Prepared by the researcher : Dr. Abozer Magzoub Mohamed – International Islamic University of Malaysia IIUM – Institute of Islamic Banking and Finance
Democratic Arab Center
International Journal of Economic Studies : Twenty-third Issue – November 2022
A Periodical International Journal published by the “Democratic Arab Center” Germany – Berlin.
:To download the pdf version of the research papers, please visit the following link
As Islamic finance evolves and expands annually, Equity financing remains relatively small in size and practice. In Islamic finance, equity financing (risk sharing) has remained an oft-studied issue and focus of discussion since establishing Islamic financial institutions about four decades ago. This study explores the question, “what are the major issues and challenges facing the prevalence of Equity finance?”. Face-to-face interviews are employed to achieve the research objectives. The Central Bank of Sudan CBOS and Islamic banks in Sudan were contacted for this study. The researcher conducted 30 interviews with central bank staff (regulations and inspections), Islamic bank managers and Islamic scholars. The researcher employed Nvivo software to present the results. According to the study’s initial findings, supervisors believe that regulations, guidelines, objectives, and instructions support Equity finance. According to this study, Equity Finance is hard to follow up and monitor and directly impacts banks’ capital depletion if the finance defaults.
Governmental banks provide more equity finance compared to private commercial banks, which is usually because government banks have no pressure on profit distributions and the ability to restructure the capital. Following the data analysis, Nvivo concluded that four specific recommendations might help banks move toward equity finance. These recommendations include providing new guarantees for equity finance, knowledge and competence of commercial bank staff, and reducing the risk-weighted assets for Mudarbah and Musharkah. This study will be of significant value to national and international regulatory agencies as it explains why Islamic banks and financial institutions are unwilling to offer equity finance often instead of debt-based finance. However, the market needs for equity finance are higher.
In Islamic finance, equity financing (risk sharing) has remained an oft-studied issue and focus of discussion since establishing Islamic financial institutions about four decades ago. Arguably, the interest in equity financing – a combination of Musharkah, Mudaraba, and other variations based on these two. It is not by happenstance; Shari’ah advocates and recommends a system that promotes equitable wealth distribution and avoids excessive wealth concentration and deprivation in owning wealth. Since Riba (interest) is prohibited in Islam, equity financing seeks to avoid debt-related financing; in fact, the raison d’être for establishing Islamic financial institutions introduces a genuine mode of equity financing (Sadique, 2012). In this case, the Islamic financial services industry IFSI is expected to develop an impressive profit and loss-sharing modes as its central allocation tool to avoid interest (Farooq, 2007). Although sale contracts such as Murabaha and other sale contracts are also permissible under the Shariah parameter, the unique feature of Profit and Loss Sharing PLS in Musharkah and Mudarbah represents the paradigm of Islamic finance (Bing, 2008).
Moreover, financial institutions could extend funds to their clients through debt or equity financing. However, the former usage is more pronounced in practice than the latter since it will provide a more equitable finance mode that shares risk and rewards between both parties. While the conventional banking and finance system is principally founded on debt financing, these types of finance are supposed to be minimum in Islamic finance. The Basel Committee for Banking Supervision (BCBS) defines Equity Finance exposure as “Equity exposures are defined based on the economic substance of the instrument. They include both direct and indirect ownership interests, whether voting or non-voting, in the assets and income of a commercial enterprise or of a financial institution that is not consolidated or deducted” (Basel II (2006). International Convergence of Capital Measurement and Capital Standards, 2013). According to the abovementioned definition from BCBS, we can notice it is limited to the conventional type of equity financing. Hence, it is not similar to Equity financing in Islamic finance.
Islamic banking and finance are synonymous with interest-free and profit and loss sharing with distinct characteristics (Mohd. Ariffin, Kassim, & Abdul-Razak, 2015). However, the inapplicability of stare decisis of equity financing by Islamic banks is questionable. Usually, equity financing is less common than debt-based modes structured on various markup schemes, such as Murabaha, Ijarah, Istisna, etc. According to Jalil (2005), Islamic equity financing has dominated theoretical literature on Islamic banking and finance during its early stage. However, the actual up-to-date practice of Islamic banks seems to focus their financing approach on markup, commissioned manufacturing, or leasing. That can be attributed to the prevalence of conventional practice in the Islamic banking industry.
According to the researcher, no prior study has empirically determined the key issues and challenges facing equity finance in Sudan. This knowledge is the primary contribution of this research. As a result, the literature will take on a new dimension in several ways on how equity finance evolves. The supervisory authority has been interviewed on the role of supervisors in facilitating the utilisation of equity finance. It will also be utilised to describe equity finance practicality and various reasons hampering bankers from using this mode, which will result in a high degree of dependency on debt-based finance. The Board of Directors (BOD) is also responsible for designing risk tolerance and risk appetite for Islamic banks to increase their profits and maintain their capital adequacy according to the supervisory threshold. Fourth, this study contributes to the body of Islamic banking and finance knowledge by emphasising the importance of equity finance, allowing entrepreneurs and new customers access to financial services despite the lack of collateral and guarantees. Fifth, the study emphasises the need for flexible and resilient guidelines for Islamic banks to successfully execute equity finance, protect bank capital, promote access to finance, and acquire legitimacy from authorities and society that support the partnership and enhance innovations. Equity finance will increase access to finance and financial inclusion and facilitate small and medium enterprise schemes.
The inception of Islamic equity-based financing could be traced back to the pre-Islamic era of paganism (Jahilia) when equity-based financing (e.g. Mudaraba) was used as a standard investment vehicle. Especially by those people, such as soldiers, orphans, or government officials, possessed surplus funds but could not do the job themselves. During this period, Mudaraba was particularly common and was later approved by Islam. Similarly, the emergence of the Holy Prophet witnessed the prevailing practice of Musharkah in Arab commercial activities. Thus, this mode of financing was not only ratified by the Holy Prophet but carried out business based on Musharkah (Al-Harran, 1993; Hamoud, 1995; Sapuan, 2016).
Moreover, the prohibition of usury during the early stage of Islam was one of the basics of Muslim society. In particular, it has echoed the adoption of equity-based financing as the primary source of financing from Mudarib’s s perspective. Since the Islamic religion came with comprehensive guidelines for what is permitted to be done and what is not, all Islamic scholars from various schools of thought have accepted Musharkah and Mudaraba and their primary forms as recommended modes of financing (Hamoud, 1995; Sapuan, 2016). Hence, the classical practices of Musharkah and Mudaraba during the early period of Islam have provided the basis for the modern Islamic banks’ current formulae.
In addition, the emergence of financial intermediation and modern limited liability company that came with their unique features have raised requirements for Ijtihad to keep changing the formulae, according to Shari’ah, to meet the needs of modern commercial transactions. In addition, cooperation between Muslim brothers remains an essential value of Islam’s economic philosophy that focuses on ensuring justice, development, and growth. In short, the need to achieve the following (cooperation, modern financial intermediaries, etc.) has promoted the establishment of modern Islamic financial institutions to introduce a genuine mode of financing (Hamoud, 1995; Sadique, 2012; Sapuan, 2016). As discussed shortly, Islamic banks should play and provide funds to their entrepreneur for various business activities is an ultimate issue when considering a choice between equity-based financing and debt-based financing (Thomas & Thofeek, 2005). Any Muslim who wants to follow Islamic banking should also agree to the Islamic rules. The banking system should also include the implementation of Islamic Shariah. Since adherence to Shariah rules and principles are the standard practice adopted by all the Islamic banks in the country. Moreover, future entrepreneurs also need to be aware of the Islamic banking system and the Laws that should be followed. Therefore, there is no backlash between Islamic Shariah and standard banking operations.
Risk sharing is a fundamental principle in the Islamic economic system. The Islamic financial sector is built upon the Islamic economy. The provider of funds (usually Investment account holders IAH) channels funds to financial intermediaries based on profit and loss sharing. The loss-sharing mode is based on Mudaraba, and PLS Islamic banks accept deposits based on Wakalah, Qard and reverse Murabaha. Upon receiving the funds, financial intermediaries also forward them to the fund users partly based on profit and loss sharing (Mudaraba & Musharkah) and partly on sale finance (Murabaha, IMP, Salam). Islamic finance is tantamount to a participatory sport, where everyone participates in sharing the risk; this is to a certain extent different from conventional finance, which is risk-averse when a minority bears the risk, but the majority risks nothing (Al-Jarhi, 2004a, 2004b). This risk-bearing mechanism suggests that the Islamic economic system provides a platform beyond mere capital market integration between capital providers and entrepreneurs; however, a more prevalent financial market structure can reach macroeconomic goals with greater efficiency and stability (Al-Jarhi, 2017).
Moreover, risk sharing is almost absent in conventional finance. For example, on the resources incentivised side, customers provide customers to financial intermediaries based on Interest-bearing loan contracts; in return, both principal and interest are guaranteed on the customers’ deposits by the banks receiving deposits. Moving to the resource use side, banks will consider this finance as a liability on the entrepreneurship side, and he has to pay back the principal plus the interest regardless of his business success or not. Moreover, the conventional Bank is only involved in collateral risk, not entrepreneurship activities. In this case, using collateral has enabled banks to limit their monitoring of their borrowers without increment in default risks since the collateral will represent the first line of defence in case of default. Conventional banks are eligible to charge and compensate for any arrears even if there is a default. Stability and equitable growth challenges are arguably challenging to achieve through debt financing since one side will benefit from the expense of the other. Which transfers the burden of losses from financiers to entrepreneurs, even at microfinance levels, distorts economic incentives, increases systemic risk, and renders financial regulation more complex (Abbas Mirakhor & Nabil Maghrebi 2015)
A qualitative approach is used to understand Equity finance’s primary role and indicators (Moflih, 2016). Researchers used a variety of interpretative approaches to characterise, decode, and understand the meaning of certain more or less naturally occurring events that occur in the social environment rather than the frequency of their occurrence (Cooper & Schindler, 2011). “Qualitative research and case studies might provide answers to “what” inquiries, as well as “why” and “how” ones, in a more detailed and comprehensive manner” (Alam, Islam, & Runy, 2021).
It was decided to use semi-structured interviews to collect data and better grasp the study problem. Semi-structured interviews are when the interviewer asks a few questions that have been prepared but have some latitude in the questions (Dane, 1990). Due to its versatility, the researchers were able to investigate in-depth the respondents’ points of view, which resulted in a broader range of information in the replies (Dane, 1990). This approach allows respondents to express their thoughts based on their experiences and expertise (Saunders, Lewis, Thornhill, & Bristow, 2019). Due to its differences from the other interview methods, this one allows interviewees to express their perceptions of the supplied information or phenomena (Berg, 2004). It is also crucial for explaining and comprehending events and providing a more excellent grasp of respondents’ situations (Bryman & Bell, 2007).
The researchers conduct a face-to-face interview during the study process to clarify and better grasp the research questions. Face-to-face interviews allow participants to give more detailed replies. In qualitative research, this approach helps participants comprehend the questions and ensures their freedom while expressing their ideas (Gillham, 2000). In interviews with regulators, treasury managers, Shariah department executives, and investment specialists, issues and challenges in equity finance at Islamic banks have been explicitly addressed. As a result of the research study, 30 respondents were interviewed (Alam, Rahman, et al., 2021) and symbolically coded.
Research strategy is also a judgement that links research objectives and questions to processes for data collecting, processing, and the results of the data obtained (Yin, 2009). The Nvivo has been picked to evaluate transcriptions and other documents and improve data analysis (Gibbs & Su, 2002). The Nvivo programme is used for initial coding, categorisation, and theme creation from the collected data (Strauss, 1987; Alam, 2020). Additionally, it allows for a more environmentally friendly data administration approach than the traditional paper and pencil method (Alam, Rahman, et al., 2021).
For this study, the researcher travelled to Sudan and had to go to the respondents’ workplaces for the interviews. The respondents were located in Khartoum, Sudan’s most significant financial and industrial city, the country’s capital city. The interview was performed in the lapse of four months. The lists of respondents were in total of 30. R1 through R30 have been allocated to the respondents as pseudonyms to protect confidentiality. The average age of the interviewees was 46, with 12 of them holding managerial roles and 5 being an investment and treasury experts. 15 respondents were from full-fledged Islamic banks, 15 came from the supervisory authority, and they were from banking regulations and supervision (on-site & off-site). All managers are mature enough to comprehend the concepts of equity finance, risk-weighted assets RWA, Risk Perception, and capital adequacy calculations.
As Nvivo required coding for each item, themes or nodes coded to present the text instructively were identified. In data analysis, themes are unique patterns across data sets related to a particular study issue (Fereday & Muir-Cochrane, 2006). According to the code, we have most of the themes from the role of the supervisory authority in promoting equity finance (N=28) from all the respondents. Then there are 51 and 49 references regarding the role of risk weights attached to equity finance and monitoring and following equity finance. Cash outflows and impact on banks’ NPFL and profits are fourth and fifth, with 30 and 41 references, respectively. The primary themes are bold, and there are several sub-themes within them. Each node includes a description of the theme’s sources and references. There are some variations in language because one theme was designed for supervisors while the other was designed for the market players.
There are four major issues and challenges, as determined by Nvivo’s data analysis of the interviews. The first theme, Current Investment Situation, explained the first three objectives, which focused on the current practice of Equity-Based financing in Sudan and what are the challenges preventing Islamic banks from moving Equity-Based financing to their main banking businesses, in addition to the impact of equity-based financing on the Bank’s capital and the level of contribution to the NPLF. The answers from both informants, regulators and supervisors came in different sub-themes, which mainly focused on current practice, investment behaviour, the main challenges and the impact on the Bank’s profit. Nvivo detected a theme and categories.
Respondents’ perspectives on issues and challenges in promoting equity finance for Islamic banks in Sudan are presented in this framework. According to the literature, Islamic finance principles have a unique and specific feature: risk-sharing on the assets via equity finance and liability via profit-sharing investment accounts. Therefore, the economic system where true risk-sharing exists is the Islamic economic system, where risk-sharing is considered its primary feature. In this economic system, risks are shared from resource incentives to when resources are channelled to the users (Khalifa. M, 2016). This sharing methodology is not the same in conventional economies, where significant financing portions are issuing government and household debt instruments and borrowing from banks (Khalifa. M, 2016)). In the following lines, many responders address the notion of risk-sharing:
“We usually explain to the customer of the PSIA the risk surrounding his investment and how he can opt for deposit insurance to mitigate the risk of losing the capital. For the investment of PSIA in equity finance, usually at our Bank, we create a pool of investment that includes (a current account, investment account, saving account and shareholder’s capital), and then we invest in various activities. We do not specify each account to a specific investment mainly because the Bank will use the pool available for investment regardless of its source and cannot link it to specific finance unless it is a restricted investment account. Nevertheless, the profit margin will differ according to each category (current, investment or saving account), but we commingled all the funds in one pool when we used these accounts‘ (R5)
“The practical practice in financing Murabaha in Sudanese banks is represented in the customer’s request from the Bank to buy specific commodities and sell them to the customer in instalments. With an additional amount to them as a profit to the Bank under a contract of sale of the commodity with a specific profit agreed upon in advance by the two parties, the original purchase price is added. This practice is carried out in its current form for all receivables Postponed sales” (R9)
“This can be considered an advantage for equity finance, and it provides a significant time for banks and the customer.” (R11)
“Islamic banking in Sudan back to 1983. However, it started in 1994 through many circulars that explained various standards, and the banking act established the Shariah governance and Shariah framework. The most common mode discussed was Murabaha for Purchasing Order MPO since normal Murabaha was not allowed because pure Murabaha will make banks look like traders.” (R16).
Equity finance risk-weighted assets and their implication on how this mode can be used were discussed in this section. According to (Maha Mehmet 2017), when it comes to specific contracts, the equity financing contracts that usually attract higher RWA play a vital role as an early warning indicator for increasing NPLF since it reflects the high-risk level of the finance portfolio.
“Murabaha has only default risk (credit risk), but the principal and profit will remain. However, for equity finance, the banks might lose their capital and also the issue of market risk in Musharkah assets.” (R11)
“The current practice does not help in identifying high-risk operations before and during implementation due to many factors, the most important of which are: the difficulty of accurate assessment of the risk, the credibility of the customer, and technical issues that are not available for banks to measure and monitor risks, and the lack of accuracy of the actual activity and its size until after a long period in which signs of failure or weakness appeared, and thus weakening The possibility of determining the weight of the risk promptly.” (R13)
This is due to the customer’s experience and how he manages the Musharkah or Mudarbah, which leads to profit or loss, as the Bank’s intervention in the management is less than the clients. At the same time, the losses fall on the bankside in Mudarbah and according to the participation in Musharkah. As for Murabaha, there are sufficient guarantees of up to 125% of the value of the financing, and they are liquidated in case the client defaults, so it takes fewer risk weights.” (R17).
Another issue discussed was the absence of equity finance and its impact on entrepreneurs and new customers. The emerging Islamic Financial Services Industry (IFSI) is being championed as an ideal alternative to the interest-based conventional financial system and an authentic way out of the looming impasse of interest rates and leveraging debt. Islamic financing, mainly through Profit and Loss Sharing PLS contracts, is prescribed as a cure for the ills of debt-based finance and an opportunity for entrepreneurs to share, rather than bear, the risk of starting new businesses and expanding existing ones (Rasem. Kayed, 2012).
“Usually, equity finance is not an easy option for small customers or entrepreneurs, as the Bank fears providing this mode to customers without experience. Hence, banks provide equity finance solely to excellent customers with long experiences and good financial positions.” (R7)
“The entrepreneurs are the most affected parties since this type of finance serves the development of the business sector more than others. As for new clients who do not have guarantees, this does not seem to be accurate in reality because the issue of guarantees in Musharkah covers misconduct, negligence or breach of contract terms. Moreover, it does not need to provide a guarantee in the ordinary meaning, and the Rab al-mal (the Bank) does not require a guarantee for the capital. As for the Musharkah, the capital is paid with agreed shares. The guarantee is not an obstacle that prevents implementation (also within the limits of the misconduct, negligence or breach of contract terms). (R9)
Based on the above discussion, it is concluded that reducing the risk weights of equity finance is very important for promoting equity finance among Islamic banks in Sudan. An innovative collateral and guarantees system to assist banks in covering the lack of collaterals in equity finance will promote equity finance among Islamic banks. We have an updated information system where banks can use this information to decide customers’ integrity and credibility.
This study explores the question, “what are the issues and challenges facing Islamic banks when implementing equity finance?”. Face-to-face interviews are employed to achieve the research objectives. The central Bank and Islamic banks in Sudan were contacted for data for this study. Nvivo concluded that four distinct roles affect the promotion of equity finance among Islamic banks. These roles include providing new guarantees for equity finance, knowledge and competence of commercial bank staff, and reducing the risk-weighted assets for Mudarbah and Musharkah. Currently, Mudarbah got an RWA of 400%, while Musharkah can be 300% if it is in the listed project while unlisted projects can be assigned 400%, which is considered a very high weight compared to Murabaha or Ijarah. Promoting equity finance is essential since these contracts are unique for IIFS. Efforts are needed for an Islamic financial system to move away from debt-based finance and stand different from the conventional system; equity finance issues and challenges must be addressed and resolved by supervisors and market players.
AbdHalim, N., AbdRajak, A. A., & Jaaman-Sharman, S. H. (2016). Bai Bithaman Ajil (BBA) modelling by Qardhul Hasan. American Institute of Physics, 1750(30001), 1–5. https://doi.org/10.1063/1.4954537
Abdul-Rehman, A., Benamraoui, A., & Dad, A. M. (2017). Empirical evidence from Pakistan is a comparative study of Islamic and conventional banks’ risk management practices . Journal of Banking Regulation. https://doi.org/10.1057/s41261-017-0046-z
Abu Ghuddah, A. (1998). Ijarah ( Lease ). Technical Report. Retrieved from http://www.albaraka.com/media/pdf/Research-Studies/RSIJ-200706201-EN.pdf
Ahmad, S., & Abdul-Rahman, A.-R. (2012). The efficiency of Islamic and conventional commercial banks in Malaysia. International Journal of Islamic and Middle Eastern Finance and Management, 5(3), 241–263. https://doi.org/10.1108/17538391211255223
Al-Harran, S. (1993). Islamic finance : partnership financing. Petaling Jaya: Pelanduk Publications (M) Sdn Bhd.
Al-Jarhi, M. A. (2004a). Islamic Finance: An Efficient & Equitable Option. Jeddah: Islamic Research and Training Institute. Retrieved from http://www.developmentandfaith.org/uploaded-files/research-archives-pdf/1214327934.mabid.pdf
Al-Jarhi, M. A. (2004b). Remedy For Banking Crises: What Chicago and Islam Have in Common. Islamic Economic Studies, 11(2), 23–42.
Al-Jarhi, M. A. (2017). An Economic Theory of Islamic Finance. ISRA International Journal of Islamic Finance, 9(2), 117–132. https://doi.org/https://doi.org/10.1108/IJIF-07-2017-0007
Amuda, Y. J. (2015). Current Issues in Islamic Banking and Finance. International Journal of Economics, Commerce and Management, III(4), 1–15.
Aoki, M. (2013). The contingent governance of teams: analysis of institutional complementarity. In Comparative Institutional Analysis (pp. 230–249). Cheltenham: Edward Elgar Publishing. https://doi.org/doi: 10.2307/2527079
Ariff, M. (2017). Islamic Banking in Malaysia : The Changing Landscape. Institutions and Economies, 9(2), 1–13.
Arshad, N. C., & Ismail, A. G. (2011). Regulation on the Parameterized of Mudarabah Contract: a Critical Analysis. International Journal of Economics and Research, 2(3), 157–189. Retrieved from http://www.ijeronline.com
Askari, H., Iqbal, Z., & Mirakhor, A. (2009). New Issues in Islamic Finance and Economics: Progress and Challenges. John Wiley & Sons (Asia) Pte. Ltd. https://doi.org/10.1017/CBO9781107415324.004
Asutay, M. (2007). The conceptualisation of the Second Solution in Overcoming the Social Failure of Islamic Banking and Finance : Examining the Overpowering of Homoislamicus. IIUM Journal of Economics and Management, 15(2), 167–195.
Azmat, S., Azad, A. S. M. S., Ghaffar, H., & Bhatti, I. (2015). Why is interest-free Islamic banking not free from interest ? Melbourne: Deakin University.
Bank Negara Malaysia. (2013). Shariah Requirements, Optional Practices and Operational Requirements of Musharakah. Kuala Lumpur.
Bank Negara Malaysia. (2015). Shariah Requirements, Optional Practices and Operational Requirements of Mudarabah. Kuala Lumpur.
Beck, T., Demirgüç-Kunt, A., & Merrouche, O. (2013). Islamic vs conventional banking: Business model, efficiency and stability. Journal of Banking and Finance, 37(2), 433–447. https://doi.org/10.10
3). Bank vs bond financing over the business cycle. Economic Synopses, (31), 1–3.
Cox, K. C., Lortie, J., & Stewart, S. A. (2017). When to pray to the angels for funding: The seasonality of angel investing in new ventures. Journal of Business Venturing Insights, 7(February), 68–76. https://doi.org/10.1016/j.jbvi.2017.03.003
Creswell, J. W. (2009). Research design: Qualitative, quantitative, and mixed methods approach (3rd ed.). Thousand Oaks,
Elmi, N. A. (2012). Equity-Based Versus Debt Based Financing: Current Practice of Islamic Banks – A Critical Review From Shariah and Socio-Economic Perspective. Insaniah University College Kedah. Retrieved from http://www.academia.edu/download/35235239/Equity_Vs_Debt_based_financing_-_Thesis.pdf
Siddiqui, S. H. (2002). Islamic Banking: True Modes of Financing. Journal of Islamic Banking & Finance, 19(2), 11–24.