Islamic Banking: Sharing Risk For Caring Society

The only certainty in this world is ‘uncertainty.’ Risk is an integral part of our daily life, which can’t be avoided fully but can be minimized and shared. To have a harmonious society, people with sharing and caring minds is a must. If we care about others and vice-versa it will be a win-win game and a congenial ambiance will lead toward a peaceful society craved by all of us.

I don’t know if there is any business having 100% guarantee of running on profit all the time. When the business cycle has expansion or boom, the borrowers can pay back the money smoothly and there is no point of sharing the risk but the profit only. The bank is happy to have the fixed rate of return without any risk. May be, the borrowers are also happy as they are earning 30% and giving only 10% to the bank. Almost everything seems to be in order then. On the other hand, when there is any recession or trough, the borrowers face difficulty in paying back the loan to the banks smoothly which is very innate and realistic. Here the banks show an impractical approach by creating pressure for recovery which further deteriorates the business health so far. The sustainable approach could have been; let’s share both the profit and loss together. Here lies the necessity of Profit and Loss Sharing (PLS) banking.

Change is permanent though not necessarily better all the time. Transformation in living status can change the disciplines we are taught in schools, colleges, or universities. The world has already experienced a number of economic systems, i.e., mercantilism, feudalism, socialism, and capitalism etc. The entry of one system with a view to addressing the real needs of the people causes the exit or refinement of earlier one. The incompatibility of a system with the reality of contemporary human requirements ensues the thinking from different perspectives. In mercantilism, trade was a zero-sum game; a nation can gain in international trade only at the expense of other nations. In capitalism, trade is considered to be a positive sum game; both the nations can gain. Before and during the great depression, it was believed that the less government intervention, the better. In late 1930s it was felt that government intervention should be welcome and idea of fiscal policy came in. In course of time, fiscal policy seemed to be insufficient and monetary policy evolved. Later on in 1970s supply side economics came into existence. All those evolutions were the demands of time. In reality human behaviors, tastes, and preferences play the central roles being considered in formulating viable policies, rules and guidelines for ensuring a sustainable development of a society. The bottom line is if a system can’t address the real needs of the human beings for whom the whole world has been created by God, that system is bound to go. May be for that very reason the proverb goes like, ‘Necessity knows no laws.’ Unfortunately, most of the times for tackling a very small number of wrong doers the laws are created inhibiting the large number of civilized people to enjoy their bona fide and logical demands comfortably. At the end the honest people go dissatisfied. May be for that very reason more laws in some way indicate less trustworthiness in a society so far.

Now, if everything changes over time, should there be any universal principle(s) not to compromise in any kind of changes? To address this question another core question we may ask ourselves ‘what is the main purpose of being in this world?’ The answer will depend on whether the respondent is a theist or an atheist. Let’s assume we all believe in existence of almighty God, the hereafter to encounter a trial on the basis of activities in this world, and provision of the hell and the paradise. Let’s take for granted that our purpose is to become happy in this world and be allowed for the heaven in the hereafter. Given that, globally renowned think-tanks from economists to spiritual leaders are thinking about national well-being measurement system should it be GDP (Gross National Product) or GNH (Gross National Happiness)? Our neighboring country ‘Bhutan’ is already way ahead in this initiative. There is a direct relationship between the level of development in a financial system and economic development in general. Banking industry of our country has 2.67% contribution in GDP. Let’s not underestimate this contribution overlooking the point that banking is an intermediary business. Apart from this direct contribution in GDP, this industry has a significant indirect role through financing in literally each and every sector of the economy. Of course, the main source of this finance is not the banks’ equity rather the deposits from individuals. Banks have just mediated the whole process.

There are two main groups in every society, those who have surplus money but are not able to or do not want to invest on their own and those who are able to operate as producers, but do not have enough money to invest. Here lies the existence of a third party shouldering responsibility of collecting surplus money from savers/depositors and allocating it to producers/borrowers. However, since there is an interest rate, ‘riba’, in mainstream banks, which is prohibited not only in Islam rather in all major religions of the world. Some Islamic scholars and entrepreneurs initiated to establish a new banking system which is able to carry out the main functions of banks without the problem of riba.

In existing typical or mainstream model, banks don’t share any risk with the borrowers. Then, can we blame only the banks for that? The answer will not be a resounding ‘yes’ or ‘no’ rather it depends. To answer this question we must bear it in our mind that banking is a go-between business. Risk sharing has close relationship with ownership. In mainstream banking, the source of fund i.e. deposit is not based on sharing risk principle rather the depositors are assured of receiving fixed rate of interest irrespective of interest earned by the bank from credit disbursement. Here the loan, bank disbursed, doesn’t belong to the banks rather to the depositors. Without having the ownership how much logical it is for banks to share the risk of credit? Due to difficulties faced by the debtors if banks want to share the risk and incur loss, the owners i.e., depositors must agree foremost. Otherwise, they will hold the bankers liable for that loss. Consequently, the bank will encounter more severe trouble to trade off that loss because by nature banking industry is highly leveraged as the equity of a bank compared to deposit amount is much less i.e. about 90% of a bank’s fund is from depositors.

On the contrary, in the contemporary Islamic banking both in our country and abroad the source of fund is mostly based on PLS basis. Here in Islamic banking, the relation between the bank and the depositor is not a mere debtor and creditor rather like business partner. The depositor is providing the fund and the bank is engaging labor. Furthermore, they agree to share the income generated from investing that fund according to their mutually agreed proportion. If there is any loss, bank will lose its labor invested and the funder/depositor will lose his/her money.

In case of deploying fund, Islamic banks across the globe mostly practice mark up based financing a.k.a. Bai mechanism. In this principle an Islamic bank buys goods as per the specification of the client and sells the same adding some margin or mark up with the cost price of the product. Like other real life buying and selling, there is no scope of sharing the risk because the bank has already sold out the goods and the ownership has also been transferred. In existing 8 full-fledged Islamic banks, 18 Islamic banking branches, and 24 Islamic banking windows of our country it is seen that of total investment/lending 69.13% is under buying & selling i.e. Bai principle, 22.34% under lease financing, 2.10% under quard, 4.77% others and only 1.66% is under Profit and Loss Sharing/partnership basis i.e. musharaka and mudarabah principles.

In some aspects, this interest free mark up based Islamic banking system is doing better than mainstream counterpart like ensuring proper use of fund through real asset backed transactions, and speculation free dealings etc. In risk sharing perspective, both the mainstream banks and mark up based Islamic banks play the same role; they don’t share the risk. The mainstream banks can’t even think of sharing risk with the borrowers unless their source of fund is based on PLS. In this regard, certainly, Islamic banks have some edge over mainstream banking as they have fund based on PLS principle. The economists plausibly believe through Profit and Loss Sharing (PLS) model Islamic banking has a more important role to play than mainstream banking systems to build a sustainable financial market.

This scenario triggers a very logical question; if deposit is collected based on PLS principle why not fund deployment or investment on the same principle? As the source of fund in Islamic banking is based on sharing risk motto, through PLS mechanism, this investment risk should have been shared more effectively. If there is a demand of investment based on PLS and there is fund in Islamic banks mobilized under PLS principle, why isn’t this practiced by the Islamic banks? This very basic question may make us rethink how much demand is there? Firms taking loan from mainstream banks and mark-up based Islamic banks can enjoy tax facilities because they pay corporate tax after deducting the bank interest/profit. Now, if any firms take equity financing through this PLS mode of Islamic banking, they can’t enjoy the same. However, if there is any loss in the business, the firms can enjoy the benefits of this equity based financing as they don’t have to pay any profit to the bank. Islamic banks interested to explore the PLS banking encounter a complex situation when they see that, firms prefer debt/mark up based funding to equity based funding if there is chance of higher profit but they prefer equity based funding to debt/mark up based funding if there is chance of less profit. They also feel discouraged to go for PLS financing when there is doubt of transparency in business reporting by the clients. Of course, there are some ways to settle these issues and more to discover. The tax authority needs to consider the issue positively for the betterment of the society at large.

Venture Capital can be one of the options for practicing investment based on PLS principle in Islamic banking. This venture financing is very helpful for promoting the entrepreneurship in our country. Silicon Valley, the technology capital of the world, has been blessed with this venture financing model. Today’s giants like Microsoft, Google, and Apple, were once financed by this venture capital. Good to know that, Venture Investment Partners Bangladesh Limited (VIPB), and BD Venture Ltd., have already launched their activities in our country. Some mainstream banks, NBFIs, and insurance companies have joined them as corporate shareholders. Islamic banks can explore this avenue too.   

As there is difference in fundamental principle of Islamic banking, the regulation should also be in line with that differentiation. Same rules and regulations will not fit for both the mainstream and Islamic banks so far. Unlike mainstream banks, in Islamic banks the source of fund is based on PLS system. So, the Capital Adequacy Ratio (CAR) requirement for Islamic banks need not be the same as for mainstream banks.

Sharing both the profit and loss for caring society can’t be one way traffic rather two-way like give and take. To have a harmonious peaceful caring society, all of the stakeholders must come forward like individual piece of an entire puzzle. If one piece deliberately lapses, the system does not work properly. The fact is to introduce the Profit and Loss Sharing based bank financing, all concerned must do their respective parts. For building a caring society through risk sharing based banking, as the supply side is apparently ready, now is the time for demand side to embrace it. To make this demand and supply side fully ready for this sustainable banking model, Islamic banks’ major role is to educate them properly. When this is done the regulators have no reason to discourage it at all. Rules and laws are not anything final and unchangeable. To me, the regulatory issues will not be any problem at all. Rather, for building a caring society through PLS based banking, the authorities concerned have every reason to welcome it warmly through providing necessary legal and regulatory support. Given that, we may have a caring society full of people sharing the risk of others; let’s not forget ‘together we build, divided we fall.’

(The opinion expressed in the article is the writer’s own and not that of the organisation  he is working for.)

Md Nurul Islam Sohel, R&D, Islami Bank Bangladesh Limited, is pursuing Executive MBA at IBA (DU).

Originally published on www.thefinancialexpress-bd.com