A Deeper Understanding on the Prohibition of Riba

By

Neelam Daryanani

September 2008

A Management project presented in part consideration for the degree of

Master of Business Administration.

ACKNOWLEDGEMENT

This dissertation is successfully completed with the generous assistance of

many individuals.

I would like to take this opportunity to thank my project supervisor, Professor

M. Shahid Ebrahim, for his invaluable support in supervising this project. Without his
guidance, this project would probably have taken a longer time to complete.

My gratitude goes to the authors in the bibliography, whose work has been a
rich source of reference and information.

I am grateful to my fianc whose love, encouragement and support has been

an inspiration in writing this paper. And finally, to my mother who has been the
source of my strength throughout this MBA program.

ABSTRACT
This paper focuses on understanding the reasons for the prohibition of interest.
Lending without interest is a difficult concept to grasp for those educated in the
Western system as interest is the backbone of all conventional modes of finance. This
paper takes the several different perspectives to probe if there are valid reasons other
than a religious prohibition on interest.

Chapter one and two provide a background and historical perspective on the
Islamic Financial Industry.
Finance.

Chapter three focuses on the basic principles of Islamic

The next three chapters focus deeply on the different perspectives in

understanding the prohibition of riba:

the religious perspective, the consumers

perspective and the economic perspectives of debt and interest.

Chapter eight

highlights the more common Islamic Financial Instruments with some examples and
provides some comparison to western financial models as well.

This paper looks closely at the religious prohibition of interest and also how it
affects an individual, a corporation and the economy as a whole. It highlights the
perils of the current banking system.

This sheds light on the validity of the

prohibition and draws attention to the negative effects of riba. The author hopes that
with this, future financial engineers in the Islamic System will be cautious in imitating
conventional banking practices and focus instead on financial products that embody
the spirit of Islamic Finance.

TABLE OF CONTENTS
Abstract
Chapter 1

Background of the Islamic Financial Industry

Table 1 Growing Size of Islamic Funds

6
6

Chapter 2

The Resurgence of Islamic Finance

Table 2 Growing Impact of Islamic Banking
in Malaysias Financial System
Table 3 Stages of Evolution of the
Islamic Financial Services Industry

11

Chapter 3

The Concepts of Islamic Finance

The Prohibition of Interest (Riba)
The Prohibition of Gharar
The Prohibition of Maisir
Zakat
Islamic Investment Ethics

12
12
14
15
16
16

Chapter 4

A Deeper Understanding of the Prohibition of Riba:

A Religious Perspective
What is Riba?
Is Islam the only religion to denounce Interest?

18
18
26

Chapter 5

The Prohibition on Interest: A Consumer Perspective

Table 4 Credit Card Balances Outstanding in Asia, End 2005
Table 5 Distressed Credit Card Debt in Asia
The Islamic Alternative

30
31
32
36

Chapter 6

A Corporate Perspective:
Focusing on the Agency Costs of Debt

42

An Economic Perspective: The East Asian Crisis

Table 6 Banking & Other Crisis
Table 7 Debt Equity Ratios for East Asian Corporation
Table 8 Interest Cover for East Asian Corporations
Table 9 Indonesia: Potential & Actual GDP

48
49
50
52
53

Chapter 7

10

Chapter 8

Chapter 7

Islamic Modes of Finance: In Theory & Practice

The Mark-Up Principle
Bai Murabahah
Bai Muajjal
Lease Based Principle
Ijara
Ijara wal Iqtina
Advance Purchase Principle
Bai Salam
Istisna
Benevolent Loan
Qard Hassan
Profit & Loss Principle
Musharakah: Long-Term Equity Financing
Hybrid Islamic Financial Products
Mudarabah
Sukuk
Table 10 Anatomy of a Sukuk
Table 11 Modes of Islamic Financing in Bank Negara Malaysia
Table 12 Islamic Modes of Finance 2005-2006

Conclusion

56
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66
67
68

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Notes

74

Reference

76

Appendix
Appendix I
Leverage of East Asian Corporations from 1992-1996
Appendix II
Maturity Structure of Corporate Debt from 1992-1996
Appendix III Cash Flow Coverage EBITA/Interest Payable
Appendix IV Cumulative Output Loss for Each Crisis Country 1997-2002
Appendix V GDP Growth Rates for Each Crisis Country 1991-2002(%)

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Chapter 1
Background of the Islamic Financial Industry

In the last two decades, Islamic banks have grown in size and number around
the world. Exponentially increasing demand around the world for Shariah-compliant
financial products and services is the driving force of the Islamic banking industrys
rapid expansion. Islamic assets worldwide are currently estimated to be $500 billion
as compared to about $150 billion in the mid-1990. It is still growing at 10% per year
over the past 10 years, placing Islamic finance in a unique global asset class. Islamic
banks market shares stand at 17% and 12% in the six Gulf Cooperation Council
(GCC) countries and Malaysia respectively. The table below is an example of the
massive growth in some sectors of Islamic Finance.

Table I

Growing Size of Islamic Funds

Source: Kuwait Financing House, 2007

An example of the success of investing in Islamic principles is the

performance of Islamic mutual funds. The Amana Income Fund was one of 2007s

top performers ranked in the top 2% of its category with an approximate return on
investment of 13%. Because Amana cannot invest in companies that charge interest
or those with large debts, it has not been impacted by the fallout from the credit
crunch. Similarly, other Islamic mutual funds weathered the recent credit turmoil
highlighting the validity of following Islamic principles in investing.

This is an example of why Islamic Finance has been generating so much

attention in International Finance Markets. A brief look at the resurgence of Islamic
Finance is warranted to understand the developments of this industry to date.

Chapter 2
The Resurgence of Islamic Finance

Even in the 7th century, Muslims already had a thriving economy based in
Islamic principles. While Europe was still in the Dark Ages, culture and knowledge
thrived in the Islamic world. Until the 13th century, Islamic financial instruments
rivaled what was available in Western economies. Although banks did not exist,
innovative financial instruments were a part of commercial life like bankers without
banks.

However, in the 15th century, as Western civilizations went through the age of
renaissance, scientific discoveries and industrialization, the Muslim word stagnated
(Warde, 2000).

The colonization during the 16th and 17th century delayed the

development of Islamic financial models. By the late 17th century, European banks
were established in Turkey, Egypt and Iran (Zineldin, 1990). A new economic system
that was an offspring of the marriage of capitalism and imperialism was founded in
Europe. By the 19th century, most of the Islamic world was brought into a Western
system that embraced interest and disassociated socio-ethical norms from the
economic system.

The rebirth of the interest in Islamic Finance occurred in the late 1970s with
the development of Islamic Financial Institutions. Three factors contributed to this
(Archer et. al., 2002). First, Islamic nations gained political independence in the
1950s and 1960s. Second, an awareness of an Islamic identity was rising. Third,
Middle Eastern countries were flushed with funds due to oil production and the sharp

oil increase in 1973-1974. The sudden flush of petrodollars necessitated the need for
Islamic financial vehicles.

This led to the founding of Mit-Ghamar Bank in Egypt (1963-1967), credited

to be the first example of an Islamic Bank. It combined the idea of a German savings
bank with the principles of rural financing operating in accordance of Islamic
principles. The Nasr Social Bank (1971-1976) followed which sought to assist the
weaker sections of society. In 1975, the first large Islamic Banks were established,
namely Islamic Development Bank & Dubai Islamic Bank. These were landmark
events in the emergence of contemporary Islamic finance and banking industry. They
served as catalysts in the rise of Islamic Banks throughout the 1970-1980s. The next
step in the evolution of the industry was the full Islamicization of the banking systems
in Pakistan (1979), Sudan (1982) and Iran (1983).

In Southeast Asia, the first Islamic Bank was established with the conception
of Bank Islam Malaysia Berhad (1983). This led to the eventual dual-banking
system currently in place in Malaysia. The phenomenal growth of Islamic finance
and its impact on the Malaysian financial system is displayed in the table below.

Table 2
Source:

Growing Impact of Islamic Banking in Malaysias Financial System

The Asian Banker 2008, Issue 75

In the 1990s leading European and American banks such as HSBC, ABN
Amro, Goldman Sachs, Standard Chartered, Citibank etc. began to focus on interest
free banking and offered either Shariah-compliant products or opened Islamic
subsidiaries, signaling the vast and untapped potential in the Islamic Financial market.

Subsequent events included the development of the Dow Jones Islamic Market
(DJIM) family of indexes to help investors invest according to Islamic guidelines, the
creation of a sizable array of Shariah compliant equity funds and the extension of
Islamic principles to fields of insurance, leasing and real estate finance. The stages of
evolution of the Islamic financial services industry are illustrated below:

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1970's
Insitution:
-Commercial Islamic
Banks
Products:
-Commercial Islamic
banking products
Area:
-Gulf/Middle East

1980's
Insitution:
-Commercial Islamic
Banks
-Takaful
-Islamic investment
companies
Products:
-Commercial banking
products
-Takaful
Area:
-Gulf/Middle East
-Asia Pacific

1990's
Insitution:
-Commercial banking
products
-Takaful
-Islamic investment
companies
-Asset management
companies
-Brokers/Dealers
Products:
-Commercial banking
products
-Takaful
-Mutual Funds/Unit
trusts
-Islamic bonds
-Shariah-compliant
stocks
-Islamic stockbroking
Area:
-Gulf/Middle East
-Asia Pacific

2000's
Insitution:
-Commercial banking
products
-Takaful
-Islamic investment
companies
-Islamic investment
banks
-Asset management
companies
-E-commerce
-Brokers/Dealers
Products:
-Commercial banking
products
-Takaful
-Mutual Funds/Unit
trusts
-Islamic bonds
-Shariah-compliant
stocks
-Islamic stockbroking
Area:
-Gulf/Middle East
-Asia Pacific
-Europe/Americas
-Global Offshore
Market

Table3 Stages of Evolution of the Islamic Financial Services Industry

Source: Adapted from Islamic Capital Market Fact Finding Report, July 2004

Though still evolving, the resurgence of the Islamic Finance and the demand
of Shariah compliant products fulfill the prediction of the pioneers of modern Islamic
finance on the viability of equity sharing, ethical, and justice oriented socio-economic
system.

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Chapter 3
The Concepts of Islamic Finance

The term Islamic Finance denotes financial transactions that adhere to the
provisions of the Shariah (Islamic Law). Islam is as a complete way of life with its
own legal code that dictates the conduct of Muslims in every aspect. The laws and
norms of the Shariah are derived from four major sources: The Quran, The Sunnah,
Qiyas and Ijmaa (Al-Omar and Abdelhaq, 1996). The first two are the primary
sources that guide Muslims on any issue. In the absence of any clear guidance, the
remaining sources are relied on as a secondary source.

Islamic finance has its origins from the teachings of the Shariah, which
dictates the following principles that Islamic financial institutions must strictly adhere
to:
a. All transactions must be interest free
b. Avoidance of speculative activities.
c. The implementation of Zakat.
d. Compliance to Islamic Investment Ethics

The Prohibition of Interest (Riba)

While the Quran prohibits riba unambiguously and denounces this practice as
being unjust and exploitative, it does not clearly specify whether riba is interest or
usury, resulting in many debates on what constitutes riba.

12

The interpretations on riba can be lumped under three main headings: the
liberal, mainstream and conservative. Briefly, the liberal view supports the narrowest
definition of riba by equating riba with usury. Usury is defined as an excessive rate of
interest compounded at short intervals. In this view, bank interest is outside of the
sphere of riba. The mainstream view argues that any contractual increase is riba,
encompassing bank interest. The conservative view includes both usury and bank
interest while also accounting for all other forms of economic exploitation.

The idea that a financial system can operate without a rate of interest, as
prescribed in the mainstream view of riba, is perplexing to many accustomed to a
fractional-reserve banking system.

Some common questions often raised when

discussing Islamic finance are: How does an entire financial system operate without
there being a price of capital? How does an Islamic financial structure allocate
funds? How do investors get a return on their investment if there is no charge for the
use of their funds? What is the basis for the prohibition of the most fundamental
variable in a financial system?

The abolition of interest (riba) is a central tenet of the Islamic system, but it is
not an adequate description of the system as a whole (Khan & Mirakhor, 1986). In
Islam, money is merely potential capital that must be put into productive use, with a
certain risk involved for it to justify a return. That interest is justified as a result of
savings is rejected as by Muslim scholars as such a moral justification only applies if
the savings is used for additional investment to create additional capital and wealth
(Iqbal & Mirakhor, 1987). Individuals who abstain from consumption and save
should not be rewarded for it unless it is turned to productive investment. The Islamic

13

solution to the prohibition of Riba lies in trade or partnership or other productive

economic activities.

Nine hundred years ago, Imam Al-Ghazzali, a celebrated Muslim thinker and
philosopher wrote Riba is prohibited because it prevents people from undertaking
real economic activities. This is because when a person having money is allowed to
earn more money on the basis of interest, either in spot or deferred transactions, it
becomes easy for him to earn without bothering himself to take pains in real
economic activities.

This leads to hampering the real interests of humanity,

because the interests of humanity cannot be safeguarded without real trade skills,
industry and construction. (Hamid, 2006)

The Prohibition of Gharar

Closely related to the issue of Riba in Islamic Finance is the concept of

Gharar. This involves the presence of ambiguity or uncertainty in a contractual
relationship that may provide one party an unfair advantage over the other. Any type
of transaction where the (1) subject matter, (2) the price, or both are not determined
and fixed in advance amounts to uncertainty. Hence, dealing in derivatives and
hedging is not permissible.

Gharar is also interpreted as the degree of information asymmetry & the

absence of information that can lead to one of the parties committing deceit or other
fraudulent activities. This can lead to the nullification of an existing contract.

14

The prohibition of Gharar is one of the main precepts promoting of fairness

and justice in financial transactions. Full disclosure by both parties would ensure that
Gharar elements are avoided, mitigating risks of disputes and litigations.

The Prohibition of Maisir

Around 95% of the transactions in the foreign exchange markets are

speculative in nature, many using complex financial derivatives.

Many see this

virtual economy to have a terrible potential for disrupting the underlying real
economy. This was evidenced in the collapse in 1995 of Barings, Britains oldest
bank. It is also believed to have precipitated, if not caused, the 1997 Asian meltdown
(Gray, 1998).

Speculative activity, which is the equivalent of gambling, is taboo because of

its predisposition to lead to instability.

This prohibition extends to derivative

transactions like Options, Futures, Swaps and Forward contracts (Ayub, 2002). It is
also illegal to have any business associated with the gambling industry in general.

While risk-taking in business transactions is allowed, gambling in any of the

forms mentioned above is prohibited as it diverts the individuals efforts away from
productive activities and encourages wealth-creation without effort. The main idea is
that investors should spend their effort searching for projects that are sound, that
adhere to the Shariah, and share in the success or failure of that project (Maniam et.
al, 2000).

15

Zakat

Zakat is one of the five fundamental pillars of Islam. This principle states that
all things belong to God, and that wealth is held by human beings in trust. The word
Zakat means both 'purification' and 'growth'. Our possessions are purified by setting
aside a proportion for those in need. The Quran has repeatedly encouraged Muslims
to pay Zakat.
Those who believe perform good deeds,
establish prayer and pay Zakat, their reward is
with their Lord, neither should they have any
Fear, nor should they grieve.

Zakat is a built-in mechanism in Islam for ensuring the redistribution of wealth

and the protection of a fair standard of living for the poor. It is a compulsory religious
payment or tax on the wealth. Zakat is also incorporated in Islamic banks which are
required to establish a Zakat fund and pay Zakat on the profits earned. This payment
is in addition to any conventional tax imposed.

Thus, the Islamic bank pays dual

taxes Zakat and corporate business tax.

Islamic Investment Ethics

Investing in production and consumption is guided by a strict Islamic ethical

code. Muslims are not allowed to invest in the manufacture, supply and consumption
enterprises that may involve alcohol, tobacco, pork, pornography, illegal drugs and
other harmful products even if investing in these activities are profitable.

16

This

prohibition is extended to cover any activity which is harmful to the individual or

society.

Islam supports private wealth creation in a way that there are no abnormal
profits because of unfair competitive advantages. Islamic financial institutions, in
turn, ensure reasonable returns on assets and equity and strive to promote the socioeconomic welfare of the societies in which they operate (Siddiqi, 2004).

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Chapter 4
A Deeper Understanding of the Prohibition of Riba:
A Religious Perspective

What is Riba?

Riba is usually translated into English as usury or interest, but in Islam, it has
a broader meaning. Riba is derived from the root word rbw. It means growing, or
exceeding or self-generated expansion. When applied to commercial activities this
implies that money accrues value intrinsically with the mere passage of time elevating
the concept of money from a medium of exchange to idolatry, a forbidden concept in
Islam.

The Quran has taken such a hard approach towards interest is mainly because
Islam stands for establishing a just and economic system free from all kinds of
exploitation (Chapra, 1985).

Riba is forbidden in the Quran in four separate

revelations. Each revelation emphasizes in increasing severity the graveness of the

sin of riba. The first revelation states:

That which you give as riba to increase the peoples

wealth increases not with God; but that which you give
is charity, seeking the goodwill of God, multiplies
manifold. (Surah al-Rum, verse 39)

This first verse promises a divine reward for providing charity but does not
clearly define the cause of forbidding riba, neither does it provide a clear definition of

18

the term. It merely emphasizes that riba provides benefit to an individual instead of
society as a whole, as it only profits the wealthy. It has also been interpreted as
emphasizing the spiritual gain in Zakat.

The second verse below provides some clarity to the definition of riba. It
shows a graduated increase in the prohibition by using a stronger term take instead
of give. It describes the practice of the Jews in Medina who employed a similar
restriction of interest, as prohibited in the Book of Deuteronomy, but only among
themselves. Some jurists interpret this verse to imply that the usury banned to the
Jews & Muslims are the same and narrowing down the prohibition of riba, as the Jews
did, is viewed unfavorably in the Quran.

And for their taking riba, even though it was forbidden

for them, and their wrongful appropriation of other
peoples property, We have prepared for those among
them who reject faith a grievous punishment. (Surah
al-Nisa, verse 161)

The third verse is also most often used to justify that the prohibition of riba
only pertains to usury, or the doubling and redoubling of the principal. There is
disagreement on whether this verse is meant to restrict the ban on riba or merely to
express the increasing aspect of the principal. As expressed by Sayyid Qutb, the
multiplying effect is no more than a description of the state of affairs and not a
condition relevant to the imposition.

19

O believers, take not doubled and redoubled riba, and

fear God so that you may prosper. Fear the fire which
has been prepared for those who reject faith, and obey
God and the Prophet so that you may receive mercy.
(Surah Al Imran, verses 130-2)

And finally, the last verse of the Quran, stringently denounces the practice of riba.

Those who benefit from riba shall be raised like those

who have been driven to madness by the touch of the
Devil; this is because they say Trade is like riba
while God has permitted trade and forbidden riba.
Hence those who have received the admonition from
their Lord and desist may have what has already
passed, their case being entrusted to God; but those
who revert shall be the inhabitants of fire and abide
therein forever. (Surah al-Baqarah, verse 275)

The succeeding verses to the text above1 emphasize divine chastisement. This
last verse establishes a clear distinction between trade and riba. The text But if you
repent, you can have your principal is the argument used to justify the prohibition
of all interest because it implies that even a minimal amount above the principal is an
increment and therefore it is riba.

20

The debate on what constitutes riba rages on due to the lack of clear definition
in the Quran. Other sources are used by judicial scholars to understand and determine
what constitutes riba.

Ibn Qayyim categorized riba into obvious (jalliyy) and

concealed (khafiyy). The obvious riba pertains to riba in loans (riba al-nasia) and the
concealed to riba of excess or riba of barter (riba al-fadl). Sanhuri differentiated
between the Quranic riba (riba al-jahilyah), which is forbidden per se, and the riba in
delay (riba al-nasia) to differentiate between the prohibition of usury and bank
interest. He also reiterated that the riba in barter is forbidden only to close the roads
to the pre-Islamic riba.

The Quranic riba is defined as the continuous multiplication of the sum of

capital against a fixed extension of the term of payment of debt following a default
(Rahman, 1964). The highly exploitative aspect of this contract comes from lack of
stipulation of a predetermined excess in the contract. That is why at the time of
settlement of debt, if the borrower is unable to pay, he is given an option to defer, but
the principal owed is doubled or quadrupled, at the mercy of the lender. This form of
riba is often compared to the western concept of usury which only covers exploitative
loans used for consumption. However, in pre-Islamic Arabia much of the loans were
used for commercial and business financing implying that this prohibition covered
both productive and consumptive loans. Ibn Hanbal, founder of the Hanbali School,
stated that this practice - 'pay or increase' - is the only form of riba the prohibition of
which is beyond any doubt (Vogel & Hayes, 1998). Under this definition of riba,
interest is allowed as long as it is not excessive.

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The riba of barter (riba al-fadl) is prohibited from the statement attributed to
the Prophet:
Gold for gold, silver for silver, wheat for wheat,
barley for barley, dates for dates and salt for salt like
for like, equal for equal, hand to hand; if the
commodities differ, then sell as you wish, provided that
the exchange is hand-to-hand. (Ubada Ibn al-Samit).

The basic rules that guide the prohibition of riba of barter were derived from
hadiths, a set of statements attributed to the Prophet Muhammad. Other than the
Zahiris, who refused to extend the application of the commodities to other than those
stated in the hadith, the four schools of Sunni jurisprudence Hanafi, Maliki, Shafi
and Hanbali agree that they are only some examples of items that are prohibited.
However, they disagree on what other items are covered in the prohibition as they
have dissenting opinions on the underlying reasons for the prohibition.

The Hanafi approach was the broadest, stating that any item sold by weight or
volume was subject to the rules of riba in barter. The Shafis, only applied this
prohibition to metals like gold or silver, and included all kinds of food to the
prohibition. The Malikis provided the narrowest interpretation by limiting the scope
of metals to gold and silver. With respect to food, they limited the scope to nonperishable staple food items. The Hanbalis position is less clear, but it is generally
understood that they follow the same view as the Hanafis.

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There is one exception to the rule regarding trades that involve the barter of
goods: As long as the counter-values are of different genera, all jurists agree that the
parties could make their own terms of exchange providing it was a spot transaction.
In the case of trades involving the same genera, traders are encouraged to enter in to
back-to-back trades. Thus, the rules of riba of barter are a prohibition of trading with
a class of goods on the basis of differences in quality. The result of the prohibition of
riba in barter is ensuring that traders mark to market to ensure market efficiency.

While during the time of the Prophet Muhammad, barter transactions were a
prevalent aspect of the economy; it is not in todays commercial transactions. The
significance of this debate lies in the treatment of money as a commodity. Majority of
the Muslim scholars agree that treating currencies as a commodity is prohibited. Gold
and silver were used as the basis of exchange for value during that time and
currencies are used in modern financial transactions for the same reason.

Ibn Qayyim, a well known Hanbali jurist explains that currency needs to be
fixed and regulated to value artifacts sold accurately. If currencies were to fluctuate
in prices like normal commodities, then financial transactions would be impaired. The
risk of commoditization of a currency encourages speculative transactions that are
unrelated to commerce and leads to the destabilization of productive sectors of the
economy.

Finally, the riba in loans or the riba in delay is (riba al-nasia) defined as a
contractual increase or benefit, whether or not it is monetary, on loaned capital. The
word nasia means to postpone or defer. Under this definition of riba, all forms of

23

interest are riba. There is no differentiation between simple or excessive interest. It

also covers the pre-payment of loans as the phrase without inflicting or receiving
injustice is interpreted as without increase or diminution (El-Gamal, 2001).

The riba in delay also limits transactions covering the trading of the six
commodities, discussed in the riba in barter, on a deferred basis. While the riba in
barter does not prohibit the trading of same genera of commodities as long as the
counter-values are equal and the delivery is immediate, the riba in delay prohibits the
trading of the same commodities if the delivery is deferred even if the counter-values
are equal. While the four schools agreed that the prohibition for deferred trade
covered the six commodities and agreed that it also covered other deferred trades as
well, they differed on the scope of the prohibition against deferred trades.

For the Malikis, the prohibition against the six commodities was because they
were food items, and all deferred trades where both the counter-values involved food
was forbidden by the riba of delay. The Shafis applied the same theory to the
deferred trade of food. Both schoolsShafi & Malikiagreed that gold and silver
were subject to both the rules of riba in barter and riba in delay as they served as
pricing instruments. However, with respect to commodities that were not subject to
the rules of riba in barter and were not food items, the Malikis permitted deferred
trades unless:

1. The counter values were of the same kind

2. The counter values were not equivalent.

24

The Shafis, on the other hand, permitted all deferred trades as long as the
counter values were not food, and that particular transaction would have been
permitted under the rules of riba in barter.

The only exception is the deferred

exchange for gold and silver, which were absolutely prohibited.

The Hanafis

prohibited the deferred trading of all commodities sold by weight or volume, unless
one of the counter-values was gold, silver or copper or a good not sold by weight or
volume.

In addition, deferred trades of the same commodity were categorically

prohibited even if the counter values were equal. The Hanbalis follow similar views
as the Hanafis.

Thus, the Shafis took the narrowest view of the riba of delay as the rules of
riba of delay were not applicable to the trade as long as the counter-values were not
subject to the rules of riba in barter.

The Hanafis & Hanbalis gave the broadest

interpretation to the principle, while the Malikis took a stand between these two
extremes. All the schools however, permitted deferred trades if one of the two
counter-values was gold, silver or copper and the other counter value was food or any
other commodity.

They also permitted the deferred trading of food or other

perishable goods for non-perishable items. As long as the trade did not violate the
formal rules of the riba of delay or the riba of excess, then the jurists were
unconcerned with the pricing terms agreed on between the parties involved.

There are varying opinions on the applications of the prohibition of riba. Ibn
Rushd explains that the controversial nature of riba is due to the drawing of analogy
from the prohibitions found in the Prophetic teachings. Applying the doctrine of riba
to transactions other than those specified in the texts is knows as the analogy of

25

resemblance.

This is regarded by some jurists to be unconvincing as it is

jurisprudentially weak as compared to an analogy of principle. They reject majority

of the extension of the prohibitions. For Ibn Rushd, it was the problematic nature of
the analogies used by the Sunni schools of law which created the substantially
different interpretations of the scope of the riba prohibitions.

Whatever the disagreements are, the majority agree that riba is prohibited by
the Prophet Muhammad. A summation of why Riba is prohibited in the Quran is
provided below (Siddiqi, 2002):

Riba corrupts society

Riba implies improper appropriation of other peoples property
Ribas ultimate effect is negative growth
Riba demeans and diminishes human personality
Riba is unjust

Is Islam the only religion to denounce Interest?

There is evidence of interest being charged at rates of at least 20% on loans of

silver and barley as early as the third millennium BCE in the civilization of Sumer.
When the debtors were unable to pay this interest, they were placed in bondage to
wealthy landowners, prompting the Babylonian monarch to issue occasional
annulment of debt servitude. This practice may be one of the reasons for the strict
prohibition of usury in the Torah. The term usury in the Old Testament does not refer

26

to the modern meaning of usury as excessive interest, but rather a prohibition of all
interest regardless of rate.

Judaism contains the same strong ethical and lawful bans against the taking of
interest as in Islam. The Hebrew word for interest ribith is very close to riba in
Islam. In the Torah, the prohibition of usury or interest is almost always used in the
context of protecting the poor from injustice.

In the Book of Leviticus (25:3537)2, any charging of interest is considered as

neshek in Hebrew. It is derived from the word nashak which literally means bite
and almost always refers to a serpent. Accordingly charging of interest is sometimes
translated as biting usury. It talks of individuals who fall into difficulty, and that
charging them interest is morally wrong.

In Exodus 22:24 the prohibition of usury is again explicitly referring to the

poor.
If you lend money to my people, to the poor among you, do not act toward them as
a creditor; exact no interest from them

The prophet Ezekiel (18:48), referred to as Hizqeel in the Quran (21:85) writes that

The upright man ...oppresses no one, returns pledges, never steals, gives
his own bread to the hungry, his clothes to the naked. He never charges usury on
loans, takes not interest.

27

In the New Testament, there is a tale of how Jesus evicted the money changers
from the temple in Jerusalem for practicing a kind of usury. Jewish pilgrims arriving
in Jerusalem to pay the temple tax needed a half shekel coin as this was the only silver
coin that did not portray the head of a pagan Roman emperor. The usurers of the
Temple changed Roman coins for the half shekel. The exchange of coin for coin was
simultaneous, but the usurers took more weight of silver from the pilgrims than they
gave. This is very similar to the Islamic prohibition of riba in barter involving
currencies.
In the Book of Deuteronomy (Deuteronomy 15:1-11)3 it exhorts creditors to
grant a remission of debt every seven years until such a time as there will be no poor
individuals within the community.

It can be seen that the connection of the

prohibition of usury is closely tied to poverty.

In another passage (Deuteronomy 23:20-21)4 explains that the Jews were

forbidden to charge interest among themselves, but were allowed to charge interest to
foreigners. A double standard that was condemned in the second Quranic verse
discussed earlier. This loophole led to various attempts by lenders to avoid the usury
prohibitions. The question of whether usury was permitted changed to how much was
permitted. The gradual erosion of the prohibition of usury led to the Catholic Church
saying, in the late 19th century, that . . . the faithful who lend money at moderate
rates of interest are not to be disturbed, provided they are willing to abide by any
future decisions of the Holy See (Divine, 1967).

The moral condemnation of usury is also evidenced in other cultures such as

those of the Early Greeks. To Greek philosophers, the taking of interest was seen as
28

intolerable, and having no place in their ideal city-states (Divine, 1967). Aristotle held
the view that moneys purpose was solely as a medium of exchange; money was a
sterile thing, incapable of bearing fruit. He believed that the taking of interest
wrongly involved gain from money itself, instead of from the activities of exchange
which money was meant to facilitate (Glaeser and Scheinkman, 1998; Gordon, 1982),
a view that is strongly endorsed in the Islamic prohibition of riba.

In the Indian or Vedic usury laws, the political sage Kautilya also provided
some rulings on the restriction of interest loans to the poor for fourth-century BCE.
He provided a distinction between production loans and consumption loans in relation
to interest in Vedic society ((Glaeser and Scheinkman, 1998).

Islam is not the only religion to ban interest as exploitative. Major religions
and cultures have banned usury since antiquity but the anti-usury stance has been
displaced by modern moral ambivalence. If moral oppositions are raised at all, they
are to the taking of excessive amounts of interest rather than the taking of interest per
se. This is, in fact, the meaning conveyed through modern use of the term usury.
Islam is one of the few segments that believes, from a majority perspective, in the
absolute prohibition of interest.

29

Chapter 5
The Prohibition on Interest:
A Consumer Perspective

One of the primary arguments for the necessity of debt and lending at interest
is that it helps to smooth consumption needs.

When an individual experiences

negative income shocks, he relies on debt to meet his short-term consumption needs,
and when he has a surplus year he lends to others who are experiencing negative
income shocks. The resulting levels of borrowings have led to a society that is
overburdened by debt. Some of the most pressing issues in consumer debt include,
but are not limited to, the rapidly increasing levels of credit card debt, swelling
consumer bankruptcy & the practice of predatory payday lending.

The poorer sections of society who have difficulty accessing credit markets
turn to payday lenders. These lenders provide a high interest 2-4 week loan backed
by a postdated personal check that a borrower promises to repay out of his next
paycheck. The nature of payday lending is similar to the credit card concept of a
revolving interest if the borrower is unable to make a full payment within the due
date. The result is a continuous flow of interest-only payments at very short intervals
that never reduce the principal. As payday loans are exempt from many state and
local usury laws, it has become an easy access to funding for credit impaired
households, and many become chronic borrowers. This practice has a serious wealth
depleting effect on already financially fragile families.

For those individuals that can access credit markets, they turn to alternative
forms of funding like credit cards. In America, a recent study (Demos, 2005) revealed

30

that Americas escalating $US800 billion credit card debt is incurred not just by the
poorer sections of society but also by the middle class. Almost 70% of poor & middle
class Americans are dependent on their credit cards as a safety net to pay for basic
living expenses and health. These are expenditures that are normally state-subsidized
and evidence that current systems in existing capitalist economies are inefficiently
distributing wealth across all sections of society.

It is not just the United States that is caught up in high levels of personal debt
but also Southeast Asian countries like Taiwan and Korea. They experienced high
growth in credit card debt with 9% and 15% respectively as compared to the 7%
growth in the United States in 2005.

Total credit card usage volume increased by

200-500% in many Asian Markets in 1998 to 2005.

Per Capita

% of Total
Loans

Korea
Korea (2002)
Taiwan, China

675
2,006
1,369

5.5
21.3
6.7

% of
Household
Loans
11.0
45.1
14.9

Hong Kong SAR

1,181

3.3

8.2

4.6

Malaysia
Singapore
Thailand
Japan
United States

168
379
59
527
2,854

3.0
1.5
2.5
1.8
10.5

6.1
2.9
14.0
6.6
37.0

3.4
1.4
2.0
1.6
6.8

% of GDP
4.2
14.7
8.8

Table 4 Credit Card Balances Outstanding in Asia, End 2005

Source: Data from BIS Quarterly Review, June 2007

The increase in credit card usage led to over-borrowing which resulted in a

high level of personal bankruptcies. Korea, for example, had household delinquencies
31

reach 3.8 million at the end of 2003, constituting 17% of the economically active
population. In five years, distressed credit card debt rose from 7.5% of total credit
card receivables to 34%. It even led to disruptive contagion in Korean financial
markets contributing to a weakening corporate capital spending into 2004.

By

resorting to debt as a short-term fix, the issue is exacerbated as they fall deeper into
debt, which has a long-term negative impact due to increasingly unproductive
segments in society requiring government assistance.

1999

2000

2001

2002

2003

H1
2004

Hong Kong

4.8

3.9

8.6

13.5

8.2

5.4

Korea

N.A.

7.5

7.3

11.8

34.0

N.A.

Malaysia

5.2

5.1

4.6

4.1

4.7

4.2

Philippines

22.6

22.0

21.6

18.7

19.4*

N.A.

Singapore

2.7

2.9

2.6

1.7

3.5

3.2

Table 5 Distressed Credit Card Debt in Asia, in % Of Total Receivable

Source: Data from MPRA Paper No. 944, He et. al.

These funds, which can be used more productively on improving societal

welfare, is expended in supporting financially impaired individuals.

Whereas

previously borrowing was a stigma, a sign of poverty, or financial mismanagement, it

has now become a way to instantly raise one's standard of living. The effect of high
borrowing for personal consumption leads to high consumer debt and ultimately
lowers the individuals welfare.

32

Usury is an issue that must be tackled systematically, as part of

a wealth creation and redistribution policy that reduces the need
for high-risk, high-interest loans. As the contemporary situation
illustrates, issues of debt and usury are impossible to separate
from broader economic trends and injustices. (Mews &
Abraham, 2007).

To control for the negative aspects of consumer lending, usury laws were
established for the protection of the poor & the needy from predatory lending
practices.

Usury laws are considered as the one the earliest types of consumer

protection laws, in place for over a millennia in a wide variety of cultures to protect
the needy from the greedy (Berger, 2002).

In a provocative study, Glaeser and Scheinkman present an argument on the

need and effectiveness of usury state laws. They argue that usury state laws are a
form of primitive social insurance allowing transfers of wealth from individuals
having a low marginal utility of income to individuals with a high marginal utility of
income, i.e. from people who can lend money to people who need to borrow money.
They further argue that under certain conditions, usury laws can be Pareto-improving
institutions in economies with missing contingent markets.

The concept of

insurance here is that individuals will be willing to lend money at a lower interest rate
i.e. below the free-market interest rate when they are rich in order that they are able to
borrow money under these conditions when they are poor. The costs of usury are
reduced, under this principle, for two reasons. First, their rationale applies only to
consumption loans; hence they limit the restrictions on interest only to these types of

33

loans. Second, they maintain that credit will not be reduced since the insurance
rationale states individuals would ex ante prefer income to be transferred from the
state where they are lending to the state of the world where they are borrowing.
Their model hinges on the fact that the loan supply is highly inelastic. Therefore,
under that assumption, if usury laws only apply to consumption loans and if people
are willing to lend funds for such purposes, then it is possible that the benefit of the
lower interest rate will be Pareto-improving.

Because there are many alternative uses of capital, a prohibition of high

interest rates will simply lead creditors to refuse to lend to high-risk debtors and
instead lend to lower-risk debtors at legal rates or to seek other investment options.
Caveats that caps on loan interest rates would contract loan supply and raise the cost
of borrowing go back at least 300 years.

The writings of John Locke in 1691

projected that credit supply would decline from lowering a prevailing usury ceiling
from 6% to 4% (Persky, 2007). A century later, Adam Smith similarly argued that
efforts to cap the charging of interest on loans would raise the cost of borrowing, as
the borrowing was going to occur in any case and this regulation, instead of
preventing, has been found from experience to increase the evil of usury; the debtor
being obliged to pay, not only for the use of the money, but for the risk which his
creditor runs by accepting a compensation for that use. He is obliged, if one may say
so, to insure his creditor from the penalties of usury (Persky, 2007).

Modern day studies show evidence that usury laws do restrict the amount of
credit available to the poor. Using a collection of company-level data from large
national creditors during 1971, a study examined lending volumes across states found

34

that that the supply of loans fell sharply as state rate ceilings fell from observed
maximum rates of 40% to the minimum of 10% (Greer, 1974). A 1972 National
Commission on Consumer Finance report noted that legal rate ceilings may reduce
the price of personal loan credit to some borrowers, but when ceilings are sufficiently
low to affect the observed market rate in a significant way, there is a substantial
reduction in the number of borrowers included in the legal market. Another study
found that low income households in states with usury ceilings had significantly
lower levels of consumer credit than low-income households in states without usury
ceiling. There is a similar outcome for middle-income households, but the drop in
credit is not as large (Villegas, 1989).

These findings refute Glaeser and

Scheinkmans argument that usury laws act as effective means of social insurance
achieving an efficient redistribution of wealth.

To sum up, debt is required for consumption smoothing, and to ensure that
borrowers are protected, usury state laws are established. However, this merely leads
to the shrinking of the supply of credit.

To counteract this shrinking supply,

consumers resort to usurious activities like pay-day lending and credit card borrowing
to meet basic needs. This leads to spiraling personal debts and higher bankruptcies.
Ultimately, society bears the burden of supporting unproductive sectors. Therefore,
the argument that presupposes debt as a necessary need is dubious. How then is it
possible to achieve social welfare while banning debt and interest?

35

The Islamic Alternative

The spiraling costs of debt with usurious interest payments, similar to the
Islamic riba al-jahilyah, have been proven to have disastrous results to consumers
welfare. Prager (as cited in Schein, 2003) notes that there would be no lending at all
on zero interest rates no matter how limited were the savings options of individuals.
Similarly, Glaeser & Scheinmans model also argue that banning interest altogether
would not be social welfare improving.

The Islamic model refutes both these arguments as lending without interest
occurs using Islamic Financial instruments.

The need for usury to smooth

consumption demand and usury state laws to protect individuals welfare is

unnecessary.

The moral principle underlying the welfare provision in Islam is

embodied in the concept of Zakat, the religious duty imposed on Muslims to donate a
proportion of their disposable income to members of the community who are in need.
Zakat seeks to remove systemic conditions that promote economic exploitation of
human beings by others, a core concept in all Islamic teachings.

Zakat is enrobed with religious sanctity and ensures redistribution of wealth,

not by coercion, but through the acceptance of moral principles (Dean and Khan,
1997).

It curbs the human tendency towards acquisitiveness and greed curtailing

consumption that is beyond his means as this often leads to high debts and personal
bankruptcies. It serves as a reminder to the rich to share their wealth with those who
are impoverished. As such, it is instrumental in meeting the social and economic
needs of members of its community without requiring them to resort to usurious

36

loans. Lastly, it serves to prevent the morbid accumulation of wealth in few hands
and to diffuse it before it assumes threatening proportions (Mannan, 1970). The
depreciation of money in the levy encourages individuals to either donate this
amount as required by their faith or find investment opportunities to offset the
decrease in value of their holdings leading to the circulation of wealth within the
community.

The Quranic verse dealing with the disbursement and the beneficiaries of
Zakat reads as follows:

The State revenues are only for the poor and the
destitute, and those who work for these (revenues),
and those whose hearts are to be reconciled, and for
freeing the necks (of prisoners and slaves), and those
heavily charged, and in the path of God, and for the
wayfarers; a duty imposed by Allah, Allah being
knower, wise.

These eight categories are, in fact, very comprehensive and are seen by a
number of contemporary scholars as defining the social responsibilities of a Muslim
State. The two principal categories are the poor and the needy.

While the two

categories refer to the needythe difference between them being that one begs and
lets his needs be known, while the other does not inform others of his needs (Islahi,
1988). The other categories include individuals who are appointed collectors of Zakat,
recent converts to Islam, and the emancipation of slaves. These uses of Zakat widen

37

the scope from merely caring for subsistence levels of food, clothing and shelter to
preventing the exploitation of individuals and taking care of community needs. Zakat
is not only meant to serve as a broad safety net but also to help promote community
growth and prevent economic exploitation. This is evident in the last three uses
prescribed helping those heavily indebted, for promoting the cause of God, and
helping travelers.

These basic categories for Zakat were outlined in the seventh century when
resources were limited and poverty was pervasive. Today, authorities try to make
these teachings relevant to the community while complying with the original tenets of
Zakat. In Malaysia, for example, the Baitulmal Division of the Islamic Council, has
expanded the definition of Those in bondage or to free slaves to include three
items: To free Muslims from ignorance; to free a Muslim community from a very
oppressive condition; and to free those trapped in prostitution. In Malaysia hospitals,
medical and cash aids to the destitute and poor, patient treatment fund, etc. are
serviced by Zakat. In Yemen public hot bath, water facilities, wells for irrigation and
household water use arranged through Zakat funds have been used to sustain hundreds
of citizens for decades (Carapico, 1998).

The endorsement of Zakat to help those who are heavily indebted can be taken
to mean helping victims of hardships & natural disasters. In the days of Caliph Umar
bin Al-Khattab, the State provided interest-free loans to individuals to help them get
back on their feet. Therefore in Islam, unlike in Western cultures, the absence of
interest does not necessarily curtail lending for benevolent reasons. In present day
Islamic economies, Zakat is used to provide disaster-relief funding. Small business

38

loans are also familiar means of promoting economic enterprise as the payment of
Zakat has also been integrated in Islamic Financial Institutions. In two Islamic Banks,
namely bank Islam Malaysia (Berhad) and the Bahrain Islamic Bank, Zakat is paid at
approximately 6.13% and 1.69% respectively in addition to the conventional income
tax. Some Islamic banks provide the privilege of interest free loans only to the
holders of investment account with them. Some extend it to all bank clients. Some
restrict it to needy students and other economically weaker sections of the society. Yet
some other Islamic banks provide interest free loans to small producers, farmers and
entrepreneurs who are not qualified to get finance from other sources.

In Pakistan, where Zakat is distributed at a district level, 46% of the district

level distribution for a year is used for maintenance allowance of the targeted
recipients of Zakat. Provincial and local Zakat committees use a significant portion of
Zakat funds for human and spiritual, and skills development of orphans or poor
meritorious children. For example, provincial Zakat committees provide 50% and
20% of its share to general education institutions and religious schools (deeni
madaris), respectively, as stipends and scholarships through educational institutions
(Hasan, 2006). This is in line with the philosophy expressed by Caliph Umar If you
give Zakat, enrich the recipients.

There are a few challenges in the effective implementation of Zakat. Firstly,

while there is a unanimous agreement to the principle itself, disagreements exist
amongst the Islamic schools of jurisprudence about the nature & extent of Zakat. The
rules on the liability of Zakat are disputed as the Quran itself is virtually silent on the
property and wealth objects to be taxed. Mainstream jurists emphasize that the tax

39

should be imposed on types of wealth that were prevalent in the seventh and eighth
century namely: agricultural produce, livestock, precious materials and minerals but
they have differing rates of taxation for each of these categories ranging from 2.5%
for precious metals to 20% for minerals. Many Islamic economists have suggested
that the levy should be extended to modern income-generating activities like
manufacturing and services. More conservative jurists object to this view and insist
that such innovative interpretations violate the Quran. As a result of these debates,
state officials in most countries where Zakat is compulsory fall back on a compromise
solution by extending the scope of coverage to include new sources of income. At the
same time, they keep close to the original rates for traditionally recognized revenue
resources. Around the simple moral premise of Zakat, as with Riba, there has
developed a wide array of complex rules, exceptions and penalties.

There is also dispute on how Zakat should be administered. At first all these
taxes were paid directly to the government but in the time of the third Caliph Uthman,
it was decided that Muslims could spend the tax directly to its beneficiaries as
prescribed by the Quran without the intermediation of the government. While there
is still some dispute as to whether Zakat should be administered by the state or private
individuals, in the great majority of Muslim countries, decentralization has remained
the pattern for Zakat payment. Consistent with this decentralized policy, Zakat is
collected by a range of social agencies, including religious schools, welfare
associations, village councils, and local networks of family and neighbors. However,
in countries like Saudi Arabia, Pakistan, and Malaysia, the government has
reestablished the policy of governing Zakat through state agencies.

40

Zakat is an outstanding mode of public finance, although the application is

subject to issues on collection and administration. Having a consistent policy on what
constitutes Zakat as well as how it should be administered would greatly increase the
ease of collection and disbursement to those who are entitled to it. The potential for
Zakat in addressing the welfare needs of the Islamic community is enormous
providing that it is properly managed. An estimate undertaken in 2003 showed that if
Zakat is properly distributed even in a poor county like Bangladesh, the amount of
annual Zakat distribution may be almost equivalent to the amount the government
spends in the health sector every year (Hasan, 2006).

Zakat provides a practical and moral basis for welfare provision in an Islamic
society eliminating an individuals propensity to fall prey to the evils of usury while
trying to meet his consumption needs. It allows for interest-free loans for poverty or
calamity stricken individuals.

It makes provisions to help those who are

overburdened with debt to improve their economic situation.

It provides for

education to enable individuals to be self-sufficient to improve his means. Zakat is

regarded as the most effective insurance measure against social ills even if a
pragmatic approach may be required in order to extend its scope (Ahmad, 1991). The
Islamic approach to distributive justice takes into account not only the provision of
bare necessities but goes much further to enable them to enjoy a reasonable standard
of living (Peerzade, 1997). Its overall goal is to achieve social welfare while adhering
to Islamic ethics as its underlying impulse is compelled for the public good.

41

Chapter 6
A Corporate Perspective:
Focusing on Agency Costs of Debt

A corporation can finance its investments by raising either equity or debt.

Equity represents ownership in the corporation where an investor receives a
proportionate share of an uncertain future stream of income from the corporation. The
equity owner's potential loss is limited to the amount he has invested if it is a limited
liability corporation. Debt represents a promise of a fixed payment to the lender. If the
corporation defaults on this promise, the firm may be liquidated. The proceeds of the
liquidation are paid to the firm's lenders up to the amount of the promised payment. If
the liquidation payment is less than the promised payment, the lenders bear the loss.

Therefore, a central issue in corporate organization is the corporate leverage

choice.

The question of how much debt should be included in the finance

portfolio? has led to numerous studies attempting to find the optimal capital structure
for organizations. This is a significant decision for any business organization not only
because of the need to maximize returns to various organizational stakeholders, but also
because of the impact such a decision has on an organizations ability to deal with its
competitive environment.

An early theory presented by Modigliani and Miller called the irrelevance

proposition (1958) assumes that the market value of a firm is independent of its
capital structure. They arrived at this conclusion by assuming the absence of market
imperfections e.g. the absence of taxes; transaction costs, and bankruptcy costs. They
later revised their model to include taxes showing a positive relationship between the

42

value of the firm and its leverage due to a debt tax shield effect. Under this model,
organizations can and should utilize 100% debt for financing investments but
empirical studies show this is not the case.

The incentive to utilize debt, and its corresponding tax shelters, is weakened
by agency costs of debt which is encountered in a highly leveraged company. Jensen
& Meckling (1976) identify three agency costs of debt:

The opportunity wealth loss caused by the impact of debt on

the investment decisions of the firm

The monitoring and bonding expenditures by the bondholders

and the owner-manager

Bankruptcy and reorganization costs

The wealth loss that arises in the presence of debt in a firms capital structure
is primarily due to the risk shifting behavior of the owner- manager. He operates the
firm on behalf of equity, and is only concerned with cash flows from non-bankrupt
states. As a result, he will tend to accept projects that are too risky but with large payoffs in good states. The bondholders anticipating this maximizing behavior of the
owner-manager will charge a higher price for the debt capital resulting in a reduced
value of the firm. The residual loss is the agency cost resulting from the need to
raise funds through debt to make the investment.

Bondholders would naturally want to restrict the manager from such riskshifting behaviors and will write contracts to control managerial behavior. The cost

43

of writing & enforcing the contract, and the reduced profitability of the firm as a
result of restrictions on managerial flexibility is defined as monitoring cost.
Ultimately, it is the owner-manager of the firm who will pay these costs as
bondholders will factor this in when deciding on the price of the debt. The firms
manager, in order to minimize these costs that reduce the value of the firm, will
undertake in advance to provide bondholders with reports that allow them to monitor
managerial behaviors. These are costs are known as bonding costs. Asymmetry of
information increases monitoring and bonding costs as bondholders try to grasp the
actual value of the firm.

Debt provides a tax benefit to firms but at the same time, it also adds on
pressures of fixed payments on principal and interest. If the firm is unable to meet
these obligations, then it goes into bankruptcy, and ownership of the firms assets are
legally transferred to the bondholders. In theory, if bankruptcy were costless, then
there would be no effect to the firms value. In practice, however, the costs of
bankruptcy decrease a part of the remaining value of the firm and the total value of
the firm falls. Prior to purchasing bonds, the bondholder estimates the probability of
occurrence of bankruptcy and will charge a higher price for the debt accordingly,
leaving the owner-manager to bear the entire wealth effect of the costs of bankruptcy.
Research suggests that while out-of-pocket bankruptcy costs may not be necessarily
huge; the firm may still suffer due to indirect costs. Management time is diverted,
key employees leave the organization, and customer and supplier confidence may be
shaken. This is particularly true of firms with intangible assets such as reputation,
patents and human capital. Thus, intangibility of assets increases agency costs of
debt.

44

A firm may ultimately avoid bankruptcy but still incur agency costs similar to
that discussed above if they are in a state of financial distress. Financial distress is
defined as a low cash-flow state in which the firm incurs loses without being
bankrupt.

Opler and Titman (1994) provide empirical evidence that financially

distressed firms lose significant market share to healthy competitors in industry

downturns. Chevalier (1995) using data from the supermarket industry finds evidence
that debt weakens the competitive position of a firm. Froot et. al. (1993) suggests a
financially distressed firm may have to forgo positive Net Present Value (NPV)
projects due to costly external financing.

Myers (1977) agrees with Jensen and Mecklings analysis that suboptimal
investment policy is an agency cost induced by risky debt. However, he presents a
different argument. Myers argues that debt, specifically risky debt, in some states of
nature, will restrain firms from investing in positive NPV projects leading to
underinvestment. This occurs when shareholders perceive that the profits will be used
to pay off existing debt holders. The cost of the suboptimal investment strategy
reduces the market value of a firm and this loss is ultimately absorbed by the
companys shareholders. He argues that a firm which has no debt or can issue riskfree debt will make decisions that maximize firm value. Thus, in the absence of
corporate taxes, the optimal solution is to issue no risky debt. In the presence or
corporate tax and interest tax shields, there is a trade off the between the tax
advantage of debt and the suboptimal behaviors of owner-managers. In addition,
when growth options are available, the opportunity cost of underinvestment is due to
leverage, thus high growth firms should rely more on equity financing rather than debt

45

financing to maximize firm value. Growth firms lose more of their value when they
go into distress.

Myers concludes that there is a definite limit to how much firms can borrow.
He proposes that credit rationing can occur in perfect capital markets. A firm can
only borrow up to a certain point, after which it cannot borrow more by offering to
pay a higher interest rate as it may actually decrease the amount of credit available to
the firm.

Agency costs of debt are magnified as the leverage of an organization

increases. Chang (1987) depicts that due to agency problems of debt, leverage is
negatively correlated with profitability. Kester (1986), Friend and Hasbrouck (1988)
and Titman and Wessel (1988) have found that there exits a negative association
between leverage and profitability.

While the tax-shield on interest rates generates an initial increase in the market
value of the firm, after a certain point these tax-shields have diminishing returns.
Once a company is over-leveraged, the value of the firm drops due to the agency costs
of debt. Islam supports the view that debt is not meant for business transactions. In
fact, the only type of debt allowed is where there is no expectation of return (Qard
Hassan). It is a benevolent loan allowed more for charitable rather than business
intent. The prohibition of usurious interest in Islam is rooted in the belief that it leads
to exploitation and a destruction of value. This is illustrated in how an ownermanagers behavior changes in the presence of debt in his organizations capital
structure. Both the manager-owner and the bondholder try to maximize their

46

respective values to the detriment of the other, the overall result being a loss in the
firms market value.

Islamic Finance addresses all these issues by creating financial instruments

that minimizes agency costs of debt. By linking financing to a physical asset, the
risk-shifting behavior of owner managers are alleviated. Tangibility of an asset
makes it more difficult for the owner-manager finance a higher-risk project while
borrowing for a safer one from the bank. The under-investment issue is similarly
addressed when the asset is collateralized.

Information asymmetries are also

decreased when the bank becomes a partner in equity or hybrid instruments as it has
access to all the information needed to carefully assess the financial situation of the
entrepreneur.

The interest regime accepts only those projects whose expected returns are
higher than the cost of debt, and therefore filter out projects which could be
acceptable under the Islamic profit sharing system (Zaher & Hassan, 2001). By
rejecting positive NPV value projects, there is an impact not just to the firm that loses
value, but to the community as it means fewer jobs that might otherwise have been
created by new investments. High leverage also makes an organization vulnerable to
external shocks and on an aggregate scale can affect an entire economy.

47

Chapter 7
An Economic Perspective:
The East Asian Crisis

How well has the prevailing economic & financial systems served in
promoting the real well-being of sovereign countries?

Capitalism, the most dominant economic system, has not been able to narrow
the gap between the haves and the have-nots. There exists a huge income gap in
this system as it reinforces the unequal distribution of capital skewed in favor of the
wealthy. Likewise, Socialism promoting collective ownership of production factors
and control of distribution factors has failed to induce both collective development
and personal self-actualization, thus retarding the process and rate of economic
growth.

Similarly, Communism, stressing property ownership and control of

production, distribution and supply by a whole classless society, could not co-exist
with human dynamisms and aspirations. It fell short of bringing about economic
satisfaction in individual and collective life.

Looking at how well the current international architecture has served most
economies, the single most striking piece of evidence of its failure is the high
frequency of financial crises, particularly since 1973. The frequency of banking
crises since 1973 is about 10% per annum for each country out of 21 mainly
developed countries and about 12% for a wider sample of 56 countries which include
emerging market economies (Bordo 2002; Eichengreen 2002).

48

Table 6

Banking & Other Crisis

Source: Eichengreen (2002)

This frequency is approximately double the rate during the Gold Standard
1880-1913 when each country faced a one in twenty risk of crises in any given year.
It is higher than the Bretton Woods era (1945-1973) of pegged but adjustable
exchange rates and limited capital mobility. Other than the interwar period (19191939) which includes the Great Depression, it is the highest incidence of crises since
1880.
The 1997 East Asian crises highlight how excessive reliance on short-term and
foreign currency nominated debt leads to economic instability. As Rogoff (2003)
notes:
private flows to emerging markets are remarkable for their
unpleasant side effects - wild booms, spectacular crashes, overindebtedness, excessive reliance on short-term and foreign-currency
denominated debt, and protracted stagnation following a debt crisis.
[There] is an excessive reliance on dangerous forms of debt, such
as foreign-currency denominated debt and short-term debt, which
aggravate the pain of crises when they occur.

49

The instability of an economy depends on the evolution of the liability

structures of the firms that comprise it. As firms make finance and investment
decisions over a boom period, they become more fragile as their payment
commitments increase relative to gross profits due to an increasing dependence in
short-term-debt financing. The increased fragility of individual firms imply that the
economy as a whole becomes financially unstable as well, increasing its vulnerability
to a financial crises (Minsky, 1995)5.

The onset of the crisis is triggered by a

sequence of events which shake the confidence of lenders in the firms ability to
obtain cash flows to meet payment commitments. This describes the events that led
to the twin crisis of East Asia. Our interest lies in how the private sectors behavior
led to the financial crisis that also triggered the currency crisis.

Leverage
180
160
Hong Kong

Total Debt/Equity

140

Indonesia

120

Korea

100

Malaysia
Philippines

80

Singapore

60

Taiwan
40

Thailand

20
0
1

Table 7
Source:

Debt Equity Ratios for East Asian Corporation

Data from Appendix 1

The levels of leverage across the East Asian countries prior to the crisis varied
widely. Thailand and Koreas high leverage ratios contrasted with the moderate
50

debt/equity ratios of Hong Kong, Philippines and Taiwan (Appendix 1). An important
observation, however is that the debt equity ratio was rapidly increasing as shown in
Table 7. In Thailand, for example, leverage increased from 91% in 1992 to 155% by
the end of 1996. Similar trends are observed in Korea, Malaysia and Indonesia.

This rapid build up of leverage was due to high levels of investment propelled
by firms goals of high growth. Growth was regarded as more important that profit or
firm value maximization and high levels of investment led to a decline in the
profitability of the corporate sector.

The investments were primarily financed by large scale inflows of capital

encouraged by a credible pegged exchange rate system. Banks, the primary recipients
of the international capital inflows, integrated these into the domestic financial system
increasing their foreign currency exposure. In addition, since about 60% of the
inflows were short term for most countries, it led to a serious maturity mismatch
(Appendix 2).

The crisis hit when speculators recognized that the inflows of capital
investments would dry up in the near future as the private sector, overburdened with
debt, would be unable to service its interest payments. The table below shows the
deteriorating ability of the East Asian corporations to cover interest payments by
1996.

51

Hong Kong
Indonesia
Korea
Malaysia
Philippines
Singapore
Taiwan
Thailand

10

12

EBITDA/Interest Payable
1996

Table 8
Source:

Interest Cover for East Asian Corporations

Data from Appendix 3

Since the capital inflows were supporting the pegged exchange rate, once they
stopped, the government ran out of foreign exchange reserves resulting in a currency
crisis. This crisis was driven by the unsustainable deficit of the private sector which
led to the reversal of capital inflows.

The twin crisis was a result of the interaction between the currency markets
and the banking sector. Since bank lending was mainly used to fuel a bubble in the
stock and real estate markets, the crisis led to a corresponding collapse in asset prices.
The resulting credit crunch led to many corporate bankruptcies. The sale of assets of
these failing companies generated further declines in asset values and the further
deterioration of both the financial and corporate sectors.

52

The costs of the financial crises were massive. An estimate of the costs using
forgone output for the four Asian countries hardest hit by the financial crises,
Indonesia, Korea, Malaysia & Thailand, are estimated at US$917 billion for the
period of 1997-2002. Indonesia experienced larger falls in output and income during
and after the crisis than that of the USA in the Great Depression. It is also estimated
that the poverty headcount in Indonesia doubled after the crisis, from 7-8% in 1997 to
18-20% in 1998 (Suryahadi et al. 2000). The rest of the other Asian countries actual
output had not returned to its potential level by 2002.

Table 9

Indonesia: Potential & Actual GDP

Source: World Bank Database as cited in Griffith-Jones & Gottschalk, 2006

The output losses also led to lower economic growth for the years following
the crisis (1997-2003). Average growth before the Asian crisis was at 7.3 % for
Korea, 8% for Indonesia & Thailand, and 9.6% for Malaysia. The average growth
over 1997-2002 was 4.5% in Korea and 0.5% in Indonesia (Appendix 5).

While there are other factors:

poor corporate governance, institutional

features such as financial and legal systems, underdeveloped financial markets and
the role of each respective government that contributed to the East Asian crisis, the

53

high levels of corporate debt was a main contributing factor that precipitated the
crisis.

Islamic Finance proposes the shift to a more equity oriented financial system
as a way of reducing the volatility in financial markets. Equity financing improves
economic health as banks will have more incentives to do their jobs properly when
making risk- assessments. The IMF also favors equity financing by arguing:

Foreign direct investment, in contrast to debt-creating

inflows, is often regarded as providing a safer and more
stable way to finance development because it refers to
ownership and control of plant, equipment and infrastructure
and therefore funds the growth-creating capacity of an
economy, whereas short-term foreign borrowing is more
likely to be used to finance consumption. Furthermore, in the
event of a crisis, while investors can divest themselves of
domestic securities and banks can refuse to roll over loans,
owners of physical capital cannot find buyers so easily.
(Cited by Chapra, 2006)

While debt is a cheaper source of financing during a boom period, the

destabilizing effect of debt in recessionary times is evident in the example of the East
Asian Crisis. During periods of recession, business failures increase as indebted
companies fail to earn enough to make interest payments on their debt. The nature of
debt requires that payments be made whether or not an organization is financially able

54

to do so leading to bankruptcy costs. Even if bankruptcy is avoided, the firm still

suffers through costs of financial distress that erode the companys value.

The

aggregate result on an economic level can be higher poverty levels, higher

unemployment and lower economic growth levels.

Equity-based & hybrid Islamic products, which combine features of debt &
equity, mitigates the risks of a pure debt instrument. Equity, while more costly during
an economic upturn, offers more flexibility as profit sharing only occurs when the
organization is financially healthy. Islamic hybrid instruments have the same
flexibility as pure equity instruments, and a fixed payment that has a debt like
aspect that insures the discipline of payment without the expanded liability caused by
interest rates.

Islamic Finance relies on this system which minimizes the risk of bank failures
and increases the stability of the banking system. This removes the destabilizing
effect of interest rates and leads to a more stable exchange rate system. Thus, a
system that does not rely on the erratic behavior of interest leads to a more stable
investment climate, and ultimately a more stable economy.

55

Chapter 8
Islamic Modes of Finance:
In Theory & Practice

Islamic Finance has developed a myriad of financial instruments that may be

classified in conventional financial terms as debt, hybrid, and equity securities
(Ebrahim, 1999) to encourage trade and business while remaining in compliance with
Islamic principles.

While all Islamic financial contracts do not involve the payment of interest,
some are classified as debt-like as it involves regular payment schedules to prevent
default similar to conventional debts. The most common instruments in this category
are Bai Murabahah & Bai Muajjal, Ijara & Ijara wal Iqtina, Istisna & Bai Salam,
and Qard Hassan.

Mark Up based Principle:

Saeed (1996) notes four basic features of a Murabahah contract:
1. The buyer should have complete information of all the related costs and the
original price of the commodity. The profit margin must be a percentage
of the total price plus costs. These costs can include, but not be limited to
a fee, covering handling charges, transaction costs or risk premium.
2. The sale item should involve goods or commodities and not money.
3. The sale item should be owned and in the possession of the seller such that
he is capable of delivering it to the buyer.
4. The payment is deferred with specific terms clearly stated in the contract.

56

The Bai Murabahah transaction is a cost plus profit transaction where a

buyer wishing to purchase a tangible asset approaches an Islamic Bank to effect the
purchase on his behalf from a supplier. The bank then sells it back to the buyer at
cost plus a reasonable profit. Capital and profit are payable on terms agreed on
between both parties. The markup on the asset cannot be changed during the life of
the contract.

The Bai Muajjal is similar to the Bai Murabahah transaction in most aspects.
The key difference is that the Islamic Banks allows a deferment of the payment
through installment to facilitate the purchase of the asset.

A key characteristic of Murabahah contracts is that ownership of the asset

remains with the bank until all of the payments have been made, unlike conventional
debt where the ownership is immediately transferred to the buyer.

From a modern

finance perspective, it is equivalent to an asset backed risky loan and is a popular

substitute for interest-based conventional trade financing in Islamic Banks. Research
shows that Islamic banks in general have been using Murabahah as their major
method of financing, constituting approximately seventy-five percent of their assets.
This percentage is roughly true for many Islamic banks as well as Islamic banking
systems in Pakistan and Iran. As early as 1984, in Pakistan, Murabahah-type
financing amounted to approximately eighty-seven percent of total financing in the
investment of PLS (profit and loss sharing) deposits (Saeed, 1996).

However, there are serious misgivings about the popularity of this mode of
finance. As returns are larger the longer the period of repayment stipulated in the

57

contract, many argue that there is no difference in pricing the sale of an asset in
excess of it original amount to riba as it represents a fixed rate of interest to the lender
(Siddiqui, 1983 & Saeed, 1996). Additionally, when a when a debtor is unable to
make a payment within the specified time, in theory, Islamic Institutions should give
him time to repay the debt. However, in practice, with the support of Religious
Supervisory Boards, Islamic Banks charge a fine to be incorporated in the contract.
This is aligned to conventional finance practice of charging extra interest charges as
penalties.

Thus, there are arguments that from an economic viewpoint, the

Murabahah financing and interest-based financing are comparable and the difference
lies only in their contractual features.

Lease Based Principle:

Ijara is similar to a conventional leasing concept where the lessor, the Islamic
bank, leases the asset to the lessee for rental payments covering a specified period of
time but with no option to own the asset. Ijara wal Iqtina, on the other hand, is
similar to a lease to purchase option in conventional finance.

There is no effective difference between the conventional & Islamic operation

of the leasing concept. It must, however, meet some conditions for it to be acceptable
in an Islamic framework (Al-Omar and Abdel-Haq, 1996).
1. Both parties should be clear on what service the asset is supposed to
provide and the purpose for which it is being rented. Its usage must
comply with Islamic laws.

58

2. The ownership of the asset remains with the lessor who is responsible for
its maintenance.
3. The leasing contract is terminated when the assets stops giving service
for which it was rented. If the asset gets damaged during the contract
period the contract still remains valid.
4.

The price of the asset, if sold to the lessee once the contract expires,
cannot be predetermined. It can only be settled when the contract is
expired.

As of 10 years ago, leasing already accounted for about 10% of Islamic

financial transactions (Iqbal, 1997) and remains one of the most popular modes of
Islamic finance today. Products involved in Islamic leasing cover a range of asset
classes from European oil refineries to medical equipment in the United States.
Banks like Citicorp & Kleinworth Benston have become more active in Islamic
leasing and funds have been raised from both Muslim & non-Muslims investors
(Collett, 1995) as it promises higher yields than trade finance and is geared more
towards medium and long-term financing, an important feature for business
investments.

Advance Purchase Principle:

Bai Salam refers to advance payment or forward buying. It is a short-term

commodity contract where the buyer pays the seller the negotiated price of a product
with a future promised delivery date.

It is similar to forward contracts of

conventional finance except that in Islamic instruments the rate of return is based per

59

transaction rather that to time. In addition, unlike conventional forward contracts, the
purchaser pays for the entire transaction in cash at the time of contract to facilitate
working capital requirements e.g. a manufacturer needing capital to produce a final
good for the buyer. The entire risk is also borne by the buyer alone, unlike in forward
contracts where it is borne by both parties. In return for the advance payment and the
added risk, the buyer receives a more favorable price for the goods. An important
feature of the Bai Salam contract is that the underlying asset must be standardized, of
a determinate quality and easily quantified.

Istisna is a deferred delivery sale similar to a Bai Salam contract. It is a predelivery financing and leasing model used mostly to fund long-term and large scale
activities very similar to the conventional work-in-progress financing of capital
projects like construction. Unlike the Bai Salam which requires an upfront cash
payment, Istisna may be paid in installment payments at any agreed upon time, even
exceeding the delivery date. This model is still a very new product in Islamic finance.

Benevolent Loan:

Qard Hassan is a zero return loan that the Quran exhorts Muslims to make to
the needy.

Islamic financial institutions are allowed to charge a one-time

administrative fee as long as it is not tied to the amount or the maturity of the loan.

In theory, this loan is meant more as an act of kindness than a financing tool
for business. There may be some situations where a firm may be eligible for such a
loan; it is questionable whether it should be a mainstream and regular form for

60

financing for Islamic enterprises (Chapra, 1985). While not required, the recipient of
a benevolent loan can choose to reward the provider with a return in excess of the
original amount loaned. In practice, although banks cannot insist on payments above
the loan, they provide this facility expecting corporate borrowers to return the loan
with sums above that which was originally borrowed.

As the return on the principal is not guaranteed in Qard Hassan, it cannot be

viewed as an appropriate financing tool for large scale commercial projects. In spite
of this, there have been a few attempts to utilize Qard Hassan in bond issues. An
example of which is the 1994 issue of M$300 million of Islamic Debt Securities (IDS)
by Petronas, the national oil company of Malaysia. The maturity value of the bond
was at face value but it offered a detachable warrant as a token to its subscribers. The
warrants permitted holders to buy shares in Petronas Dagangan Berhad at a fixed
price at a future date. As a predetermined rate is not normally allowed in a Qard
Hassan facility, these warrants were offered separate from the IDS and were tradable
separately.

The popularity of debt-like contracts has been attributed to issues like adverse
selection (Kuran, 1993; Khan & Mirakhor 1987) where Islamic Banks get capitalists
that have not successfully received loans from conventional banks. They are more
likely to have high-cost investments and more likely to divert borrowed funds.

Although Islamic debt-like contracts are widely used, there is some dispute on
their acceptability due to the underlying fixed return on investments implicit in the
contracts. Most Islamic scholars agree that these contracts are permissible, but should

61

still be restricted or avoided as they may open back doors to the forbidden riba
(Siddiqui, 1983; Khan, 1987). Other concerns are that mark-up financing may inhibit
economic growth as it discourages entrepreneurs from investing in new projects.

Profit and Loss Principle:

The heart of Islamic Finance lies in the profit sharing principle. Profit sharing
modes seek to avoid debt-financing and instead use partnership and equity-financing,
similar to venture capitalism.

Broadly, Profit-loss sharing is a contractual

arrangement between two or more transacting parties, which allows them to pool their
resources to invest in a project to share in profit and loss. Most Islamic economists
contend that PLS based on two major modes of financing, namely Mudarabah and
Musharakah, is desirable in an Islamic context wherein reward-sharing is related to
risk-sharing between transacting parties. (Dar and Presley, 2000)

Musharakah: Long-Term Equity Financing

This Islamic product is essentially a joint venture where the main investment
is capital. Two or more persons contribute to the financing and management of the
business in equal or unequal proportions. This product is similar to the modern
concept of partnership except that in conventional finance, banks are not allowed to
be partners in this type of contract. Under this type of equity finance, the profit
agreement and the length of the joint venture is decided upon in advance. Loss is
shared in proportion to the capital contribution unless the loss is proven to be due to
negligence of one party.

62

There different schools of thought on the types of Musharakah contracts. One

school emphasizes unlimited partnership where each partner is equal in personal and
financial status, thus contributing equally to the partnership. This type of partnership
is based on mutual agency, each being fully liable for the financial commitments of
his partner in all financial matters.

A more restricted view states that the partners

may not necessarily be equal and that the mutual agency only covers areas of trade
and commodities agreed upon. Liabilities are only limited according to each partners
capital contribution to the total investment.

Hybrid Islamic Financial Products

Mudarabah security (as cited in Ebrahim, 1999) combines the features of

both equity and Islamic debt contracts. Akin to a Western concept of limited
partnership, this Islamic mode of finance involves one partner providing the capital,
generally the Islamic Bank, while the other party contributes labor to run the business.
The ratio of the profits is determined ex-ante and is determined by market forces
(Siddiqui, 1987). In case of loss, if it is incurred in the normal course of business and
not due to any neglect or misconduct on the entrepreneurs part then it is to be borne
entirely by the capital-owner or the Islamic Bank. This justifies the banks share in the
profit. The entrepreneur also forfeits any wages that may have been accrued to him.
In case of negligence or misconduct by the entrepreneur, then Ibn Qudama states if,
however, the loss is a result of a misuse or a violation of the conditions of the
contract on the part of the working partner, then he alone will be liable to cover it
(Sarker, 1999).

63

Mudarabah, also known as Trust Partnership, can be restricted or unrestricted.

A restricted Mudarabah is where the capital-owner specifies restrictions on the traded
item, time of trade, place or trading or even with whom the entrepreneur should trade.
The restrictions pertaining to time or individuals are endorsed in both the Hanbali and
Hanafi Schools but not approved in Shafi and Maliki Schools.

An unrestricted

Mudarabah does not place any of the above restrictions on the trading activities of the
entrepreneur.

Mudarabah can involve multiple parties. In this case shares are issued to
represent a stake in the business. Shares are issued in the form of certificates which
are transferable. The shareholder is entitled to a proportion of the profit or loss of his
capital. Neither the return of the principal nor profit is guaranteed to the holder
similar to a conventional stock market; the difference being that the Mudarabah
certificate must comply with Shariah laws.

Trading in stocks is allowed but trading in transferable stocks leads to

speculative activity and riba. An experiment by the Islamic Investment Company of
the Gulf to curb this issue was to state the value of Mudarabah certificate at periodic
intervals based on the actual progress of the project. The values of the certificate
reflected the principal plus or minus the profit or loss incurred. Exchanges were
transacted on the basis of this value. This procedure prevented the face value of a
certificate from differing from its market value thus eliminating capital gains that lead
to riba while supplying liquidity to individuals.

64

Sukuk

Another recent innovation in the Islamic Market is Sukuk offerings. This is a

hybrid product as its structure combines debt and equity features. Essentially, a Sukuk
is a participation certificate against a particular asset or a collection of assets. It
represents a proportionate level of ownership over assets for a defined term. The cash
flows generated by the risks and returns of the underlying assets are passed back to
the investor. The structure of a Sukuk offering is comparable to the process of
securitization in conventional markets. Like a conventional bond, it provides a
predictable level of return. However, a key difference is that a bond represents only
debt of the issuer whereas the Sukuk represents an ownership stake in the asset.
While a bond creates a borrower-lender relationship, the relationship in Sukuk
depends on the underlying contract of the Sukuk.

For example the first Sukuk

offering in Singapore combined both the features of Musharakah and Ijara. It was a
S$25M Musharakah bond for the purchase of an office building. The Islamic Council
(MUIS) entered into a Musharakah Agreement contributing S$9M with the bond
investors contributing S$25M. Capital contributions and profit sharing ratios were at
26.5% and 73.5% respectively. The Ijara Agreement was entered between Fusion
Company, the building owner, and Freshmill Pte. Ltd. who would manage the
tenancies and guarantees as annual Ijara income of S$1.19M to be shared equitably
between MUIS and the bond investors based on the profit ratios.

65

Funds
Mobilizing
Entity

SPM Balance Sheet

Credit
Enhancement

Special Purpose

Mudarabah
SPM
SPM/SPV
SPV

Pool of Assets
(Ijarah/Leases)

Assets

Ijarah Assets

Liabilities

Sukuk
Certificates

Servicing

Investors: IFI
IFIs, Conventional
Institutional Investors,
Pension Funds
etc

Table 10 Anatomy of a Sukuk

Source: Iqbal (1999)

At the core of a Sukuk offering is a Mudarabah contract. One party acts as an

agent for the capital-owner/s with a pre-arranged profit sharing agreement. The
Mudarabah contract is used to create a Special Purpose Mudarabah like a
conventional Special Purpose Vehicle to acquire assets which are Shariah-compliant
and issue the corresponding certificates. The tradability of the issued certificates is
dependent on the nature of the underlying asset of the Sukuk.

There is some controversy on the trading of Sukuk for Murabahah debt. In

Malaysia, this practice is allowed providing that the underlying receivable is tied to an
actual trade transaction or tied to a commercial transfer of a non-monetary interest. A
more mainstream view argues that Murabahah debt cannot be securitized as trading

66

debt for debt is not allowed in Islam. The sale of a document representing money is
similar to the trading of monies which is considered riba.

Sukuk securities are still largely concentrated in Malaysia and the Gulf States
focusing mainly as assets in Islamic jurisdictions but it is a rapidly growing business
with the involvement of private companies, state corporations, governments, Islamic
financial institutions and even Western investment banks.

Modes of Finance

2000 2001 2003*

1. Al-Mushakarah

1.4

0.7

0.5

2. Al-Mudarabah

7.0

7.3

3. Al-Istisna

0.9

1.3

0.7

4. Al-Ijarah

4.3

3.0

1.4

5. Al-Murabahah

6.4

6. Al-bay bi thaman al-djil

48.3

49.1

47.4

7. Al-Ijarah thumma al-bay 22.2

23.3

27.9

8. Other Islamic Contracts

15.9

15.3

15.7

Total

100

100

100

Table 11 Modes of Islamic Financing in Bank Negara Malaysia (% share)

Source: Bank Negara Annual Reports2001 & 2002 by Zubair Hassan (2005)

The core is Islamic Finance lies in equity financing but in practice these
modes of finance are largely ignored. Most Islamic Financial Institutions rely on
Murabahah, a financing mode that is high in risk-avoidance and promises a relatively
high return which allows them to compete effectively with conventional banks. This
67

is illustrated above using Bank Negara as an example. Equity and hybrid equity
modes account for only 8.4% and have been declining in the succeeding years while
debt-like modes account for a substantially high percentage

This pattern is also repeated in other banks as evidenced by the data provided
by the Islamic Development Bank on all its member countries in the table below.
While Murabahah is widely accepted in Islamic finance, there is nothing unique about
it. The reliance on this type of financing negates anything distinctly from Islamic
from Islamic Financial Institutions.

Table12
Source:

Islamic Modes of Finance 2005-2006

IDB Annual Report, 2006

Literature identifies the reluctance of Islamic financial institutions to use profit

sharing models of finance and explains the overwhelming use on non-PLS modes.
Dar and Presley (2000) enumerate several explanations:

68

Profit sharing contracts are inherently vulnerable to agency

costs of equity as entrepreneurs have disincentives to put in
effort and have more incentives to report less profit than a selffinanced manager-owner.

To function efficiently, profit sharing contracts require welldefined property rights.

In most Muslim countries where

Islamic banks operate, these are not well defined or protected,

and thus are considered less attractive or more likely to fail if
used.

Islamic institutions have to offer less risky modes of financing

compared to the existing profit sharing modes to enable them to
compete with existing conventional banks and financial
institutions.

The restrictive role of the investors in the management of the

business, and thus the dichotomous nature of the profit sharing
contracts makes them non-participatory allowing sleeping
partnerships.

Equity financing is not practical for short term projects as a

result of the high risk involved making Islamic Banks rely on
more debt-like modes of finance to ensure liquidity.

Unfair treatment in taxation is also another hurdle as profit is

taxed while interest is tax-exempt. This leads to an associated
issue of tax evasion which makes profit-sharing a less desirable
mode of finance.

69

Lastly, secondary markets for Islamic financial instruments, especially

Mudarabah and Musharakah are virtually non-existent resulting in a
failure to effectively mobilize financial resources.

In order for Islamic Finance to realize its objectives it is important to close the
gap between theory and practice. Understanding the reasons behind the reluctance to
use profit sharing Islamic modes will help to develop more instruments that close this
space. There is already some discussion among Islamic scholars that developing
more hybrid instruments will help to decrease the reliance on debt-like contracts and
promote more equity sharing which is in the spirit of Islamic Finance.

70

Chapter 9
Conclusion

Islamic Finance is deeply rooted in religion. The precept under which it

operates is guided by the religious prohibition of riba and other Islamic teachings.
While the prohibition of interest is not unique to Islam, it has been all but eradicated
in other major religions. Capitalism is currently the dominating economic concept.

In order for Islamic finance not follow the same route, it is imperative to
understand not just the religious reasoning for this prohibition but the social,
corporate and economic implications as well. From a social perspective, the use of
debt and consequently interest as a tool to smooth consumption has led to higher
personal bankruptcies, and the dependence on predatory lending practices that lower
instead of improving the social welfare of individuals. Usury state laws have not
successfully protected individuals from the evils of usury.

In contrast, Islam

promotes the redistribution of wealth through Zakat. It encourages each member of

the community to contribute towards the welfare of its members eliminating the need
to resort to debt, avoiding its negative effects. Zakat is no doubt plagued by issues
pertaining efficient collection and administration, but the potential is enormous.
Thus, it is imperative that current issues be addressed to realize its capability to
promote social welfare.

Debt decreases firm value as it promotes under-investment and risk-shifting

behaviors in owner-managers.

Islamic mark-up modes of finance uses secured debt

which reduces the leverage-induced underinvestment issues as well as preventing the

ability of entrepreneurs to borrow and use capital for higher risk projects. In addition,
71

Islamic mark-up modes reduce the bankruptcy costs that arise in case of default as the
assets are unambiguously owned by the lender until it is fully paid. On an aggregate
economic scale the negative effects of debt are magnified to such an extent that it can
lead to an economic crisis as depicted by the example of the East Asian Crisis. A
more equity based firm, using pure equity or hybrid instruments, can avoid the pitfalls
induced by conventional debt.

It can avoid exchange exposure risks caused by

foreign debts. The term and structure of the assets and liabilities are symmetrically
matched through profit sharing arrangements. In addition, close link between the
process of real-asset creation & value addition on one hand and the financial &
monetary expansion on the other hand ensures a more stable economy that avoids the
volatile swings of a highly credit based economy.

While by no means an exhaustive list, a short discussion of some aspects of

improvement for Islamic finance is necessary. One of the current challenges faced by
Islamic Finance is a lack of religious consensus as depicted by the debates on riba &,
the collection of Zakat. There is no universally accepted Islamic religious body and
hence each Islamic Financial Institution creates its own Shariah board to seek
approval when developing new instruments.

Thus, an instrument approved and

accepted by one bank or in one specific country may be rejected by another e.g.
Malaysias approval for a Murabahah Sukuk which is quite controversial. Forming a
council that represents the different schools of thought to determine uniform rules and
policies will help to expedite the introduction and uniform acceptance of new
products.

72

There is also a need to provide more innovative products. By relying on

traditional modes of financing, institutions tend to opt for the safer mark-up modes to
avoid taking excessive risk and profit sharing modes are largely ignored. Offering
more tools to help manage risk while addressing longer term needs of investors may
realize the Islamic ideal of risk-sharing in business enterprises and promote more
profit sharing investments.

It will also allow Islamic banks to compete more

effectively with the conventional banks. This will help to resolve issues of adverse
selection and moral hazard that they are currently subjected to.

Whereas the conventional finance focuses primarily on the economic and

financial aspects of transactions, the Islamic system places equal emphasis on the
ethical, moral, social, and religious aspects, to improve equality and justice for the
good of society as a whole. It is a sound alternative to the conventional financial
system already in place.

73

Notes
1

God deprives riba of all blessing but blesses charity; he loves not the ungrateful

sinner.
Those who believe, perform good deeds, establish prayer and pay the Zakat, their
reward is with their Lord; neither should they have any fear, nor shall they grieve.
O believers, fear God, and give up the riba that remains outstanding if you are
believers.
If you do not do so, then be sure of being at war with God and his Messenger. But, if
you repent, you can have your principal. Neither should you commit injustice nor
should you be subjected to it.
If the debtor is in difficulty, let him have respite until it is easier, but if you forgo out
of charity, it is better for you if you realize.
And fear the Dar when you shall be returned to the Lord and every soul shall be paid
in full what it has earned and no one shall be wronged.
(Surah al-Baqarah, verses 276-81)

Leviticus 25:3537, it says: If your kinsman, being in straits, comes under your

authority, and you hold him as though a resident alien, let him live by your side: do
not exact from him advance or accrued interest, but fear your God. Let him live by
your side as your kinsman. Do not lend him money at advance interest, or give him
your food at accrued interest.

Every seventh year you shall practice remission of debts. This shall be the nature of

the remission: every creditor shall remit the due that he claims from his fellow; he

74

shall not dun his fellow or kinsman, for the remission proclaimed is of the Lord. You
may dun the foreigner; but you must remit whatever is due you from your kinsmen.

(Y)ou shall not deduct interest from loans to your countrymen, whether in food or

anything else that can be deducted as interest; but you may deduct interest from loans
to foreigners. Do no deduct interest from loans to your countrymen, so that the LORD
your God may bless you in all your undertakings in the land that you are about to
enter and possess.

While Minskys arguments assumed a closed developed economy, many subsequent

works have made attempts to extend this model to open developing economies

75

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Appendix

Appendix I Leverage of East Asian Corporations from 1992-1996

Total Debt/Equity

1992

1993

1994

1995

1996

Hong Kong

26

23

33

36

39

Indonesia

59

54

58

81

92

Korea

123

129

127

132

NA

Malaysia

31

29

38

45

62

Philippines

81

78

50

49

69

Singapore

37

34

33

45

58

Taiwan

71

73

71

67

65

Thailand

71

81

103

135

155

Source:

Data from Michael Pomerliano

Emerging Market Quarterly, Winter 1998

Appendix II Maturity Structure of Corporate Debt from 1992-1996

Total
Current
Liabilities/
Total
Liabilities

1992

1993

1994

1995

1996

Average

Hong Kong

58

62

63

64

61

62

Indonesia

52

56

56

50

45

52

Korea

64

52

53

52

N/A

55

Malaysia

66

64

61

61

59

62

Philippines

51

52

60

58

54

55

Singapore

77

82

80

60

78

75

Taiwan

64

66

65

68

61

65

Thailand

64

64

62

60

60

62

Source:

Data from Michael Pomerliano

Emerging Market Quarterly, Winter 1998

82

Appendix III Cash Flow Coverage EBITA/Interest Payable

1992

1993

1994

1995

1996

Ave.

Hong Kong

19.29

25.85

21.77

13.59

11.07

18.31

Indonesia

0.03

0.52

2.18

3.07

2.44

1.65

Korea

1.42

1.41

1.89

1.77

1.07

1.51

Malaysia

9.09

9.76

11.73

9.62

6.74

9.39

Philippines

1.89

2.59

2.93

4.31

3.68

3.08

Singapore

12.4

14.37

11.7

8.8

8.05

11.06

Taiwan

5.73

4.71

6.3

5.12

4.08

5.19

Thailand

4.63

4.12

3.83

2.47

1.92

3.39

Source:

Data from Michael Pomerliano

Emerging Market Quarterly, Winter 1998

Appendix IV Cumulative Output Loss for Each Crisis Country

1997-2002

US$ Billion

% of GDP, 2002

Indonesia

345.9

113

Korea

178.1

26

Malaysia

87.8

69

Thailand

305.2

157

Total

917.0

72

Source: Data from Michael Pomerliano

Emerging Market Quarterly, Winter 1998

83

Appendix V GDP Growth Rates for Each Crisis Country

1991-2002 (%)
Average
(1991(19911996)

1997

1998

1999

2000

2001

2002

Average
(1997(19972002)

Indonesia

7.8

4.7

-13.1

0.8

4.9

3.4

3.7

0.5

Korea

7.3

5.0

-6.7

10.9

9.3

3.1

6.4

4.5

Malaysia

9.6

7.3

-7.4

6.2

8.5

0.3

4.1

3.0

Thailand

8.2

-1.4

-10.5

4.5

4.8

2.2

5.4

0.7

Source: Data from Griffith-Jones & Gottschalk

Asia 2015 Conference, March 2006

84