ABSTRACT be borne by the fund provider, while

ABSTRACT  

The low
participation of Islamic banks in equity financing modes has become one of the
problems in the development of the Islamic banking industry. This arrangement
is unique to Islamic banking and account for its superiority over conventional
banking on grounds of ethics and efficiency. The qualitative method is adopted,
where the data collected to the present study by library research. This paper
tries to analyze why Islamic banks are avoided in involving of equity
financing. It is also to analyze the challenges regarding these Islamic equity
financing modes. By the end of this paper, the implications of equity financing
and solutions are proposed to this matter. Thus, this paper attempts to discuss
the challenges of profit and lost sharing faced by Islamic banking industries.

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Keyword: equity
financing, mudharabah, musharakah, challenges, Islamic banking

 

1. Introduction

The Islamic
Banking and Finance (IBF) movement has become a rapidly growing phenomenon in
the Muslim world. Many problems and challenges regarding to Islamic equity
financing must be addressed and resolved. Therefore, the low participation of
Islamic banks in equity financing modes has become one of the problems in the development
of the industry (Febianto,
2010).

Equity
financing instruments for Islamic banking contracts are based on the Mudharabah
(profit sharing) and Musharakah (profit loss sharing) principles. These
financing methods are the alternatives to conventional debt financing that is
based on rate of interest (riba). Equity financing involves mutual sharing of
risks and profits between two parties. These equity financing instruments
reflect the Islamic view which is fund provider and entrepreneur do not bear
all the risk by his own and resulting in an equal distribution to both parties
involve and do not allow the entrepreneur in monopolizing the economy (Febianto,
2009).

According to
Sapuan (2016), in the case of Mudharabah, the parties involve are the fund
provider (rabbul mal) who supplies the financial capital and the entrepreneur
(mudarib) who supplies the expertise and management, will take part in profit
sharing business. Both parties will share profits from the business according
to the agreed ratio between both parties. In the event of failure, all losses
must be borne by the fund provider, while the entrepreneur would lose his time
and effort.

On the other
hand, Musharakah is a joint partnership structure with profit and loss sharing
which has two or more partners in providing capital and share profits and
losses. In this contract, it allows for each party to get involved in a
business that shares the profits and risks. The fund provider will get profit
from a portion of the actual profits earned upon the agreed ratio. In addition,
the fund provider also will share in any losses (BNM, 2010). 

However, practically,
Mudharabah (profit sharing) contract is less preferred compare to debt
financing instruments because of the asymmetric information problems that
continuously exist in this mode of financing (Samad,
Gardner, & Cook, 2005). The asymmetric information becomes
the first reason why Islamic banks preferred debt financing instrument compared
to equity financing instruments (Febianto,
2009). The asymmetric information on Mudharabah contract, an
entrepreneur who manages the business fund have full control of the business
and have more information regarding the business and its profitability which
the Islamic bank does not have permission to access it. The inefficiency in
information will lead two major problems, such as adverse selection and moral
hazard. Due to these, there is a lack of interest among Islamic financial
institutions to use Mudharabah as a financing vehicle (Sapuan,
2016).

Therefore, the
objectives of this study are two folds: first, to examine the challenges of Mudharabah
(profit sharing) contract face by Islamic banking sectors, and second, to
evaluate the solutions to the inherent problems such as asymmetric information.
The remainder of this paper proceeds as follows: Section 2 discusses the challenges
of equity financing instruments; Mudharabah and Musharakah contracts. Section 3
highlights the implications and solutions to the asymmetric information problems
in equity financing instruments.

 

2. Challenges of equity financing instruments

From the previous studies,
it is found that there are several reasons why banks do not choose equity
financing in business such as the difficulty to expand businesses through
equity financing due to limited opportunities to reinvest the earnings and also
due to moral hazards and adverse selection that needs for a closer monitoring
of the business (Munawar 2007; Iqbal & Molyneux, 2005). However, in reality
it is very difficult to implement Islamic banking in this technological age. Therefore,
the first Islamic bank in Malaysia, Bank Islam Malaysia Berhad (BIMB) has used
to grant Musharakah and Mudharabah based on financing although the number was
small and resulted there were some who were successful and some who failed (Abdul-rahman
& Nor, 2016).

According to BIMB, the
bank is always look for the most suitable candidates to grant financing although
Musharakah and Mudharabah based financings are not widely available to
customers as both are relatively high risk. The financings of Musharakah and Mudharabah,
which are based on profit and loss sharing, require customers who have the
potential to manage the capital wisely as to generate profit, and not to incur
loss. Therefore, Islamic banks should be very careful in investing their funds,
as this is highly risky. Based on the findings from the previous studies, in
summary, there are four challenges that could lead to obstacles in the
implementation of Musharakah and Mudharabah financing modes in general;

i.
High risk

Risks and uncertainties
always exist in business outcomes. Therefore, Musharakah and Mudharabah
financings are classified as high-risk investments. These concepts of financing
are difficult to be implemented due to their high probability of failure due to
entrepreneurs’ lack of skills and experience in doing business (AlMaimani
& Johari, 2015). Islamic banks tend to be very
cautious in providing financing due to the concept of a partnership through
profit and loss sharing. The invested funds are mostly owned by depositors who
always expect their money to be safe so that the Islamic banks have to replace
the depositors’ money if loss occurs.

Thus, there are numerous actions
to be undertaken in order to reduce risks which will ultimately lead to
increase of operational cost (Febianto,
2010). So that, market demand, production costs, competition,
and the financial leverage of the company seeking financing need to be
considered by bank before approving these types of financing. To assess the
authenticity of the financial plan, the analysis of all these complex factors
needs a high level of expertise, not only from the aspect of economy, business
and finance.

ii.
Selection

The selection process
causes a big challenge to Islamic banks in providing financings that are based
on Musharakah and Mudharabah. The Islamic bank needs to find the right partner as to ensure the shared
business is generating profit. Islamic banks must ensure that the
selected business partners have the right experience and huge business potential
to expand. The selection is difficult because it requires the evaluation of
various aspects of risk (Louati,
Gargouri Abida, & Boujelbene, 2015). Islamic banks should choose a
company that has a long track record and an acceptable financial performance
before offering capital to selected partners. Islamic banking institutions
offer profit and loss sharing to ensure the safety of depositors’ fund.

 

However, the spirit of the
establishment of an Islamic bank that maintains the concept of fairness and
justice and to contribute to the community in need of financial assistance will
not be achieved if Islamic banks are only providing Musharakah financing to big
corporations with good financial position. If this event continues, Islamic
banking will be no different from conventional banking with the rich getting
richer, the poor getting poorer. Islamic banks need a paradigm shift, from the
role of a financial intermediary to the real entrepreneur for the benefit of
society as a whole and to ensure the sustainability of Islamic banking in the
long term. Islamic banks
can still offer Mudharabah and Musharakah financings to small companies as long
as the partners or the companies are able to convince them through the planning
and operation of the business that they have the potential to be jointly
developed.

iii.
Demand

Basically, the demand for equity
financing; Musharakah and Mudharabah contracts is highly requested by entrepeneurs
who are lack of capital and still in the early stage of their businesses (Atiek,
Purwati, Si, Ulfah, & Si, 2016). Entrepreneurs from small and medium
industries that are still new in business are interested in Musharakah and Mudharabah
financing (Huda,
2012). Small
and medium companies are exposed to high risk of failure because of the unknown
business potential. When a profit and loss sharing contract is provided,
any loss incur by the business should not be questioned unless there is proof
of negligence and malpractice against the Shariah. This is a huge challenge to
Islamic banks.

However, there are no any
reasons for Islamic banks to refuse providing Mudharabah and Musharakah
financing in spite of the demand from the high-risk small and medium companies.
Moreover, the cost of monitoring companies is lower than monitoring
individuals. Despite the cost, monitoring is a vital aspect in reducing risk.
Being a large entity, the Islamic banks have the advantages of sourcing an
efficient management compared to the individual investors. To ensure the
success of Musharakah and Mudharabah financing, Islamic banks should change
into a genuine entrepreneur, starting with the selection of bankers who do not
only have the skills to assess the financial position, but also understand the flow
of the business that will influence the business risks of an industry while
working to ensure that all transactions are Shariah compliant.

iv.
Capital security

The safety of the capital
has to be ensured in any investment made. However, in reality Islamic banks do
not have the access to get to know the information regarding the proposed
business and its profitability thus Mudharabah is very risky for the entrepreneurs
(Sapuan,
2016). Without any capital guarantee, the Islamic banking do
not offer Mudharabah or Musharakah contract to clients. The guarantee for the
safety of capital may take in the form of collateral such as housing or landed
assets that have high value and secured. Guarantee is extremely important in
protecting the capital in the event of fraud and mismanagement by the partners.
The capital guarantee will also indicate the determination and commitment of
both parties in conducting the business.

However, not all partners
can afford to provide capital guarantees since those requesting for financing are
clients who lack the capital (Abdul-rahman
& Nor, 2016). This is a big challenge for Islamic
banks in providing financing through Musharakah and Mudharabah if the Islamic
banks’ mindset is still based on the framework of financial intermediaries. On
the other hand, from the entrepreneurs’ view point, financing without the
capital guarantee can still be implemented with an efficient and effective risk
management which is also in line with the Shariah.

 

3. The implications and solutions of equity financing
problems

As discussed
above, the problems facing such as asymmetric information that lead to moral
hazard, adverse selection by the Islamic banking industries can be reduced by
overcoming the challenges such as screening, monitoring and supervising of the
entrepreneur by the capital provider.  In
addition, the principle of trusteeship, fairness and mutual consultation help
to reduce the problems in Mudharabah and Musharakah contracts (Sapuan,
2016). Moreover, this asymmetric information problem can be
reduced by analyzing the complex factors from the financial leverage of the
company that seeks for equity financing (Abdul-rahman
& Nor, 2016).

When the asymmetric
information problems are reduced, these equity financing modes can help the
small and medium business to grow (Huda,
2012).  Furthermore,
Islamic banks must ensure that the selected business partners have the right
experience and huge business potential to expand so that Islamic banks do not
have problems in selecting the right clients that seek for financing. Besides,
to ensure the success of Musharakah and Mudharabah financing, Islamic banks
should change into a genuine entrepreneur, starting with the selection of
bankers who do not only have the skills to assess the financial position, but
also understand the flow of the business that will influence the business risks
of an industry while working to ensure that all transactions are Shariah
compliant. Nevertheless, these Islamic equity financing instruments will
attract people to use it as the Islamic banking system continues to grow (Samad
et al., 2005).

 

 

 

 

Conclusion

Musharakah and
Mudharabah contracts have the potential to grow in Islamic banking industry in
spite of huge challenges they have faced. These two contracts are able to
provide and have the opportunities to have a joint contract between
entrepreneurs and Islamic banks which leads to improving the Muslim’s economy
as it is compliant to the Shariah. Through risk sharing between entrepreneurs
and Islamic banks, these contracts could help the cooperation in business and
eventually eliminate the selfishness in both parties because risks and profits
are shared equally in partnership contracts. The challenges and solutions have
been discussed in this paper will be overcome in the future if the Islamic
banks take the role as genuine entrepreneurs. Therefore, Mudharabah and
Musharakah contracts would be able to support Malaysia to become an
international Islamic financial hub.