Industry players are calling for equity-based financing in place of the traditional form of debt financing. However, as NAZNEEN HALIM learns, there’s still a long way to go.

Once the concept of profit and loss sharing is accepted in the practice of Islamic finance, all illusions are dispelled, and there is really no need to over-glamorize or complicate it. However, as all things in life go, this is easier said than done. In Malaysia and the Middle East, more than 70% of Islamic transactions remain debt- and sales-based, despite Musharakah- and Mudarabah-based transactions being the “purest” form of Islamic finance.

Calls throughout the industry have been made in recent months for the shift from debt-based financing to equity-based financing. However, most practitioners believe that there is still much work to be done. In essence, the proverbial light at the end of the tunnel still remains to be seen.

Azrul Azwar, chief economist at Bank Islam Malaysia, one of the largest Islamic banks in the country, attests to this: “Equity-based financing is hot on the lips of regulators, but in reality the market is still not ready, essentially because there is no demand from customers.”

The fundamentals
Various guidelines have been issued for the mobilization of equity-based financing into the mainstream system, including Bank Negara Malaysia’s Capital Adequacy Framework for Islamic Banks (CAFIB) which allows for greater flexibility for banking institutions to undertake equity-related activities, according to the institution’s internal risk management policies.

Equity-based financing covers a gamut of areas including corporate banking — where the bank goes into a joint venture (JV) with an entrepreneur, and client-bank relationships — where the client places money in the bank. 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 uphold the true principles of profit-loss sharing and engage in productive economic activity.

In the case of debt-based financing, however, a single party is made to absorb all the risk. Dr Monzher Kahf, a prominent Shariah scholar, is a strong proponent of equity-based financing, stating that the prevention of finance provided solely on the creditworthiness of the end user without regard for the purpose of the funds will create a more just economic environment.

Professor Rodney Wilson of Durham University elucidates that the limitations of debt finance are increasingly evident at both the micro and macro levels. “Borrowing has its uses, of course, but inevitably leads to problems if it is used as a means of financing risky ventures or projects which are of a long-term nature. In contrast, equity finance means that it is the provider of capital who takes on the risk. The fact that there is flexibility in the pay-off, which is related to the project being backed, actually serves to reduce risk and enhance the likelihood of successful outcomes,” he states.

From theory to practice
Among the first prominent equity-based deals to transpire from the Islamic capital markets was Kuwait Finance House Malaysia’s (KFHM) US$1.3 billion (RM4.16 billion) real estate project in 2005. The bank is reported to be on its fourth building project utilizing a similar equity concept, and remains one of the few banks to do so. Despite KFHM’s efforts and several other contracts and projects, equity-based financing makes for only 2% of the entire Islamic capital market.

However, Nik Norishky Thani (caricature), specialist at Bank Negara Malaysia’s Islamic banking and Takaful department, also brought to light the activities of Malaysia’s Permodalan Nasional Berhad (PNB) which, despite being a conventional government-linked institution, invests in companies and employs venture capital techniques, inadvertently practicing equity-based financing.

“It (PNB) adheres 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,” he states.

As the global financial system emerges from the debt crisis and banks shy away from assuming added risks, practitioners want Islamic finance to rely more on partnership structures and less on straight financing; hence the heightened realization among regulators and practitioners to put words into action.

Also, equity financing such as Musharakah and Mudarabah are said to be closer to the Shariah’s aim of ensuring that gains and losses are shared equitably, and a shift back to it would help banks win new business beyond its traditional markets. However, while equity funding is commonly associated with higher returns, bankers say it may not necessarily be more profitable than debt as the latter allows for higher leverage.

Keith Leach, head at Alburaq in the UK which offers Shariah compliant home financing, echoes this sentiment: “The lack of equity-based products at present is basically due to market conditions. Banks themselves would need more equity to be able to lend in this way, and our investors in the Gulf who are buying real estate in the UK would rather take up Shariah compliant bank financing rather than utilizing their own equity. Also, debt-based financing currently affords higher returns to the customers and comes with tax benefits.”

Bank Islam’s Azwar also believes that an equity-based approach is currently not viable, for banks in Malaysia at least.

Regulatory-wise, he believes that this form of financing is not attractive in the marketplace. He attributes this to the 400% capital charge imposed on banks under Bank Negara Malaysia’s CAFIB framework.

Under the Internal Ratings-Based (IRB) approach — which is an evolution from the previous Basel II framework — capital charges on unquoted shares stand at 400%, while quoted shares carry a 300% charge.

The Standardized Approach (SA), on the other hand, imposes a 150% capital charge on non-publicly traded instruments, and 100% on publicly traded instruments.

“When a bank has more equity-based assets in its portfolio, the capital charge imposed is higher due to higher risk,” Azwar explained. The added risk, he said, is borne from the linked asset, and accounting-wise it is harder to keep track of due to the need to evaluate the asset value.

Badlisyah Abdul Ghani (caricature), CEO of CIMB Islamic, however begs to differ. “In terms of financing for the purchase of quoted or unquoted shares, there may be some impact on banks, depending on the readiness of the bank to follow the SA or the IRB approach. Notwithstanding this, I do not see significant impact as it is merely a matter of effective capital management and allocation by banks.”

According to him, the main reason why banks are not actively pursuing Mudarabah and Musharakah activities is not because of the CAFIB but rather due to risk management issues including legal risk.

Abdul Ghani also believes that doing both Islamic equity and debt will broaden the profit generation capacity of banks. He highlights that the difference between equity and Mudarabah and Musharakah in the markets is their liquidity: “Equity is liquid, but Mudarabah and Musharakah are illiquid. However, if Mudarabah and Musharakah are used to facilitate a margin financing product, it will be known as equity financing.” He also stressed that equity business such as margin financing, warehousing facility and IPO financing carry different risks under the Basel and IFSB frameworks.

Much work to be done
Debt- and sales-based contracts are relatively well-tested in the Islamic markets and legal courts, as opposed to equity-based financing. A Gulf-based lawyer reveals that he is uncertain if there are even legal theories pertaining to equity-based financing at present.

“It is difficult to project at this stage whether or not courts are well-equipped to handle this sort of Shariah issues. Various dispute resolution mechanisms such as arbitration, mediation and the court of law have to be resolved.”

It is not hard to understand why debt- and sales-based contracts are still very much alive and kicking in the Islamic capital markets. If banks are familiar with debt financing and are profiting from it, it is only natural to stick to what works. The only way to create a paradigm shift is through regulatory support, education, dialogues and creation of safeguards to minimize the risk involved.