TO AVOID riba, returns earned must be the result of one’s efforts or risk-taking. Thus, debt financing, which incurs little effort and no risk-taking since all risk is transferred to the borrower, is prohibited.

Despite this, many Islamic banks are comfortable with debt-based financing with only the labels changed.

Aside from terminology, there is little that is different between an Islamic bank’s balance sheet and those of conventional banks.

The preponderance of debt financing under the murabaha and ijara type contracts and the dearth of risk-sharing contracts like mudarabah and musyarakah are testimony to how far Islamic banks have gone to mimic conventional products and thereby deviate from their original rationale.

While not wanting to expose depositors to risk may seem altruistic, the truth may be that Islamic bankers and their shareholders want the easier way of shunning risk and remaining within their comfort zones.

While debt contracts shield the bank from the underlying business risk, they also prevent banks from benefitting from the upside potential.

The choice between debt and risk-sharing contracts boils down to the trade-off between risk and return.

Whether risk-sharing is worthwhile for banks is clearly an empirical question.

To understand how different the risk profile of Islamic banks and their depositors would be if risksharing instead of debt contracts were used, a study was undertaken using counterfactual analysis.

All 16 of Malaysia’s Islamic banks were examined over 2009 to 2015. The objective of the study was twofold. First, determine how much higher risk Islamic bank balance sheets would be subjected to; and second, determine whether the incremental return justifies the incremental risk.

The study essentially compared the current income of the Islamic banks with estimated returns that could be earned from risk-sharing instruments.

The returns were then stress-tested at different levels up to three times their baseline volatility.

For each Islamic bank, the financing amount by economic sector and income from such financing was retrieved from their financial statements.

The actual rate of return for each sector was determined by computing the returns of listed companies within the sector and taking the weighted average according to the bank’s portfolio.

AFRICAN ENERGY IMAGE

These proxy sectoral rates of return were then applied to the bank’s balance sheet. In addition to returns, the volatility and coefficient of variation were also computed.

The results showed for 14 of the 16 banks, risk-sharing financing would have produced returns that were two to three times higher. The real sector returns were indeed higher, however, the risk per unit return as measured by the coefficient of variation was lower for the real sector than that of the current financing form.

While risk-sharing finance would have exposed banks to higher risk, the incremental returns more than compensate for the additional risk.

The stress tests showed the risk-sharing model to be robust under different stress levels. What all these results imply is that the conventional thinking that risk-sharing would be unnecessarily risky for banks and their depositors is flawed.

If fact, Islamic banks may be doing a disservice to their depositors and stakeholders by not undertaking risk-sharing finance.

Given the historically low interest-rate environment and profit compression, moving into risk-sharing would make immense strategic sense and benefit shareholders and depositors.

While academic studies are often trivialised as being hypothetical and detached from reality, there is one real life example that Islamic bankers and policymakers cannot ignore: Rabobank of the Netherlands.

As a result of a consolidation of small agricultural cooperatives, Rabobank is today a global leader in food, agriculture and sustainability-oriented banking. What truly differentiates Rabobank from others is the extent of direct real sector investment it undertakes. It has innovated alternatives such as crowd funding and matching potential depositors directly with borrowers.

Such intermediation would make Rabobank more mutual fund rather than bank-like. Yet, going by Global Finance magazine, Rabobank was ranked among the World’s Top 50 Safest Banks for 2018.

Courtesy By: https://themalaysianreserve.com/