ISLAMIC BANKING FROM THE IDEAL TWO-TIER MUDARABAH TO A FIXED

RETURNS MODEL RATIONALIZING THE BLATANT DIVERGENCE.

MUHAMMAD ARSALAN
CHEVENING SCHOLAR AT DURHAM CENTRE OF ISLAMIC ECONOMICS AND FINANCE
arswasti@yahoo.com

The four decades old Islamic Banking Industry (IBI), despite of its double digit growth,
efficiency and resilience, has attracted a lot of censure from scholars owing to its departure
from the utopia of profit and loss sharing (PLS) and an equitable social-oriented institution,
turning in to a profit maximizing debt based financial intermediary. We find plethora of
research, anguished with sarcastic phrases like Shariah Arbritrage (Elgamal 2006), old-wine
in new bottle, marriage of Convenience (Samers M., 2015) broadly due to its divergence
from initially conceived two-tier Mudaraba structure to a fixed return asset and liability of an
IB(Khan F. 2010). This paper takes a pragmatist approach to contextualize and rationalize this
deviation by highlighting the key internal and external challenges and anomalies that IBs are
dealing with, and sets out the way forward to address them.

Estimated around USD 1.3 Trillion, Islamic Banking Industry has come a long way from a
humble initiative of Mit Ghamr (1963) in Egypt and Dubai Islamic Bank (1975) to the present
day where we see 430 Islamic Financial Institutions (IFIs), 191 Islamic Banking Windows
spread across 78 countries. The table below depicts a historical growth of the IBI.

Electronic copy available at: http://ssrn.com/abstract=2677690

Islamic Banks at the Cross Roads What is Pulling it Back?

A better understanding of the digression of IBs towards pseudo-debt products warrants a critical
appraisal of the Islamic Banking model, its externalities and the market dynamics. The figure
below present the two-tier Mudarabah model idealized for IBs with PLS modes on either side of
Balance sheet of an Islamic Bank

:
Nevertheless, the present day asset side of IBs depict a contrary picture, with a heavy tilt towards
trade/debt based products especially Murabaha. The table below presents the distribution of assets
of IBs:

Electronic copy available at: http://ssrn.com/abstract=2677690

The blatant divergence between the theory and practice has been charged to many factors
originating from the unique risk profile due to contractual arrangements, coexistence with its
conventional counterpart, regulatory pressures, governance mechanisms, customer segments and
expectations etc.

IBs dwell in a conventional system, wherein not only the market, but even the regulator
operates on ex-ante fixed terms. Even the effective pricing of sovereign debt is pegged to some
conventional benchmark, making it a fixed rate at-source proposition. Moreover, to wither the
Withdrawal risk, IBs are expected to offer their Investment Account Holders (IAH)
market competitive payoff, giving birth to the infamous Displaced Commercial Risk (DCR)
(Sundararajan V, 2007). DCR effectively reflects the tension between IAH and equity
shareholders, wherein market competitive returns are offered to IAH, at the expense of
shareholders equity holders effectively keeping the IAH remote to the rate of return
risk. A schematic representation is as follows:

Electronic copy available at: http://ssrn.com/abstract=2677690

The DCR is managed through prudential reserves such as PER and IRR, which subsequently brings
in the sophisticated debate of agency problem and stakeholder corporate governance. A
schematic representation of the overall profit distribution framework and prudential reserves is
illustrated in the following diagram.

The pursuit to offer smoothened, market tracking returns to the IAH has implication on the
overall risk appetite, product and tenor of the financing assets on the books of an IB justifying IBs logical preference for short term, debt based and blue-chip lending to manage
the asset liability mismatch and the subsequent liquidity risk. The challenge here is that of
the overall Asset-liability management and rate of return risk, wherein it is a fixed term and
fixed returns asset side funded by on-demand PLS deposit base offering a market tracking
varying returns. This situation is further exacerbated by the lack of liquidity instruments,
inter-banks and Lender of last resort facilities which burdens the efficiency of the IBs. The
table below elaborates the risk issues and concerns pertinent to IAH deposits.

On the other hand Capital adequacy regulations (CAR), which has direct implication on the
asset composition and the risk appetite, by means of high risk weightages assigned to equity
modes as compared to the debt based. Despite of IFSB regulations to incorporate PLS nature
of the IAH liability in to the CAR of IBs, it is recognized as capital protected fixed return
deposit in majority of jurisdiction with an exception of few.

On top of it, the contractual nature of financing arrangements, wherein banks effectively bear
the market risk of the inventory on its balance sheet adds on to the pressure on expensive
capital of the IBs. Needless to mention, the interrelated and unique risk such as operational
risk, shariah non-compliance, reputational and fiduciary risk facing an IB. Moreover the
jurisdictional heterogeneity in terms, legal system, Banking laws and regulatory
framework, makes it further strenuous for IBs to manage the workout procedure, arbitration
and dispute resolution in lending transaction. This weaves a knotty situation for IBs, leading
it to maintain a conservative risk profile based on fixed return debt based products. The table
below summarizes the risk management consideration

Moreover, in the wake of the fact that most of the human resource being trained in conventional
setting have unfavourable risk perceptions and lack the capability as well as the will to advent
in to equity.

Who Would Bell the Cat: Shariah Supervisory Board or Board of Directors?
Besides the structural problems, another contentious issue is on the role of SSB in defining the
social character (i.e. through equity modes) of IBs, wherein IBs presumably are enterprises
serving economic, legal, ethical and social goals. Researchers like Elgamal (2006) asserts it to
SSB up to the extent of calling them as Rent seeking shariah arbitrageurs, whereas
Ahmed.H (2011) pursues a rational approach limiting the SSBs to shariah compliance,
commissioning the maqasid based goals to be addressed by the board of directors in coherence
with corporate strategy and target market segments. The table below endorses the IBs
insistence on shariah compliance and performance driven market orientation for product
development with least consideration for Islamic values.

The interplay of SSB and BOD have unique implications on the overall Corporate Governance
to protect the right of stakeholders, notably the voiceless PSIAH (with no voting rights) and the
weak voiced minority shareholders, which give birth to a new specie of agency problem and
information asymmetries Grais et al. and hence add to complexities towards the deployment of PLS
modes on the liability side of an IB. The figure below schematically represents the unique corporate
governance mechanism, highlighting the role shariah audit to safeguard the interest of IAH and other
stakeholders.

Market Appetite of PLS modes

Khan T. 1995 provides an interesting explanation on the demand of PLS modes. On the asset side,
i.e. the relationship between the supply (bank) and demand (borrower) of funds, mature companies
tend to have a preference for Mark-up modes, to augment profit retention and re-investment
in growth; on the contrary entrepreneurial growth oriented companies are attracted towards PLS
modes. Given the dual pressure on their risk profile and CAR, IBs can only viably extend PLS mode
to mature companies. This mismatch contributes to overall lack of equity modes on the asset
side. Moreover the lack of information infrastructure leads to information asymmetry, which also
curbs sectoral and geographical diversity in IBs assets (Dar & Presley 2000).

PLS Modes in Real World Agency Theoretic Perspective

Dar and Presley (2000) and Ahmed H. 2002 elaborating on the agency theoretic analysis of the PLS
based modes, asserted the need of for the balance of incentive, management and controls to
mitigate agency conflict and the risk of moral hazard and information asymmetry, given the
disincentive to perform and under report profits. While Ahmed H. 2002 viewing it from a different
angle, insisted on the collateralization of PLS financing to address moral hazards. Dar & Presley
2000 further asserts that the incentive compatibility should be crafted, in a way that both the
counterparties stick to the terms of the contract an idea that resonates with the popular metaphor of
Skin-in-the-Game (Taleb N. et al 2012).

The table above highlights the significantly less incentive compatibility of the PLS modes which
may rationalize the reluctance of IBs towards them.

IBs Resilience in Global Financial Crisis: Give the devils its due
Despite of all the criticism, IBI stayed relatively immune to the contagion toxic effects of financial
crisis given its embeddedness in the real economy, when the worlds derivative assets were valued
around ten folds of the GDP of the world. Hence, the limitations IB model due to Shariah
Compliance turned in to a blessing in disguise by shielding it from speculative leverage, derivatives,
cross-investments and debt based securities.

So What Went Wrong?

The contemporary Islamic Finance is a result of political movement of the post-colonial Muslim
world, in pursuit of an economic system in line with their faith aspirations. Such transformation
warranted Islamization of knowledge vis--vis economic system. A review of the impediments
discussed in the previous sections, claim their origin in the transaction level which subsequently
can be mapped to the inadequacies on either cultural, organizational or institutional
formations, as framed by the New Institutional Economics (NIE) (Ahmed H. 2012)
The idea of the above discursive recourse wasnt to present an apologetic account of IBs inability
to pursue equitable modes, but to present a critical appraisal of the complexity of the matter.
It is the Failure of Islamization of Knowledge, that lead to failure of Islamization of economy. There
exists a unanimous consensus amongst scholars (Kuran, Kahf, Siddiqui, Zarqa cited from Ahmed.H
2012) on the irrational romanticism with the historical idealistic PLS modes, in absence of the
holistic theoretical framework and scientific knowledge. IBs today, is a pragmatist co-optation of
the secular finance resulted due to non-existent Islamization of knowledge as illustrated below
(Asutay M. Lecture):

Under the same strand of thought, Ahmed H. (2012) presents a cogent explanation of the lacklustre
ingenuity of the contemporary Islamic Finance, by attributing it to the marginal adaptation as against
intrinsic evolution, owing to stagnant knowledge creation based on Islamic ontological and
epistemological sources.

This reverse engineering approach of mechanistic determinism through the narrow

fiqhi/prohibitionist lens, coupled with limited product level commercial research to produce
Islamic analogue of conventional products can never serve the ideals of Islamic Banking.

Towards an Equitable Islamic Bank The Way Forward

Citing Mahmood Elgamal (2006) metaphor, IBs need a shift from Christian Shoe towards a fairly
priced and good shoe. This transition necessitates a collaborative multidisciplinary effort
towards original basic and applied knowledge creation following an Innovative engineering
approach, to shape in the orientation of the culture, institutions and organization formats. Only
this can potentially would built a congenial eco-system for an IB to pursue its social and ethical goals
based on Islamic Ethos. The role and organization of SSBs (preferably that of an independent and
national level) is enormous towards the transformation from Shariah Compliant to Shariah
Based Islamic Banking. SSB has to engage in innovative ijtihadi effort following a social
good/maqasid based approach for knowledge creation - to restore the ingenuity of form and
substance and win the confidence of the most important stakeholder i.e. Muslim client (the loyalist
as well as rational floater). Moreover, there is a need of joint ijtehad of financial economists,
academics, practitioners, jurists and shariah scholars to pursue a functional approach, instead of
product mimicry. This joint ijtehad should expand its footprint to test the viability of other
organizational format such as Non-profits, Mutual Cooperatives, Venture Capital and eventually
design Institutional arrangements for the efficient dissemination of the rewards of a just and
equitable financial Intermediation system.

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