Islamic corporate financing: does it promote profit and loss sharing?

• DOI: http://doi.org/10.1111/beer.12120
• Date: 01 October 2016
• Published date: 01 October 2016
• Author: Marizah Minhat,Nazam Dzolkarnaini

Islamic corporate financing:

does it promote profit and loss

sharing?

Marizah Minhat

1

and Nazam Dzolkarnaini

2

1. The Business School, Edinburgh Napier University,Edinburgh, UK

2. Salford Business School, University of Salford,Salford, UK

Islamic financing instruments can be categorised into profit and loss/risk sharing and non-participatory

instruments. Although profit and loss sharing instruments such as musharakah are widely accepted as the

ideal form of Islamic financing, prior studies suggest that alternative instruments such as murabahah are

preferred by Islamic banks. Nevertheless, prior studies did not explore factors that influence the use of

Islamic financing among non-financial firms. Our study fills this gap and contributes new knowledge in several

ways. First, we find no evidence of widespread use of Islamic financing instruments across non-financial firms.

This is because the instruments are mostly used by less profitable firms with higher leverage (i.e. risky firms).

Second, we find that profit and loss sharing instruments are hardly used, whilst the use of murabahah is

dominant. Consistent with the prediction of moral-hazard-risk avoidance theory, further analysis suggests

that users with a lower asset base (to serve as collateral) are associated with murabahah financing. Third, we

present a critical discourse on the contentious nature of murabahah as practised. The economic significance

and ethical issues associated with murabahah as practised should trigger serious efforts to steer Islamic

corporate financing towards risk-sharing more than the controversial rent-seeking practice.

Introduction

The presence of the Islamic finance industry in the

global capital market is increasingly acknowledged.

Unfortunately, the development of this industry has

not been without issues. In theory, profit and loss/

risk sharing has been accepted as the epistemological

foundation of Islamic finance because it is consistent

with the Islamic philosophy of promoting fairness

(Ayub 2007; Mirakhor & Smolo 2013). In practice,

the cornerstone of the growth in Islamic finance,

thus far propelled by governments and the strong

participation of financial institutions, has been

criticised for deviating from profit and loss sharing

(Warde 2000; Saleem 2005; Ayub 2007; Raphaeli

2009; Khan 2010). The divergence between theory

and practice is indeed an interesting issue (Rice

1999). This issue motivates us to explore the reality

of Islamic corporate financing with three research

questions in mind, as described below.

First, despite numerous positive claims regarding

the growing importance of Islamic finance (e.g.

Financial Times 2011), we still do not know to what

extent non-financial firms are using Islamic instru-

ments in corporate financing, and why. Prior studies

have mainly documented financing instruments

offered by Islamic banks (e.g. Aggarwal & Yousef

2000; Chong & Liu 2009; Khan 2010), but the litera-

ture falls short of providing empirical evidence on

the use of Islamic financing instruments by non-

financial firms. This gap in knowledge motivates us

to provide such empirical evidence as a novel contri-

bution to the literature.

Second, we question which type of Islamic financing

instruments is most used by non-financial firms, and

why. Appendix 1 summarises the different types of

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doi: 10.1111/beer.12120

482

Business Ethics: A European Review

Volume 25 Number 4 October 2016

Islamic instruments. While profit and loss sharing

instruments such as musharakah are mostly preferred

because they are consistent with the Islamic philoso-

phy of promoting fairness (Ayub 2007; Mirakhor &

Smolo 2013), the way that alternative instruments

such as murabahah is practised, has been criticised by

many learned scholars (Saleem 2005; Ayub 2007;

Khan 2010). Although previous studies have recog-

nised the preference of Islamic banks for offering mur-

abahah financing (Aggarwal & Yousef 2000; Chong &

Liu 2009; Khan 2010), it is still empirically unknown

which instrument is more often used among non-

financial firms. This gap in the knowledge motivates

us to identify the most commonly used Islamic instru-

ment and explore factors that might influence such

usage among non-financial firms.

Third, we question whether murabahah as prac-

tised can be considered ethically sound. This line of

inquiry is motivated by the prospect that Islamic

finance might be able to create a socially responsible,

ethical and stable financial system (Kayed & Hassan

2011; Ullah et al. 2014). Our critical discourse on

murabahah as practised aims to reinforce the signifi-

cance of the empirical evidence presented in this

study. This discourse is not unreasonable given that

a number of Sharia scholars, legal scholars, Islamic

finance practitioners and academics have also raised

ethical concerns about the current practice of mura-

bahah (Warde 2000; Saleem 2005; Ayub 2007;

Raphaeli 2009; Khan 2010). Fostering such concerns

is not inconsistent with socially responsible literature

(see, for example, Graafland et al. 2006; Ullah et al.

2014; O’Mara-Shimek et al. 2015). We believe that

more discourse of this sort can trigger serious efforts

to steer the Islamic finance industry towards the ideal

paradigmatic form.

Our study contributes new knowledge about the

reality of Islamic finance in several ways. First, we

find no evidence of widespread use of Islamic financ-

ing across non-financial firms, despite numerous

claims regarding the growing importance of Islamic

finance. We find that Islamic instruments penetrate

long-term financing more than short-term financing.

Our further analysis reveals that Islamic financing

allows highly geared, less profitable firms (i.e. risky

firms) to access further financing. This finding sug-

gests that Islamic financing seems to appeal to risky

firms, who would otherwise face difficulties in access-

ing additional conventional financing. This insight,

which has not been documented in prior studies,

enhances our knowledge about the significant role of

Islamic financing in helping risky firms in need.

Second, we find that the presence of profit and loss

sharing (i.e. musharakah) in corporate financing is

negligible, whereas the use of murabahah is preva-

lent. We discover that murabahah constitutes about

30% of corporate firms’ use of Islamic financing

instruments. Consistent with the prediction of

moral-hazard-risk avoidance theory (Aggarwal &

Yousef 2000; Ayub 2007), further analysis suggests

that users with lower tangible fixed assets (to serve as

collateral) exhibit a greater use of murabahah. This

observation implies that collateral deficiency dis-

incentivises financiers from sharing the risk (or

losses) of corporate firms that are susceptible to

managerial moral hazard. Financiers, in this case,

will secure a fixed return by pushing the use of mura-

bahah instead of offering profit and loss sharing.

This intuition, which has not been documented in

prior studies, advances our understanding of why

murabahah has become a preferred instrument in

Islamic corporate financing.

Third, we argue that murabahah can be abused so

as to camouflage riba-based financing that deviates

from profit and loss sharing theory. Although devia-

tion from this theory can help weakly collateralised

firms to access further financing, the prospect of riba

being camouflaged through murabahah should trig-

ger unreserved religious-based ethical discourse due

to the exploitative motives such a practice may

entail. Contentiously practised murabahah may also

trigger doubt on the ability of Islamic financing prac-

tice, in its current form, to offer a legitimate ethical

financing alternative.

The remainder of this paper is organised as fol-

lows. We first present the literature review that

includes the background on the Islamic finance

industry, the findings of previous studies and the the-

ories that motivate our research questions, and

detailed definitions of musharakah and murabahah.

Next, we examine the extent and nature of the

Islamic instruments used by non-financial firms. We

then empirically analyse the characteristics of users.

We also perform empirical analysis to elucidate the

popularity of murabahah financing. In the penulti-

mate section, we offer a critical discourse on

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Volume 25 Number 4 October 2016

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