Equity-based financing is said to be the crux of Islamic finance, why then is the industry still fixated on debt-based financing?
Personally, I believe that it is in the banks’ DNA to do debt. This is what banks are set out to do. However, there are bodies such as (Malaysia’s) Permodalan Nasional Berhad which invests in companies and employs venture capital techniques, it is not an Islamic bank but by character such an organization is practicing equity-based financing. They adhere to the overall concept of putting in money and getting real economic activity going by investing into new products and technology. Although arguably, banks may be in a better position to look at this, they should not be the only ones. That’s what information symmetry is all about — who is in a better position to actually carry out that kind of business. To successfully implement equity-based financing, the Bank will have to be good at a lot of things which are market driven and specific to equity-based financing such as risk assessment, due diligence, asset valuation, project financing, monitoring and management coupled with a very specialized set of expertise in areas they would like to do business in - be it construction, agriculture or manufacturing to name a few.

Is equity-financing feasible from a legal point of view?
In my view, we are still at an early stage. Debt or sales-based contracts are quite well tested in the market and our legal courts. When it comes to Equity-based financing by Islamic banks for example, I’m not sure if there are even legal theories out there; so that is a potentially very big issue.

Personally, I always like to be practical: If I asked you to go into business with me, you would definitely like to know how we are going to resolve our dispute if things don’t work out. There are various dispute resolution mechanisms such as arbitration, mediation and the court of law but whether or not they are well-equipped to handle this sort of Shariah issues is difficult to project at this stage.

This scenario is similar to the 90’s when we were working on Sukuk where the model or structure was there, so the steps here would probably be the same. I anticipate more forums and roundtable discussions covering the action plans on what has to be done to promote equity-based financing. We are definitely not short of capable institutions and we are equipped with a certain amount of talent. A lot of these mechanisms are readily available and just needs to be switched on to address this issue in greater detail. But we would always encourage more participation to boost the numbers from the current 2%.

What spurred all this recent talk about equity-based financing?
The idea for equity-based financing was always there. It was not precipitated by any event in particular although the global economic crisis certainly made industry players re-examine their long held beliefs in the financial system. It could also be that there is a realization in Islamic finance that the industry needs to expand beyond the existing practice. The numbers clearly show that the industry trend is to focus more on sales-based contracts and the question now is how to address it. However, we must also not forget that these sales-based contracts have been approved by Shariah scolars and adopted by the IDB as well as various Sovereigns to finance infrastructure investments.

If banks are already familiar with debt financing, and making lots of business from it, it is difficult to shift your focus, and there will be people to answer to – the shareholders. The more we understand about equity-based financing, and the more issues are cleared out— similar to when Sukuk was first introduced; then more products will reach the market. And, if we have the right safeguards, we will have a balanced market where there is Equity and debt-based financing. Both forms of financing have their own unique sets of risk, therefore the bigger issue to me is solving those risks.

Of course there is no such thing as zero risk, but hypothetically speaking, if you were to pitch a Musharakah and Ijarah structure to a AAA company, they would be more receptive to the latter because Ijarah is well tested. As opposed to Mudarabah and Musharakah where the risk is not tested. It is a great idea and the banks may see the value of it, but they will be more hesitant. It is an entirely new ball-game, and we need to be able to reduce the risk to a point where it can be tackled should any future risk materialize. Risk management is not necessarily just about zero-ing the risk, but knowing where the weak points are, and knowing how to manage it.

How important are investors in mobilizing equity-based financing in the market?
I was in a forum recently and the message I was putting across - which most bankers agreed to is that any product we put forth needs to have a market to it. Everyone will have a different level of demand, and anticipate different levels of risk. If there are investors and clients out there who want to take this sort of risk — which I believe there are, we should be able to cater to them. In the same vein,
before Sukuk was popularized, issuers were uncertain if there would be a market. But anecdotal evidence was there: you had bodies like Tabung Haji and various Shariah compliant buy-side that needed a place to put their surplus and wanted fixed income instruments. Therefore investors are very important, but the product should, at all times, be tailored to someone who wants to buy it; it’s Investment Banking 101, really.