Dilemmas and Challenges in

Islamic Finance

The phenomenal growth of Islamic finance in the last few decades has been
accompanied by a host of interesting questions and challenges. One of the critical
challenges is how Islamic financial institutions can be motivated to participate in
the ‘equity-like’ profit-and-loss sharing (PLS) contracts. It is observed that Islamic
banks are reluctant to participate in the pure PLS scheme which is manifested by
the rising concentration of investment on murabaha or mark-up financing. This
phenomenon has been the hotbed of academic criticism on the contemporary
practice of Islamic banking. This book explains the ‘murabaha syndrome’ in light
of the incentive provided by the current institutional framework and what are the
changes required in the governance structure to mend this anomaly.

Yasushi Suzuki is Professor at the Ritsumeikan Asia Pacific University, Japan.

Mohammad Dulal Miah is Assistant Professor at the University of Nizwa, Oman.

Islamic Business and Finance
Series Editor: Ishaq Bhatti

There is an increasing need for western politicians, financiers, bankers, and indeed
the western business community in general to have access to high quality and
authoritative texts on Islamic financial and business practices. Drawing on exper-
tise from across the Islamic world, this new series will provide carefully chosen and
focused monographs and collections, each authored/edited by an expert in their
respective field all over the world.
The series will be pitched at a level to appeal to middle and senior management
in both the western and the Islamic business communities. For managers with
a western background the series will provide detailed and up-to-date briefings
on important topics; for the academics, postgraduates, business communities,
or managers with western or Islamic backgrounds the series will provide a guide
to best practice in business in Islamic communities around the world, including
Muslim minorities in the west and majorities in the rest of the world.

Islamic Financial Economy and Islamic Banking

Masudul Alam Choudhury

God-Conscious and the Islamic Social Economy

Masudul Alam Choudhury

Labor in an Islamic Setting

Edited by Necmettin Kizilkaya and Toseef Azid

Islamic Macroeconomics

A Model for Efficient Government, Stability and Full Employment

Raja Almarzoqi, Walid Mansour and Noureddine Krichene

Dilemmas and Challenges in Islamic Finance

Looking at Equity and Microfinance
Edited by Yasushi Suzuki and Mohammad Dulal Miah

For more information about this series, please visit www.routledge.com/

Islamic-Business-and-Finance-Series/book-series/ISLAMICFINANCE
Dilemmas and Challenges in
Islamic Finance
Looking at Equity and Microfinance

Edited by Yasushi Suzuki and

Mohammad Dulal Miah
First published 2018
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Contents

List of figuresviii
List of tablesix
List of contributorsxi
Forewordxii
TUN ABDULLAH AHMAD BADAWI

Forewordxiii
PROFESSOR DR MOHAMMAD HASHIM KAMALI

Forewordxv
DATUK DR MOHD DAUD BAKAR

Prefacexvi
YASUSHI SUZUKI AND MOHAMMAD DULAL MIAH

Acknowledgementsxvii

Introduction 1
YASUSHI SUZUKI AND MOHAMMAD DULAL MIAH

PART I
Dilemmas and challenges on the prohibition of riba
and gharar9

  1 Heterodox vs. Islamic views on interest and uncertainty:

Commonalities and contradictions 11
YASUSHI SUZUKI AND MOHAMMAD DULAL MIAH

  2 A critique to a naïve critique to ‘murabaha’ ‘tawarruq’ syndrome 28

MOHAMMAD DULAL MIAH AND YASUSHI SUZUKI
vi Contents
  3 An inquiry into the scope of ‘acceptable’ gharar 45
MOHAMMAD HASHIM KAMALI, YASUSHI SUZUKI AND MOHAMMAD
DULAL MIAH

PART II
Issues in Islamic equity finance and microfinance59

  4 Altruism and reciprocity in Islamic equity fund: New

Institutional and philosophical speculations 61
YASUSHI SUZUKI AND MOHAMMAD DULAL MIAH

  5 Anatomy of Islamic venture capital: Typology of Bahraini/

Indonesian Islamic venture capital 77
YASUSHI SUZUKI, A. K. M. KAMRUL HASAN AND SIGIT PRAMONO

 6 Sukuk environment and challenges in Bangladesh and

Malaysia (with the supplement of the Japan-sukuk case) 95
S. M. SOHRAB UDDIN, NAHID AFROZ AND YASUSHI SUZUKI

  7 A comparative study between the Grameen and Islamic

modes of microfinance in Bangladesh with reference to
Islamic microfinance in Pakistan 111
YASUSHI SUZUKI, HELAL UDDIN AND MOHAMMAD DULAL MIAH

  8 An impact assessment of Islamic Saving–Loan and

Financing Cooperatives in Indonesia: Preliminary findings
from the artificial neural networks technique 127
YASUSHI SUZUKI, SAIFUL ANWAR, SIGIT PRAMONO AND TRISILADI
SUPRIYANTO

PART III
Dilemmas and challenges in governance structure145

  9 Anatomy of governance structure in the mode of Islamic

finance: An emphasis on the governance over Shari’ah boards 147
YASUSHI SUZUKI, SIGIT PRAMONO AND ONI SAHRONI
 Contents vii
10 A comparative study on Shari’ah compliance frameworks:
Is the integrated or separated model well suited to Bangladesh? 163
S. M. SOHRAB UDDIN, ASIF NAWAZ CHOWDHURY AND YASUSHI
SUZUKI

11 Alternative views upon the ‘division of work’ and

‘specialization’ towards a new mode of profit–loss sharing 177
YASUSHI SUZUKI AND MOHAMMAD DULAL MIAH

Conclusion 190
YASUSHI SUZUKI AND MOHAMMAD DULAL MIAH

References194
Index212
Figures

4.1 NIE (TCE) framework explaining anomaly of Islamic

venture capital71
5.1 VCBB’s net profit (US$ million), return on capital, total
investment to total assets, and leverage from 2006 to 201687
5.2 Comparison of total asset of PNM, PNM Venture Capital, and
PNM Ventura Syariah in 2016 and 201591
5.3 Comparison of total financing of PNM, PNM Venture Capital,
and PNM Ventura Syariah in 2016 and 201591
5.4 Comparison of total revenue of PNM, PNM Venture Capital,
and PNM Ventura Syariah in 2016 and 201591
5.5 Typology of Islamic financial institutions including Islamic
venture capital firms93
6.1 Malaysian Sukuk issuance101
6.2 Sukuk mechanism in Bangladesh104
6.3 Sukuk mechanism in Malaysia104
6.4 List of significant guidelines and practice notes on Sukuk105
8.1 Portion of MSME financing in Indonesia’s Islamic banks129
8.2 The networks training process142
8.3 The validation evidence of artificial neural networks performance143
9.1 Multiple principal–agent structure in the mode of Islamic finance149
Tables

2.1 Lending (financing) structures of Islamic banks35

2.2 Financing income of Islamic banks36
2.3 Income from murabaha (in percentage) of different Islamic
banks in Bangladesh and Indonesia37
2.4 Income share of murabaha of Islamic banks in Malaysia and Pakistan38
3.1 Comparison of the post-Keynesian view and the Islamic mode
of investment of looking at animal spirits against uncertainties in
enterprise and speculation52
5.1 Differences between Islamic microfinance and VC78
5.2 VCBB’s total asset concentration88
5.3 Comparison of total asset and total financing of the banking
industry, Venture Capital Company and PNM in selected years90
5.4 Comparison of selected financial performance of PNM, PNM
Venture Capital, and PNM Ventura Syariah in 2016 and 201592
6.1 Sale, financing, and net outstanding amount of BGIIB99
6.2 List of major government and corporate Sukuk securities
in Malaysia100
6.3 Basic aspects covered by the guidelines103
7.1 Performance of Grameen Bank115
7.2 Loan disbursement and outstanding trend in MF sector116
7.3 Purpose, period and ceiling of investment117
7.4 RDS performance from 2012–2016117
7.5 Microfinance industry in Pakistan122
7.6 Performance in NRSP-MB123
7.7 Share of Islamic advances in NRSP-MB123
8.1 PPI scorecard for Indonesia133
8.2 Statistical description of parameters134
8.3 KSPPS-BMI members’ PPI score and PPP upon the
international standard138
8.4 KSPPS-BMI members’ PPI score and PPP upon the national
standard139
8.5 Comparison of statistical description for each parameter139
x  Tables
  8.6 KSPPS-BMI members’ PPI score and PPP upon the KSPPS
standard140
  9.1 Comparison of the governance mode over Shari’ah board
between Malaysia and Indonesia152
10.1 Separated model in GCC countries167
10.2 Integrated model in Malaysia, Pakistan, Sudan, and Indonesia168
10.3 Initiation of and experience in Islamic banking by different types
of banks169
10.4 Number of meetings and change in members of SSB of full-
fledged Islamic banks170
10.5 Number of banks registered in CSBIBB171
10.6 Involvement of the members of CSBIBB in banks engaging in
Islamic banking172
10.7 Nature of involvement of the members of CSBIBB in banks
offering Islamic banking172
10.8 Issues associated with the Shari’ah compliance framework of
Islamic banks in Bangladesh173
A1 Criteria for selecting members for SSB of Islamic banks175
A2 AAOIFI compliance items176
Contributors

Editors and contributors

Yasushi Suzuki is Professor at the Ritsumeikan Asia Pacific University, Japan.

Mohammad Dulal Miah is Assistant Professor at the University of Nizwa, Oman.

Contributors

Nahid Afroz is a graduate student at University of Chittagong, Bangladesh.

Saiful Anwar is Vice Director of the Postgraduate Program on Islamic Finance
at STIE Ahmad Dahlan, Jakarta and member of Risk Oversight Committee of
PT. Bank Rakyat Indonesia Syariah, Indonesia.
Asif Nawaz Chowdhury is a graduate student at University of Chittagong,
Bangladesh.
A. K. M. Kamrul Hasan is a doctoral student at the Ritsumeikan Asia Pacific
University, Japan.
Mohammad Hashim Kamali is Professor and founding CEO of International
Institute of Advanced Islamic Studies (IAIS), Malaysia.
Sigit Pramono is Chairman of SEBI School of Islamic Economics and Lecturer
at University of Indonesia, Indonesia.
Oni Sahroni is Lecturer at SEBI School of Islamic Economics and member of
Dewan Syariah Nasional (National Syari’ah Board) at the Majelis Ulama Indo-
nesia (Indonesian Ulama Council), Indonesia.
Trisiladi Supriyanto is Shari’ah board member of Koperasi Syariah Benteng
Mikro Indonesia and Lecturer at Universitas Ibnu Khaldun, Indonesia.
Helal Uddin is a doctoral student at the Ritsumeikan Asian Pacific University,
Japan.
S. M. Sohrab Uddin is Professor at University of Chittagong, Bangladesh.
Foreword

Islamic finance has been growing at an amazing pace since the time of its incep-
tion on a larger scale in the mid-1970s. According to the Islamic Financial Services
Industry Stability report, the assets with Islamic financial institutions (IFI) grew
to US$ 1.89 trillion as of the first quarter of 2017. The upsurge of Islamic finance
can be attributed to the increased popularity of Islamic banking not only in the
Arab or Islamic countries but also in some Western countries including the UK,
the US, and Singapore. Besides Islamic banks, conventional banks are also offer-
ing Islamic banking services by either opening new branches tagged after ‘Islamic
banking branch’ or opening a new window labelled ‘Islamic banking window’.
Numerous reasons have been cited as the causes of rising popularity of this distinct
model of finance. The primary among them is the desire of the Muslim population
to embrace the Islamic faith in their economic and social lives.
Although modern Islamic finance began its journey in the 1970s in the Middle
Eastern countries, the Malaysian government took it to a new height by taking
pragmatic and goal-oriented long-term strategic plans. Specially, in the commer-
cial banking and Sukuk market, the country introduced innovative products to
meet the market demand. Several governmental agencies’ initiatives like introduc-
ing comprehensive Islamic banking regulations, allowing the conventional banks
to open Islamic banking windows, establishing educational institutes to promote
the research on Islamic finance, developing Shari’ah-approved stock and so forth
made Malaysia as an international Islamic finance hub. It also attracts many Mid-
dle East financial groups to start operations in Malaysia.
My vision was to bring the Islamic financial system as a parallel to the Western
financial model. In so doing, we have been challenged to resolve several dilemmas
facing the Islamic financial system. The field of Islamic finance is expanding ram-
pantly in the Muslim countries and beyond due to its relevance to development
and social justice. This phenomenal growth has accompanied a host of interesting
questions and challenges some of which are sorted out and refuted in this book.
Readers interested to know about these challenges and dilemmas and the way to
resolve them may find this book worth reading.

Tun Abdullah Ahmad Badawi

The 5th Prime Minister of Malaysia
Foreword

Professor Yasushi Suzuki, a post-Keynesian economist by training, is an avid reader

and enthusiastic scholar of Islamic finance. His enthusiasm on the subject is shown
by his many contributions to the field, which are also well received by scholars
and specialists in the field. Professor Suzuki recently visited the International
Institute of Advanced Islamic Studies (IAIS) Kuala Lumpur, Malaysia and Yusof
Ishak Institute (ISEAS) Singapore as a visiting research scholar where he had the
opportunity to exchange views with different stakeholders of Islamic finance. It
was during his stay at IAIS Malaysia that I had the opportunity to know him and
gain closer familiarity with his works. As a passionate researcher in the field, he
raises questions and engages the reader in issues and challenges Islamic finance are
facing at present. He has evidently felt it essential to answer some of these ques-
tions in the midst of many issues of wider interest in Islamic finance. Professor
Suzuki has travelled to many Muslim countries, including Malaysia, Bangladesh
and Indonesia, and communicated with researchers in these countries who are
currently engaged with a variety of issues of topical interest in Islamic banking and
finance. The current book is a result, to a large extent, of these endeavors.
Islamic finance, through its journey in the last four decades or so, has expanded
into various branches and areas. Although the beginning was marked solely by the
presence of Islamic banking, the field has expanded over the years into such other
areas as venture capital, microfinance, cooperative enterprises, and Islamic bonds
or Sukuk. However, the banking segment still dominates the Islamic financial
system, contributing to about three-fourths of the total Islamic financial assets.
Thus, any success and failure of this distinct financial model is bound to be largely
attributed to the Islamic banking system. But the reality is that Islamic banks like
their conventional counterparts are profit-seeking institutions. They attempt to
maximize their return by investing within the permissible areas of Islamic law, and
the given boundaries of the applied laws of the land. This strategy has led them
towards the concentration of particular modes of finance, which have generated,
in turn, extensive academic debates as well as public criticisms.
Professor Suzuki and the fellow contributors of this volume have delved into
these discussions and criticisms to unravel the causes and rationales behind them.
They have set their goals clearly at the outset of this book, and were able to con-
vincingly achieve them by following scientific methodologies. It is apparent from
xiv  Mohammad Hashim Kamali
the tenor of their analyses that the book has not fallen short of achieving the goals
it has set for itself. Prospective readers will thus find the book interesting and
informative, and a product also of inquisitive yet mature scholarship in the field.

Professor Dr Mohammad Hashim Kamali

Founding CEO, International Institute of Advanced Islamic Studies (IAIS)
Foreword

The rise of Islamic finance in the last couple of years has heralded the importance
of this particular discipline to the socio-economic lives of the Muslim population.
Islamic finance has penetrated in countries with a majority Muslim population
but it has also marked its presence in countries lacking large Muslim populations,
which manifests that this distinct financing model possesses some social and eco-
nomic benefits to offer. To single out a particular benefit, Islamic finance has been
playing a critical role in propelling economic growth by including a segment of
the population that remained out of conventional finance mainly due to their
belief in the Islamic faith.
In its remarkable journey in the past few decades, Islamic finance has received
not only applauded acceptance from society but also some criticisms. Most criti-
cisms, however, are pointed towards ameliorating some apparent inconsistencies
or critical deficiencies of the model. Thus, they deserve to be addressed for the
greater interest of Islamic finance. This effort requires, first, a clear understand-
ing about the challenges Islamic finance is facing at present followed by a coher-
ent analysis about the available means to overcome these challenges. The current
book is well positioned for this academic colloquium. It brings forth a host of
interesting questions in a clear and concise academic manner and attempts to
answer them logically backed by practical evidence.
The book is fresh in ideas and diverse in analytical perspectives. Readers inter-
ested to know about the existing practice of Islamic financial institutions would
find it helpful in refreshing their views in Islamic finance and what to expect in the
future.

Datuk Dr Mohd Daud Bakar

Founder and Group Chairman, Amanie Group
Preface

The book is divided into three parts. Part I deals with dilemmas and challenges on
the prohibition of riba and gharar. We aspire to explain the economics of Islamic
finance linking the central thesis of Islamic finance to some prominent schools
of economic thought. Part I also offers a comprehensive analysis of the accept-
able level of gharar through the lens of New Institutional and Post-Keynesian
Economics. Part II argues on the issues as to who should challenge participatory
finance as instructed by Islamic Shari’ah. This part, the central part of the book,
focuses on various mechanisms and options for participatory finance including
Islamic venture capital firms, Sukuk, and Islamic microfinance institutions. Part
III looks at the current challenges and dilemmas Islamic financial institutions are
facing now and the ways to address them for a sustainable and resilient Islamic
financial system. One potential avenue which has been emphasized is that the
governance structure should be designed in such a way that is conducive for the
overall growth and prosperity of Islamic finance.
The diversification and absorption of risk and uncertainty embedded in incu-
bating innovative start-ups and empowering marginalized people is a great chal-
lenge for the Islamic financial system as a whole. However, it is not easy to design
a mode of finance which aims at achieving a delicate balance between mobilizing
funds from risk-averse depositors and creating as well as accumulating enough
wealth in society for incubating risk-neutral investors or donors who would be
willing to absorb various risks and uncertainty exposed to innovative start-ups or
to empower marginalized people. Apart from an idealistic view, this book sug-
gests, from a view point of Institutional Political Economy, that the Islamic finan-
cial system should take a trial-and-error process to evolve upon the ‘specialization’
and ‘division of work’ in credit risk screening activities and financial intermediary
functions. We would be more than happy if this book encourages further studies
in the Institutional Political Economy of Islamic finance.

Yasushi Suzuki and Mohammad Dulal Miah

November 2017
Acknowledgements

The editors would like to thank Routledge/Taylor & Francis Asia Pacific for their
guidance and continuous support towards the publication of this book. Yasushi
would like to acknowledge that his work was supported by JSPS Grant-in-Aid
for Scientific Research (C), Grant Number 15K03374. He would like to thank
Akiko Suzuki for her constant support and inspiration, and Mohammad Hashim
Kamali, Mohamed Azam Mohamed Adil, Mohd Daud Bakar, and Muhammad
Hakimi Bin Mohd Shafiai for their encouragement and support. Mohammad
Dulal would like to convey his gratitude to Professor Suzuki Yasushi for his con-
tinuous guidance and support to successfully complete this project. He would
also like to express his sincere gratitude to Mir Ferdousi for her constant support
and motivation. Special thanks go to Dr S. Arockiasamy for his encouragement to
be involved with research. Many thanks are due to Dr Gholamreza Chabokrow,
Shamshudheen Arumathadathil, and Syed Mahbubur Rahman.
Introduction
Yasushi Suzuki and Mohammad Dulal Miah

One of the salient characteristics of Islamic finance that distinguishes it from the
conventional financing model is that the former complies, in objectives and opera-
tions, with Shari’ah (Islamic law). Two major prohibitions – prohibition of riba
(interest) and prohibition of gharar (uncertainty) – underlie the basic Shari’ah
principles. Qur’an (2: 275–76) clearly states that dealing with riba is ‘sinful’.
Instead, Shari’ah norms and principles encourage ‘profit-and-loss sharing’ (PLS)
financial transactions. Islamic financial institutions have evolved to offer finan-
cial products which comply with Islamic Shari’ah. Some of these products are
designed with features resembling participatory finance (musharaka) and trust-
based finance (mudaraba) which are equity-like PLS-based contracts while others
are characterized by sale- or leased-based mark-up transactions (mudaraba, ijara,
bai bithman ajil, bai salam etc.). As of the first quarter of 2017, equity-like PLS
contracts accounted for less than 5 percent of the total financing of Islamic banks.
In contrast, mark-up or cost-plus financing combined more than 71 percent in the
same period. This manifests that Islamic banks are reluctant (or discouraged) to
participate in equity-like PLS schemes.
We note, first, that murabaha is a Shari’ah-compliant product, but many
Islamic economists insist that it does not fully embody the spirit of PLS financing.
This issue has been still controversial in the academic discussion. Islamic idealistic
economists are of the view that Islamic banks should practice equity-like PLS-
based financing otherwise their raison d’être is difficult to justify. This is, indeed,
a critical challenge which Islamic finance scholars must explain. In refuting this
challenge one must confront a dilemma. Islam encourages equity-like PLS con-
tracts which are embedded in risks and fundamental uncertainty. In other words,
increasing equity-like PLS-based investment in the portfolio of Islamic banks
means embracing more risk as well as uncertainty, as well as exposing them to
occasionally ‘excess’ uncertainty (gharar) which is prohibited by Islamic Shari’ah.
This is a dilemma which seeks to be explained convincingly. The existing literature
of Islamic finance rightly identifies the dilemma but pays much less attention to
unfolding the paradox.
Second, it is suggested that agency problems should be mitigated if Islamic
economies really wish to witness a surge in equity-like PLS-based financing (Mau-
rer, 2002; Khalil et al., 2002; Farooq, 2007). In so doing, Islamic banks should
2  Yasushi Suzuki and Mohammad Dulal Miah
initiate tighter screening and monitoring policies for participatory financing
(trust-based financing may entail different dimensions in financing). This pre-
scription is important but secondary only as far as Islamic banking is concerned.
The primary concern centres on the question of what extent should Islamic banks
be allowed to accept risks involved with participatory or trust-based financing.
Banks are financial intermediaries. They collect funds by selling deposits to the
mass population and lending (investing) these funds to borrowers (entrepreneurs)
who employ them in different projects. The payback of depositors’ funds thus
critically depends on the success of these projects that are subject to fundamental
uncertainty. Although tighter screening and prudential monitoring as suggested
by Islamic economists can be effective tools for resolving adverse selection and
moral hazard problems, these tools are unlikely to be effective in eliminating
uncertainty involved with entrepreneurial projects.
Both Islamic and conventional banks face the same uncertainty of entrepre-
neurs but at a varying degree. Conventional banks usually enter into a debt-
contract with their clients. Debt-contracts unlike equity contracts allow banks
only a limited interest on a firm’s stake. However, debt-contracts in most cases are
secured by the collateral. Even in the case of unsecured loans, debt-contracts enti-
tled to be preferred over the residual owners in case of a firm’s liquidation. This
implies that debt-like contracts are more secure than equity contracts. In contrast,
equity holders as partners are, in general, ranked at an advantageous position to
have direct access to the information on the firm. Therefore, higher risk in equity
financing is linked with higher expected return. Should Islamic banks be allowed
to take more risk for higher return? The answer to this question would help us
understand the extent to which Islamic banks should be involved with participa-
tory finance and why murabaha concentration is a logical choice for Islamic banks
under the existing institutional underpinnings.
Third, Islamic financial institutions, besides their typical role of providing
finance following Shari’ah principles, are also expected to make a positive contri-
bution in poverty alleviation by fulfilling the socioeconomic objectives of ‘social
justice’ in accordance with the objectives of Shari’ah. Altruism and reciprocity are
highly encouraged by Islamic teaching and may contribute to setting up various
financial institutions including Islamic angel investors and microfinance institu-
tions to finance start-ups and microenterprises. However, strong reciprocity – a
propensity to cooperate and share with others similarly disposed even at personal
cost – may create a dilemma. For instance, strong reciprocity may force altruists to
withdraw their support when they perceive that the person receiving the help does
not sincerely try enough to be self-sufficient or uphold moral upstanding. Since
these attributes of human beings are intangible and cannot be easily measured,
altruists may abstain from altruistic contributions based on his self-assessment,
which sometimes may prove wrong. This is again a conundrum which needs to be
resolved for a broader development of Islamic finance.
The current literature has given much less emphasis on these contemporary
issues and, thus, falls short of providing a comprehensive explanation for resolving
these dilemmas and challenges. Furthermore, the anatomy of Islamic equity and
 Introduction 3
microfinance has not been given adequate attention in Islamic finance literature.
Although some noteworthy theoretical contributions are prevalent in the exist-
ing literature, theoretical arguments in most cases are not supplemented well by
empirical analyses. This edited volume is a humble attempt to bridge this gap. It
aims to unfold critical dimensions of these issues for a rigorous academic discus-
sion so that pragmatic solutions can be agreed upon. Keeping this in mind, chap-
ters for this book have been carefully selected with the aim of offering a balanced
discussion between three major issues of Islamic finance: (1) dilemmas and chal-
lenges on the prohibition of riba and gharar, (2) issues in Islamic equity finance
and microfinance, and (3) dilemmas and challenges in governance structure.
The book is divided into three parts. Part I deals with ‘dilemmas and challenges
on the prohibition of riba and gharar’. This part consists of three chapters. Chap-
ter 1 aspires to explain the economics of Islamic finance linking the central thesis
of Islamic finance to some prominent schools of economic thought. The authors
briefly describe the current financial architecture which is marked by the shift of
the economic epicenter from industrial production to financial capitalism. This
change has facilitated the rise of a new class called the ‘rentier’ class that derives
major income from exploiting the scarcity value of capital. Drawing evidence from
the Keynesian and Marxian analyses, this chapter links the economics underlying
the prohibition of interest and uncertainty of Islamic finance to investment and
employment as well as social equality and justice. In the Marxian theory, the cir-
culation from ‘idle’ money to ‘interest-bearing’ capital for production is drawn as
engines for the mode of capitalism. On the other hand, the Marxian school is very
concerned about inequitable distribution of wealth and income resulting from the
concentration of financial capital. Similarly, to achieve full employment by ensur-
ing sufficient investment, Keynes advocated the realization of a low rate of interest
for seeking ‘social justice’. While this line of argument is compatible with Islamic
philosophy, the authors point out the dilemmas and difficulties faced by Islamic
finance in mediating and accumulating idle money to capital for production in the
process of industrialization.
Islamic financial institutions particularly banks have designed their products
complying with Shari’ah principles. Murabaha is one but noteworthy among
them. In a typical murabaha contract, Islamic banks purchase the goods to be
supplied to clients at a ‘cost-plus’ or ‘mark-up’ price. Clients may pay a lump
sum amount instantly and the remaining on a deferred installment basis. Since
sale-based transactions are permitted in Islam, murabaha is a Shari’ah-compliant
product. The mark-up price of murabaha is pre-fixed which helps banks avoid
uncertainty involved with PLS-based transactions.
However, there is a huge outcry in regard to the rising concentration of
murabaha financing. The logic of the criticism relies on the fact that murabaha,
although Shari’ah-compliant, does not uphold the spirit of equity-like PLS financ-
ing. Islamic principles encourage PLS-based transactions so that associated risks
and uncertainties can be shared between participating parties. Many Islamic ‘ide-
alist’ economists insist that the current practice of Islamic banks is a detour from
this spirit. Chapter 2 offers an elaborate discussion as to why Islamic banks prefer
4  Yasushi Suzuki and Mohammad Dulal Miah
murabaha financing to equity-like PLS financing. The authors are of the view
that the gross criticism against murabaha concentration is unfair. They argue that
the encouragement towards equity-like PLS-based financing which is associated
with higher risk and uncertainty and the parallel prohibition of gharar may have
created a dilemma leading to the rise of so-called murabaha syndrome. Based on
this understanding they argue that, under the existing institutional framework,
murabaha syndrome can be ironically justified and compatible with the incentives
provided by the system. This particular finding is interesting and deserves fur-
ther analysis for designing appropriate institutions conducive for a vibrant Islamic
financial system.
Although gharar is instructed to be avoided, there should be a realm of accept-
able level of it because contracts are inevitably incomplete, which implies that
some level of uncertainty exists in every transaction. Thus, financial institutions
have to deal with their clients in a state of incomplete contract or in the pres-
ence of uncertainty. To what extent should Islamic banks deal with gharar so
that depositors’ interest (welfare) on the bank is adequately protected? Chapter 3
attempts to answer this question. In so doing, it offers a comprehensive analysis
of the acceptable level of gharar through the lens of New Institutional and Post-
Keynesian Economics. The chapter is well equipped evidently and very interactive
analytically to demark that realm. The authors draw their analysis of both Islamic
jurisprudence and contemporary economic thought and argue that gharar is not
prohibited wholesale but rather transactions that involve too much or excessive
uncertainty should be prohibited. The authors further contend that Islamic finan-
cial institutions should challenge even major uncertainty if it is associated with
‘enterprises’, while they should avoid even minor uncertainty on ‘speculations’.
Who should challenge participatory finance as instructed by Islamic Shari’ah?
This issue permeates Part II of this book. This central part of the book focuses
on different mechanisms and options for participatory finance including Islamic
venture capital firms, Sukuk, and microfinance institutions. Chapter 4 sheds
an analytical light on the feasibility and dilemmas of mobilizing Islamic equity
funds for the particular mode of participatory finance. The authors first derive
some important motivating factors including altruism and reciprocity which are
emphasized in the Muslim scriptures to be adopted by the believers. Islam as a
religion encourages followers to maintain trust and reciprocity. At the same time,
it strongly prohibits the actor’s opportunistic behavior. The virtue of altruism and
reciprocity should encourage Muslim capitalists to finance those entrepreneurs
who are financially stranded. On the other hand, the element of trust should
work as a guidepost for entrepreneurs not to behave opportunistically. If prop-
erly maintained, these social lubricants can overhaul the drawbacks resulting from
incomplete contracting. The authors, however, are prompt to remind that trust
and other moral virtues of actors are intrinsic and difficult to preserve. As a conse-
quence, these virtues should be supplemented by tangible regulations.
While Chapter 4 enumerates a broader venture capital (VC) environment,
Chapter 5 provides evidence on various aspects encountered by Islamic VC firms.
The authors analyze two large VC firms each from Indonesia and Bahrain. One of
 Introduction 5
the salient contributions of the chapter is that it develops some typology based on
their extended analysis of these cases. The authors show that VC firms particularly
in matured economies explore innovative venture seeds, challenging ‘high risk’
but ‘high return’ profit opportunities whereas banks’ patronized VC firms are
shown to be very conservative in financing entrepreneurs. Also, some VC firms
evolve to target the real estate financing because they lack basic knowledge and
skills to absorb projects’ versatile risk. There are other VC firms which are backed
by the government. They merely facilitate funds mainly from the state to enter-
prises without challenging the risky ventures much. This typology would help pol-
icymakers develop VC strategies appropriate for macroeconomic characteristics.
Typical Islamic indirect financial products are not highly suitable for sovereign
debt or large-scale corporate financing demand. This drawback has largely facili-
tated the evolution of Sukuk or Islamic bond, a comparatively recent addition to
the line of Islamic financial products. Unlike the conventional bond in which the
holders of the bond are simply the creditors and receive periodic fixed interest,
Sukuk gives the owner undivided ownership of some tangible assets underlying
the debt and receive profit earned from the investment of the Sukuk amount.
Although Sukuk is not an equity-based product it has, however, the hybrid nature
of debt and equity. The fixed income provision of Sukuk makes it a debt-like
instrument whereas the ownership of assets or the perpetual Sukuk appears to
have an equity-like nature. Due to its advantage of having access to a large pool of
liquidity in many Muslim countries, Sukuk issuance has increased significantly in
the recent period. Alzaharani and Megginson (2017) report that Sukuk markets
have experienced an average growth of 27 percent per year in the last two decades.
The industry amounted to $318.5 billion at the end of 2016 (IFSB, 2017).
Malaysia has sustained itself as the largest Sukuk outstanding market in 2016,
accounting for 46.4 percent of the total market, declining from 50.6 percent in
2015. The share of Saudi Arabia accounts for 17.4 percent followed by the UAE
(10.5 percent) and Qatar (5.9 percent). These statistics show that Malaysia offers
itself as an example for other countries that aim to develop their national Sukuk
market. In this regard, Chapter 6 can be of particular interest which provides a
comprehensive analysis of the Malaysian Sukuk market and the governance struc-
ture underlying it. Comparing the Sukuk markets in Bangladesh and Malaysia the
authors argue that the differences between these two Sukuk markets can be attrib-
uted to differences in the legal and regulatory framework, availability of Sukuk
instruments, awareness of corporations about the benefits of Sukuk etc. Based on
their in-depth analysis the authors argue that emerging economies can material-
ize the benefits of this innovative Islamic product but such an attempt requires
proper planning and coordination among regulatory authorities, Islamic banks,
Islamic financial institutions, Shari’ah scholars, and other market participants.
What makes the chapter more interesting is that it examines the genesis and devel-
opment of the J-sukuk (Japan Sukuk) market. Although the issuance of J-sukuk is
yet to be seen, readers interested to know about the regulatory frameworks evolv-
ing in a region that is lacking large Muslim populations to encourage a financial
product originally based on ethical concerns of Islam may find it worth reading.
6  Yasushi Suzuki and Mohammad Dulal Miah
It is evident that Islamic banks follow the suit of conventional banks as far as
ventures and Small and Medium sized Enterprises (SME) financing are concerned.
Both clusters of banks prefer financing large firms which have established reputa-
tions and historical track records as well as which possess significant tangible assets
that can be made collateral against borrowing. This strategy of Islamic banks is
logical from the perspective of their limited risk absorbing capacity. SMEs lack
sufficient information required for a comprehensive assessment of the borrowers’
creditworthiness. Thus, Islamic banks limit their exposure to such firms. How-
ever, marginalized borrowers of SMEs are deprived of the necessary financing.
Historically, microfinance institutions and cooperative enterprises have catered
the financing needs of these SMEs and marginalized borrowers to a large extent.
The last two chapters of Part II bring various dimensions of these issues.
Chapter 7 offers a comparative study between conventional and Islamic
microfinance in Bangladesh. Needless to say, Grameen Bank (GB), a renowned
microfinance institute which originated in Bangladesh, is known worldwide for
its pivotal role in eradicating poverty through financing the marginal borrowers.
The model is thus followed by many developing countries across the world. The
authors in this chapter are keen to check the feasibility of the GP model to be
adopted by Islamic microfinance providers. In so doing, they analyze in detail
the Rural Development Scheme (RDS), an Islamic microfinance institution
(IMFI) under the auspices of Islami Bank Bangladesh Ltd. and identify some
critical constraints to its growth. It has been found that the shortage of funds,
improper regulatory infrastructure, and asymmetry of information restrict the
growth of IMFI. Taking into consideration the nature of operational differences
between GB and RDS, the authors are very cautious in suggesting what RDS
can learn from the success story of GB. In particular, market information and
funds recovery method of GB can be of particular interest to RDS. The authors
add an additional dimension by showcasing the problems and prospects of some
IMFIs in Pakistan.
Islamic Saving–Loan and Financing Cooperatives (KSPPS) of Indonesia are
one example which was modelled after the GB with some modifications. This
cooperative was later converted to a Shari’ah-compliant microfinance institution.
Chapter 8 discusses the target of KSPPS on poverty alleviation. The authors esti-
mate how many of KSPPS’ clients are likely to live under the poverty line upon
the international standard, the national standard in Indonesia, and the KSPPS
target, respectively. The authors point out that the national standard is a bit indul-
gent. Simultaneously, the authors find that, even upon the KSPPS standard, more
than three-quarters of the respondents are likely to live under the poverty line.
The outreach of Islamic Saving–Loan and Financing Cooperatives to marginal-
ized clients is perhaps very limited in Indonesia. This chapter also makes a meth-
odological contribution to the existing scientific method of impact assessment
of microfinance by introducing the concept of ‘artificial neural networks’. To
facilitate the discussion on how well or poorly Islamic finance could contribute to
poverty alleviation, the method of impact assessment should be critically assessed
for its improvement.
 Introduction 7
The current challenges and dilemmas for Islamic financial institutions need to
be addressed for a sustainable and resilient Islamic financial system. To accom-
plish this objective, governance structure should be designed in such a way that is
conducive for the overall growth and prosperity of Islamic finance. Part III of this
book takes this issue into consideration. In particular, Chapter 9 explicates the
governance structure of the Shari’ah board and proposes what is further required
to make the board Shari’ah minded as well as knowledgeable about modern
economics and finance. This chapter analyzes various principal–agent relations
involved with the Islamic financing paradigm. In addition to conventional agency
problems, Islamic financial institutions encounter one additional layer in their
governance structure, the Shari’ah board, which is appointed and remunerated by
the concerned financial institution. The Shari’ah board thus appointed may have
maintained their de facto independence (in practice) but they lack the independ-
ence de jure (in appearance). Thus, the authors propose remedies to make a board
independent both de facto and de jure. A distinct characteristic of this chapter lies
in the authors’ attempt to tell an insider’s story about the nature and functions of
a Shari’ah board, echoing the tone of a Shari’ah board member having versatile
experiences in serving different Shari’ah boards. Their solid suggestions in this
chapter are also substantiated by discussing the corporate governance codes of the
UK. Although different in nature, the authors find these particular codes a great
learning tool to remodel the Shari’ah board.
From the perspective of Shari’ah independence, two roughly distinct models –
separated vs. independent – are noticed in the Islamic world. For instance some
countries follow a separated model in which the Shari’ah board has been bestowed
with a high degree of independence. In contrast, an integrated version which is
modelled upon the harmonization among different entities related to banking
regulations and operations is followed by a cluster of countries. Chapter 10 offers
a detailed analysis of integrated vs. separated models of Shari’ah boards and their
distinctive characteristics. The authors then check if the integrated or separated
model suits well to the available Islamic financial infrastructure in Bangladesh.
Upon analyzing the existing practice of the governance structures the authors
find that the model currently practiced in Bangladesh consists of a few country-
specific features which make it distinct from the two widely used models. These
distinctive features have been elaborated in this chapter along with their related
pros and cons.
The current mode of profit-and-loss sharing provides, in practice, an idea of the
difficulty for Islamic banks in assuming equity-based financing. It is impractical to
expect the acceleration of participatory financing without preserving much higher
margins of security to cover further profit-and-loss sharing risk. Shari’ah scholars,
the regulatory authority, and other professionals need to design an appropriate
financial architecture which can create different (and socially acceptable) levels
of margin opportunities for Islamic banks to avail the benefit from the variety of
Islamic financing as declared by Shari’ah. The final chapter, Chapter 11, takes
these issues into consideration. In light of the challenges and dilemmas covered
in this book, the chapter suggests some mechanisms which are believed to be
8  Yasushi Suzuki and Mohammad Dulal Miah
helpful for policymakers in designing an appropriate policy framework conducive
for PLS-based Islamic finance.
The authors specifically propose a model based on ‘specialization’ and ‘divi-
sion of work’. In so doing, they highlight the sensitivity of the banking industry
to any adverse economic and financial shocks. Since banks deal with depositors’
funds, they must be very cautious in exposing themselves to excessive risks and
uncertainties. From this vantage point the authors argue that it won’t be so sen-
sible to suggest Islamic banks be involved extensively with equity-like PLS-based
financing. Given that murabaha is a Shari’ah-compliant product and receives a
high demand from Muslim societies, Islamic banks’ concentration on murabaha
financing is rational. The authors thus suggest that Islamic banks should limitedly
be involved in musharaka financing. On the other hand, entrepreneurs financing
needs based on PLS contracts should be catered by venture capital firms whereas
microfinance institutions can meet the demand for marginalized borrowers. To
materialize this integrated PLS-based Islamic financial model, some institutional
constraints identified in this chapter should be wiped out.
Part I

Dilemmas and challenges

on the prohibition of riba
and gharar
1 Heterodox vs. Islamic views
on interest and uncertainty
Commonalities and
contradictions
Yasushi Suzuki and Mohammad Dulal Miah

1. Introduction
One of the dominant principles of Islamic finance is the prohibition of ‘riba’ or
interest and ‘gharar’ or uncertainty. For the people in the Abrahamic monothe-
istic faith, in particular, for Muslims, this is a divine rule and in principle believers
of this faith should accept the rule for their benefits in this world and the world
hereafter. Despite the fact that we cannot assess the benefits of the life hereafter,
some worldly benefits derived from the prohibition of riba and gharar should be
logically explained from the perspective of economic and social circumstances.
No doubt, interest is an essential element of finance and is embedded in our
financial systems. In the absence of interest, financial architectures of most cap-
italist economies might have been different from what they are today because
modern economies are increasingly tending towards a financial system where risks
and uncertainties are modeled to be quantified as premiums which are traded in
the financial markets. Such a practice, nevertheless, has accompanied perils and
promises. On the promise side, increased quantification of risks has made invest-
ment in the financial markets easier than ever before, which in turn helps attract
a large base of investors. Firms in shortage of funds can capitalize on issuing new
innovative securities (repackaged mortgages, complex derivatives and so forth)
to these investors. On the contrary, innovation in the financial products may also
prove to be catastrophic. Lohmann (2011, p. 650) asserts “the latest attempt to
keep things moving by expanding credit has meanwhile led to an unlimited, and
ultimately catastrophic, expansion of risk.”
Islam as a religion does not stand alone in prohibiting interest and uncertainty.
Other major contemporary religions in the past barred paying and receiving inter-
est although all religions except Islam have gradually detoured from this prac-
tice (Lewis, 2007). Similarly, some philosophical thoughts have emerged which
explicitly explain the functions of interest in the economy and their ultimate con-
sequence on society. One such view is the heterodox school of economics which
contrasts itself from the neoclassical orthodox school of self-centric (rational)
individualism. The heterodox view of Keynes and Marx is of particular interest in
this regard because the Marxian and Keynesian traditions shoot a skeptical look
towards those rentier-functionless investors who earn and accumulate wealth
through financing means upon interest without directly taking part in productive
activities. We find Islamic prohibition of interest and uncertainty compatible, to a
12  Yasushi Suzuki and Mohammad Dulal Miah
good extent, with this heterodox thesis. This chapter aims to link the heterodox
perspective on functionless investors to the Islamic prohibition of riba and gha-
rar. The chapter also takes into account the benefits interest-free transactions may
offer to society in regard to justice and equity, as well as the challenges faced by
Islamic and heterodox views.
The chapter has been structured as follows: Section 2 describes the Islamic prin-
ciples of prohibition of riba and gharar whereas Section 3 discusses the heterodox
view underlying the concept of interest and uncertainty. Section 4 sheds an analytical
light on the relevance of heterodox and Islamic views in this particular context. In
doing so, an emphasis is placed on the role of functionless investors in the econ-
omy and how their activities invite welfare-reducing impacts on society. However,
the idea of interest-free transactions is not free from challenges. The primary chal-
lenge evolves from the fact that, in the absence of interest, mobilization of idle funds
accumulated by risk-averse investors may be infeasible. This point along with other
critical challenges and how Islamic finance in particular plans to deal with these chal-
lenges will be discussed in Section 5. Section 6 offers an interim conclusion.

2.  Islamic principles of interest and uncertainty

There are various verses revealed in the Holy Qu’ran prohibiting riba. According
to Siddiqi (2004) there are a total of 12 verses in the Qu’ran which deal with riba
and the word riba directly appears eight times. Chapter 2, Verse 275 states:

Those who practice usury and interest, (their condition is such as) they will
not be able to stand except like the standing of one who has lost his reason
under the influence of Satan (devil). That is so because they say, “Trade is just
like usury and interest”. Whereas Allâh has made trade lawful and made inter-
est unlawful. Then whosoever has received (this) admonition from his Lord
and keeps away (from usury and interest) he may keep whatever (interest) he
has taken in the past. His matter rests with Allâh. As for those who revert (to
the practice of usury and interest) it is these who are the fellows of the Fire,
therein shall they live for long.

Some other verses also explicitly mention various aspects of riba. For instance,
Verse 276 (of Chapter 2) states, “Allâh annuls usury and interest and promotes
charity” and Verse 278 reads, “O you who believe! Take Allâh as a shield and
forgo all outstanding gains from usury and interest if you are indeed believers.”
Strong provision for punishment is promulgated for those who deal with riba.
Verse 279 states, “But if you do (it) not, then beware of war from Allâh and His
Messenger. But if you turn away (from such an unlawful transaction) then you
shall have your principal (without interest) back.” In collecting the sum, a provi-
sion has been stated favoring the debtors. For instance, Verse 280 reads:

If any (debtor) be in straitened circumstances there shall be respite (for him)

till (his circumstances) ease. But that if you remit (the debt) by way of charity
(for the sake of God), it is better for you, if you only knew.
 Heterodox vs. Islamic views on interest 13
The above verses clarify some important points about riba. First, riba is pro-
hibited outright without any reservation. Second, riba is defined as the excess of
principal. Third, severe punishment is provisioned for those who, despite know-
ing, deal with riba. Fourth, trade is solemnized and is separated from riba.
Islam is a religion born in the Arabian Desert, where trade constituted the most
important, “perhaps even the sole economic activity, favors merchants, property
rights, free trade and market economy” (Çizakça, 2011, p. xv). As such, Islam
is called the religion for merchants (Ayub, 2007; Çizakça, 2011). The business
ethics in the Islamic mode of transactions are related to the civilized urban way of
life at the birth of Islam. The holy Prophet had spent half of his life working as a
merchant in Mecca, where the urban culture flourished and the values for facilitat-
ing fair transactions among merchants in equal positions were shared. The holy
Prophet mentioned that trade constituted nine-tenths of the livelihood of early
Muslims. In fact, of the four righteous Caliphs, Abu Bakr was a cloth merchant
and Uthman was an importer of cereals (Çizakça, 2011, p. xiv).
The values being shared among merchants have developed the concept of con-
tracting and the importance of respecting mutual property rights in the Muslim
community. Islam recognizes the role of the market and the freedom of individu-
als in business and trade while restraining the freedom to engage in business and
financial transactions on the basis of a number of prohibitions, ethics and norms.
It is widely known that the prohibition of riba, gharar and maisir (gambling) is
the most strategic factor that defines invalid and voidable contracts and demar-
cates the overall limits which should not be crossed (Ayub, 2007, p. 12).
Islam as a religion did not stand alone in the past in prohibiting riba. An examina-
tion of the world’s dominant religions shows that they all prohibited interest. The
Abrahamic faith traditions – Judaism, Christianity and Islam – took initial strides
to prevent adherents from charging any interest on loans (Looft, 2014). While
the Jewish and Christian faiths have both evolved to draw distinctions between
acceptable interest and usury, Islam still explicitly forbids charging any interest on
loans. Usury is referred to as a rate of interest greater than that which the law or
public opinion permits (Looft, 2014). Looft (2014) points out that, nevertheless,
there are still voices within Christian communities that deride all forms of interest
as usury, referring to the following poem written by Peter Maurin who co-founded
the Catholic Worker Movement in 1933: (i) Before John Calvin people were not
allowed to lend money at interest, (ii) John Calvin decided to legalize money-
lending at interest in spite of the teachings of the Prophets of Israel and the Fathers
of the Church, (iii) Protestant countries tried to keep up with John Calvin and
money-lending at interest became the general practice, (iv) And money ceases to
be a means of exchange and began to be a means to make money, (v) So people
lent money on time and started to think of time in terms of money and said to each
other: “Time is money” ’(Looft, 2014, pp. 114–115). Islam has not relented to
pressures from the market and has continued to maintain its stance that charging
interest on loans is usurious and a violation of Islamic law. Now the important ques-
tion is why Islam relentlessly adheres to the prohibition of riba.
It is difficult to get explicit Qur’anic text on the logic as to why interest is
prohibited because the rationales are more implicit than explicit. Also, there is a
14  Yasushi Suzuki and Mohammad Dulal Miah
possibility that the contemporary stock of knowledge may not have adequately
decoded the logics implied in the Qur’an. Albeit, Siddiqi (2004) analyzing the
context of various Qur’anic verses summarizes five broader reasons; (i) interest
corrupts society, (ii) interest implies improper appropriations of others’ prop-
erty, (iii) interest slows down the growth of real sectors, (iv) interest demeans
and diminishes human personality and (v) interest is simply unjust. As we men-
tioned earlier, the Qur’an does not provide detailed analysis of the rationale of
prohibition of interest. The rationales outlined earlier in the chapter are identified
and articulated by Islamic scholars, who are subject to error. The only rationale
in regard to the provision of riba that can be sensed from the Qur’anic verse
is related to ‘exploitation’ or ‘injustice’. It is stated in the Qur’an as, “deal not
unjustly (by asking more than your principal) and you shall not be dealt with
unjustly” (Chapter 2, Verse 279).
Different aspects of exploitation have been discussed in the existing literature.
For instance, Al-Qaradawi (2013) who summarizes the explanation from an ear-
lier Islamic scholar (Imam Fakhr al-Din al-Razi, 1149–1209 AD) takes a general
view that in a lender–borrower relation, the former is usually wealthy whereas the
latter is poor. This disparity may lead to exploitation of the latter by the former.
K. Ahmad (1980) refers to Sayyid Abul A’la Mawdudi who supports the view that
interest is indeed a means of exploitation. Mawdudi further notes that interest can
be considered a way of transferring wealth towards the favor of haves which results
in inequality. Similarly, Farooq (2009) argues that many Muslims have resorted to
interest-free Islamic banking not merely because it is Islamic, but because it would
help society to be free from exploitation. In the same token, Looft (2014) stresses
that lending money at interest without any means of sharing risk between lenders
and borrowers creates a relationship where weak and vulnerable individuals can be
easily exploited by more powerful ones. Chapter 3, Verse 130 of the Qur’an reads,
“O you, who believe, consume no riba doubled and multiplied.” Similarly, Chap-
ter 30, Verse 39 reveals, “And whatever you give for riba to increase within the
wealth of (other’s) people will not increase with Allah.” Farooq however, raises
a concern about the deficiency of modern Islamic literature in casting a focused
attention to the issue of exploitation from the perspective of interest. Farooq
(2012) argues that while the traditional arguments on prohibition of interest are
indicative of an apparent anti-exploitation concern, the reality is that the intel-
lectual and theological framework within which this discourse is framed does not
demonstrate a genuine and adequate understanding of the extent and nature of
exploitation in the contemporary world.
Although deficient in an appropriate analytical model, the above Qur’anic verses
prove that Islam treats interest as a means of expropriation of the disadvantaged
by the capitalists with the intent to increase the latter’s accumulation. This in
turn creates inequality in society leading to oppression, chaos and anarchy, which
undermine the social peace and amity. However, solid empirical assessment of
these rationales, which requires comparative analysis, cannot be performed because
currently no country can be found which follows pure Islamic rules. Second,
institutional-level analysis is infeasible owing to the fact that the current mode
 Heterodox vs. Islamic views on interest 15
of Islamic financing is dominated by murabaha or mark-up financing instead of
musharaka and mudaraba (this aspect is also the major concern of this book).
Like riba, avoiding gharar is another salient principle of Islamic finance. In the
Islamic mode of investment and financial intermediation, excessive uncertainty
is perceived in two dimensions; one refers to the lack of clarity in the terms and
essence of the contract, the other refers to the uncertainty in the object of the
contract (Ayub, 2007; El-Gamal, 2006). Complete contracting is intrinsically
impossible. Therefore, some measure of uncertainty is always present in contracts.
El-Gamal (2006, p. 58) notes that “jurists distinguished between major or exces-
sive gharar, which invalidates contracts, and minor gharar, which is tolerated as
a necessary evil.” Also, the uncertainty in the object of the contract cannot be
avoided in any business. The problem, however, “was that the extent of uncer-
tainty making any transaction Haram had not been clearly defined” (Ayub, 2007,
p. 58). Ayub (2007) refers to gharar-e-kathir and gharar qalil (too much and
nominal uncertainty) and agrees that only those transactions that involve too
much or excessive uncertainty in respect to the subject matter should be pro-
hibited. Al-Saati (2003) suggests that the Hadith (which prohibits gharar) does
not intend to prohibit all gharar, but intends to prohibit gharar which can cause
dispute and cannot be tolerated.
Basically, Islamic principles of economics focus on clarity and lack of ambigu-
ity, just and fair treatment for all and care for the rights of others (Ayub, 2007).
So far as these principles are necessarily ethical, incubating small- and medium-
sized enterprises (SMEs) would be acceptable to an extent in which the associ-
ated major uncertainty can be shared and absorbed in the community through an
adequate profit–loss sharing (PLS) agreement (Suzuki, 2013). Ayub mentions:

for a more efficient economy, we must promote systems in which people work
in productive pursuits rather than unproductive ones. Change the system to
relate it with real sector activities and all those clever dealers who earn huge
profits out of thin air could become doctors, industrialists, business people
and teachers instead.
(n.d., p. 2)

This provides the evidence that engagement in enterprise rather than speculation
seems to be preferable in the Islamic mode of investment. In addition, the prohi-
bition of gharar embedded in speculation is considered the wisdom for minimiz-
ing the potential periodic financial disaster.

3.  Heterodox perspective on interest and uncertainty

In order to compare and contrast the heterodox view with the Islamic logic of the
prohibition of riba and gharar, it would be worthwhile to focus on the context
in which Islam restricts riba and gharar. As mentioned earlier, the prohibition
of riba in Islam is fueled by the spirit of social justice whereas the prohibition of
gharar aims at reducing potential conflicts or disagreements regarding qualities or
16  Yasushi Suzuki and Mohammad Dulal Miah
incompleteness of information. The heterodox view of Marx and Keynes is com-
patible with the idea of restricting interest as well as uncertainty.
Differentiating itself from the dominant neoclassical ideology of methodologi-
cal individualism, the heterodox school explains the economic system by its rela-
tionship between and among parties engaged in producing goods and services
for society. Lee (2009, p. 8) elaborates that heterodox economics is “concerned
with explaining the process that provides the flow of goods and services required
by society to meet the needs of those who participate in its activities”. This means
that it is the social analysis that underlies the heterodox view (Lawson, 2006).
Social analysis constitutes social structures which deal with the structures of pro-
duction (the use of inputs to produce the output), social-economic classes (capi-
talist vs. workers) and the capitalist state (Lee and Jo, 2011). These elements of
social analysis owe a lot to the contribution of Marx and Keynes.
Marx’s analysis of interest is rooted in his analysis of the production system. In
the Marxian production process, money [M] is first accumulated and converted
into means of production which are transformed into commodities [C]. Com-
modities are then sold and reconverted into money again with surplus [M’ = M
+ ΔM; where ΔM is the surplus]. Or in other words, the M-C-M’ is the ideal pro-
duction circuit where M stands for industrial capital as it is employed by its owner
to the production process. In the circuit, the ‘idle’ or ‘stagnant’ money accumu-
lated in society is collected and mediated by financial intermediaries as ‘interest-
bearing capital’. Marx (1959) postulated that the exchange of interest-bearing
capital is confined merely to the exchange of hands between money capitalists
and functioning capitalists. But it is not a phase by which commodity metamor-
phosis or even reproduction of capital takes place. The latter is achieved when
interest-bearing capital “is expended a second time, in the hands of the active
capitalist who carries on trade with it, or transforms it into productive capital”
(Marx, 1959, p. 231). Since the functioning capitalist produces some surplus in
the production process [ΔM] utilizing the capital lent by the money capitalist, the
former shares a portion of the surplus with the latter which is known as ‘interest’.
Marx (1959, p. 230) contended, “he (functioning capitalist) would thereby pay
the use-value, the use-value of its function as capital, the function of producing a
profit; (and) part of the profit paid to the owner is called interest.”
In the parlance of Marxian analysis, maximum magnitude of interest [i] can be
equal to the magnitude of the profit [ΔM] generated through the production pro-
cess because interest is merely a part of profit paid by the industrial capitalist to the
money capitalist. In this relation, we can sense an inverse relation between interest
and profits [Π] of enterprises. However, variations in interest rate does not neces-
sarily affect the value or the price of commodities (from which surplus is derived)
but only have an effect on the distribution of surplus value or total profits between
money capitalists and functioning capitalists. Given that C, the labor value of non-
labor means of production, is constant, the rate of profit is therefore determined
by the real wage rate [W]. Marx considered the rate of profit to be determined by
the distribution conflict between capital and labor [ΔM = M’ - (C + W)]. The rate
of interest (r) influences only the distribution of surplus between money capitalists
 Heterodox vs. Islamic views on interest 17
and functioning capitalists and makes the rate of profit of enterprise [Π] a residual
variable [Π = ΔM - r].
For Marx, interest is an alien to the movements of industrial capital, the rate of
which is determined by the class struggle between money capitalists and industrial
capitalists. “It is only the competition between these two kinds of capitalists which
creates the rate of interest” (Marx, 1959, p. 252). If a large number of capitalists
wish to convert their accumulation into money capital, the rate of interest would
fall due to the comparative abundance of money capital compared to industrial
capital. The money capitalist would find interest income insufficient to live by
which would force some of them to transform into industrial capitalists. As soon
as money capital is lent out to industrial capitalists, interest on it grows, fulfilling
the most ardent desire of the hoarder.
Marx further related the magnitude of interest to the cycle of economy in which
he mentioned that a low rate of interest corresponds to the period of prosperity or
extra profit. The reason is that in the period of prosperity the regularity of hand-
some returns can adequately fulfill the increased demand for industrial capital and
prevents the level of interest from rising. In contrast, “a maximum of interest up
to a point of extreme usury corresponds to the period of crisis” (Marx, 1959,
p. 243) because during the crisis period money is borrowed even at an extreme
rate to meet the payment requirement.
Besides the natural demand and supply, Marx also stressed that the interest rate
may rise due to speculative use of credit. Marx argued:

The supply of an article can also fall below average, as it does when crop fail-
ures in corn, cotton, etc., occur; and the demand for loan capital can increase
because speculation in these commodities counts on further rise in prices and
the easiest way to make them rise is to temporarily withdraw a portion of the
supply from the market. But in order to pay for the purchased commodities
without selling them, money is secured by means of the commercial “bill of
exchange operations.” In this case, the demand for loan capital increases, and
the rate of interest can rise as a result of this attempt to artificially prevent the
supply of this commodity from reaching the market. The higher rate of inter-
est then reflects an artificial reduction in the supply of commodity-capital.
(1959, pp. 369–370)

Marx further noted that a capitalist society is featured by the main relationship
of exploitation and class between worker and capitalist. In societies where this is
an example of dominant relation, there exists a relation of indebtedness arising in
the credit market. Marx argued referring to the pre-capitalist society that the class
struggle resulted from the conflict between debtor and creditor. The usurer’s cap-
ital which has the mode of exploitation of capital without its mode of production
was pervasive in that stage of society (Eslter, 1986, p. 86). Exploitation through
usurer’s capital or financial capital, according to Marx, gives no impetus to the
development of productive forces. In other words, such a functionless investor has
neither the incentive nor the opportunity to improve the methods of production
18  Yasushi Suzuki and Mohammad Dulal Miah
because he is not necessarily seeking ways to further residual return. From this
perspective, Marx argued that it is unfair that some should be able to earn an
income without working, whereas others must accept the toil. Capitalist extrac-
tion of surplus value is therefore equivalent to theft, embezzlement, robbery and
stealing (Eslter, 1986, p. 95). Marx (1959, p. 399) noted:

Talk about centralisation! The credit system, which has its focus in the so-
called national banks and the big money-lenders and usurers surrounding
them, constitutes enormous centralisation, and gives to this class of parasites
the fabulous power, not only to periodically despoil industrial capitalists, but
also to interfere in actual production in a most dangerous manner – and this
gang knows nothing about production and has nothing to do with it. . . .
These bandits . . . are augmented by financiers and stock-jobbers.

On the other hand, Keynes (1936, p. 150) stated that the rate of interest is
not the price “which brings into equilibrium the demand for resources to invest
with the readiness to abstain from present consumption (savings)” but rather it
is the price “which equilibrates the desire to hold wealth in the form of cash with
the available quantity of cash”. This implies that it is ‘liquidity’ rather than ‘sav-
ing’ which is the function of the interest rate. A lower rate of interest means less
reward for parting with liquidity or cash. At this circumstance, people will have
less incentive to sacrifice their liquid position and vice versa. For Keynes, liquidity
preference (L) along with the quantity of money (M) determines the actual rate
of interest (r) in a given circumstance. The fundamental speculative demand for
money among them can be stated as M = L(r).1
Keynes established the arbitrary relationship between savings upon swinging
propensity to save, investment upon expectations and rate of interest upon chang-
ing liquidity preference. On the other hand, as his philosophical speculations for
seeking an ideal society, Keynes advocated for the realization of a low rate of inter-
est: “It is to our best advantage to reduce the rate of interest to that point rela-
tively to the schedule of the marginal efficiency of capital at which there is full
employment” (Keynes, 1936, p. 343). The question is: How low should be the
rate of interest? Should it ultimately be zero?
From Keynes’s perspective upon his concept of social justice, so far as full
employment is achieved, a much lower rate of interest would be desirable. Accord-
ing to Keynes, the scale of investment depends on the relation between the rate of
interest and the schedule of the marginal efficiency of capital (MEC). In theory,
a lower rate of interest, zero rate of interest at the extreme case, upon the ample
availability of loanable funds, which is independent of interest rate, would encour-
age the borrowers (mainly enterprises) to make more investments so far as their
prospective yield of the investments remains at a satisfactory level (the MEC in the
general theory depends on the relation between the replacement cost [the supply
price of a capital asset] and its prospective yield).
Like Marx, Keynes viewed the inequality of income that results from enterprise
is desirable; however, inequality of income that results from ownership of wealth
 Heterodox vs. Islamic views on interest 19
is undesirable (Minsky, 1975). The rentier class retains the cumulative oppres-
sive power and uses it to exploit the scarcity value of liquid capital. But economic
growth could be better satisfied if capital ceases to be scarce.
It is worth noting that the MEC, based on which the rate of interest is to be
determined targeting the full employment, is subject to the subjective swings of
mood of the borrower. The swings of mood stem from general uncertainty. Simi-
larly, individual preference for liquidity is subject to the condition of uncertainty
as to the future of the rate of interest, which is also fixed by mass psychology. This
postulates that the Keynesian analysis of interest rate is linked greatly to his analy-
sis of uncertainty. Keynes stated:

By uncertain knowledge, let me explain, I do not mean merely to distinguish

what is known for certain from what is only probable. The game of roulette is
not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond
being drawn. Or again, the expectation of life is only slightly uncertain. Even
the weather is only moderately uncertain. The sense in which I am using the
term is that in which the prospect of a European war is uncertain, or the price
of copper and the rate of interest twenty years hence, or the obsolescence of
a new invention, or the position of private wealth owners in the social system
in 1970. About these matters there is no scientific basis on which to form
any calculable probability whatever. We simply do not know. Nevertheless,
the necessity for action and for decision compels us as practical men to do
our best to overlook this awkward fact and to behave exactly as we should
if we had behind us a good Benthamite calculation of a series of prospective
advantages and disadvantages, each multiplied by its appropriate probability
waiting to be summed.
(1937, pp. 213–214)

Uncertainty makes our decision processes complex and volatile and thereby can
have an important impact on the demand for an investment. Since the level of
investment and the rate of interest were determined largely by expectation, uncer-
tainty would also matter to determine both the MEC and liquidity preference
schedules. They tend to put less weight on the matters which are highly uncertain
than the factors about which they “feel somewhat confident, even though they
may be less decisively relevant to the issue than other facts about which our knowl-
edge is vague and scanty” (Keynes, 1936, p. 33). This point reflects the current
trend of mounting financialization in which uncertainties embedded in complex
financial products are codified using sophisticated models and hence positively
influence investors’ confidence towards accepting excess financial leverages, which
gradually leads to financial fragility.
The relevance of the heterodox view on interest and uncertainty to the modern
financial architecture is to be deduced. An increased role of rentiers has been par-
ticularly noted along with its adverse consequences of financialization. Increased
commoditization of complex financial products owing to the innovation of
sophisticated financial modeling which helped reducing embedded uncertainty
20  Yasushi Suzuki and Mohammad Dulal Miah
with these products apparently seemed to increased actors’ favorable expectations
about the future outcome. This in turn prompted actors to engage with financial
speculation, leading to mounting levels of indebtedness and financial fragility.

4. Relevance of interest and uncertainty to the current

financial world
The core issue to the prohibition of interest lies in the exploitation by money capi-
talists and/or the people being engaged in the financial industry. An opportunity
to earn interest encourages economic agents to accumulate wealth and earn income
even without engaging in productive activities. Accumulation of wealth through
financial channels (particularly surplus and interest) other than the traditional
means of production and exchange of commodity has resulted in the shift of the
economic epicenter from industry to finance (Foster, 2007). As a consequence, the
financial market has become the pace-setter of all markets as wealth effect, posi-
tive and negative, plays a crucial role in economic cycles, in which “gambling with
analysis, advice, appraisal, advertising, and commission-charging becomes a major
growth industry” (Dore, 2000, p. 6). More functionless investors who seem to
exploit profit margins in the process of financial flows are growing.
The dominance of finance in the economy, especially in capitalist economies,
began to grow at a noticeable scale in the final quarter of the twentieth century
when industries in those economies faced tremendous competitive pressure from
the rest of the world owing to the nascent pace of globalization. In response to
this threat, firms started shifting their investment and operations from production
to finance. Such a shift has helped the financial industry contribute a larger share
to the GDP. Epstein and Power (2003) report that the rise of rentier income
between the periods of the 1960s–1970s and the 1980s–1990s was tremendous.
In the 1950s, profit earned by US financial corporations as a proportion of national
income averaged 9.5 percent which rose to 45 percent in 2002 (Mukunda, 2014).
Mukunda further reports that profits earned by finance and insurance industries
accounted for 37 percent of the profit all other sectors combined in 2013. This
means that more than one-third of dollars earned in the US economy go to the
financial institutions. Including the financial activities of non-financial firms would
make the estimation unbelievably high. In the 2000s, Ford’s income from selling
loans was more than its income from selling cars, while GE Capital generated
approximately half of GE’s total earnings (Mukunda, 2014). On the other hand,
financial costs to non-financial firms increased manifold. Crotty (2005) shows
that the payments to financial sectors in the form of interest, dividends and share
buybacks by non-financial firms as a proportion to cash flow accounted for 20 per-
cent in the 1960s, 30 percent in the 1970s and 75 percent in 1990. As the cycle
goes on gearing up more financial activities and profit thereof, available funds for
investment in tangible assets are drained from real to financial markets.
In contrast to the prohibition of interest, the core issue to the prohibition of
(excess) uncertainty lies in the reality in which the future is not knowable by human
 Heterodox vs. Islamic views on interest 21
beings. Frank Knight distinguishes between risk and uncertainty in which he defines
risk as a future event that can be assigned a probability, whereas uncertainty cannot
be quantified objectively. However, the innovation of sophisticated financial mod-
els has presumably attempted to turn entrepreneurs’ uncertainty into risk. These
models have been given enormous importance as objective, or at least objectifi-
able, measures of risk assessment tools. It seems that the current financial world has
deliberately ignored the heterodox (post-Keynesian) view on the difficulty of deal-
ing with fundamental uncertainty embedded in economic activities. Pacces (2010)
argues that the neoclassical economic theory, including financial modeling, has tra-
ditionally neglected the Knightian distinction due to its mathematical intractability.
This detour from the basic economic principles has repeatedly paved the way for an
unsustainable rise of finance and the resulting financial crisis.
Recurrent financial crisis in the capitalistic system construes that crises in the
financial markets are systemic in which investment is more or less exposed to
fundamental uncertainty. An analysis of financial crises reveals that most waves
of financial bubbles are the result of excessive risk-taking by lenders’ optimism.
Stiglitz (2012) argues that in the post Glass–Steagall era some banks have shoul-
dered the amount of risk that they are practically unable to absorb. Similarly,
Calomiris and Haber (2014) show that in the post-Second World War period
banks in the worlds’ most developed economies became excessively leveraged
and maintained smaller amounts of low-risk assets. Financial and non-financial
institutions were engaged heavily with the trading of toxic financial products
such as financial derivatives, leading to excessive (or uncertain) risk exposures of
enterprises.
We emphasize that the excessive risk-taking underlies the swings of mood –
optimistic or occasionally opportunistic behavior – in decision-makers under the
conditions of uncertainty. Intermediaries and brokers have taken packaging and
repackaging of securities so far and ambiguously that the final investors could
rarely trace the origin of cash flows on which payment on securities he/she holds
depends. It is ultimately the cash flows generated by the investors or entrepre-
neurs who, as mentioned earlier, are subject to fundamental uncertainty. Pacces
(2010) argues that wholesale investors accepted to finance banks dealing with
securitization because they disregarded the uncertainty of the liquidity they were
generating. Ostensibly sophisticated financial models, which were believed to pre-
dict flawlessly the default probability of entrepreneurs, helped boost investors’
confidence in this particular regard. In reality, these models’ predictive accuracy
was proved to be illusionary rather than the representation of the real scenario.
For instance, predictions sometimes appeared to be so unrealistic that the default
rates for CDO tranches calculated by top rating agencies exceeded projections, on
average, by 20,155 percent (Nelson and Katzenstein, 2014, p. 377). This proves
that uncertainty cannot be treated like risk. Both Islamic and heterodox views
issue strong cautionary notes for dealing with uncertainties whereas the new clas-
sical models increase investors’ confidence and attract agents to embrace uncer-
tainty to such an extent that they are financially unable to absorb it.
22  Yasushi Suzuki and Mohammad Dulal Miah

5.  Challenges to Islamic and heterodox views

Modern capitalism, albeit its setbacks resulting from the excessive reliance on
finance, throws serious challenge to the view which heterodox and Islamic eco-
nomics endorse in regard to risk and uncertainty. Keynes (1936, p. 344) argues
that “the owner of capital can obtain interest because capital is scarce . . . but there
are no intrinsic reasons for the scarcity of capital.” For Keynes, interest cannot be
the price of financial capital because the rate of interest depends on the monetary
supply and the demand which are based upon the income level and the liquidity
preference of holders. Therefore, interest can be kept minimum, even zero at the
extreme case, so far as a state of full employment is achieved.
However, it is worth noting that the scale of investment is not always promoted
by a low rate of interest as assumed in the general theory. Despite the availability
of sufficient funds, screening and monitoring activities by (functional) lenders and
investors still matter in order to respond to the general uncertainty from which
lenders suffer, and thereby contribute to the optimal allocation of risk funds. For
banks as financial intermediaries, their nominal net profit from lending (particu-
larly in the case of lending upon ‘floating rate’) is not affected by the change in
the market reference rate as the funding rate for banks, so far as the spread margin
as risk premium towards their borrowers remains unchanged and the loan expo-
sure to them remains the same. In other words, banks’ net profit from lending
upon the floating rate is affected only if (i) banks consider their borrowers’ low-
ered funding costs to reasonably lower their probability of default (to increase
their probability of success), then banks are willing to increase the loan exposure
towards their borrowers when risk-adjusted returns are expected to be increased;
and (ii) the borrowers increase the demand of fund-raising for their investment.
The above (i) is related to banks’ subjective judgment of screening and monitor-
ing, while the above (ii) depends on the borrowers’ subjective sentiment of invest-
ment. Both are, by nature, arbitrarily determined.
Second, we should ask how a low rate of interest can attract the ultimate fund
providers. In the Marxian tradition, the analysis of banking credit and interest is
undertaken on the basis of Marx’s approach such that stagnant (or idle) money
is systematically generated in the course of industrial accumulation, transformed
into interest-bearing capital by the credit system and returned to accumulation
to receive a share of surplus value (Itoh and Lapavitsas, 1999, p. 61). The money
capital accumulated through the sale of commodity capital as well as the hoard
of temporarily idle money of the industrial and commercial capitalists (workers,
the state or anyone else) are collected and centralized in the financial institutions,
and transformed into potential money capital available to industrial capital (Fine
and Saad-Filho, 2004). Needless to say, a lower (or zero) rate of interest would
be less attractive to the idle money holders. Less money capital available to indus-
trial capital would be less contributing to the capital accumulation for society. In
respect to Marx’s theory, the circulation of M-C-M’ or M-M’ in the interest-free
mode where expected incomes are not pre-determined is considered slower than
that in the capitalist mode where a certain interest margin is offered. On the one
 Heterodox vs. Islamic views on interest 23
hand, Islamic principles are contributing to squeezing functionless financiers by
giving them less opportunities of exploiting. Similarly, in the process of squeez-
ing functionless financiers, the functional financiers who are expected to have the
partner’s strategy in participatory financing for incubating new industries are also
possibly squeezed.
Islamic banks mobilize deposits on the basis of PLS agreement and to some
extent on the basis of wakalah (agency) against pre-agreed service charges or
agency fees. While sharing profit or loss arising on investments, they earn a return
on their trading and leasing activities by dint of the risk and liability undertaken
and adding value in real business activities (Ayub, 2007). We note the following
threat and sanctions mechanisms which encourage prudent screening and moni-
toring in the Islamic mode of banking. First, Shari’ah rules are considered the
cornerstone of Islamic financial products and services. If depositors or customers
become aware that the products they have in their portfolios are not Shari’ah
compliant, it would seriously undermine customer confidence in the Islamic bank
concerned or, on a larger scale, in the Islamic financial services industry as a whole
(Bhambra, 2007, pp. 204–5). Second, a conservative credit screening policy is
pursued from the perspective of loss aversion. Risk-averse depositors will look for
low-risk forms of financing, for instance, murabaha and other similar asset-backed
financing. El-Gamal (2006) refers to what Islamic finance practitioners call ‘dis-
placed commercial risk’. This may arise if Islamic bank depositors suffer a loss
compared to the conventional bank depositors and therefore withdraw their funds
from the Islamic bank (El-Gamal, 2006, p. 155). A conservative credit screening
policy is also pursued from the perspective of avoiding the risk. Third, strict prac-
tice of PLS principle is a rarity in Islamic banking operations and in most cases the
return for the depositors is homogenous for all banks irrespective of their scales of
profitability (Chong and Liu, 2009; Farook and Farooq, 2011, Zaher and Has-
san, 2001).
It is highly likely that some Islamic banks are hesitant to share losses with their
depositors maintaining their franchise value as prudent monitors to avoid the dis-
placed commercial risk. Credit risk is similar to conventional banking, but credit
risk management and recovery process are far more complicated in the Islamic
banking system than in conventional banking (El Tiby, 2011). Unlike conven-
tional banks, Islamic banks have to absorb not only the credit risk but also the risk
associated with the compliance of Islamic Shari’ah, that is, Shari’ah risk. Accord-
ingly, within the difference between the rates of profit received and profit paid
(borrowing rate and lending rate, respectively, in conventional banking), Islamic
banks need to reserve a cushion to absorb the unexpected loss and the transaction
costs associated with the Shari’ah compliance to maintain the franchise value.
In parallel, we should note that under the prohibition of gharar and the PLS
framework, it may have created a dilemma of the so-called murabaha syndrome
leading to the financial disintermediation (particularly the drain of long-term
funds) for hampering the potential of SMEs. Long-term growth may suffer as a
result. Suzuki (2013) suggests that on the condition that the best effort to avoid
the incompleteness of the contract is made, it should be acceptable, to an extent
24  Yasushi Suzuki and Mohammad Dulal Miah
in which the associated uncertainty in enterprises can be shared and absorbed
in the community through an adequate PLS agreement, to incubate small and
medium enterprises in agricultural and industrial sectors (see Chapter 3 of this
book). However, the issue on the acceptable or unacceptable level of gharar is
still controversial. How Islamic financial institutions will tackle the murabaha syn-
drome while improving the financial intermediation to industrial potentials entails
further argument (see Chapter 2 of this book).
As is argued earlier in this chapter, it is possible that the prohibition of riba
makes it difficult to collect and centralize the temporarily idle money in order to
transform it into potential money capital available to industrial capital. Çizakça
(2011) laments that the difficulty of collecting deposits without offering interest
results in the rise of Islamic banking dominated by merely Shari’ah-compliant
asset-based financing including murabaha rather than by the dominance of
profit-and-loss sharing mudaraba (trust-based contract) and musharaka
(partnership/equity-based contract) that are developed by the divine rules pre-
scribed in Islamic Shari’ah. However, the current PLS mode gives Islamic banks
less incentives to assume equity-like financing along with higher credit risk. As
Suzuki and Uddin (2014) point out, it is impractical to expect the acceleration
of participatory financing without preserving much higher bank rent opportuni-
ties for Islamic banks to compensate for Shari’ah PLS risk. The dilemma in the
Islamic mode of mobilizing financial resources can be analyzed from the Marxian
political-economy view on money and credit.
From the Marxian political-economy perspective, capital is considered the sum
total of social relations between capitalists and workers, but also the ceaseless
movement of value in pursuit of self-expansion.

The latter is best thought of as a circular flow; capital value starts as money,
becomes material inputs for production through market purchases (means
of production and labor power), turns into finished commodities through
production, and returns to money (augmented by surplus value generated in
production, i.e. profit) through sale of finished commodities.
(Lapavitsas, 2003, p. 67)

In the trend of financialization, interest-bearing capital (IBC) as represented by

the M-M’ circuit where money stands apart from the production process is also
considered the ceaseless movement of value in pursuit of self-expansion. On the
other hand, IBC represents a claim on surplus value that has yet to be produced.
In this light, since there can be no guarantee of production and appropriation
of surplus value, it is hardly surprising that the financial sector should be capable
of financing overproduction and generating spectacular speculative bubbles and
equally spectacular crashes. Nor is it surprising that the possibility of fraud is ever
present, even though ‘fictitious capital’ of this kind has become increasingly nec-
essary for real accumulation (Fine and Saad-Filho, 2004).
If this Marxian view is held, it seems infeasible to eliminate the role of func-
tionless financiers in the movement, while maintaining appropriate incentives to
 Heterodox vs. Islamic views on interest 25
the functional financiers. Or, in other words, we cannot tame the spirit of finan-
cialization without simply killing ‘the golden goose’ – the rentier; and at the same
time, continuous financialization is engulfing the real economy.
Perhaps, this dilemma can rationalize the partnership strategy upon the PLS
between industrial capitalists and money capitalists (fund providers) widely
observed in Islamic finance. Islam does not allow rentier income from interest;
rather it encourages profit-and-loss sharing financial contracts so that uncertainty
involving with the future income is shared by contracting parties. However, it
is a great challenge for Islamic banks and depositors to diversify and absorb the
general uncertainty.
Under the recent trend of ugly neologisms – “marketization plus financializa-
tion” (Dore, 2000; Dore, 2008; Dore, 2011), the orthodox and traditional con-
ceptualization of the decision-making process under ‘measurable’ uncertainty or
risk has gained a total domination of the subject. The post-Keynesian and hetero-
dox view on the decision-making under ‘unmeasurable’ uncertainty a la Knight
is nearly dead particularly among the practitioners in financial markets. Since the
consequences of actions extend into the future, accurate forecasting is essential
for making objectively rational choices. But in the real world, most choices take
place under conditions of uncertainty. The screening and monitoring actors (the
banks as lenders and the investors as fund providers) are working under condi-
tions of uncertainty. This means that monitoring activities are not mechanical, and
that they are intrinsically based on subjective judgments that are often extremely
difficult. The fundamental implication of Keynes’s uncertainty is that all economi-
cally meaningful behavior derives from agents’ efforts to protect themselves from
uncertainty (Dymski, 1993). While the functional financiers who deal with vari-
ous ranges of credit risk under conditions of uncertainty are required for our soci-
ety, it makes sense of the emergence of the functionless financiers who pay their
efforts to protect themselves from uncertainty. How can we expect the Islamic
mode of financial intermediation to transcend this dilemma?

6  Concluding comments
In this chapter we have attempted to explain the economics of the Islamic prohi-
bition of riba and gharar and the compatibility of this principle to the heterodox
perspective on interest and uncertainty. Islam strictly forbids dealing with profits
on loans irrespective of interest or usury. Severe punishment has been provisioned
in the Islamic teaching for those who violate this principle. Since religion is a
spiritual element of human life the benefits of complying with religious princi-
ples cannot be objectively measured. Nevertheless, some implications of religious
teaching should be reflected in our social and economic life. In this pursuit, we
find the economics of Keynes and Marx compatible with the Islamic prohibition
of interest and uncertainty.
Key rationale that underpins the interest-free argument lies in the prevention
of exploitation. In a lending relationship, the person who is poor usually borrows
(debtor) from the wealthy individuals or merchants (creditors). Since the debtor
26  Yasushi Suzuki and Mohammad Dulal Miah
is already poor, the burden of extra payment would lead his financial position
to further deterioration, perhaps entangling him in a vicious cycle of poverty. In
contrast, the creditor who does not take part in any real activities would enjoy
a pre-determined return just because of postponing his current consumption to
the future. Can the ethics in the mode of interest-free lending including mush-
araka, mudaraba and wakalah avoid this cumbersome situation? This ethics may
draw a prescription for modern capitalism where the lending relationship is domi-
nated by the entrepreneurial class as debtor and the surplus depositors as credi-
tors. Although the modern concept of entrepreneur-lender replaces the typical
poor-rich relation in lending activities, the opportunity of exploitation remains
in place. This opportunity has been analyzed from the context of the heterodox
school. It is argued that the capitalist mode of production and distribution, as it
stands today, relies heavily on financing activities leaving the real economy behind
(crowding-out effect). This trend has paved the way for the emergence of a capi-
talist class which artificially attempts to make capital scarce and hence hikes exor-
bitant interest as its use-value, which according to the Keynesian school should
not exist. Keynes, instead, argued as his philosophical speculation that interest rate
at the minimum should be lower if it ensures full employment. Similarly, Marx
finds capital to be a machine for exploitation (as well as an engine for the mode of
capitalism). In exchange of supplying capital in the production system, capitalists
exploit the surplus value produced by the working class, which according to Marx
is opposite to the spirit of equality and social justice.
In a similar fashion, it is argued that modern capitalism has put tremendous
effort to accurately model uncertainty using some probabilistic theories. Such an
endeavor has undoubtedly created enormous opportunities for economic agents
to profit from engaging with trading securities in the financial markets. In addi-
tion, such models at times provided regulators with greater legitimacy for their
decisions although the tendency of commoditizing risk and uncertainty as well
as sophistication of financial products created over-optimism about the financial
markets and products. Over-optimism created by the innovation of financial prod-
ucts and risk management models facilitated the formation of bubbles. Eventual
burst of a bubble in the past left a lot of scary marks in the economy including
decline in consumer wealth and prolonged unemployment.
However, an interest-free world upon the PLS is not so easy to implement at a
time where interest is embedded in every sphere of our economy. In this regard,
attempts have also been made to highlight the challenges the interest-free school
often faces in the context of the capitalistic mode of financing. Keynesian logic for
a lower interest rate is very restrictive because the argument that a lower interest
rate leads to higher investment as well as employment is conditional upon other
economic variables. In the same token, the Islamic prohibition of interest suffers
from a dilemma. For instance, the existence of uncertainty on the one hand and
the non-existence of interest on the other make it difficult for Islamic financial
institutions to mobilize deposits and expand loans. This has resulted in the con-
centration of Islamic murabaha financing instead of true PLS contracts. Some
 Heterodox vs. Islamic views on interest 27
of these challenges and their possible explanations are discussed in detail in the
following chapters.

Note
1 In the general theory, Keynes distinguishes the transactions, precautionary and
speculative motives for holding money. Keynes wrote the demand for money as:
M = L1(Y) + L2 (r), where L1 is the liquidity function corresponding to and income
Y and L2 is the liquidity function of the rate of interest r. In this formulation L1
reflected the transactions motive and L2 the speculative motive (Minsky, 1975).
2 A critique to a naïve critique
to ‘murabaha’ ‘tawarruq’
syndrome
Mohammad Dulal Miah and Yasushi Suzuki

1. Introduction
Islamic banks are prohibited from dealing with interest (profits on loans) and
excess uncertainty, the two dominant features embedded in conventional bank-
ing practices. Instead, the Islamic mode of banking is required to offer various
financial products complying with Shari’ah principles. Shari’ah principles endorse
a profit-and-loss sharing (PLS)-based mode of financing instead of interest-based
loans. In particular, musharaka (participatory finance) and mudaraba (trust-
based finance) are considered purely PLS-based financing. Under this financing
paradigm, assets and liabilities of Islamic banks are integrated in the sense that
borrowers share profits and losses with the banks which, in turn, share profits
and losses with the depositors. There are other financial contracts permissible in
Islam and are practiced by Islamic banks across the world. For example, mura-
baha (mark-up) financing is most popular among Islamic banks whereas ijarah
(leasing), bai bithman ajil or bai muajjal (variant of murabaha), bai salam (for-
ward sale contract), and istisna (commissioned or contract manufacturing) are
also offered by Islamic banks. These products, although permitted in Islam, are,
according to the classification by Çizakça (2011), the Shari’ah-compliant financ-
ing, rather than the purely Shari’ah-based financing.
Although many Islamic banks claim to invest and finance complying with
Islamic principles, scholars however dissent in opinion as to whether Islamic
banks are really Islamic. For instance, Chong and Liu (2009) comparing the
deposit rates between Islamic and conventional banks conclude that the deposit
of Islamic banks is not interest free (in passing, it is worth noting that Islamic
banks offer ‘hidah’ rate for wadi’ah yad-dhomanah (saving account holders, and
‘indicative profit rate’ for mudharabah saving account holders. We will discuss this
issue later). Ariff and Rosly (2011) argue in the context of the Malaysian bank-
ing system that Islamic banking is not very different from conventional banking.
Similarly, Aggarwal and Yousef (2000) and Khan (2010) contend that Islamic
banking activities in most instances are still functionally indistinguishable from
conventional banking. In the same token, Dusuki (2007) contends that the cur-
rent practices of Islamic banking entail that this model of banking in reality is not
different from conventional banking practices since the net result of Islamic bank-
ing operations is the same as that of conventional banking.
 A critique to a naïve critique 29
In contrast, Beck et al. (2013), drawing evidence from a large number of banks
worldwide, find that Islamic banking activities are different from conventional
banking although the difference is limited. They particularly show that the fee
income, which they consider an indicator of difference, is higher for Islamic banks
than the conventional banks. Similarly, Miah and Uddin (2017) find in the con-
text of GCC countries that the operation of Islamic banks is different from the
conventional banks. Salient features of Islamic banks that distinguish this model
from the conventional banking model are also documented in many studies (see
Metwally, 1997; Olson and Zoubi, 2008).
Critics of Islamic banking support their arguments drawing evidence from
the analysis of investment patterns of Islamic banks. Suzuki et al. (2017) ana-
lyze income from different financing activities of Islamic banks of Malaysia, Indo-
nesia, Pakistan, and Bangladesh. They find that although Islamic banks comply
with Shari’ah principles their mode of investment is dominated by murabaha or
mark-up lending which is close to conventional banks’ lending. Similarly, Aggar-
wal and Yousef (2000) drawing evidence from a large number of banks find that
murabaha and ijara constituted about 52 percent of the total financing of Islamic
banks in 1994 which increased slightly to 56 percent in 1995. In contrast, mush-
araka and mudaraba combined 20 percent in 1994 which also increased slightly
to 23 percent in 1995. Yousef (2004) provides relatively recent evidence on the
concentration of mark-up financing of Islamic banks. His analysis shows that
mark-up financing comprises 86 percent of the total financing of Islamic banks in
the Middle East, 70 percent in East Asia, 92 percent in South Asia, and 56 percent
in Sub-Saharan African countries.
In this chapter we aim to critically evaluate the naïve critic of murabaha concen-
tration. In so doing we provide some recent data collected from the audited finan-
cial statements of banks in the GCC countries to check the status of murabaha
concentration in the region. We then assess if there is any change in the financing
pattern of Islamic banks over the years. Finally, we refute some criticisms aimed at
murabaha concentration. We argue that the preference of Islamic banks for debt-
like financing over the participatory mode of investment is a rational choice given
the current financial set-up.
The chapter has been structured as follows: Section 2 briefly describes the
Shari’ah-based and Shari’ah-compliant banking products. Section 3 highlights
the murabaha concentration in the GCC countries whereas Section 4 critically
evaluates the critics of murabaha concentration which is followed by a brief
conclusion.

2. Shari’ah-based vs. Shari’ah-compliant banking

products
Although the spirit of Islamic finance is rooted in the PLS mode of financing
such as musharaka and mudaraba which are purely Shari’ah-based ‘participatory’
products, the evidence provided in the previous section shows that most Islamic
banks prefer to deal with products which are akin to debt-like instruments. Mura-
baha, ijarah, tawarruq, bai bithman ajil (bai muajjal) are some examples which
30  Mohammad Dulal Miah and Yasushi Suzuki
are not based on participatory financing but they comply with Islamic Shari’ah.
We briefly describe the salient features of these products.

2.1  Shari’ah-based products

Musharaka: The Arabic root of the word musharaka is shirkah which means being
a partner or sharing. In the Islamic banking context, musharaka refers to a joint
partnership in which a bank and an entrepreneur join together for the purpose
of a business. According to the general contract rule, all the necessary precondi-
tions of a valid contract must be present. Partners contribute capital and manage
the business jointly. Also, partners share profit according to a specific ratio, while
the loss is shared according to the ratio of the contribution of capital.1 It is to be
noted that the ratio of profit for each partner must be determined in proportion
to the actual profit earned by the business; hence, it is not allowed to fix a lump
sum amount for any one of the partners, or any rate of profit tied up with his
investment. Moreover, the contract will be void in the absence of a predetermined
profit-sharing ratio.
Musharaka is an independent legal entity and the bank may terminate the joint
venture gradually after a certain period of time or upon the fulfilment of certain
conditions. According to the musharaka principles every partner has the right to
take part in its management and to work for it. However, upon the consent of
contracting partners, a single partner can take care of the musharaka on behalf of
others. In such a case the sleeping partner shall be entitled to profit only to the
extent of his investment, and the ratio of profit allocated to him should not exceed
the ratio of his investment. However, if all the partners agree to work for the joint
venture, each one of them shall be treated as the agent of the other in all matters
of business. Any work done by one of them in the normal course of business shall
be deemed as authorized by all partners.
There are two types of musharaka according to Islamic Shari’ah, Shirkat-
ul-Mulk and Shirkat-ul-Aqd. In Shirkat ul-Mulk, partners are involved with joint
partnerships of certain properties voluntarily (such as the purchase of an asset
upon mutual agreement) or partners join in the venture automatically (in the case
of inheritance). Shirkat-ul-Aqd on the other hand can literally be translated as a
partnership effected by mutual contract or a joint commercial enterprise. The basis
of joint partnerships can be capital (Shirkat Ul-Mal), expertise or labor (Shirkat
ul-a’mal), or it can be based on credit such as purchasing at deferred price and
selling at spot price (Shirkat Ul-Wujuh). Since it is purely a PLS-based contract,
musharaka is considered an ideal alternative to interest-based financing.
Mudaraba: Mudaraba is also another type of PLS-based contract which can
be translated as trust finance, profit sharing among trustees, and equity sharing
and profit-sharing basis (Haron and Azmi, 2009). Kettell (2011) argues that the
mudaraba contract is established as being permissible by the consensus of the
Islamic scholars and is not based on primary sources of the Shari’ah.
In a mudaraba contract, one partner who provides the required funds is called
‘rabb-ul-mal’ whereas the partner who is entrusted with the money and managing
 A critique to a naïve critique 31
the business is known as the agent or ‘mudarib’. Although mudaraba seems to
be similar to musharaka, Hasan (2014) points out differences between these two
types of contracts. First, mudaraba is suitable for short-term projects or projects
for specific purposes such as constructions whereas musharaka is based on equity
participation in an ongoing business. Second, the profit-sharing ratio may have
no relation with the loss sharing ratio in mudaraba whereas in musharaka the
profit-and-loss sharing ratio can be identical. In mudaraba, the ‘rabb-ul-mal’
provides the capital and only the ‘mudarib’ participates in managing the busi-
ness, whereas in musharaka all the parties provide capital and reserve the right to
participate in management. Thus, the capital provider bears all the losses and the
‘mudarib’ earns a profit share, if the project is profitable.
As the fund provider, the rabb-ul-mal may specify a particular business for
the mudarib if the former is interested to invest in a particular business. If the
mudarib agrees to participate in this particular business, the resulting mudaraba
is called ‘al-mudaraba al-muqayyadah’ (restricted mudaraba). But if the
rabb-ul-mal leaves the option to mudarib to undertake whatever business
he wishes, the mudarib shall be authorized to invest the money in any business
he deems fit. This type of mudaraba is called ‘al-mudaraba al-mutlaqah’ (unre-
stricted mudaraba).
Islamic banks most often use two-tier mudaraba. In the first-tier, the bank and
the depositors agree on a mudaraba contract in which depositors supply the fund
(rabb-ul-mal) and the bank acts as manager (mudarib). The depositors place their
money in the bank without any guarantee that they would receive return of the
principal. Like the ordinary mudaraba contract, the depositors bear any losses.
Also, they share profits with the Islamic bank in accordance with a pre-agreed
ratio. In the second-tier, the bank agrees with a customer or an entrepreneur to
supply necessary funds (rabb-ul-mal) for projects which the entrepreneur would
manage (mudarib). Here, the bank bears all the losses and shares profits result-
ing from the normal course of business according to a pre-agreed ratio. It reflects
that in a two-tier mudaraba, the bank plays the role of an intermediary between
depositors and customers. Banks bear all the losses in the second-tier contract
which they must transfer to the depositors, though, in practice, the so-called dis-
placed commercial risk discourages Islamic banks to fully transfer the losses to the
investment account holders. Even if they could fully transfer all the losses, this
may have an adverse effect on the deposit collection compared to the conventional
banks. Thus, Islamic banks must ensure that investment portfolios are sufficiently
diversified. Otherwise, Islamic banks are discouraged to be engaged as the owner
of ‘mudaraba’ capital.

2.2  Shari’ah-compliant products

Murabaha: Murabaha is the dominant mode of finance of Islamic banks across
the world. The term ‘murabaha’ refers to a particular kind of sale. Unlike ordi-
nary sales, the seller in murabaha transactions discloses the real cost of the object
offered for sale to the buyer and adds a certain profit above the cost price. Thus,
32  Mohammad Dulal Miah and Yasushi Suzuki
murabaha is known as a mark-up sale. The mark-up may be a lump sum amount
or may be based on a percentage. In murabaha transactions, the buyer can make
the payment at spot or at a subsequent date agreed upon by the parties. Islamic
banks should not charge differently if the payment is made spot or any time in the
future.
There is a serious debate as to whether murabaha or mark-up transaction really
complies with Islamic principle. The debate stems from the fact that the mark-up
or the extra charge above the cost price is pre-fixed which is akin to conventional
bank lending. Since the profit earned from murabaha is certain and pre-fixed,
some Islamic economists criticize that murabaha is simply a conventional banking
product in the guise of the Islamic name.
In a traditional murabaha transaction the buyer (customer) usually asks a seller
(bank) to buy a particular product which the former promises to buy from the
latter at a certain mark-up price. Shari’ah scholars consider this an invitation to
do business together (Kettell, 2011). Upon the request from a prospective buyer,
the seller (bank) locates the product according to the specification and possesses
the legal title of the product. The bank then sells this product finally to the cus-
tomer at a mark-up price. In this commercial transaction of Islamic banks, profits
are made from sales. Whereas ‘profits on loans’ are unlawful, ‘profits on sales’ are
allowed. Thus, murabaha, even if it is sometimes ambiguous whether it is falling
into the PLS scheme, is considered a Shari’ah-compliant product.
However, murabaha transactions should satisfy certain conditions to be a
Shari’ah-compliant product. Salient among them are as follows. The subject
which is to be sold should exist at the time of sale which implies that transactions
for any goods to be produced in the future are not permissible. Moreover, the
bank must own the subject and take constructive (title) or actual possession of
the good before selling it to the customer. The sale transaction must be instant
and absolute and the subject of sale must be a property of value which means that
money cannot be exchanged for money; exchange should be either commodity
for commodity or commodity for money. In addition, the delivery of the sold
commodity to the buyer must be certain and should not depend on a contingency
or chance.
Hasan (2014) contends that the murabaha contract does not defy the Shari’ah
norms. However, Islamic scholars sometimes question this mode of contract
because of its overuse. Although murabaha is a Shari’ah-compliant transaction,
it contributes less to the purpose for which PLS-based ‘participatory’ finance is
designed and instructed. For instance, musharaka and mudaraba create real eco-
nomic value through creating a joint venture for a certain specific purpose or a
project whereas murabaha mostly takes ownership of an existing asset and hence
contributes less to the value addition in an economy compared to mudaraba and
musharaka contracts. This proposition, however, does not sufficiently consider
the possibility that murabaha would contribute to economic value addition by
helping the manufacturers buy the raw materials for their products.
Also, there are other issues which are at the centre of debate. For instance,
how to decide mark-up amount or percentage? How high or low should it be?
 A critique to a naïve critique 33
Charging less or more may hurt the business of Islamic banks as in most cases they
are competing with conventional banks. Presumably, Islamic bank managers are
concerned about (i) the cost of fund and (ii) the expected margin of profits.
Tawarruq: Tawarruq is a reverse murabaha. In this contract, the buyer buys an
asset from a seller (usually from a bank) at a cost-plus basis on a deferred payment
system (murabaha contract). The buyer then sells the same asset to a third party
(a bank usually manages the sale) on a cash basis. Thus, tawaruuq is called reverse
murabaha. The buyer basically borrows the cash needed to make the initial pur-
chase. Later, when he secures the cash from the second transaction, the buyer
pays the original seller the instalment or lump sum payment he owes. This sort
of transaction is somewhat controversial because the intention of the commodity
purchases isn’t for the buyer’s use or ownership. Some scholars believe that the
transaction isn’t Shari’ah-compliant.
Bai bithman ajil: Bai bithman ajil (BBA) is also a popular product of Islamic
banks particularly for long-term needs of clients. BBA, whereby the payment is on
deferred terms and musharakah mutanaqisah or diminishing partnership (DP),
dominates home financing contracts in Malaysia. For BBA contracts, before the
bank can sell the asset (a house) from the customer, the bank has to either purchase
the asset from the customer (bay’ al-’inah) or enter into a novation agreement
with the customer and the developer. Under the DP, the bank and the customer
jointly own the asset and the bank will allow customers to buy out the bank’s share
in the asset progressively. In some countries such as Bangladesh and Pakistan,
BBA is known as bai muajjal. Under this contract the seller earns a profit margin
on his purchase price and allows the buyer to pay the price of the commodity at a
future date in a lump sum or in instalments. He has to mention expressly the cost
of the commodity. The margin of profit is mutually agreed upon. BBA is valid
if the due date of payment is fixed in an unambiguous manner and can be fixed
either with reference to a particular date or by specifying a period, but it cannot
be fixed with reference to a future event the exact date of which is unknown or is
uncertain.

3.  Murabaha concentration of Islamic banks

As mentioned previously in the chapter, there are some products which are equity-
like ‘participatory’ financing while some products are ‘debt-like’ financing. It is
practically difficult to collect segregated data on financing and investing patterns
of Islamic banks due to differences in reporting style. As a consequence, exist-
ing literature cannot provide convincing aggregate data compiled from a sizable
number of banks. Here we have attempted to collect data pertaining to financing
pattern of Islamic banks in various countries.
First, we have examined the financing and investment pattern of Islamic banks
of GCC countries going through their audited financial statements. As expected,
the reporting style varies among banks. Some banks do not segregate data accord-
ing to financing pattern or investment types such as murabaha, mudaraba, mush-
araka, istisna, ijara etc. We have checked almost all the retail Islamic banks of
34  Mohammad Dulal Miah and Yasushi Suzuki
GCC countries. Then we have examined financing types shown in the balance
sheet of banks as well as income from different financing sources for the financial
year 2015 and 2016. We offer only comparative analysis to avoid the currency
conversion problem because almost all the banks use their local currency as report-
ing currency except a few banks which use international currency. We have tried
to reduce the financing categories to widely practiced terms such as mudaraba,
musharaka, murabaha (in few instances, mutajara is included in murabaha), and
ijara. The rest are grouped as ‘others’ which includes BBA (bai muajjal), tawar-
ruq, bai salam, istisna, wakala, and other Islamic financial products. Table 2.1
and Table 2.2 depict the overall picture.
It is evident from the data that Islamic banks in GCC countries are comfortable
in dealing with Shari’ah-compliant products instead of Shari’ah-based products.
Financing in Shari’ah-based products averaged only 5 percent of the total finance
extended by GCC Islamic banks in 2015 which remained almost the same in
2016. Few among the sample banks did not report any amount in the musharaka
and mudaraba categories either because they did not finance based on musharaka
and mudaraba principles or the amount was too small to report separately.
Based on our reported data, Islamic banks of Bahrain seem to be the leader of
Shari’ah-based financing in the GCC countries. Bank Al Salam tops the list hav-
ing 37 percent share of PLS finance in 2016. Al Baraka Islamic Banks and Bahrain
Islamic Banks rank second and third, respectively, in the list.
Among the debt-like finance, murabaha dominates the list. In 2016, the mura-
baha mode of financing averaged more than 55 percent of the total financing
of Islamic banks in GCC countries. The maximum percentage of this particular
category accounts for about 90 percent of the total finance in Khaleeji Commer-
cial Banks. Al Rajhi Bank was the least provider of murabaha finance in 2016
(25.84 percent). Murabaha and ijara combined accounts for on average 87 per-
cent of the total financing of these banks. There is however no apparent difference
in 2015 and 2016.
We also report data of the income share of Islamic banking (in Table 2.2) in
commensuration with the financing pattern reported in Table 2.1. The matching
of data reported in both tables indicates the accuracy of the calculation. Income
data shows that the share of Shari’ah-based income accounted for little more
than 5 percent of total income of sample banks. In contrast, the share of mura-
baha accounts for 56 percent of banks’ total income in 2016, a slight increase
from 2015. As expected, ijara is the second major source of income for banks
after murabaha. Murabaha and ijara combined 50 percent at the minimum
and 100 percent at the maximum of the total income of the sample banks (see
Table 2.2).
The concentration of debt-like financing of Islamic banks in GCC countries is
not a stand-alone case but rather it is a common phenomenon of Islamic banks
everywhere. We collect data from the literature to examine the financial struc-
ture of Islamic banks in four Muslim-dominant countries: Bangladesh, Pakistan,
Indonesia, and Malaysia (see Tables 2.3 and 2.4). Like dual banking systems in
other countries, Islamic finance contributes a significant portion to meet the total
Table 2.1 Lending (financing) structures of Islamic banks (as percentage of total financing)

Bank 2016 2015

Mudaraba Murabaha Ijara Others Mudaraba and Murabaha Ijara Others

and musharaka musharaka
KSA
Bank Al Bilad 3.36 61.65 34.99 0.00 5.65 60.25 34.10 0.00
Al Rajhi Bank 0.00 25.84 73.96 0.20 0.00 23.23 76.61 0.17
UAE
Abu Dhabi Islamic Bank 1.11 57.45 41.07 0.37 1.19 59.25 39.09 0.47
Sharjah Islamic Bank 0.82 29.79 63.43 5.96 0.86 34.36 60.85 3.93
Emirates Islamic Bank 0.21 59.41 31.79 8.59 0.42 61.56 30.79 7.24
Ajman Bank 0.00 42.33 57.22 0.46 0.00 43.93 55.67 0.40
Bahrain

Khaleeji Commercial 2.65 89.49 0.00 7.86 7.10 83.35 0.00 9.55
Al Baraka Islamic Bank 22.51 42.85 19.84 14.81 14.24 49.65 24.59 11.52
Kuwait Finance House Bahrain 0.05 44.63 55.32 0.00 0.16 44.85 54.99 0.00
Ithmar Bank 5.61 79.05 0.00 15.34 4.05 80.45 0.00 15.51
Bahrain Islamic Bank 15.94 60.71 23.34 0.00 17.03 61.02 21.95 0.00
Al Salam Bank Bahrain 37.31 34.62 28.06 0.00 38.08 37.92 24.01 0.00
Kuwait
Warba Bank 0.00 83.78 16.05 0.18 0.00 75.30 24.42 0.28
Kuwait International Bank 0.00 32.88 16.39 50.73* 0.00 33.74 17.00 49.25*
Qatar
Qatar International Islamic Bank 0.76 68.47 21.83 8.95 1.00 71.84 19.20 7.96
Qatar Development Bank 0.00 54.67 44.26 1.07 0.00 61.21 37.35 1.44
Qatar Islamic Bank 0.59 62.46 19.53 17.42 0.64 63.41 19.23 16.72
Barwa Bank 0.00 68.92 22.69 8.39 0.00 71.64 16.39 11.97
Average 5.05 55.50 31.65 5.27 5.02 56.50 30.90 5.13
Minimum 0.00 25.84 0.00 0.00 0.00 23.23 0.00 0.00
Maximum 37.31 89.49 73.96 17.42 38.08 83.35 76.61 16.72

Source: authors’ calculation based on the audited financial statements of banks

*
Since murabaha and wakala are reported separately in the balance sheet, we have included wakala in ‘others’ category
Note: there are two banks in Oman. However neither of them segregates data according to financing or investment patterns
Table 2.2  Financing income of Islamic banks (as percentage of total financing income)

Bank 2016 2015

Mudaraba and Murabaha Ijara Others Mudaraba and Murabaha Ijara Others
musharaka musharaka

KSA
Bank Al Bilad 4.15 65.80 30.05 0.00 5.70 58.60 35.70 0.00
Al Rajhi Bank 0.00 28.86 70.52 0.62 0.00 22.33 77.12 0.55
UAE
Abu Dhabi Islamic Bank 1.10 58.99 39.71 0.19 1.09 59.90 38.80 0.20
Sharjah Islamic Bank 0.00 33.55 62.90 3.55 0.00 34.63 62.02 3.35
Noor Islamic Bank 0.00 72.25 14.98 12.77 0.00 72.99 17.30 9.70
Emirates Islamic Bank 0.24 56.01 28.57 15.19 0.29 59.26 29.92 10.53
Ajman Bank 7.61 44.17 47.54 0.68 9.39 44.72 44.14 1.75
Al Hilal Bank 5.30 76.59 17.80 0.31 4.03 79.22 16.47 0.29
Bahrain
Bahrain Islamic Bank 18.24 58.32 23.44 0.00 20.31 59.56 20.13 0.00
Al Salam Bank Bahrain 35.16 33.13 25.82 5.89 30.68 26.06 23.73 19.53
Al Baraka Banking Group 9.25 79.44 9.95 1.37 7.90 80.79 9.84 1.47
Kuwait
Kuwait International Bank 0.00 37.88 16.72 45.40 0.00 43.30 17.07 39.63
Qatar
Qatar International Islamic Bank 1.09 72.96 23.56 2.39 1.37 72.98 24.22 1.43
Qatar Islamic Bank 0.57 57.21 19.11 23.11 0.70 50.60 20.83 27.87
Barwa Bank 0.00 60.96 22.68 16.36 0.00 59.74 15.53 24.73
Average 5.51 55.74 30.22 8.52 5.43 54.98 30.19 9.40
Minimum 0.00 28.86 9.95 0.00 0.00 22.33 9.84 0.00
Maximum 35.16 79.44 70.52 45.40 30.68 80.79 77.12 39.63
Table 2.3 Income from murabaha (in percentage) of different Islamic banks in Bangladesh and Indonesia

Bank Year

2011 2012 2013 2014 2015

Bangladesh
Islami Bank Bangladesh Ltd. 58.20 (4.13) 58.68 (3.78) 59.18 (4.18) 60.02 (2.98) 58.56 (2.64)
First Security Islami Bank Ltd. 75.22 (0.00) 75.22 (0.00) 73.60 (0.00) 75.05 (0.00) 73.31 (0.00)
Export Import Bank of Bangladesh Ltd. 19.79 (0.00) 19.77 (0.21) 18.57 (0.66) 16.67 (1.10) 14.01 (1.38)
Shahjalal Islami Bank Ltd. 15.63 (0.00) 17.10 (0.00) 15.97 (0.05) 11.63 (0.10) 9.44 (0.00)
Social Islami Bank Ltd. 6.03 (0.42) 4.63 (0.41) 3.49 (0.67) 1.80 (2.26) 1.27 (1.89)
Al-Arafah Islami Bank Ltd. 25.66 (0.00) 15.93 (0.00) 11.56 (0.00) 10.75 (0.00) 8.06 (0.00)
Union Bank Ltd. NE NE 24.16 (0.00) 64.07 (5.75) 63.70 (15.73)
Indonesia
PT. Bank Syariah Mandiri 58.00 (32.00) 66.00 (26.00) 69.39 (22.95) 69.83 (20.11) 64.29 (21.01)
PT. Bank Muamalat Indonesia 47.00 (43.00) 48.00 (42.00) 46.32 (45.09) 44.66 (45.82) 43.15 (47.29)
PT. Bank Mega Syariah Indonesia 88.00 (2.00) 85.00 (0.00) 89.47 (0.20) 93.40 (0.34) 92.46 (0.56)
PT. Bank Rakyat Indonesia Syariah 59.00 (16.00) 66.00 (18.00) 65.39 (23.04) 65.04 (24.39) 60.27 (26.48)
PT. Bank Negara Indonesia Syariah 51.00 (13.00) 56.00 (13.00) 64.05 (12.92) 71.58 (11.62) 72.20 (12.69)
PT. Bank Central Asia Syariah 31.00 (14.00) 36.00 (27.00) 42.99 (50.84) 47.75 (46.99) 48.96 (45.86)
Source: Created by authors based on Suzuki, Uddin and Pramono (2018)
Note: figures in parentheses represent the income from profit-and-loss sharing mudaraba and musharaka. NE stands for ‘not established’
Table 2.4 Income share of murabaha of Islamic banks in Malaysia and Pakistan (data in parenthesis shows income from PLS-based financing)

Bank Year

2008 2009 2010 2011 2012

Malaysia
Bank Islam Malaysia Berhad 55.26 (0.08) 69.08 (0.08) 59.66 (0.04) 59.66 (0.04) 59.10 (0.04)
Bank Muamalat Malaysia Berhad 41.57 (0.07) 36.47 (0.21) 40.46 (0.41) 41.67 (0.31) 49.43 (0.00)
Al Rajhi Banking and Investment 99.88 (0.00) 99.90 (0.00) 99.91 (0.00) 99.90 (0.00) 99.93 (0.00)
Corporation (Malaysia) Berhad
Pakistan
Al Baraka Bank Pakistan 72.06 (11.31) 78.92 (8.55) 55.89 (17.70) 56.90 (16.43) 48.05 (19.54)
Bank Islami Pakistan 35.34 (31.99) 30.89 (34.37) 40.41 (35.93) 31.00 (38.33) 27.03 (26.10)
Burj Bank Ltd. Pakistan 42.86 (38.57) 30.42 (45.12) 51.91 (34.01) 53.68 (34.64) 29.88 (26.98)
Dubai Islamic Bank Pakistan Ltd. 13.96 (6.45) 11.59 (6.82) 13.01 (1.58) 11.81 (1.38) 13.72 (1.62)
Meezan Bank Pakistan 35.70 (19.70) 35.63 (17.23) 33.28 (12.15) 27.00 (10.93) 21.36 (0.07)
Source: adapted from Suzuki et al. (2017)
 A critique to a naïve critique 39
financing needs in these four countries. The existing financing pattern of Islamic
banks in the sample countries clearly exhibits the concentration of murabaha
financing. For instance, major income of Islamic banks in Bangladesh comes from
the asset-based financing. Only one of the reported banks has been engaged in
profit-and-loss sharing modes although the percentage is insignificant (less than
5 percent during the period under study). This phenomenon reflects a pure domi-
nance of murabaha financing.
Contrasting to the scenario in Bangladesh, Islamic banks in Indonesia and Paki-
stan engage with the PLS mode at a larger extent. However, the dominance of the
murabaha mode is still prevalent in both countries, as it reflects in the percentage
of income in most of the reported banks under each case. Thus, the lending pat-
terns of the Islamic banks in each of the countries can be linked to their respective
performance indicators. However, a point to note is that Islamic banks in Indo-
nesia and Malaysia contribute to musharaka modes of investment which is seri-
ously skewed towards real estate financing (diminishing musharaka) and cannot
be considered pure ‘participatory’ PLS investment.
The financing pattern of Islamic banks in Malaysia deviates from that of Indo-
nesia and Pakistan but conforms to the financing pattern of Bangladesh. For
instance, Islamic banks in Malaysia are significantly engaged in sales-based trans-
actions, especially murabaha and bai bithaman ajil even though Malaysia is rec-
ognized as one of the pioneering countries where the development of Islamic
finance and banking has been prevalent since 1983. The country has placed itself
in a position to be considered an Islamic financial hub in the international financial
market.
Not only that the murabaha concentration is universal for Islamic banks but also
there is no sign of change in this trend. Referring to Aggarwal and Yousef (2000)
we have shown that murabaha and ijara constituted about 52 percent of the
total financing of Islamic banks in 1994 compared to musharaka and mudaraba
which combined 20 percent. Also, Yousef (2004) shows that mark-up financing of
Islamic banks constituted 86 percent in the Middle East, 70 percent in East Asia,
and 92 percent in South Asia. Our analysis of data proves that there is no apparent
change of murabaha concentration in the last 25 years or so. In some countries
however the concentration has intensified further.

4.  Critic on the naïve critics of murabaha concentration

Because of excessive concentration on murabaha mode of finance, Islamic bank-
ing and finance has received enormous criticism in this particular regard. How-
ever, critics are neither specific about the rational of this concentration nor do
they offer a thorough analysis of its remedies. Obviously, some criticisms which
aim at clarifying the theological foundation of Islamic banks (Choudhury, 2007;
Kuran, 1996; El-Gamal, 2006) deserve more attention. Kuran (1996) argues that
the question of Islamic financing is not about whether it can increase productivity
or economic performance but rather Muslim attempts to adopt Islamic financial
models in their economic lives as a means of protecting their cultural identity
40  Mohammad Dulal Miah and Yasushi Suzuki
which underlies their moral sentiment. Kuran further argues that Islamic finance
is a costly alternative to conventional banking. Historical roots of Islamic finance,
on which Kuran recourses for this conclusion, may prove him correct. But, over
the years Islamic financial institutions have come out of this moral tradition and
successfully competed in terms of productivity and performance with the conven-
tional banks. Rapid expansion of Islamic banking and finance does not endorse
the ‘moral view’ that the clients and customers of Islamic banks are driven merely
by moral sentiment rather than economic rationales. Productive efficiency and
financial stability of Islamic banks are widely documented in the existing literature
(see for example, Khan and Mirakhor, 1987; Siddiqui, 2001; Beck et al., 2013;
Miah and Sharmeen, 2015). The embedded benefits of efficiency and stability
may offset the cost disadvantage of Shari’ah-compliance model even if repetitive
transactions are required for a single contract, as it currently practiced.
Chong and Liu (2009) compare the changes in interest rate of Islamic banks
in response to the changes in interest rate of conventional banks and find that
changes in conventional deposit rates cause Islamic investment rates to change
(not vice versa). Based on this evidence they conclude that Islamic deposits are
not interest free, but are closely pegged to conventional deposits. This conclusion
is flawed indeed.
The fact that the Islamic deposit rate follows the conventional deposit rate does
not invalidate the proposition that Islamic deposits are based on profit-and-loss
sharing (PLS). Although we should observe, in general, a non-stationary pattern
of deposit rate pertaining to Islamic banks, there may have strategies to neutral-
ize the fluctuation. Usually, Islamic banks offer ‘hidah’ rate for wadi’ah yad-
dhomanah (saving account) holders, and ‘indicative profit rate’ for mudaraba sav-
ing account holders. The point is whether or not the rate is legally predetermined
and committed. The hidah rate and indicative profit rate are, in practice, quoted
by Islamic banks, but legally not committed to pay. The deposit of Islamic banks is
not interest free in a sense that they are not offering any return. At the same time,
the deposit of Islamic banks is interest free in a sense that they do not have any legal
obligation to pay any predetermined rate of deposit under the PLS agreement.
As argued before, most investments of Islamic banks take place in the form of
cost-plus pricing. Islamic banks face a problem as to what should be proper magni-
tude of mark-up. If the mark-up is set too high, banks may suffer from lack of bor-
rowers whereas too low rate would cause a negative impact on the profit of banks.
Islamic banks can avoid the dilemma by improving the credit risk management (by
engaging in the repeated transactions of the same type of asset-based financing)
or by reducing the cost of fund. Since major funding source for banks is deposit,
a strategy to reduce the cost of fund means to reduce the return on deposit which
in turn, can be associated with decline in deposit of Islamic banks. This scenario
entails that Islamic banks are forced by the competitive financial markets to pair
their rates to conventional banks mechanized through profit equalization reserves
(PER). In this sense, it is rational that the rate paid on Islamic banks deposit
should have a positive relationship with the conventional banks.
 A critique to a naïve critique 41
However, the concentration of debt-like instrument including murabaha and
ijara in the Islamic banking system is a proven fact. As a result, many scholars con-
clude that Islamic banks are not different from conventional banks. For instance,
Ariff and Rosly (2011) argue that most of the products and services of Islamic
banks mimic those of conventional banks and operate with interest in a disguised
form. Similarly, Kuran (1996, p. 441) notes that although Islamic banks claim
to be interest free in their operation, the deposit-taking and lending operations
of these banks tend to be based on interest but Islamic banks disguise this fact
through “the use of terms like ‘markup’ and ‘commission’ to designate what is
tantamount to pure interest”. In the same token, Khan (2010) notes that Islamic
banks offer similar services to conventional banks except the fact that conven-
tional banking terminology are replaced by Arabic terms.
Rosly and Bakar (2003) are also critical to the contemporary practices of Islamic
banks. They judge Islamic banking through the lens of morality and argue that
major Islamic banking products including murabaha and ijara resemble to interest-
based financing and thus can be regarded as immoral. Hamoudi (2007) echoes
the same critical tone and argues that the failures of Islamic finance which have
led to the creation of a bizarre and highly artificial construct that does nothing to
address the social concerns that are the central reason for the creation of Islamic
banking and finance. Similarly, El-Gamal (2006) regards the existing practices of
Islamic banks as ‘Shari’ah arbitrage’ because, for El-Gamal, conventional lend-
ing practices are replicated in Islamically acceptable ways in the balance sheets of
Islamic financial institutions. He further maintains that the Islamic finance indus-
try has degenerated into one that is dominated by form over substance.
Although some of these criticisms are ill-founded or misdirected, the proposi-
tion to be endorsed universally for Islamic banking and finance is that debt-based
instruments, despite gaining approval from Shari’ah scholars, should be kept
as minimum as possible. At the same time, the number of equity-like contracts
should be gradually increased if the overall social welfare objectives as envisioned
in Islamic economics are to be realized.
We would feel it difficult to simply accept the perspective of Islamic ‘perfection-
ist’ economists concerning the ‘murabaha’ concentration. Bakar (2016) gives a
warning that Islamic economists advocate ‘wealth distribution’ while forgetting a
much more important element, which is ‘wealth creation’. We should cast doubt
on the naïve conclusion reached by Islamic economists that equity-like ‘participa-
tory’ financing be prioritized over debt-like financing upon the assumption that
mudaraba and musharaka financing can be provided on a large scale without
affecting the capital adequacy requirement. For instance, participatory financ-
ing of Islamic banks is risker than the debt-like financing which implies that an
increase in this mode of finance is likely to increase risk-weighted assets at a higher
percentage. This literally translates that Islamic banks which have substantial share
in the participatory mode of investment would be required to maintain higher
amount as statutory reserve. Since banks are not earning any return on statutory
deposit but pay profit to depositors, the overall cost of banks tends to rise. Thus,
under a regulatory environment in which Islamic and conventional banks have to
42  Mohammad Dulal Miah and Yasushi Suzuki
maintain a fixed capital adequacy ratio, it is a rational move for Islamic banks not
to dedicate too high of an amount to the participatory mode of finance.
Another question is: How feasible it is to achieve these socio-economic
objectives through Islamic financing under the contemporary Islamic episte-
mological foundation as well as financial set-up? The concurrent interpretation
of Islamic epistemology does not convincingly clear an apparent paradox gener-
ated by Islamic financing principles. For instance, Islam encourages PLS-based
financing. At the same time it prohibits associated uncertainty (gharar). An
attempt to increase PLS financing implies embracing fundamental uncertainty
of entrepreneurs. Critics, however, have paid much less attention to this funda-
mental issue than it really deserves. We offer a detailed discussion on this issue
in Chapter 4.
Moreover, the existing financial set-up is unfriendly to the PLS-based financing.
In mudaraba, banks work as fund providers (rabb-ul-mal) whereas entrepreneurs
manage the business (mudarib). In this relation, rabb-ul-mal should fully trust the
mudarib with the fund at the latter’s disposal. As discussed earlier, the parties share
profit as per the predetermined ratio. However, in the case of any loss, the rabb-
ul-mal is the one who bears all the financial losses whereas the mudarib accepts the
loss of his labors. A severe agency problem persists in this relation. How should a
bank ensure that the mudarib will work up to the expectation for making a project
successful even though he does not bear any financial losses? In addition, absence
of a financial loss sharing provision may prompt entrepreneurs to accept higher
risk believing in the premise that he may materialize good return if the project is
successful but will lose merely his labor in the case of failure. Of course, a tighter
screening and monitoring regime can reduce the likelihood of shirking and moral
hazard. Although the relevance of screening and monitoring is equally important
for commercial lending, risk-taking incentives are different. Debt covenants may
provide more protection to financiers than a simple mudaraba/musharaka con-
tract as it stands today. Thus, debt-like contract instead of participatory financing
is a rational choice for Islamic banks.
In the two-stage mudaraba contract, as mentioned earlier, banks work as inter-
mediary between the entrepreneurs and the depositors. If there is any loss in the
project undertaken by an entrepreneur, he will pass the financial loss to the bank
which in turn transfers the loss to the depositors. Assume that an entrepreneur
which is a legal entity (public limited company) or an already well-off entrepre-
neur requests funds from Islamic banks under mudaraba contract for a new project.
How far is it Islamically logical that a loss suffered by a well-off entrepreneur will
be passed on to many small savers (rabb-ul-mal)? Such a project would socially and
religiously not be so suitable. This is another hurdle for participatory financing.
The origin of these anomalies and contradictions can be attributed to the inabil-
ity of Islamic epistemology in decoding properly the scripture of Islam (Qur’an).
El-Gamal argues:

most Quranic legal verses tend to be general in nature. . . . In the economic

realm, the Quran orders believers to fulfill their contractual obligations. . . .
 A critique to a naïve critique 43
However, the Quran does not state clearly which contracts are valid, and thus
must be kept, and which are invalidated and voided.
(2006, p. 27)

Legal content of the Qur’anic verses should be obtained through Prophetic

Sunna, as well as juristic analyses. Classical Islamic jurisprudence should be prop-
erly analyzed to derive an explanation for resolving these issues. Only then we can
expect the penetration of participatory Islamic finance.

5. Conclusion
In this chapter we have attempted to briefly describe the salient products of
Islamic banks. While mudaraba and musharaka are equity-like PLS contracts,
Islamic banks have shown their reluctance to these particular modes of financ-
ing. Although the existing literature concludes based on some anecdotal facts that
Islamic banks’ financing is seriously skewed towards debt-like contracts such as
murabaha and ijara, the literature provides less persuasive data supporting this
claim. The reason can be attributed to the difference in the reporting style of
Islamic banks. We have attempted to provide some empirical data on this issue
from the Islamic banks of GCC countries; although the same reporting prob-
lem persists, we have been able to collect data from a sizable number of banks.
Analysis of the data shows that financing of the sample Islamic banks is heavily
concentrated on debt-like finance. More than nine-tenths of the total financing
of Islamic banks are expanded in the form of murabaha and ijara. Accordingly,
major income of these banks comes from these two financing sources. Further-
more, there is no change of this trend over the years.
Criticism against the concentration of debt-like financing has spawned recently.
Some scholars have argued that the contemporary practice of Islamic banks is
nothing but the surface change in which conventional banking terms are merely
replaced by Arabic words. While the criticism against murabaha remains valid, the
blanket assertion that Islamic banks are not really Islamic is invalid. The debt-like
finance including murabaha, ijara, and istisna are not truly Shari’ah-based prod-
ucts but they are Shari’ah-compliant and Islamic.
Now the question is: Does the debt-like finance really uphold the spirit of
Islamic finance? There is no simple answer for that. Among many purposes of
Islamic finance, increase in efficiency and equity are at the core of classical Islamic
jurisprudence. Because Islamic finance arranges multiple sales and purchase con-
tracts for a single transaction which are subject to brokerage commissions and fees,
the Islamic banking model is believed to be costlier than the conventional model.
However, Islamic banks may have offset these adversaries through attaining inter-
nal efficiency and greater financial stability. Second, the criticism that debt-like
finance does not contribute to the creation of economic value may not be neces-
sarily true because Islamic banks through murabaha contracts help manufactur-
ers and traders to acquire production equipment and inputs for their production
process and hence create economic value.
44  Mohammad Dulal Miah and Yasushi Suzuki
Also, we like to say that the debt-like finance is ironically the logical conse-
quence of the existing financial set-up under which Islamic banks operate. For
instance, Islamic banks can capture a sizable amount of rent from expanding debt-
like financing. This provides them with the less compelling evidence to engage in
the participatory mode of financing including mudaraba and musharaka.
The solution to this problem, as many economists argue, hinges on the revival
of substance-oriented Islamic jurisprudence. In addition, mechanisms are to be
devised ex ante as safeguards against agency problems embedded in participatory
finance. In practice, the current mode of PLS provides an idea of the difficulty
of assuming equity-like ‘participatory’ financing. It is impractical to expect the
acceleration of participatory financing without preserving much higher security
margins to cover further PLS. Shari’ah scholars, the regulatory authorities, and
other professionals need to design an appropriate financial architecture which can
create socially acceptable levels of margin opportunities for Islamic banks, so that
participatory financing may deal with fundamental uncertainty which should be
socially diversified and absorbed under the concept of PLS.

Note
1 Opinions differ among four Imams of Islam in respect to distribution of profit.
For instance, Imam Malik and Imam Shafi’i opine that profit of musharaka is to be
shared according to the proportion of investment while Imam Ahmad ibn Hanbali
views that it is the agreement between the partners not the investment that should
dictate the profit ratio. Iman Abu Hanifah, on the other hand, argues that under
normal circumstances, profit can be shared according to a pre-agreed ratio. How-
ever, the profit-sharing ratio of a sleeping partner cannot be more than the ratio
of his investment. But in the case of loss, all the Muslim jurists are unanimous on
the point that each partner shall suffer the loss exactly according to the ratio of his
investment.
3 An inquiry into the scope of
‘acceptable’ gharar
Mohammad Hashim Kamali, Yasushi Suzuki
and Mohammad Dulal Miah

1. Introduction
Avoiding gharar is one of the main principles of Islamic finance. The literal mean-
ing of the word gharar is fraud (al-khida’), but in transactions the word has often
been used to mean risk, uncertainty, and hazard. In a contract of sale the word
gharar often refers to uncertainty, and the ignorance of one or both parties of the
substance or attributes of the object of sale, or of doubt over this object’s existence
at the time of contract (Kamali, 2000, p. 84). Gharar is, however, a broad concept
and may carry different shades of meanings in different kinds of transactions. In
the Islamic mode of investment and financial intermediation, gharar is perceived
in two dimensions; one refers to the lack of clarity in the terms and essence of the
contract, the other refers to the uncertainty in the object of the contract (Ayub,
2007, pp. 59–60; El-Gamal, 2006, p. 58).
Complete contracting is intrinsically impossible. Therefore, some measure of
uncertainty is always present in contracts. El-Gamal (2006, p. 58) notes that “jurists
distinguished between major or excessive gharar, which invalidates contracts, and
minor gharar, which is tolerated as a necessary evil.” Also, the uncertainty in the
object of the contract cannot be avoided in any business. “The problem, however,
was that the extent of uncertainty making any transaction haram had not been
clearly defined” (Ayub, 2007, p. 58). Ayub (2007) refers to gharar-e-kathir and
gharar qalil (too much and nominal uncertainty) and agrees that only those trans-
actions that involve too much or excessive uncertainty in respect to the subject
matter should be prohibited. Al-Saati (2003) suggests that the Hadith (which
prohibits gharar) does not intend to prohibit all gharar, but intends to prohibit
gharar which can cause dispute and cannot be tolerated. Kamali (2000) insists
that should there be a public good (hajjat al-nas) for it, gharar, even if exces-
sive, will be ignored. This is because satisfying the people’s need takes priority by
virtue of the Qur’anic principle of removal of hardship (raf’ al-haraj). Of course,
depending on its scale and magnitude, gharar may render a contract totally null
and void, or it may constitute a cause for indemnity and compensation (Kamali,
2000). This chapter aims to review, from a trans-disciplinary perspective, the
scope of acceptable gharar which is still controversial in the academic debate. We
follow the liberal position insisting that commercial transactions (muamalat) and
46  Mohammad Hashim Kamali et al.
contracts are permissible unless there is a clear injunction to the contrary of the
Shari’ah norm.1 Muslim jurists have held that the injunction which overrules the
basic presumption of permissibility (Ibahah) must be decisive both in meaning
and transmission (Kamali, 2000, p. 66). Upon the liberal view, we look at the first
dimension of gharar – incompleteness of contracting from the viewpoint of New
Institutional Economics, and the second dimension of gharar – uncertainty in
the object of contracting from a post-Keynesian perspective. Drawing upon these
economic perspectives, this chapter aims to propose a trans-disciplinary theoreti-
cal framework of making a contribution to the Islamic legal debate on the scope
of acceptable gharar.

2.  Incomplete contracting

The first dimension of gharar is related to incompleteness of contracting. In the
Islamic mode of investment and financial intermediation, jahl – ignorance or non-
clarity about the parties or their rights and obligations, the goods or the price – is
considered a part of gharar (Ayub, 2007, p. 61). One should not undertake any-
thing or any act blindly without sufficient knowledge, or risk oneself in adventure
without knowing the outcome or the consequences (Ayub, 2007, p. 61). Kamali
(2000) emphasizes that gharar can be summarized as occurring in four main
ways. These are on account of uncertainty and risk pertaining to the existence
of the subject matter of a sale, or its availability, uncertainty about the quantities
involved and, lastly, uncertainty about time of completion and delivery (Kamali,
2000, p. 93).
The New Institutional Economics (NIE) and Transaction Cost Economics
(TCE) have greatly contributed to building up a theoretical framework of how
the incompleteness of contracting increase the ‘transaction cost’ of monitoring,
resulting in the economic inefficiency (for instance, Arrow, 1974; North, 1981;
North, 1990; North, 2005; Williamson, 1985). In their theoretical framework
the transaction cost is defined as the economic equivalent of friction in physical
systems. In the framework by Oliver Williamson, a Nobel laureate in economics,
incomplete contracting often brings risks of ‘opportunism’. In general, opportun-
ism in terms of pursuing self-interest with guile involves subtle forms of deceit
and refers to the incomplete or distorted disclosure of information, especially to
calculated efforts to mislead, distort, disguise, obfuscate, or otherwise confuse
(Williamson, 1985, p. 47). On the other hand, the TCE tells us that ‘trust’ may,
not always but fairly often, play the role of lubricant for making the economic
system run smoothly (Arrow, 1974, p. 23). In other words, risks of Williamsonian
opportunism can be reduced by mutual trust. Trust is referred to as “attitudes
and behaviour which indicate that each person is willing to rely on the other to
act fairly and to take into account the other’s welfare”, as ‘solidarity’, and as “a
belief in future harmonious affirmative cooperation”. “Contract negotiations and
performance will likely take place more effectively if trust is present and is gener-
ated by the process” (Cohen and Knetsch, 1992, p. 442). One of the invaluable
insights of Kenneth Arrow, a Nobel laureate in economics, is to point out that
 An inquiry into ‘acceptable’ gharar 47
trust has a large and measurable economic value and has an important bearing
on economic organization. “Ethical elements enter in some measure into every
contract; without them, no market could function. There is an element of trust
in every transaction; typically, one object of value changes hands before the other
one does” (Arrow, 1974, p. 24).
In the Islamic mode of investment, Shari’ah is considered the cornerstone of
Islamic financial products and services. In theory, if all the concerned parties in
the mode share a common belief in future harmonious affirmative cooperation
(mutual trust) with Shari’ah compliance, the transaction cost of drafting and con-
tracting would be very low, because it would be enough to insert a ‘general clause’
of promising to sincerely negotiate against any future event for mutual benefits.
Arrow insists that the efficacy of alternative modes of contracting and monitor-
ing would vary among cultures because of differences in trust. To some extent,
cultural factors are related to the degree of trust relations. However, we would say
that the degree of trust even in a particular culture or society could rather vary.

Most of us operate in some middle realm where we admit social claims, some-
times forget about them for long stretches of time as we go about our daily
private role, sometimes rise to an occasion, sometimes fall miserably short, as
we assert our individuality in contexts that are not totally appropriate.
(Arrow, 1974, p. 16)

Operationalizing trust, no matter how it is defined, has proved inordinately dif-

ficult (Williamson, 1985, p. 406).
From the Williamsonian opportunism perspective, we may say that the coop-
erative mode of economic organization, where trust and good intentions are
generously imputed to the membership, has its weakness in being endowed with
few organizational responses to the debilitating effects of opportunism. “Such
organizations are easily invaded and exploited by agents who do not possess those
qualities” (Williamson, 1985, pp. 64–65). Transactions that are subject to ex post
opportunism will benefit if appropriate safeguards can be devised ex ante (Wil-
liamson, 1985, p. 48). We should note that, in other words, if safeguards are not
sufficiently devised ex ante, opportunism would possibly emerge as a troublesome
source of behavioural uncertainty in economic transactions. In our view, the first
dimension of the prohibition of gharar in a context of encouraging the parties to
pay best efforts to clarify the terms and essences of contracts in Islamic finance can
be understood as an effective institutional setting for minimizing the occurrence
of ex post opportunism.

3.  Uncertainty from a post-Keynesian perspective

The second dimension of gharar is related to the fundamental uncertainty associ-
ated with investment and financial intermediation. As economies become more
complex, it makes the screening and monitoring activities of investors and bank
managers much more difficult. Fundamental uncertainty needs to be emphasized
48  Mohammad Hashim Kamali et al.
as a primary driver of this increase in complexity. Since the consequences of actions
extend into the future, accurate forecasting is essential for making objectively
rational choices. But in the real world, most choices take place under the condi-
tion of uncertainty. Keynes defined what he meant by ‘uncertain knowledge’:

By uncertain knowledge, let me explain, I do not mean merely to distinguish

what is known for certain from what is only probable. The game of roulette
is not subject, in this sense, to uncertainty; nor is the prospect of a Victory
bond being drawn. Or again, the expectation of life is only slightly uncertain.
Even the weather is only moderately uncertain. The sense in which I am using
the term is that in which the prospect of a European war is uncertain, or the
price of copper and the rate of interest twenty years hence, or the obsoles-
cence of a new invention, or the position of private wealth owners in the
social system in 1970 [note: over 30 years later from the point in time of his
writing]. About these matters there is no scientific basis on which to form
any calculable probability whatever. We simply do not know. Nevertheless,
the necessity for action and for decision compels us as practical men to do
our best to overlook this awkward fact and to behave exactly as we should
if we had behind us a good Benthamite calculation of a series of prospective
advantages and disadvantages, each multiplied by its appropriate probability
waiting to be summed.
(Keynes, 1937, pp. 213–214)

The fundamental implication of Keynes’s uncertainty is that all economically

meaningful behaviour derives from agents’ efforts to protect themselves from
uncertainty (Dymski, 1993).
Frank Knight drew a famous distinction between ‘measurable uncertainty’ or
‘risk’, which may be represented by numerical probabilities and ‘un-measurable
uncertainty’, which cannot (Knight, 1921). Numerical probabilities are in turn
based on the possibility of repeated observation of an event that allows the cal-
culation of a statistical probability for that event. In contrast, many events in the
economic domain are not of this type. There is no repeated observation that can
give us an objective probability for the success of an innovative process. Here, the
risk involved is a subjective judgement, and this can vary across persons making
the judgement based on their experience and knowledge of subtle and unquantifi-
able aspects of a situation. The formulation of subjective probability judgements
is what Knight described as decision-making under uncertainty.
Knightian uncertainty, the same as Keynesian uncertainty, emerges when: (a)
stochastic variation is not governed by stable probability distributions; (b) agents
lack costless information providing insight into the true state of affairs in the econ-
omy; (c) agents cannot always determine the extent to which their own actions are
responsible for the outcomes they experience; (d) it is impossible to preclude the
possibility of systemic risk, because the economy has no parameters (see Dymski,
1993). Subjective probability can be distinguished from statistical or objective
probability in the sense that uncertainty cannot be reduced to measurable risks.
 An inquiry into ‘acceptable’ gharar 49
Uncertainty may be more or less ignored or, alternatively, subjective probabilities
may be applied, together with a risk premium to cover unspecified adverse events.
Since there is no precise economic theory of how decisions are made under uncer-
tainty, agents tend to observe each other’s responses and do not deviate widely
from the norm regarding which factors should be taken into account and how
much weight should be assigned to them. But, “when the crowd is wrong ex-post,
there is the making of a financial crisis” (Davis, 1995, p. 135).
Uncertainty makes the decision processes complex and volatile. Volatility stem-
ming from lenders’ (or investors’) uncertainty, in particular, in terms of subjective
probability in credit risk management, is a crucial factor contributing to the sys-
temic fragility of financial markets. Uncertainty often encourages agents to adopt
rules of thumb because standardization and coordination may be more effective
than individual prediction (Simon, 1996, p. 42). However, such standardized
rules of thumb can themselves become constraints on our decision-making: if they
acquire the status of norms, they can reduce us to mere engines of procedural
rationality. In international banking and credit operations, a codified assessment
of credit risk in purely quantitative statistical terms (i.e. the quantification of credit
risk upon the statistical expected default frequency or EDF provided by rating
agencies) is now a widespread practice. The codified rule of thumb encourages
lenders to measure expected credit losses mathematically and to maintain a capi-
tal buffer against unexpected credit losses. An important example of this para-
doxical response to uncertainty is the gradual adoption of the Basel guidelines in
international credit markets. Ironically, the convergence to standardized credit
risk modelling creates a misleading homogenization of information flows and can
contribute to undermine financial stability by amplifying herd behaviour in invest-
ment as was observed in the process of leading to the 2007–2008 US subprime
loan crisis.
Although Islamic banks and financial institutions were not always immune to
the subsequent 2008–2009 global crisis, they were to a considerable extent shel-
tered from the crisis. “Islamic finance institutions were better placed to weather
the storm, receiving increasing interest from not only the Muslim community
but also non-Muslim population around the world” (SESRIC, 2009, p. 3). SES-
RIC (2009) concludes that due to the prohibition of gharar, financing extended
through the Islamic mode can expand only in line with the growth of the real
economy and thereby help curb excessive credit expansion. “In this respect, the
prohibition on gharar is often used to support the criticism of conventional finan-
cial practices such as short-selling, speculative trading, and derivatives” (SESRIC,
2009, pp. 5–6).

3.1 Mudaraba
In passing, we wish to refer to an Islamic financial form of ‘mudaraba’. Mudaraba
is described as a special kind of shirkah2 in which an investor or a group of inves-
tors provides capital to an agent or manager who has to trade with it; the profit
is shared according to the pre-agreed proportion, while the loss has to be borne
50  Mohammad Hashim Kamali et al.
exclusively by the investor. The loss means a shortfall in the capital or investment
of the financier. The loss of the agent (mudarib) is by way of expended time and
effort, for which he will not be given any remuneration (Ayub, 2007). For the
financier, in particular, the engagement in mudaraba is associated with higher risk
and uncertainty. In the light of the principle of prohibition of gharar, how are the
Islamic financial institutions allowed to be engaged in mudaraba?
Needless to say, though any ambiguity or ignorance regarding capital or ratio
of profit makes the contract invalid, a number of sayings of the holy Prophet
(pbuh) and reports by his Companions on the subject indicate that Islamic jurists
are unanimous on the legitimacy of mudaraba (Ayub, 2007). The terms of the
mudaraba contract offered by the Prophet’s uncle Abbas were approved by
the Prophet. Abu Musa, the governor of Kufa, wanted to remit public money
to the Bayt al Mal. He gave the amount to Abdullah bin Umar and his brother,
who traded with it. The Caliph’s assembly treated it as an ex post factor mudaraba
and took half of the profits earned by the two brothers, because the public money
in their hands was not the loan. Caliph Umar also used to invest orphan’s property
on the basis of mudaraba (Ayub, 2007). Ayub (2007) points out that mudaraba,
like other contracts, calls for lawful items of trade, failing which the contract will
become void or voidable, as the case may be. Thus, a worker is not allowed to
trade in wine or swine with the mudaraba capital. He suggests that the classical
jurists generally restricted the use of mudaraba to the act of trade (buying/sell-
ing), but an overwhelming majority of contemporary jurists and scholars allow the
use of mudaraba with a wider scope for use by Islamic banks as an alternative to
interest-based financing.
While Islamic banks may hesitate to become mudaraba capital providers, there
is little problem for them to assume as the mudarib. Mudaraba is a contract of
fidelity and the mudarib is considered trustworthy with respect to the capital
entrusted to him. He is not liable for the loss incurred in the normal course of
business activities. As a corollary, he is liable for the property in his case as a result
of the breach of trust, misconduct and negligence. A guarantee to return funds can
be taken from him but can be enforced only in two situations: if he is negligent in
the use of funds or if he breaches the stipulated conditions of mudaraba. Hence,
his actions should be in consonance with the overall purpose of the contract and
within the recognized and customary commercial practice (Ayub, 2007).
The issue is whether or not Islamic banks are allowed to assume as the financier
of mudaraba. It is considered that the conversion of debt into a mudaraba is
prohibited to safeguard against the abuse of usurious loan being camouflaged as a
mudaraba, where, in essence, the financier would possibly ensure for himself not
only the recovery of his debt but also an illegal return on his loan under the cover
of his share in mudaraba profits (Ayub, 2007).

Mudaraba business can be of two types: restricted and unrestricted mudaraba.

If the finance provider specifies any particular business, the mudarib shall
undertake business in that particular business only for items and conditions
and the time set by the rabbul-mal. This is restricted mudaraba. But if the
 An inquiry into ‘acceptable’ gharar 51
Rabbul-mal has left it open for the mudarib to undertake any business he
wishes, the mudarib shall be authorized \to invest the funds in any business
he deems fit. This is called un-restricted mudaraba.
(Ayub, 2007: p. 324)

According to the majority of the traditional jurists,3 a financier in mudaraba is not

allowed to work for the joint business. He is not permitted to stipulate that he has
a right to work with a mudarib and to be involved in selling and buying activities,
or supplying and ordering. However, he has the right to oversee and ensure that
the mudarib is doing his fiduciary duties honestly and efficiently (Ayub, 2007).
In general, banks as depository corporations are expected to pay the best effort to
protect general depositors’ utility. In this context, it would make sense for banks
to keep them away from the form of financing like mudaraba, at least, ostensibly
associated with excess uncertainty, in which the financiers are allowed to retain
only the limited scope of monitoring and controlling the borrowers including
the mudarib. Should Islamic banks as depository corporation be discouraged to
be engaged in mudaraba to comply with the principle of prohibition of gharar?
Now, we look at Keynes’s concept of ‘animal spirits’ pointing out that while
objective calculations of ‘risk’ were not possible for investments, he also rejected
the idea that investments or stock markets were entirely based on mass irrational
psychology. The bridge between the two was his concept of ‘animal spirits’.
Apparently, Keynes distinguished enterprise from speculation. “It is safe to say that
enterprise which depends on hopes stretching into the future benefits the com-
munity as whole” (Keynes, 1936, p. 162).

But individual initiative will only be adequate when reasonable calculation is

supplemented and supported by animal spirits, so that the thought of ulti-
mate loss which often overtakes pioneers, as experience undoubtedly tell us
and them, is put aside as healthy man puts aside the expectation of death.
(Keynes, 1936, p. 162)

Stock markets and investments more generally required ‘animal spirits’ in indi-
vidual initiatives that supplemented and supported reasonable calculations of
risk. If prevailing animal spirits were such that no investor could afford to absorb
‘down-side risks’ for a firm, it would not be able to raise capital. The existence of
a large and diversified base of investors with a broad range of animal spirits was
therefore essential for financing the entire range of economic activities in a grow-
ing and changing economy. As long as the base as a whole keeps the strength
and capacity to absorb many different types of risks and uncertainty, the financial
market backed by such a base of investors can be dynamic and powerful. However,
if the market becomes exposed to risks and uncertainty beyond its capacity, the
propensity to periodic financial disaster would be rapidly increased.

If I may be allowed to appropriate the term speculation for the activity of fore-
casting the psychology of the market, and the term enterprise for the activity
52  Mohammad Hashim Kamali et al.
of forecasting the prospective yield of assets over their whole life, it is by no
means always the case that speculation predominates over enterprise. . . .
Speculators may do no harm as bubbles on a steady stream of enterprises. But
the position is serious when enterprise becomes the bubble on a whirlpool
of speculation. When the capital development of a country becomes a by-
product of the activities of a casino, the job is likely to be ill-done.
(Keynes, 1936, pp. 158–159)

Keynes treated the animal spirit in enterprise affirmatively, but that in specula-
tion cautiously. On the other hand, it appears that the ‘animal spirit’ against major
(excessive) uncertainty irrespective of enterprise or speculation is prohibited in the
conservative Islamic mode of investment and financial intermediation. Table 3.1
shows the comparison how the Post-Keynesian and the Islamic mode of invest-
ment would look at animal spirits against minor/major uncertainties associated
with enterprise and speculation, respectively.
El-Gamal (2006) suggests that if the commutative contract containing exces-
sive gharar meets a need that cannot be met otherwise, the contract would not be
deemed invalid based on that gharar.

A canonical example is salam (prepaid forward sale), wherein the object of

sale does not exist at contract inception, giving rise to excessive gharar. How-
ever, since that contract allows financing of agricultural and industrial activi-
ties that cannot be financed otherwise, it is allowed despite that gharar.
(El-Gamal, 2006, p. 59)

Basically, Islamic principles of economics focus on clarity and lack of ambiguity,

just and fair treatment for all and care for the rights of others (Ayub, 2007, p. 12).
So far as these principles are necessarily ethical, incubating small- and middle-
sized enterprises in agricultural and industrial sectors would be acceptable to an
extent in which the associated major uncertainty can be shared and absorbed in
the community through an adequate profit–loss sharing agreement.

Table 3.1 Comparison of the post-Keynesian view and the Islamic mode of invest-
ment of looking at animal spirits against uncertainties in enterprise and
speculation

Animal spirits in enterprise Animal spirits in speculation

Minor Major Minor Major

uncertainty uncertainty uncertainty uncertainty

Post-Keynesian Positive Positive Acceptable Cautious (or

view negative)
Islamic mode of Acceptable Cautious (or Acceptable Negative
investment acceptable)
 An inquiry into ‘acceptable’ gharar 53
Ayub mentions:

For a more efficient economy, we must promote systems in which people

work in productive pursuits rather than unproductive ones. Change the sys-
tem to relate it with real sector activities and all those clever dealers who earn
huge profits out of thin air could become doctors, industrialists, business
people and teachers instead!
(n.d., p. 2)

Engagement in enterprise rather than speculation seems to be preferably consid-

ered in the Islamic mode of investment. Ijtihad (independent reasoning) is the
main vehicle by which the Shari’ah can be adjusted so as to accommodate social
change, and it relies, to a large extent, on the proper understanding and applica-
tion of ta’lil (ratiocination) (Kamali, 2000). In accordance with the context of
ijtihad, acceptable scope of mudaraba as the financier to be engaged in enterprise
should entail further arguments.

4.  Towards a trans-disciplinary framework

The perspectives mentioned previously in the chapter by El-Gamal (2006) and
Ayub (2007) are to be supported by the liberal view in Islamic commercial law of
generally characterizing the Shari’ah as the legal system of pragmatism and con-
venience (Kamali, 2000, p. 70).

With regard to new transactions, there is in principle no need to search for

supportive evidence in the views and precedents of the early jurists, for it is
essentially incorrect to extend and apply a medieval juristic opinion to a form
of trade that did not exist in medieval times. The correct approach in such
instances would be to attempt independent ijtihad in light of the basic guide-
lines of the Qur’an and Sunnah.
(Kamali, 2000, p. 70)

Kamali (2000) points out that the madhahib have differed regarding the scope of
the parties’ liberty with respect to such stipulations. The Hanbalis have given it
the widest scope, and their contribution to the freedom of stipulation in contracts
is widely acknowledged to be the most outstanding of the rich legacy of the juristic
scholarship of the madhahib. The Hanafi and Shafii schools have taken an inter-
mediate position on the subject, but both seem close to the Zahiri stance than to
the Hanbali regarding the freedom of contract. They have departed from some
of the rigidities of the Zahiri school by recourse to analogical reasoning, juristic
preference, the consideration of public interest and custom. Consequently, they
have validated certain types of stipulations and additions to nominate contracts on
these grounds. But the Hanafis and Shafiis nevertheless remain fairly distant from
the considerably more liberal position taken by their Hanbali counterparts on the
freedom of contract. Although the Maliki school has not embraced the Hanbali
54  Mohammad Hashim Kamali et al.
view of the freedom of contract, in comparison with the other madhahib, they are
closer to the Hanbali position. The Malikis have achieved this mainly through
the application of their doctrine of unrestricted public interest (Kamali, 2000,
pp. 75– 76).
We should note the position of the Shari’ah in the area of mu’amalat, espe-
cially with regard to illicit gain (riba), hoarding and risk-taking (gharar), which
are predicated on the prevention of conflicts, exploitation and injustice among
people. There are not, in other words, founded on devotional (ta’abbudi) princi-
ples but on rational causes. This is an important Shari’ah principle that is some-
times neglected by those who maintain that the intellect and human reason have
no place in the Shari’ah. Many problems in the fields of Islamic economics, bank-
ing and finance arise from this inability to understand the proper role of reason in
the Shari’ah (Kamali, 2000, p. 78). He points out the differences between ibadat
and mu’amalat, where the basic norm in the former is submission and devo-
tion without expatiation in effective causes, but the law concerning mu’amalat is
generally founded on their rational, effective cause and benefit. This means that
the law in this area is open to rational analysis, enquiry and evaluation (Kamali,
2000, p. 78).
From the liberal position, Islamic financial institutions (IFI) are not necessar-
ily discouraged to share the associated risk and uncertainty with the small- and
medium-sized firms in the agricultural and industrial sector, so far as their enter-
prise is based on the Islamic principles of economics. On the other hand, many
scholars point out the divergence between theory and practice, for instance, the
excessive use of murabaha (‘murabaha syndrome’4), which gives a fixed rate of
return to the banks (Ayub, 2007, p. 446), and the financial disintermediation
towards small-scale enterprises (Visser, 2009, p. 139). Unless the portfolio pref-
erence of a vast majority of depositors particularly in developing countries is not
so risk-averse, it makes sense that even Islamic banks that specialize in small-scale
credit tend to restrict themselves to murabaha and bai’salam finance (Visser,
2009, p. 139).
Hyman Minsky, a post-Keynesian economist with a reputation among mon-
etary theorists for being particularly pessimistic (Kindleberger, 2000, p. 13),
contributed in great deal to modelling the fragility of the monetary system and
its propensity to periodic disaster. According to Minsky, if a business unit’s cash
flow commitments on debts are such that over some period the cash receipts are
expected to exceed the cash payments by a significant margin, the unit is said to
be engaged in ‘hedge’ financing. Then, a ‘speculative’ financing unit has cash flow
payments that exceed the cash inflows expected during some of the periods. How-
ever, the present value of the cash flow expected to accrue to the firm from owned
assets exceeds the present value of contractual cash payments. Since a speculative
financing unit has a positive net worth, the borrower may be able to refinance its
position. Finally, a ‘ponzi’ financing unit is a speculative financing unit for which
the interest portion of its cash payment commitments exceeds its net income cash
receipts, that is, business units engaged in ponzi finance have a negative net worth
in computation of present values (Minsky, 1977, p. 143).
 An inquiry into ‘acceptable’ gharar 55
The risk-averse fund should not be invested in risky ventures. “However, in
the case of single trade transactions or where satisfactory documentation is avail-
able, Islamic banks should use musharaka, as this will give them higher returns”
(Ayub, 2007, p. 446). How do the IFI, successfully or reluctantly, screen and
monitor the small-scale murabaha transaction and the musharaka or mudaraba
equity-like engagement while responding to fundamental uncertainty? Lenders’
screening and monitoring is the basis of their assessment of the extent to which
expected cash inflows will cover cash payment commitments. Minsky called the
excess ‘margins of safety’. We should ask how the IFI evaluate the ‘margin of
safety’ in the Hyman Minsky’s term, to prevent from undertaking the excess
credit risk. Minsky emphasized that the business units that engage in speculative
or ponzi finance, even in hedge finance, are vulnerable to the events that reduce
the cash flows from assets. Therefore, screening and monitoring of borrowers’
cash flow projection is critical for credit appraisal. However, monitoring is always
intrinsically imperfect because monitoring agents are always exposed to funda-
mental uncertainty.

5. Linkage between theory and practice – concluding

comments
Suzuki (2013) conducted an interview with a director and bank managers of Bank
Syariah Mandiri, the largest Islamic bank in Indonesia, reporting his impression
that they perceived the prohibition of gharar in the context of avoiding incom-
pleteness of contract or avoiding the transaction having gambling elements (mai-
sir), rather than in the context of being cautious for the major risk and uncertainty
associated with business and enterprise. Under the economic situation where the
demand for asset-based consumers financing was strong, the bank did not have
to challenge the major uncertainty associated with animal spirits in enterprise as
mentioned in Table 3.1. The bank was engaged in the musharaka financing only
in the case that it was hard to apply the murabaha scheme, such as the case of the
bridge finance for the working capital demand in the construction period of a con-
struction project. In the construction period, the cost for construction including
the labour cost for construction was not yet fixed and it was intrinsically difficult
to pledge the object building under the construction. The object building can be
pledged as collateral after the construction (Suzuki, 2013).
In general, the credit strategy of the IFI is quite conservative resulting in the
portfolio selection of the repeated and asset-based financing. The IFI are not
allowed to impose penalties from the debtors that have fallen into arrears (Holy
Qur’an 2: 280) and are not allowed to use the credit derivatives and hedging
instruments to mitigate the credit risk. Under the prohibition of gharar in a sense
of avoiding the major risk and uncertainty to share with, Islamic finance strug-
gles with the limited scope for penalty clauses under Shari’ah law (Visser, 2009,
p. 139). It makes sense that Islamic banks would rather not be involved in long-
term financing under the current legal framework, except the secured financing
like housing loans. Understandably, even Islamic banks that relatively specialized
56  Mohammad Hashim Kamali et al.
in small-scale credit tend to restrict themselves to the secured murabaha mainly
for financing the purchase of specific goods.
Ayub (n.d.) mentions that study of the behaviour of the derivatives market
reveals that it has the potential to cause a serious breakdown in the financial sys-
tem. “The degrees of leverage that are afforded by option contracts can be so
high that large unpredictable market moves in underlying prices may one day lead
to the insolvency of a major financial institution” (Ayub, n.d., p. 2). According
to him, even if arbun (down payment; a non-refundable deposit paid by a buyer
retaining a right to confirm or cancel the sale) is accepted as valid transaction,
most of the derivatives current in the market would still be unacceptable from
Shari’ah angle due to involvement to gharar (Ayub, n.d.).
Kamali (2000) insists that the role that custom has played in the development
of the Shari’ah is manifested in the acknowledgement that a great deal of what
is known in the name of ijma (general consensus), maslahah (public good) and
fatwa (juristic opinion) often originates in the customs and living experience of
the community. A ruling of fiqh, a fatwa or ijtihad which originates in urf is par-
ticularly liable to change when there is a change in its underlying urf, and hence
the legal maxim of fiqh that the ‘change of rules is undeniable with the change of
time’. Ratiocination in the Qur’an means that the laws of Shari’ah outside ibadat
are not imposed for their own sake but in order to realize certain benefits (Kamali,
2000, pp. 80–82). For instance, as for the sales at the market price (Bay’bi-Sir’
al-Suq), he suggests that in view of the considerable progress that has been made
in market techniques for price determination and forecasting, more refined and
reliable methods are now available to inject a certain degree of objectivity and pro-
fessionalism in the determination of market prices. The concern that market prices
may be liable to manipulation and distortion is no longer prominent. If the parties
wish to agree on the prevailing market price within a particular time frame, there
is no fear of excessive uncertainty or gharar, and the agreement should be seen as
a manifestation of the individual freedom of contract of the parties to determine
the terms of their contractual agreement (Kamali, 2000, p. 96).
This chapter has attempted to draw the wisdom of the prohibition of gharar
through the lens of Institutional and Post-Keynesian Economics. We looked at
one dimension of the prohibition of gharar which focuses on clarity and lack of
ambiguity, just and fair treatment for all and care for the rights of others. We also
looked at the other dimension which is related to the fundamental uncertainty
associated with investment and financial intermediation. The lens of Institutional
and Post-Keynesian Economics is useful to clarify two dimensions of gharar,
respectively. Under the prohibition of gharar (also the profit–loss sharing) frame-
work, it may have created a dilemma of the so-called murabaha syndrome leading
to the financial disintermediation (particularly the dry-up of long-term funds) in
hampering the potentials in agricultural and industrial sectors. Long-term growth
may suffer as a result. In our view, based on the best effort to avoid the incomplete-
ness of contract, it might be acceptable, to an extent in which the associated major
uncertainty in enterprise can be shared and absorbed in the community through
 An inquiry into ‘acceptable’ gharar 57
an adequate profit–loss sharing agreement, to incubate small and medium enter-
prises in agricultural and industrial sectors.
It is generally agreed that sufficient knowledge of the substance of an object of
sale to an extent that precludes the possibility of disputes between the parties, is
essential for the validity of a sale. As for the knowledge of attributes, the Hanafis
maintain that this is not a prerequisite for validity but for enforceability (luzum)
(Kamali, 2000, p. 89). How Islamic financial institutions will tackle the murabaha
syndrome while improving the financial intermediation to the agricultural and
industrial potentials should entail further arguments, we recommend, upon the
liberal position insisting that commercial transactions (muamalat) and contracts
are permissible unless there is a clear injunction to the contrary of the Shari’ah
norm.

Notes
1 This position is precisely the opposite with regard to devotional matters (ibadat),
because the basic presumption here is that they are forbidden unless there is a clear
text to validate them (Kamali, 2000, p. 66).
2 The term mudaraba is interchangeably used with qirad and muqaradah. It is pre-
sumed that while the latter two originated in Hajiz, mudaraba was of Iraqi origin.
Subsequently, the difference appears to have been perpetuated by the legal schools,
the Malikis and Shafi’es adopting the terms of ‘qirad’ and ‘muqaradah’ and the
Hanafis using the term ‘mudaraba’ (Ayub, 2007).
3 Ayub (2007) point out that it is only according to Hanbali jurists and, to some
extent, Hanafi jurists that the owner is allowed to work for the business with the
mudarib. The reason for disapproval by the majority classical position is understand-
able if the basic idea that a person enters into a mudaraba contract because he lacks
business skill is presumed to exist. But if the financier also has skill and has con-
tracted mudaraba simply because he cannot do the entire work single-handedly, the
rationale behind prohibiting him to work is not understandable.
4 Bank Indonesia (2009) shows the changes in the asset (credit) portfolio in the Indo-
nesian Islamic banks. We observe that the share of murabaha operation, secured
trading or asset-backed financing with relatively low credit risk, has been dominant
(58.9 percent in 2008, 56.3 percent in 2009, respectively). The similar situation is
observed in Malaysia. According to Annual Reports by Bank Negara Malaysia, in
the asset portfolio in the Malaysian Islamic banks, the share of murabaha and mura-
baha-related operation (bai bithaman ajil) was 48.2 percent in December 2008,
48.3 percent in December 2010; the share of operating lease and lease-to-purchase
financing (ijarah and ijarah thumma al-bai) was 33.1 percent in December 2008,
29.8 percent in December 2010, respectively. In parallel, it is worth noting that the
share of musharaka in the Malaysian IFI was only 1.1 percent in December 2008,
2.5 percent in December 2010.
Part II

Issues in Islamic equity

finance and microfinance
4 Altruism and reciprocity in
Islamic equity fund
New Institutional and
philosophical speculations
Yasushi Suzuki and Mohammad Dulal Miah

1. Introduction
Venture capital (VC) is considered a significant source of financing for early stage,
innovative, and high-growth start-up companies (Elsiefy, 2013). Successful ven-
ture capital companies would help poverty alleviation by increasing employment
and contribute to sustainable economic growth through capital accumulation to
further innovations (See Gompers and Lerner (1999a) for detail discussion on the
various roles of VC). Despite its widespread importance of financing the start-ups,
traditional mode of VC suffers from numerous shortcomings including agency
problems (Cumming, 2005), moral hazard (Bergemann and Hege, 1997), and
asymmetry of information (Trester, 1998). These problems can be minimized if
a precise and specific contract can be drawn ex ante. However, writing such a
contract is infeasible due to the presence of high transaction costs. This leaves an
enormous room for a partner in the VC to behave opportunistically (Broughman,
2010). If so, prospective financiers might find it discouraging to finance VC in the
absence of sensible mechanism devised ex ante to tackle these problems.
Islamic altruism and reciprocity may contribute to setting up Islamic VC. Based
on the best effort to avoid the incompleteness of contract, it might be acceptable,
to such an extent that the associated uncertainty in enterprise can be shared and
absorbed in the community through an adequate profit–loss sharing agreement,
to incubate small- and medium-sized enterprises in the innovative sector (see
Chapter 3 in this book and Suzuki, 2013). Çizakça (2011, p. 270) raises three
financial institutions such as waqf of stocks, Islamic venture capital, and microfi-
nance; a model of combining these institutions in its structure can play an impor-
tant role in eradicating poverty, enhancing entrepreneurial spirits, and building up
human capital in Islamic countries. In particular, he is of the opinion that venture
capital (VC) is going to be the rising star of Islamic finance because it is a Shari’ah-
based instrument and though risky, embodies huge profit potential. Despite these
competitive advantages and huge potential, Islamic VC is not yet well developed
in practice. The question is why?
This chapter aims to answer this question. In so doing, it examines the cultural
advantages of Islamic altruism and reciprocity as important institutions which may
contribute to setting up Islamic VC. The chapter further analyzes the feasibility of
62  Yasushi Suzuki and Mohammad Dulal Miah
Islamic venture capital shedding an analytical light on the tradition of New Insti-
tutional Economics (NIE) and Transaction Cost Economics (TCE). One of the
salient contributions by NIE is to support the proposition that effective contract-
ing depends upon ‘institutions’ in terms of ‘rules that constrain economic behav-
ior’, including informal or intangible institutions such as religions, traditions and
customary practices. Although there should not be an overemphasis on the cul-
tural factors, this chapter argues that the unique institutional structure, which
creates Islamic altruism and reciprocity, may enhance the supply of Islamic VC,
but simultaneously, it may cause opportunistic behavior unless appropriate safe-
guards can be devised ex ante, consequently leading to the drain of the capital for
future innovations. The structure of the chapter is as follows: Section 2 describes
the theoretical contributions of the NIE and TCE, particularly the institutions of
trust and opportunism. Section 3 applies some of these contributions to the analy-
sis of general altruism and reciprocity embedded in Islamic principles. Section 4
points out cultural advantages and limitations of organizing Islamic equity finance
which is followed by a brief conclusion.

2.  Opportunism and trust in the NIE framework

The New Institutional Economics has been concerned principally with two basic
issues of societies: economics of property rights and transaction costs (Williamson,
2000). The second issue is the concern of this chapter. Transaction Cost Eco-
nomics employs two important human behavioral assumptions. The first set of
assumption pertains to human ‘bounded rationality’ due to Herbert Simon who
convincingly argues that human beings are intendedly rational but only limitedly
so (Simon, 1961, p. xxiv). Simon (1993, p. 156) points out “they (human beings)
would be unable to make the computations required for optimal choice even if
they had perfect knowledge.” In practice, human beings are boundedly rational
partly because of information problems but mainly because of the complexity of
computing the best strategies (Simon, 1996). For Simon, even if zero transaction
cost facilitates the accumulation of all relevant information ex ante it is still pos-
sible to inaccurately model any contractual relation between contracting parties
because the human brain possesses limited capacity to process and analyze infor-
mation. Thus, bounded rationality is a critical foundation of contractual relation.
The second behavioral assumption with which the theory is concerned is embed-
ded in actors’ ‘opportunism’. For Williamson (1979, p. 234) “opportunism is a
variety of self-interest seeking but extends simple self-interest seeking to include
self-interest seeking with guile.” Or simply, it is a kind of selfishness which is a vice
whereas self-interest is a virtue.
The rational pursuit of self-interest is what makes the Adam Smith’s invisible
hands work in reality. The tendency of self-interest, an essential characteristic of
one’s well-being, is therefore, prerequisite for the market to function. In contrast,
selfishness tends to make people exclusively concerned about them without car-
ing for others. Selfish individuals may act in such a manner that imposes adverse
effects on others (Hunt, 1990). Thus, opportunism can be considered a subset of
 Altruism and reciprocity in equity fund 63
selfishness. However, the assumption about human opportunism does not neces-
sarily entail that everyone is perniciously self-interest seeker. Rather, the presence
of a few opportunistic individuals means economic exchanges should be struc-
tured to protect against potential opportunism because it is difficult to differenti-
ate between those who are less opportunistic and those who are not (Williamson,
1979).
Williamson (1985) analyzes the impact of bounded rationality and opportunism
on transaction costs. He argues that admitting human-bounded rationality in the
presence of non-opportunistic behavior does not require an extensive contract-
ing for transactions because contracting problems arising ex post due to bounded
rationality can be overcome since parties have agreed to cooperate (being non-
opportunistic) and disclose all the relevant information generated once the con-
tingencies occur. Williamson (1985, p. 20) argues, “rather than contemplate all
conceivable bridge crossing in advance, which is a very ambitious undertaking,
only actual bridge crossing choices are addressed as event unfolds.” On the other
hand, problems arising from opportunism require writing a comprehensive con-
tract ex ante even if we assume unlimited cognitive power of the human brain.
From this view, Williamson (1979, p. 234) postulates “opportunism is a central
concept in the study of transaction costs.”
Transaction cost can be defined as “the economic equivalent of friction in
physical systems” (Williamson, 1985) or the cost of “running economic systems”
(Arrow, 1974). Transaction costs, in general, include ex ante costs such as (i) find-
ing the right partners, (ii) negotiating prices, (iii) drafting and writing appropriate
contracts, (iv) ex post costs of monitoring, (v) cost of enforcing contracts, and
(vi) cost of resolving disputing and contesting terms. The magnitude of transac-
tion costs is determined by a number of different variables including the tech-
nology trading partners are dealing with, the distribution of bargaining power
between them, the presence or absence of shared cultures that induce trust and
self-enforcement and so on. In this sense, the level of transaction costs involved
with contractual relation is determined by the existing set of institutions. In the
context of NIE an ‘institution’ can be defined as rules that constrain economic
activities and behaviors. Institutions consist of both formal rules such as laws and
regulations, and informal institutions including customs, traditions, norms, and
religions (North, 1990). These institutions are devised to reduce and limit the
uncertainty of human cooperation, to give a steady structure for everyday life.
While the formal institutions can be changed quite often informal institutions
are changed very infrequently (North, 1990). As a result, informal institutions
occupy the primary focus of institutional analysis.
Among various elements of informal institutions, ‘trust’ is one but key and
essential element having a greater impact on transaction costs. Fukuyama (1995)
stresses that contracting for goods or services with people one does not know well
or trust is prohibitively costly. Trust has been defined as “attitudes and behav-
ior which indicate that each person is willing to rely on the other to act fairly
and to take into account the other’s welfare”, as ‘solidarity’, and as “a belief in
future harmonious affirmative cooperation” (Cohen and Knetsch, 1992, p. 442).
64  Yasushi Suzuki and Mohammad Dulal Miah
Furthermore, “contract negotiations and performance will take place more effec-
tively if trust is present and is generated by the process” (Cohen and Knetsch,
1992, p. 442). Fukuyama (1995), referring to what the sociologist James Cole-
man has called ‘social capital’, argues that the ability of people to work together
for common purposes in groups and organizations and their ability to associate
with each other depends on the degree to which communities share norms and
values and are able to subordinate individual interests to those of larger groups.
Fukuyama (1995, p. 10) further states “out of such shared values comes trust.”
One of the invaluable insights of Francis Fukuyama and Kenneth Arrow is to point
out that trust has a large and measurable economic value and has an important
bearing on economic organization. Arrow (1974, p. 24) notes “ethical elements
enter in some measure into every contract; without them, no market could func-
tion. There is an element of trust in every transaction; typically, one object of value
changes hands before the other one does.”
In general, opportunism in terms of pursuing self-interest with guile involves
subtle forms of deceit and refers to the incomplete or distorted disclosure of infor-
mation, especially to calculated efforts to mislead, distort, disguise, obfuscate, or
otherwise confuse (Williamson, 1985, p. 47). Moreover, risks of this opportunism
can be reduced by mutual trust. While transaction cost is defined as the economic
equivalent of friction in physical systems, we assume that trust may, not always
but fairly often, play the role of lubricant for making the economic system run
smoothly (Arrow, 1974, p. 23). However, operationalizing trust, no matter how
it is defined, has proved inordinately difficult which results inadequate and lim-
ited empirical analysis of the variable (Williamson, 1985, p. 406). Arrow insists
that the efficacy of alternative modes of contracting and monitoring would vary
among cultures because of differences in trust. Cultural factors are strongly related
to the degree of trust. Fukuyama (1995, p. 25) states “community depends on
trust, and trust in turn is culturally determined.” However, we would say that
the degree of trust even in a particular culture or society could rather vary. Arrow
(1974, p. 16) argues,

most of us operate in some middle realm where we admit social claims, some-
times forget about them for long stretches of time as we go about our daily
private role, sometimes rise to an occasion, sometimes fall miserably short, as
we assert our individuality in contexts that are not totally appropriate.

Trust makes people altruist. Although the relationship between trust and altru-
ism is intricate they are interconnected in the sense that both are greatly shaped by
a common factor, culture. Fukuyama (1995) indicates that religion is a primordial
source of culture. Thus, the association between religion (as cause) and altru-
ism (as effect) is mediated through trust. Although the relationship can be bi-
directional, the causal direction that religion affects altruism is more pronounced
in the literature than the other way around (see for example, Soroglou, 2013).
Zhao (2012) finds from his experimental research that religious people behave
more altruistically to in-group members than non-religious people. One reason is
 Altruism and reciprocity in equity fund 65
that religious belief enhances within-group interpersonal trust. With greater trust,
the chances of altruistic behavior within the group increases. This is however, not
universal. Soroglou (2013) explains two dimensions of religion affecting altruism.
The first dimension is referred to ‘coalition dimension’ which emphasizes the ‘in-
group’ vs. ‘out-group’ barriers. Altruism from this perspective can be viewed as
merely confined to those people who belong to the same community or share the
same normative beliefs and practices. In contrast, the ‘spiritual dimension’ of reli-
gion connects altruistic behavior to divinity or spiritualism. This sort of altruism
tends to achieve universal welfare. In this sense, altruism derived from religious
faith and belief can be extended universally even sometimes going beyond the
religion’s boundary.
In the Simonian view, altruistic behavior shall only be encouraged if the docil-
ity of the individual can enhance the fitness of the group as a whole even if the
individual’s personal fitness declines. This view reflects an ultimate benefits actors
receive from being altruistic, “individuals who are docile therefore have a great
advantage in fitness over those who are not docile” (Simon, 1996, p. 45). Such a
concept of altruism is purely based on the condition that the fitness loss to indi-
vidual for being altruist is less than the gain to society. This perception echoes with
the assumption of homo economicus or rational choice theory (self-interest behav-
ior). Soroglou (2013) differentiates between behavioral altruism (self-interested)
and genuine altruism (other-regarded). The former is preoccupied by the concept
that altruism can be a strategic way of advancing an altruist’s own interest, maybe
in the form of boosting his own reputation, expecting social approval, triggering
reciprocal returns from the receiver, or avoiding shame (Soroglou, 2013). Genu-
ine altruism, on the other hand, can be defined as a behavior which purely orients
to others’ well-being even at the loss of the giver’s. Such a genuine altruism can be
influenced by strong self-determination or heightened self-esteem. Elster (2006)
suggests that many charitable endeavors are performed for the inner audience.
Bringing religion in the context, inner audience can be translated as a response for
a divine or spiritual call. Altruism in this pursuit helps people behave altruistically
even if no one knows about their philanthropy. Islam as religion provides various
spiritual but pragmatic commands towards this direction.

3.  Altruism and reciprocity in Islam

Green (2005) traces the origin of ‘altruism’ to August Comte who coined the
term in the nineteenth century from the Latin word ‘alter’ which means ‘other’ or
‘care for others’. From this perspective, Green (2005) defines altruism as an inten-
tional action which is undertaken for the welfare of others without expecting any
benefits or in some cases the actor might suffer a loss. Homerin (2005) translates
the Arabic word al-ghayriah from the word ghayr, meaning ‘others’. However,
the Qur’anic meaning of ghayr tends to indicate ‘others’ in general although it
includes the intention of favoring ‘others’ than the self. Homerin (2005) further
argues that the closet of ‘altruism’ in the Arabic word can be found in the medi-
aeval Sufi term ‘ithar’ which means “preferring the other to the self” (Homerin,
66  Yasushi Suzuki and Mohammad Dulal Miah
2005, p. 84). Ithar is used in the Qur’an to mean charity (Yusoff, 2014). Like-
wise, scholars endorse charity to indicate altruistic behaviors of agents (Khalil,
2004). Hammond (1975, p. 115) specifies the concept: “altruism can be invoked
to explain any charitable behavior we may observe. But it is not quite obvious
that altruism must be invoked to explain all charitable behavior.” For Hammond
(1975), other than pure altruism, some charities are driven by egoism – a condi-
tion in which the altruist believes that his current altruistic actions would return in
the future while he is in need. Or in the view of Fong (2007) the former is uncon-
ditional altruism while the latter is reciprocal altruism. All these views conform to
our earlier discussion of behavioral altruism (egoism or reciprocal) and genuine
altruism (unconditional). In light of this discussion it is safe to equate altruism to
charity in the context of Islam. Undoubtedly, the Qur’an encourages people to be
altruist “and they give food, in spite of their love for it to poor, the orphan, and
the captive” (Qur’an, 76:8–9).
Charity in Islam can take many forms. For instance, Islam not only proposes
zakat (almsgiving) as an obligation for well-off Muslims but also makes it one of
the basic five pillars of Islam. Giving zakat can be considered an act of genuine
altruism because the actor can expect no worldly return in exchange of paying
zakat. But rather, failure to discharge this altruistic duty entails someone to be
divinely punished. Other than compulsory almsgiving, Islam strongly encourages
different voluntary charities one of which is awaqaf or perpetual charity. Hassan
(2010) defines awaqaf as a perpetual charity which is to hold certain property and
preserving it for the confined benefit of certain philanthropic purposes. Hassan
(2010) further argues that awaqaf is widely practiced by both the Muslims and
non-Muslims worldwide. This proves that altruism in Islam is pervasive and genu-
ine. While Simon views docility as a means of enhancing group fitness to survive
under the condition of human-bounded rationality (behavioral altruism), altruism
in Islam is concerned with fulfilling the socioeconomic objectives of ‘social justice’
in accordance with the objectives of Shari’ah. It is a sort of moral and religious
obligation for individuals to be altruist without thinking about worldly return
(unconditional altruism). As such, Islamic altruism is broader in scope and appli-
cation. It is mentioned in the Qur’an (4: 36) “show kindness to parents, and the
kindred, and orphans, and to needy, and to the neighbor who is a kinsman and
the neighbor who is a stranger, the companion by your side, and the wayfarer.”
This verse clearly nullifies the confinement of the purpose of Islamic altruism
merely to an increase in ‘group well-off’ or ‘group fitness’. Rather, it encourages
unconditional charity towards those who are really in need; sometimes prioritiz-
ing others’ needs over self in the pursuit of ithar. The ‘altruism’ of the Medinan
Muslims, praised by Allah in the Qur’an, was so great in its scope and impact:

And (in this wealth there is also a share) for those (the Helpers) who had set-
tled in the city (of Madinah) and had embraced the Faith before these (Refu-
gees arrived there). They love those who migrated to them for refuge and
(who) even though poverty be their own lot, found no desire in their hearts
for that which is given to them (Refugees) but they gave them (Refugees)
 Altruism and reciprocity in equity fund 67
preference over themselves. And (bear in mind that) those saved from the
covetousness of their souls are the ones to achieve the goal.
(Qur’an, 59:9)1

The strength of Islamic altruism can be derived from the basic concept of owner-
ship over wealth. In the Muslim society, there is the powerful concept of Allah’s
ownership of all wealth. Human beings are mere ‘trustees’ of this wealth (Qur’an,
3:180 and 57:10). It is summarized by Naqvi (2003:105) that the individual’s
right to spend his wealth is limited in several ways: (a) he must spend it according
to Divine wishes (Qur’an, 57:10), (b) he cannot hoard it, especially when there are
urgent social needs to be met (Qur’an, 3:180), (c) he must give it to the poor not
as charity but as a matter of the latter’s acknowledged right in his wealth (Qur’an,
70:24–25), and (d) he must spend wealth only in moderation because being spend-
thrift is both a social waste and a cardinal sin (Qur’an, 17:26–27). Attaching the
concept of ownership of the poor to the wealth of the rich bestows upon ithar,
another superior dimension missing in the economic and social analysis of altruism.
Many scholars including Mawdudi (2011) and Naqvi (2003) point out that the
Islamic right of the poor to receive their share in the wealth of the rich strength-
ens altruism significantly in running efficiently and equitably an essentially indi-
vidualistic economy, and it minimizes the free-riding and assurance problems. The
Holy Qur’an unambiguously states that the poor have a due share in the wealth
of the rich. Naqvi (2003, p. 107) further notes that “even the Rawlsian Differ-
ence Principle, which explicitly stipulates helping the poor on a priority basis, does
not include in the rich man’s wealth the right of those who cannot participate in
market exchange.” As such, he argues “Western theological systems are generally
ambiguous about recognizing the poor’s right.”
While Islam praises and encourages altruistic behavior, it also makes provisions
for punishment if somebody behaves opportunistically. For instance, the Prophet
(PBUH) said:

There are four characteristics, whoever has all of them is a true hypocrite, and
whoever has one of them has one of the qualities of a hypocrite until he gives
up: when he is trusted, he betrays; when he speaks, he lies; when he makes a
promise, he breaks it; and when he disputes, he resorts to slander.
(Saheeh al-Bukhari, Saheeh Muslim)

This implies that in Islam there is no scope for opportunism or breaking of trust.
Also, in case of any dispute ex post, partners should resolve it according to their
best wisdom with faith and morality. Any deviation from this state will turn them
into a hypocrite. The punishment for hypocrites is mentioned in the Qur’an:
“Allah has promised the hypocrites – men and women – and the disbelievers the
fire of hell; therein shall they abide. It will suffice them. Allah has cursed them and
for them is the lasting torment” (Qur’an 9: 68).
In Islam, the purpose of encouraging altruistic activities (mandatory and vol-
untary) on the one hand and provisioning punishment in the case of opportunism
68  Yasushi Suzuki and Mohammad Dulal Miah
on the other aims at achieving social equality through eradicating poverty. Some
scholars show that the difference in income between the rich and poor is less in
Muslim countries than in non-Muslim countries. Based on available data from
1990–2006, Fisher (2011) shows that the average score of Gini co-efficient in
Muslim countries is 38.0 whereas the score for non-Muslim countries is 41.1
and the difference is statistically significant. Moreover, the variation of inequal-
ity is higher in non-Muslim countries (Gini co-efficient ranges between 25 and
74) than in Muslim countries (Gini co-efficient ranges between 25 and 50). In
explaining the reason for class equality in Muslim countries, Fisher points out
that besides obligatory almsgiving, it is the social justice that occupies the pride of
place in Muslim moral thinking. Muslim society is concerned about Islamic altru-
ism as a driver for realizing this social justice.
Reciprocity, in one way or another, is embedded in altruism. Behavioral or recip-
rocal altruism is motivated by actors’ strong expectation of receiving the return
in worldly matter whereas genuine altruism is driven by expectation of receiving
spiritual or divine reward. Regardless of the motives of actors, both unconditional
altruists and strong reciprocators may support redistribution of wealth to the poor
(Bowles, 2012). Bowles further raises a crucial issue regarding strong reciprocity:

Altruism is a widely discussed and important motive for assistance to the

poor. But strong reciprocity provides a quite different perspective: Strong
reciprocators wish to help those who try to make it on their own but who, for
reasons beyond their own control, cannot, and they wish to punish, or with-
hold assistance from, those who are able but unwilling to work hard or who
violate other social norms.
(2012, pp. 145–146)

Bowles refers ‘strong reciprocity’ to a propensity to cooperate and share with oth-
ers similarly disposed, even at personal cost, and a willingness to punish those who
violate cooperative and other social norms, even when punishing is personally
costly and cannot be expected to result in net personal gains in the future (Bowles,
2012). He refers to a report in which the majority of the respondents (81 percent)
favor public funding for child care if the mother is a widow who is trying to sup-
port three children, while only a few (only 15 percent) favor public funding when
the mother has never married and is not interested in working. Bowles is con-
cerned about strong reciprocity as a driving force of making people willingly help
the poor, but withdraw the support when they perceive that the poor may cheat
or not try hard enough to be self-sufficient and morally upstanding. Bowles also
refers to ‘genuine altruism’ in the standard biological sense of the term, which is
what motivates actors to help others in situations where the actor would increase
her payoffs by not helping (Bowles, 2012, p. 131). Similarly, Segal and Sobel
(2007) argue that a reciprocal individual responds to actions he perceives to be
kind in a kind manner, and to actions he perceives to be hostile in a hostile man-
ner. Thus, the preferences of actors in altruistic performance will be influenced by
 Altruism and reciprocity in equity fund 69
the behavior of the receivers. The question is: how far the well-intention of one
measured by heavenly achievement is known to others?
In the tradition of Western political philosophy, altruism itself depends on rec-
ognition of the reality of the other persons, and on the equivalent capacity to
regard oneself as merely one individual among many (Nagel, 1970, p. 3). In con-
trast, Islamic altruism appears to depend on reciprocity backed by mutual belief
in the omnipotence and omniscience of the absolute power. As mentioned earlier,
the Qur’an unambiguously states that the poor have a due share in the wealth of
the rich. This unique institutional structure which creates Islamic altruism and
reciprocity may help the supply of the fund for those entrepreneurs who face dif-
ficulties in fund-raising. But it is impossible for the altruist to know that the receiv-
ers are staying up to the spirit of divine principles. In this circumstance, a simple
doubt about the possible opportunistic behavior of entrepreneurs can seriously
inhibit the altruism towards the entrepreneurs. From the ‘opportunism’ perspec-
tive, we may say that the cooperative mode of economic organization, where trust
and good intentions are generously imputed to the membership, has its weakness
in being endowed with few organizational responses to the debilitating effects of
opportunism. For Williamson (1985, pp. 64–65) “such organizations are easily
invaded and exploited by agents who do not possess those qualities.” Transactions
that are subject to ex post opportunism will benefit if appropriate safeguards are
devised ex ante (Williamson, 1985). We should note that, in other words, if safe-
guards are not sufficiently devised ex ante, opportunism would possibly emerge as
a troublesome source of behavioral uncertainty in economic transactions.

4.  Implication for Islamic venture capital

Basically, venture capital is identical to equity finance as well as mudaraba/
mushāraka financing. It is very close to equity-like PLS-based Islamic finance
structures, notably mudaraba and mushāraka,2 although these have to be adapted
to create the flexibility required by venture capitalists (Durrani, 2006). Çizakça
(2011) summarizes the Islamicity of VC. First, VC is identical to mudaraba and
is a part of the Prophet’s sunnah. Second, unlike a loan or a credit transaction,
there is neither interest nor collateral in a venture capital transaction. Finance
is simply provided in return for shares which is a form of equity finance. Third,
the entire system is based upon equity finance. There are no loans involved and
hence there is no question of riba. If a third-party guarantees as insurance in order
to encourage public participation, only the principal is guaranteed by the state.
Fourth, venture capital is a profit-and-loss sharing system. Profit-and-loss sharing
takes place in accordance with Islamic rules. Profit in a venture capital company
is shared according to mutual agreement. This mutual agreement is expressed in
the amount of shares the venture capital company obtains from the entrepreneur.
Loss goes entirely to the venture capitalist or financier. This is without any doubt
mudaraba. Fifth, a venture capital company is established just like a classical
Islamic shirkat, that is, a partnership for limited duration, usually for 10 years. Last
70  Yasushi Suzuki and Mohammad Dulal Miah
but not least, risks are truly shared and the venture capitalist does not demand col-
lateral from the entrepreneur.
As we mentioned earlier, Çizakça (2011) is of the opinion that VC is going to
be the rising star of Islamic finance because VC is a Shari’ah-based instrument
and, though risky, embodies huge profit potential. He refers to a dimension of
culture as an important factor encouraging entrepreneurship. He mentions that
Islam assigns the highest social status to an honest merchant struggling to earn
and enlarge its assets legitimately. It is believed in Islam that such merchants or
entrepreneurs will be exalted and shall join the ranks of the martyrs in the life here-
after. This proves that enormous social importance is attached to entrepreneur-
ship (Çizakça, 2011; Elsiefy, 2013). In parallel, the role of waqf is emphasized as
an important contributor to organizing Islamic venture capital: waqf is considered
retention of a property for the benefit of a charitable or humanitarian objective, or
for a specified group of people such as members of the donor’s family. The global
waqf will focus on three basic activities: ongoing charity (sadaqa jariyah), educa-
tion, and family waqfs (Çizakça, 2011). Ongoing charity can be interpreted as a
strategy for poverty alleviation.3
Islamic altruism strengthened by the Islamic right of the poor to receive their
share in the wealth of the rich may also contribute to organizing Islamic VC.
Successful VC companies would help alleviate poverty by increasing employment
and contribute to sustainable economic growth through capital accumulation to
further innovations. The concept of venture capital here is different from the tra-
dition of what we call social entrepreneurship even though both can be oriented
towards poverty alleviation. For instance, a social enterprise is a business with the
primary objective of the development of society and community rather than being
driven by the need to maximize profit for shareholders and owners. In the case of
venture capital, social utility is created by achieving self-fulfilling objectives. As
such, economic value creation appears to be the primary objective for VC while
social value creation is the supreme purpose of social enterprises (Seelos and Mair,
2005). Islamic altruism and reciprocity towards entrepreneurs may, in theory,
contribute to setting up Islamic VC. However, in reality, Islamic VC is not yet
well developed in Islamic economies. Figure 4.1 summarizes the discussion in this
section and links to the reasons.
Though data to empirically prove the above claim is seriously limited, anec-
dotal facts and reference from Islamic banks’ financing patterns can prove that
Islamic equity/participatory financing is tremendously drained. For instance,
Suzuki and Uddin (2014) analyze the performance of Bangladeshi Islamic banks
compared to their conventional counterparts for the period 2008 to 2012. They
find that the majority of Islamic banks’ income is derived from the asset-based
murabaha, whereas the income from equity-like mudaraba and mushāraka is
very negligible. Only three banks are involved in this mode of financing whereas
the remaining banks are totally reluctant to engage with the profit-and-loss
sharing modes. They examine and compare the ratio of interest paid to deposi-
tors against interest received from borrowers between conventional and Islamic
banks on a non-risk-adjusted basis. Based on the analysis they point out that the
 Altruism and reciprocity in equity fund 71

Islamic principles/ethics as informal institutions that determine the transaction

costs (TC) embedded in society:

(1) Prohibition of gharar (excess uncertainty), (2) profit–loss sharing (PLS),

(3) ithar or charity (Islamic right of the poor to receive their share in the
wealth of the rich), and altruistic wealth-redistributive system of obligatory
almsgiving

(X) Islamic ethics as lubricant for reducing TC

a) High degree of trust relations among the Muslim community, which

may possibly reduce the screening and monitoring costs. b) Perhaps
enhancing the supply of venture capital for entrepreneurs who face
difficulties in fund-raising.

(Y) Islamic ethics as potential friction for increasing TC

a) Prohibition of excess uncertainty and PLS make the Islamic

lenders/investors behave risk averse. b) Strong reciprocity may cause
Williamsonian opportunistic behaviorunless appropriate safeguards can
be devised ex ante, leading to drain of VC fund.

Figure 4.1  NIE (TCE) framework explaining anomaly of Islamic venture capital

riba-free banking exercised by the Islamic banking windows/branches of these

banks associated with a lower ratio than the riba-based banking in conventional
branches. To be specific, for six of the reported banks the ratio has remained con-
sistently lower during the whole period. It reveals the probability of prevailing
higher profit opportunity under the asset-based financing in the Islamic bank-
ing sector, particularly under the dominant murabaha. In the case of Pakistan,
murabaha and ijara comprise 82 percent of total financing whereas the share of
muḍāraba and mushāraka in total financing stands at merely 4 percent (IFSB,
2014). In the context of MENA, Ali (2011) shows that the proportion of mura-
baha in total financing is 75 percent. Countries like Kuwait, UAE, and Yemen
show a very negligible share of equity-based financing. The notable portion of
the mushārakah mode of financing is contributed by Saudi Arabia, Lebanon,
and Bahrain but the portion remains below 8 percent of the total financing in
all these countries. The scenario of equity financing is almost similar for Islamic
banks in all other countries.
Elsiefy (2013) raises several challenges Islamic equity finance or venture capital
currently faces, including (a) the lack of transparency and uniform legal frame-
work which creates substantial obstacles for foreign ownership and representation
in the target investee company, also the lack of the legal structure that respects
the intellectual property rights and patents. (b) There are no specific laws and
courts to judge fast in cases of dispute like in VCs or traditional Islamic muḍāraba
schemes. (c) The lack of know-how and education among investors about VC
investment and its returns and risks. (d) The lack of educational programs that
72  Yasushi Suzuki and Mohammad Dulal Miah
train young people on how to develop their ideas and become entrepreneurs. (e)
The lack of the support and backing from the government in terms of tax incen-
tives etc. While we acknowledge the lack of the ‘formal’ institutions hindering the
sound development of Islamic VC, we should also note the unique feature of the
Muslims’ ‘informal’ constraints which make them hesitate to invest in Islamic VC.
It is worth noting Naqvi’s arguments which are suggestive of answering this
question. Naqvi (2003, p. 111) points out:

it is motivationally rational for a person to sacrifice his selfish interests because

(a) ‘success’ is measured, as Islam does, in terms of one’s distance from greed
and avarice; or (b) making a sacrifice in this world enhances the expected
reward in this world as well in the hereafter.

He points out that public policy is required to assure the altruistic individual (one
who is not inclined to free-ride) that his contribution will not go to waste and that
others in society will not be allowed by the government to withhold their contri-
butions. Naqvi further notes:

An excess insistence on altruism can create a permanent tension between

what a Muslim society is required to do and what eventually gets done in
practice. Indeed, there is a real danger that if moral perfection is demanded at
all times, then the entire social system will become dysfunctional for want of the
required supply of altruism. Thus, in general, appropriate public policy must
keep a balance between self-interest behavior and moral imperative because
the principles of altruism and exchange are both mutually supportive as well
as antithetical.
(2003, p. 131)

From the Muslim perspective, there is no agency problem between the absolute
existence as the principal and its followers (including fund providers, venture capi-
talists, and capital recipients) as the agent, because the followers retain their firm
belief in the omnipotence and omniscience of the absolute existence. It is men-
tioned earlier that Islamic altruism appears to depend on reciprocity backed by
mutual belief (among the followers) in the omnipotence and omniscience of the
absolute power. At the individual level, the prospect of accountability on the Day
of Judgment would bring positive behavioral changes. However, the current-life
problem in equity finance is stemming from the structure that nobody knows
the judgment of others. In other words, nobody on earth precisely knows which
person among the others would not be allowed to enter into the Kingdom of
God on the Day. The implication of this proposition is that the expected positive
effect of Islamic principles as lubricant for reducing relevant transaction costs (X
in Figure 4.1) is currently being cancelled out by the negative effect as friction (Y)
embedded in the industry of Islamic equity finance (X - Y < 0). This is because,
first, the prohibition of excess uncertainty and PLS makes the Islamic lenders or
investors risk-averse (the murabaha syndrome). Second, strong reciprocity may
 Altruism and reciprocity in equity fund 73
cause Williamsonian opportunistic behavior of actors leading the drain of the fund
for VC firms.
The shortage of funding for Islamic microfinance provides a support to this
hypothesis. There is a growing tendency to view zakat as a source of funding for
microfinance because it appears to be ideally suited to support Islamic microfi-
nance as a poverty alleviation strategy (Karim et al, 2008; Yumna and Clarke,
2011). Yumna and Clarke (2011) however point out that although zakat is com-
pulsory charity in Islam to fight poverty, the awareness among Muslims of paying
zakat is not so high. They report that BAZNAS, the largest zakat institution in
Indonesia, only collected US$ 2.6 million in 2010, where the national potency
of zakat on household income reached US$ 61 trillion. This data tells that the
zakat fund would not be reliable as a source of funding. Besides, an institutional
analysis tells us that an excess reliance on charity may possibly cause moral hazard
or opportunistic behavior in the agent involved with the microfinance industry.
Unless appropriate safeguards and rules for protecting the right of the principal
can be devised ex ante, it makes sense that the potential moral hazard or oppor-
tunistic behavior in the agent (particularly capital recipients) would make the prin-
cipal (particularly fund providers) hesitate to share risks in enterprise if he/she is
not an unconditional altruist.
Islamic financiers have traditionally used contractual obligations to counter
agency problems. However, in theory and in practice, the Muslim principal (par-
ticularly fund providers) is exposed to higher agency risk because the fund provid-
ers have the divine obligation to share risks in enterprise under the PLS scheme as
well as to share a portion of incomes with the poor or the entrepreneurs who face
difficulties in fund-raising. This altruistic or reciprocal behavior is always moni-
tored by the absolute existence yet appropriate rules of protecting the right of the
principal (or of punishing the agent when its opportunistic behavior is revealed)
should be installed.
It is obvious that the survival of an entrepreneur depends on a lot of important
elements such as congenial business environment, the entrepreneur’s personal
characteristics, business acumen etc. However, when it comes to the question of
encouraging and protecting venture capitalists as well as ultimate investors, it is
essential to ensure that the capitalist does not perceive a material threat to be
cheated. This feeling can come from many sources but most importantly it can
stem from financiers feeling that entrepreneurs exert less than optimum effort,
show carelessness or lack of enthusiasm and sincerity, and other such problems
peculiar to traditional agency relation. Although, in the perspective of Islamic
altruism, venture financiers count on the divine rewards for helping financially
constrained entrepreneurs, nobody knows about the others’ devotion to the life
hereafter. Thus, it is crucial to devise some ex ante tangible measures to safeguard
venture financiers as well as ultimate investors. These measures can include rais-
ing awareness through spiritual quotient among entrepreneurs about the worldly
benefits (availability of finance) and divine rewards for being honest and trustwor-
thy. Also, some regulations congruent with Islamic principles can be put forth for
resolving any dispute ex post. For so doing, the availability of scholars qualified
74  Yasushi Suzuki and Mohammad Dulal Miah
to render a decision (fatwa) is to be ensured. Given the scarcity of such scholars,
training for young but promising scholars by the initiatives of the state can be
arranged. Moreover, a trustee board can be formed to insure against any potential
fraudulent or cheating activities by the entrepreneurs. Such arrangement is not
purely an insurance against the financial loss stemming from the normal course
of business but a safeguard for financiers against possible agency problems. Of
course, it might appear irrelevant installing a safeguard for an activity which is
considered charity purely driven by altruistic behavior. This question characterizes
the current reality of charitable activities in the Muslim world. First, the amount of
realized zakat is too negligible to count compared to the estimated amount. This
can be attributed to the problems of strong reciprocity. If wealthy individuals who
are suffering from a strong sense of reciprocity can be motivated through institut-
ing the means to invest in venture financing outlined in this section, the amount
of charity will definitely be increased.
The same applies to banks and non-bank financial institutions that wish to
divert some funds from mark-up murabaha financing to pure profit-and-loss
sharing transactions. Elsiefy (2014) notes that the partnership contracts are not
suitable for the banking business model because they do not fit with it. Given
the low level of development of private enterprises and high unemployment in
many Muslim countries, there is a greater scope for venture capital firms to flour-
ish. However, some changes in the legal and regulatory environment need to be
implemented because the existing guidelines to promote Islamic VC (for instance,
the Guidelines and Best Practices on Islamic Venture Capital issued by Malay-
sian Securities Commission) mainly address the VC companies and fund manag-
ers in the light of Shari’ah compliance and do not introduce any incentive and
protection guideline for fund providers. Many consulting and law firms engaged
in Islamic finance insist that the legal and regulatory framework for Islamic VC
should be developed. For instance, Azmi & Associates, one of the largest Kuala
Lumpur-based law firms, proposes that the establishment of a legal and regulatory
framework or the appropriate guidelines to regulate the industry is still one of the
critical constraints for thriving Islamic financial activities. In this regard, an effec-
tive and active Shari’ah advisory board is a critical requirement. Second, the legal
framework must be strong and internationally competitive so that it can cover
the delicate issues related to modern technology. Third, the state can provide
some support in the form of training to high-caliber individuals and management
teams with expertise in investment strategies for developing professional skills so
that they can stay up to the expectation of the financiers. For instance, entrepre-
neurs’ tendency to engage with activities which are prohibited by Islamic Shari’ah
will discourage prospective financiers. Thus, potential entrepreneurs who possess
business skills and capacity can be equipped with Shari’ah knowledge through
training so that they do not engage in activities prohibited in Islam. Moreover,
the support and backing from the government in terms of incentives like tax holi-
days and tax exemptions are to be systemized. Unless these tangibles guidelines
are devised and put into practice the unique structure which institutionalizes
Islamic altruism and reciprocity would rather drain the supply of the fund for VC,
 Altruism and reciprocity in equity fund 75
though a better system for enhancing equity finance can only be constructively
adapted through a process of trial and error.

5.  Concluding comments

Bounded rationality is human innate nature. Also, opportunism in the human
behavior is a reality. Resultantly, transaction costs of writing a precise and spe-
cific contract are significant. Societies have devised various institutions – formal
or informal – to tackle the adverse effect of these features of economic agents.
Trust has therefore transformed into a social lubricant. Islam as a religion not only
encourages followers to maintain trust and reciprocity but also strictly prohibits
any opportunistic behavior. From this perspective, this chapter has attempted to
analyze altruism and reciprocity as important institutions prevailed in Islam and
how these institutions can contribute in developing Islamic venture capital. In so
doing, the chapter has described the nature and causes of opportunism and its
associated transaction costs through the lens of NIE. Also, the role and impor-
tance of trust as an informal institution have been examined.
Citing some Qur’anic verses and Hadith as well as reviewing the existing litera-
ture on Islamic finance, we have shown that the provision of trust and reciprocity
is persuasively pronounced in Islam. According to Islamic conventions, the poor
are considered to have a share of the wealth of the rich and poverty in society is
seen as a problem which calls for strong attention by the rich. In this sense, it is a
moral obligation for wealthy individuals to finance an entrepreneur who is having
financial difficulty for materializing his entrepreneurial skill. This will bring the
financier benefits in two ways: first, he/she is complying with the Islamic teach-
ings in spending his/her wealth and can expect divine rewards; second, he/she
can earn some profit from the venture in case of success which is Shari’ah-based.
At the same time, Islam provides provision for severe punishment in belief, but the
limited punishment in practice in case of any opportunistic behavior. The moti-
vation of Islamic altruism on the one hand and the possibly reduced transaction
costs of contracting on the other should make Islamic venture capital a lucrative
investment opportunity for those who are blessed with wealth. However, Islamic
venture capital has not been well developed.
In explaining this anomaly, we have argued that only very few countries enforce
Islamic laws at the state level. In most cases, it is self-enforcing. In the absence of
strict enforcement at the state level a voluntary compliance of Islamic laws depends
on the actor’s choice. People who truly believe in divine punishment might strictly
follow self-enforced Islamic principles. In this case, a state of no opportunism can
be expected. However, this self-enforced mechanism is not enough for motivating
people to finance small entrepreneurs because this mechanism purely relies on the
belief of divine punishment. It is impossible to know ex ante agents’ cautiousness
about the divine punishment and act thereupon. It can be known only as the facts
are revealed ex post which is very late. This situation may create an uncertainty for
capitalists about agents’ behavior. People, no matter whether they are altruistic
or not, have an innate tendency to avoid a situation in which there exists any
76  Yasushi Suzuki and Mohammad Dulal Miah
possibility of being cheated. Financing purely based on good faith on the Day
of Judgment sometimes creates such a dilemma. Given the availability of numer-
ous alternatives to charity, financiers might shy away from financing VC projects.
Second, investors who wish to accomplish charity but also expect little profit from
VC financing might be reluctant to take risks involved with venture capital as long
as there are other less-risky Shari’ah-based financial products available to invest.
Choudhury (2001) however offers some modification for existing Islamic
financial instruments to be real Shari’ah-based products like venture capital. This
possibility comes to the vision due mainly to the fact that venture capital as a
pure Islamic financial investment is not yet pronounced or well formulated so that
capitalists can understand the difference between VC and other Shari’ah-based
schemes in terms of both compliance of Islamic principles and risk and return
associated with them. An aggregate effect of the lack of formal institutions on the
one hand and a clear understanding of the difference between traditional Islamic
financial products and venture capital in terms of both Shari’ah compliance and
risk-return possibilities on the other has turned Islamic financiers into ‘risk-averse’
actors. As a result, Islamic venture capital is still underdeveloped despite all these
competitive advantages embedded in the system. To overcome these obstacles,
a national financial system should devise some tangible provisions for installing
financier/investor-friendly regulations consistent with Islamic principles.

Acknowledgement
This chapter is a revised and updated version of Suzuki and Miah (2016) ‘Altruism,
reciprocity and Islamic equity finance’, International Journal of Islamic and Mid-
dle Eastern Finance and Management, Vol. 9 Issue: 2, pp. 205–221. We are grate-
ful to Emerald Group Publishing Limited for its permission on the reproduction.

Notes
1 We refer to The Holy Qur’an, Arabic Text and English Translation (2010), 9th
printing, Noor Foundation International Inc.
2 We should note the difference in them. The form of mudarabah is a trust-based
financing, while that of musharaka is a participatory financing.
3 The subsequent Chapter 7 by Suzuki, Hasan and Pramono have a different view on
this point. They consider that the major sources of funds for Islamic VC should be
(1) the pool of funds created by ambitious investors who are ready to absorb risk and
uncertainty and/or (2) the governmental initiatives upon its long-term strategy for
incubating new frontiers of business. In their view, the primary mission of Islamic
VC is to promote future innovation which would enhance the sustainability of our
economy, rather than to directly promote poverty alleviation.
5 Anatomy of Islamic venture
capital
Typology of Bahraini/Indonesian
Islamic venture capital
Yasushi Suzuki, A. K. M. Kamrul Hasan and
Sigit Pramono

1. Introduction
Venture capital (VC) is not a fresh topic in modern finance but Islamic venture
capital (Islamic VC) is relatively new in the Islamic banking and finance literature.
In this chapter we will discuss Islamic VC and its dilemma. VC cannot grow if there
are no entrepreneurial activities or entrepreneurial spirit in society. Entrepreneurs
have to build the confidence of venture capitalists in their projects through com-
mitment. Open and free communication can be considered a catalyst in building a
strong relationship between both of them (Shepherd and Zacharakis, 2001). This
chapter begins with the discussion of basic differences between Islamic microfi-
nance and Islamic VC. The rest of the chapter is structured as follows: the dif-
ferences between Islamic microfinance and Islamic venture capital is discussed in
Section 2. The evolution and relationship between entrepreneurship and VC is
discussed in Section 3. The nature of venture capital is discussed in Section 4. The
concept of Islamic VC, its evolution and the dilemmas are discussed in Section 5.
Section 6 discusses two Islamic VC – Venture Capital Bank of Bahrain and PNM
Ventura Syariah of Indonesia – as a case study to look at the performance and
operations of Islamic VC. We aim to offer a theoretical framework for classifying
different types of Islamic VC. At the end of this chapter we offer some inclusive
recommendation for Islamic VC and raise some concerns for future research.

2. The differences between Islamic microfinance and

Islamic venture capital
There is little doubt that Islamic microfinance aims to ultimately contribute to
poverty alleviation among its beneficiaries. On the contrary Islamic VC focuses
on entrepreneurship development through funding the start-ups. In Table 5.1
we attempt to clarify the basic differences between these two different streams of
Islamic finance and then we discuss in detail all points.
We highlight the following eight dimensions to clarify the differences in nature
between Islamic microfinance and Islamic VC. (1) The individual insolvent
households/unbanked households are the main clients for microfinance institu-
tions (MFI), while the innovators or new start-ups are the prime target for Islamic
Table 5.1  Differences between Islamic microfinance and VC

Elements Islamic microfinance Islamic venture capital

(1)  Main clients Individuals, microenterprises Innovators, start-ups

(2) Nature of risk and return to be Relatively high risk but not so high return Much higher risk, associated with higher
absorbed to be expected returns
(3) Size of each project (in terms of Small Large
investing money)
(4) Objectives Wealth distribution by empowering the Wealth creation
poor
(5) Instrument to control/solution I.   Group (mutual) monitoring I.  Screening and monitoring by experts
mechanism II. Governmental or NGO initiatives for and professionals
supporting the fund-raising by MFIs II. Ijtihad – of paying effort incubating
new frontiers of business
(6)  Ultimate goal/mission Poverty alleviation by empowering the Incubate future innovation for the
poor. Improving social justice sustainability of our economy
(7) Required human capacity in the Including the clients who had the limited Higher skill humans are required
investee access to primary education
(8)  Sources of funds I.  Donation from rich Muslims/ I.  Pool of funds created by ambitious
development partners (DP) investors who are ready to absorb
II.  Zakat (one kind of religious tax that risk and uncertainty
is compulsory to pay by rich/solvent II. Government initiatives upon its
Muslims) long-term strategy for incubating
new frontiers of business
 Anatomy of Islamic venture capital 79
VC. (2) In terms of the risk and return to be absorbed, microfinance, by nature,
deals with relatively high risk, but expects not-so-high returns from their base
of clients, while VC business, by nature, deals with much higher risk associated
with higher returns if the investee is successful. (3) In general, the size of each
microfinance project is small, while that of VC projects is large. (4) Islamic finance
can contribute to both ‘wealth distribution’ and ‘wealth creation’. In this cat-
egorization we may classify Islamic microfinance as a contributor to wealth dis-
tribution and Islamic venture capital as a contributor to wealth creation. (5) In
microfinance, a mutual/reciprocal monitoring mechanism in grouping their cli-
ent individuals and the regulatory framework of monitoring MFI plays a vital role
to supervise the investment of Islamic microfinance. Islamic VC companies are
expected to assign portfolio professionals of screening and monitoring upon the
Shari’ah compliance. The professionals are expected to monitor and supervise the
new and innovative investment proposal through the mind of ijtihad for making
efforts at incubating new frontiers of business. (6) The mission of Islamic micro-
finance includes alleviating poverty by empowering the poor and contributing to
social justice in wealth distribution. On the other hand, the mission of Islamic VC
is to promote future innovation which would enhance the sustainability of our
economy. (7) For MFI the clients’ educational qualification/literacy is not neces-
sarily a core criterion for screening and monitoring, while for the VC firm, the
CEO and CFO’s capacity with its leadership in planning and implementing their
business model is a core criterion for screening and monitoring. (8) For running
the Islamic MFI, the charitable and concessional funds donated by development
partners, government and zakat organizations might be inevitable. In contrast,
for running the Islamic VC, in general, the long-term fund provided by the indi-
vidual and/or governmental active institutional investors (such as pension fund)
who are ready to absorb various types of risk and uncertainty is contributing.

3. Evolution and relationship between entrepreneurship

and venture capital
The word ‘entrepreneur’ is of French origin which means ‘undertaker’ in the sense
of the one who undertakes to do something. J. B. Say, a well-known French econ-
omist in the early 1800s, characterized the entrepreneur as a person who seeks to
shift economic resources from the areas of low to high productivity (Smith and
Smith, 2000). Joseph Schumpeter used the term ‘creative destruction’ in describ-
ing the entrepreneurship (Schumpeter, 1942). Frank Knight (1921) referred to
an entrepreneur as ‘a manager of uncertainty’. Schumpeter (1934) viewed the
entrepreneur as actively seeking out opportunities to innovate. Peter Drucker
describes entrepreneurs as those who “create something new, something differ-
ent; they change or transmute values” (Drucker, 1985, p. 22).
Drucker (1985, p. 28) mentioned that “the entrepreneur always searches for
change, responds to it and exploits it as an opportunity.” He mentioned seven
sources for innovative opportunity: (1) the unexpected success, failure and out-
side event; (2) the incongruity between reality as it actually is and reality as it
80  Yasushi Suzuki et al.
is assumed to be; (3) innovation based on process needs; (4) changes in indus-
try structure or market structure; (5) demographics (population change); (6)
change in perception, mode and meaning; and (7) new knowledge both scientific
and non-scientific. Scott Shane in his book General Theory of Entrepreneurship
mentions:

The entrepreneurial process begins with the perception of opportunities,

or situations in which resources can be combined at a potential profit. Alert
individuals, called entrepreneurs, discover these opportunities, and develop
ideas for how to pursue them, including the development of a product or
service that will be provided to customers. These individuals then obtain the
resources, design organizations or other modes of opportunity exploitation,
and develop a strategy to exploit the opportunity.
(2003, p. 10)

He also mentions two core attributes of successful individual entrepreneurs such

as getting better information and being able to utilize the information in a bet-
ter way. Some researchers advocate that governmental initiatives are helpful to
explore entrepreneurial activity which leads to venturing. Culture, well-being
(quality of life) of individuals and economic freedom are the three determinants
of entrepreneurial activity (Kuckertz et al., 2015). Block et al. (2017) find (after
scrutinizing 102 empirical studies published in academic journals) that opportu-
nities for innovative entrepreneurship are exploited from various sources and it
is important to get assistance from more experienced or portfolio entrepreneurs
when developing policies to stimulate innovative behavior among entrepreneurs.
They argue that innovative entrepreneurship can emerge from four sources such
as inventors, innovative and demanding users, employees and academics because
these specific groups of individuals have frequent contact with knowledge and
research-based opportunities and thus are more likely to be engaged in innovative
entrepreneurship (Block et al., 2017). Venkataraman and Shane (2000) theo-
retically describe entrepreneurship from the Schumpeterian concept to cognitive
properties and conclude that exploits of entrepreneurial opportunities depend
on the nature of the opportunity and individual differences in perceptions. They
find from previous research that opportunity costs of pursuing entrepreneurial
activities, costs of obtaining resources, previous employment or entrepreneurial
experience influences the entrepreneurial opportunity exploitation of individuals
(Venkataraman and Shane, 2000). They argue that discovering an entrepreneur-
ial opportunity by an individual depends on information accumulation from the
past and the cognitive ability to identify a more likely to be successful enterprise.
Decisions to exploit the opportunity depend on the nature of the opportunity
and willingness to exploit the opportunity by individuals (Venkataraman and
Shane, 2000). Therefore, although entrepreneurship is an individual initiative,
its exploitation, growth and dimension depend on various factors especially the
surrounding arrangement to flourish the entrepreneurial activity.
 Anatomy of Islamic venture capital 81
Roche et al. (2008) conduct an empirical research on the Ireland technology
cluster, Castanhar et al. (2008) on the Brazilian furniture industry, and Arikan
(2008) on the New York Silicon Valley. Their findings that state support and
VC play supplementary roles to boost the cluster development in their respec-
tive research region are almost the same. For example, Arikan (2008) mentions
that the Lower Manhattan Revitalization Plan (LMRP) and New York Infor-
mation Technology Center (NYITC) initiated by the New York City mayor in
the 1990s and the venture capitalists provide risk capital to the newly emerging
entrepreneurial ventures which make Silicon Valley a hub for the high-tech sector.
Therefore, the role of government and, broadly speaking, state support are very
essential for nurturing the entrepreneurship as well as venture capitalists. Porter
(1990), in his book The Competitive Advantage of Nation, refers to the ‘Diamond
framework’ consisting with four factors such as factor condition, demand condi-
tion, related and supporting industries, and firm strategy for enhancing a nation’s
competitiveness. While talking about related and supporting industries, he argues
that the existence of internationally competitive industries within the nation
shapes the nation’s competitiveness. To build a competitive industries network,
innovation is prerequisite. Chung et al. (2008) find the positive impact on policy
intervention in the development of the Korean VC industry. Supapol et al. (2008)
mention that Chinese state-owned institutions helped the individual-owned small
business/new entrepreneurs.
Basically start-ups need ‘equity finance’ for diversifying the project risk. Usually,
‘banks’ as ‘depository corporations’ would hesitate to undertake the project risk
(project finance in terms of non- or limited-recourse finance) by start-ups. Banks
would prefer to consider the corporate risk (corporate finance); however, in the
case of the start-ups which do not have the track record in operations, banks would
face the difficulty of judging their corporate risk. Under this situation, the venture
capitalists are expected to share the project risk of start-ups or entrepreneurs. To
some extent the governmental initiatives such as fund allocation, tax exemption
for VC firms and developing the capital market are necessary as the incentives
for venture capitalists. The budget allocation for higher education is also another
important governmental initiative for incubating skilled and innovative entrepre-
neurs in society. Silicon Valley in the US is considered the birth place of VC of the
States. Silicon Valley is developed through a community initiative for incubating
entrepreneurs and venture capitalists. Silicon Valley’s inception and growing-up
stages can be divided into several stages. In 1891 Stanford University was founded
in the California area. In 1910, some individual investors arrived in the Bay Area
and they basically dealt with critical electronics components of telephones, radios
and televisions. In 1939, two Stanford graduates established Hewlett-Packard
(HP) which is considered a milestone for Silicon Valley. Later on, semiconductor
research and manufacturing companies landed in the Bay Area. In 1971 the term
‘Silicon Valley’ was popularized by electronics news. In the 1970s the private ven-
ture capital firm hugely gathered in Silicon Valley. As a result, a tremendous tech
revolution occurred in the subsequent two decades in Silicon Valley and many
82  Yasushi Suzuki et al.
innovative enterprises including Google, Facebook and Twitter were born at Sili-
con Valley (Bahrain Islamic Venture Capital Report, 2016).

4.  Nature of venture capital

Venture capital investment screening, contracting and monitoring mechanisms
are to be designed to minimize the moral hazard and adverse selection problem
(Berger and Udell, 1998). Screening starts with a comprehensive due diligence
about business, market etc. prior to investment which leads to designing an appro-
priate contract (Berger and Udell, 1998). Sahlman (1990) highlights the impor-
tance of contract design in minimizing agency costs. He argues that the role of
venture capital in various stages of investment such as seed investment, start-ups,
early development and expansion of rapid growth should be conducted with rigor-
ous screening and legal structure, which would result in minimizing agency prob-
lems between venture capitalists and entrepreneurs; on the other hand there might
arise agency problems between external investors who invest in VC firms and ven-
ture capitalists. He mentions that “there is inevitably a high degree of information
asymmetry between the venture capitalists, who play an active role in the portfolio
companies, and the limited partners, who cannot monitor the prospects of each
individual investment as closely” (Sahlman, 1990, p. 493). To avoid this problem
he stresses standardization of operating procedures and contracting by VC firms.
Amit et al. (1998) argue the importance of VC in alleviating information asym-
metry and consequently potential moral hazard problems. While analyzing the
Canadian venture capital firms’ performance between 1991 and 1996, they find
that the venture capitalists who enter in later-stage investment can overcome
potential moral hazard problems as they enter in the business as an equity partner
mitigating ‘hidden information’ or ‘hidden action’ problems possibly occurring
in the relationship with the entrepreneurs. Amit et al. (1998) also argue that even
though the VCs tend to specialize in those industries associated with higher risk
and fundamental uncertainty, they would prefer the venture with less informa-
tion asymmetries. In general, VCs would prefer the later-stage entrepreneurial
firms than the early stage firms. On the other hand, through the accumulation of
skills in screening and monitoring, VCs are expected to deal well with screening
and monitoring entrepreneurial firms compared to other unspecialized investors
(Amit et al., 1998).
Well-screening and monitoring are possible by the evaluation of observable
attributes of entrepreneurial ventures. These attributes include the tangible
assets such as ‘patent’ (Hsu and Ziedenis, 2013; Conti et al., 2013), ‘prototype’
(Audretsch et al., 2012), ‘business opportunity’ (Kaplan et al., 2009), ‘prior
knowledge’ (Shane, 2000), ‘human capital’ (Hsu, 2007; Colombo and Grilli,
2010) and so on.
The importance of VCs is that they help entrepreneurial ventures to raise the
funds which they cannot access from other sources, by way of alleviating informa-
tion gaps for the sake of the investors to absorb the risk and uncertainty embedded
in the ventures (Gompers and Lerner, 2001; Bertoni et al., 2013). VCs not only
 Anatomy of Islamic venture capital 83
provide capital but also monitor and support their portfolio companies (Gompers
and Lerner, 1999b; Macmillan et al., 1989). A positive impact of VCs with a higher
patenting rate (Kortum and Lerner, 2000;) stimulating innovation (Hirukawa and
Ueda, 2011) and company level (Chemmanur et al., 2011; Hellmann and Puri,
2000), employment and sales growth (Bertoni et al., 2011), speed of product to the
market (Hellmann and Puri, 2000), professionalization (Hellmann and Puri, 2002)
and VC’s reputation have a positive impact on firm valuation (Hsu, 2004).

5.  Islamic venture capital concept and dilemma

The provision of trust and reciprocity is clearly pronounced in Islam. In this con-
text there must be a moral obligation for successful Muslim businessmen to incu-
bate new entrepreneurs who are having financial difficulty in materializing their
entrepreneurial skill (Suzuki and Miah, 2016). They also argue that “the motiva-
tion of Islamic altruism on the one hand and reduced transaction cost of contract-
ing on the other should make Islamic VC a lucrative investment opportunity for
those who are blessed with wealth” (p. 218). Well-raising and mobilizing Islamic
venture capital through mudaraba and musharaka (M&M) depends on the coop-
eration and coordination among agents, firms and investment sectors (Choud-
hury, 2001). Choudhury (2001) advocates that through introducing extensive
participation, such as Islamic venture capital, can reduce the pre-Islamic character
of ‘sleeping partnership’ found in M&M instrument and it can be removed by
increase in entitlement, empowerment and ownership in the extensively participa-
tory enterprises. Hasan et al. (2011) mention two stages of Islamic venture capital
evolution such as ‘classical’ and ‘modern’ Islamic venture capital. While the for-
mer one deals with M&M, the latter includes the contract based on the profit–loss
sharing (PLS) and equity finance. In this section we will elaborate on the concept
of venture capital from the Islamic point of view, the evolution of Islamic venture
capital and the dilemmas in venture capital.
It is said that solutions based on the Islamic injunctions (collectively termed
‘spiritual quotient’) could serve to mitigate agency risks. However, as Suzuki
and Miah (2016) point out, the Muslim principal (particularly fund providers)
is exposed to higher agency risk unless appropriate rules of protecting the right
of the principal (or of punishing the agent when its opportunistic behavior is
revealed) are devised, because the Muslim fund providers have the divine obliga-
tion to share risks in enterprise under the profit–loss sharing (PLS) scheme as well
as to share a portion of income with the poor or those entrepreneurs who face dif-
ficulties in fund-raising (see Chapter 4). Here we look at the dilemmas of Islamic
venture capital which can broadly be categorized into two dimensions such as
conceptual dilemmas and operational dilemmas.

5.1  Conceptual dilemmas

1 Exit route: Preferred stock is the most common tool used by VC firms as ‘the
form of investment’ and the initial public offering (IPO) as an exit route.
84  Yasushi Suzuki et al.
Preferred stock is a lucrative instrument for venture capitalists. Preferred
stock option in the context of ‘gharar’ and ‘riba’ is still controversial among
Shari’ah scholars. Some Shari’ah scholars opine that preferred stock involves,
in particular, riba as it is attached with the fixed dividend which is deemed the
‘pre-determined’ rate of returns to VC firms.
2 Moral hazard: The absence of standardization in Shari’ah compliance on
venture capital may have created a moral hazard among the existing players
and confusion for new entrants. Mentionable here is that four major Mad-
habs (Shari’ah schools of law) are commonly practiced in the Muslim coun-
tries and there exist some differences in opinions/interpretations among the
four schools of Shari’ah scholars. For example, in Bahrain, Maliki Madhab
is followed and AAOFI standards are strictly followed for Islamic financial
institutions, while in Malaysia Muslims practice the Shafi’i school of laws. In
general, the Shafi’i school offers a more flexible opinion than the Maliki and
Hanafi schools which are influential in Middle Eastern Muslim countries like
KSA and Bahrain, and South Asian countries like Bangladesh and Pakistan.
We see that the differences in legal opinions (fatwa) give different incentives
to venture capitalists. On the other hand, too much flexibility in the inter-
pretation of Shari’ah principles may cause potential moral hazard problems
in the VC business. The VC industry faces the difficulty of seeking a delicate
balance in incubating new ventures while avoiding potential moral hazard
problems.

5.2  Operational dilemmas

1 Lack of experts, professionals and academicians: ‘Islamic banking’ started
to receive more attention among academics starting in the 1960s. But the
financing mode of venture capital and microfinance collected less attention in
Muslim-majority countries even in the late 1990s. A limited number of even
academic research has been done over Islamic venture capital so far. Insuffi-
cient accumulation of skill and knowledge in Islamic venture capital may have
failed to incubate the experts/professionals who are expected to screen and
monitor the innovative venture seeds. Simultaneously, the failure to incubate
the experts/professionals of screening and monitoring may have failed to
accumulate the skill and knowledge in Islamic venture capital, consequently
trapping Islamic VC in a ‘vicious circle’.
2 Weak governance in Shari’ah boards: There exist potential conflicts of inter-
est as well as “a huge paradox” (Bakar, 2016) between Shari’ah scholars and
the other stakeholders under the situation that the Shari’ah board members
are appointed and remunerated by the financial institutions (Chapter 9 in this
book discusses this issue). Besides, we should note that while we could expect
the role of the Shari’ah Advisory Council at the national level as the monitor
of standardizing the operations of the internal Shari’ah board at individual
Islamic ‘banks’; on the other hand, the monitoring mechanism at the national
and central level over the operations of Shari’ah boards in Islamic ‘VC firms’
 Anatomy of Islamic venture capital 85
is in general underdeveloped, though the regulatory framework varies in each
Muslim country, as is argued in the next list. This weak governance structure
may give an ill incentive for the Shari’ah board members in Islamic VC firms
to become too flexible or too conservative.

Now we look at some aspects of Bahraini, Malaysian, Bangladeshi and Indonesian

VC law to reflect the regulatory guidelines of these countries.

1 Bahrain Islamic VC law: Central Bank of Bahrain (CBB) is the prime regu-
lator of the country’s capital market. In September 2017, CBB published
the first Shari’ah Governance Module (SBG) for Islamic banks which will
be effective beginning 30 June 2018. According to the module, all Bahraini
Islamic Bank licensees must have a Shari’ah Supervisory Board (SSB) consist-
ing of at least three scholars specialized in fiqh-al-muamalat and for the first
time an Independent External Shari’ah Compliance Audit (IESCA) has been
made mandatory for all Islamic banks.
2 Malaysian Islamic VC law: Securities Commission, Malaysia issued ‘Guide-
lines on the Registration of Venture Capital and Private Equity Corporations
and Management Corporations’ in March 2015 for venture capital regis-
tration and the Islamic VC should also register under the same guidelines.
For Islamic VC there is a clause (no. 5.01) in the guidelines regarding the
appointment of a Shari’ah advisor, which is that:

an applicant who wishes to undertake Islamic VC or PE activities must appoint

a Shari’ah adviser to provide Shari’ah expertise and guidance on all matters
pertaining to the Islamic VC or PE activities and ensure that all aspects of the
activities are in accordance with Shari’ah requirements, including resolutions
issued by the Shari’ah Advisory Council (SAC) of the SC.
(SCM, 2015)

3 Bangladesh Islamic VC: Bangladesh Securities and Exchange Commission

(BSEC) is the chief regulator of the country’s capital market. In June 2015,
BSEC first issued the guidelines for venture capital and private equity which
is known as Bangladesh Securities and Exchange Commission (Alternative
Investment) Rules, 2015. Although the venture capital market is in a very
early stage in Bangladesh, there is a provision in the rules to form an ‘Islamic
Fund’. According to the rules, a ‘Shari’ah council’ is required in every Islamic
fund.
4 Indonesian Islamic VC: VC firms in Indonesia are categorized as one form
of non-bank financial institutions. The previous regulations related to VC
firms in Indonesia included Minister of Finance Regulation Number 18/
PMK.010/2012 of 2012 concerning venture capital companies. Basi-
cally, this regulation was issued with regard to implementing the provisions
of Articles 8 and 11 of Presidential Regulation No. 9 of 2009 concerning
financing institutions. Since the establishment of the Indonesian Financial
86  Yasushi Suzuki et al.
Services Authority (FSA) at the beginning of 2013, the arrangement and
supervision of venture capital firms in Indonesia were transferred under the
FSA’s authority. The FSA issued new regulations related to business licenses
and establishment, business management, Shari’ah principles, and govern-
ance for venture capital firms (VC) and/or venture capital firms based on
Shari’ah principles (Islamic VC) as FSA regulation No. 31/POJK.05/2014
of 2014, FSA regulation No. 34/POJK.05/2015 of 2015, and FSA regula-
tion No. 35/POJK.05/2015 of 2015. According to article 2 of FSA regu-
lation No. 34/POJK.05/2015, VC and Islamic VC take a legal form of a
limited liability company (Perseroan Terbatas/PT), cooperative, or limited
partnership (Commanditaire Vennootschap). Based on article 2 and 6 of FSA
regulation No. 35/POJK.05/2015, VC and Islamic VC’s main activities are
specified: (1) placement in equity participation, (2) quasi-equity participation
(investment in convertible bonds and/or Sukuk), (3) financing through the
purchase of convertible bonds or Sukuk issued by a start-up company, and
(4) business development or other financing activities and fee-based income
under the approval of FSA. As of 31 December 2016, there are 62 conven-
tional VC firms (in which 3 companies have Islamic windows) and 4 compa-
nies involved in full-fledged Islamic VC operations (FSA, 2016).

6.  The case of Bahraini and Indonesian Islamic VC

6.1  Venture Capital Bank of Bahrain

Venture Capital Bank of Bahrain (hereafter VCBB) is the first full-fledged Islamic
VC (offering only the Islamic mode of VC solutions) in the GCC, Middle East-
ern and North African (MENA) region, which was established in 2005. We take
VCBB as a type of Islamic VC because it has the longest track record in operating
Islamic VC and diversifies its investment portfolio into the GCC region, Turkey,
the UK and the US. Although VCBB is established in Bahrain, Bahraini nationals
occupy only 7.99 percent share in the shareholding. The Annual Report 2015–
2016 reports that the company’s shareholding composition as of 30 June 2016
was shared by KSA, Kuwait, Qatar, and UAE nationals with its share of 57.71 per-
cent, 23.66 percent, 7.78 percent and 3.29 percent, respectively. VCBB has the
Shari’ah board which is composed of three Islamic studies and fiqh scholars. The
financial performance of VCBB is presented in Figure 5.1.
In addition, the VCBB exposure industry-wise from 2007 to 2016 is shown in
Table 5.2.
While considering the net profit of the bank it shows a steady trend since 2013
to 2015 and decline in 2016. However regarding the decline of profit in 2016
VCBB explained that the fair value of losses and impairment of provisions nega-
tively affected the income statement. Moreover, VCBB experienced a negative
profit in 2010 and 2011 due to fair value losses and impairment of real estate sec-
tor investment that occurred due partly to the Arab Spring. On the other hand,
the bank has built a strong capital base through its 10-year journey. Its assets base
 Net Profit
60
47.04 Return on paid up capital
40 40
32.34 18.51
14.1 14.59 30
20 14.06 29
13.26 11 9.28
20 20
0 20
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 8.1
10 7.2 5.5 7.8
-20 6 4.9
0
-40 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
-47.6 -10
-60 -58.67
-20 -19
-22.9
-80
-30

Leverage
(Total liabilies/total equity)

Total investment to total assets 60%

49%
80% 76% 76% 75% 76% 50%
71% 70%
70% 64% 65%
58%
40%
60% 51%
50% 30% 25%
37%
40%
20% 14% 15% 14.40%
30% 11%
10% 8% 10%
20% 10% 6%
4%
10%
0% 0%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Figure 5.1 VCBB’s net profit (US$ million), return on capital, total investment to total assets, and leverage from 2006
to 2016
Source: created by authors based on the annual reports of VCBB during 2007 and 2016
Table 5.2  VCBB’s total asset concentration (industry sector-wise)

Industry sector 2007 2008 2009 2010 2011 2013 (for 2014 2015 2016
18 months)

Trading and manufacturing 4.8% 8.0% 7.5% 13.0% 18.8% 13.5% 15.0% 15.6% 11.2%
Banks and FIs 35.5% 15.8% 20.3% 18.4% 22.6% 17.7% 14.2% 7.7% 7.8%
Real estate sector 25.5% 48.4% 46.4% 33.3% 27.8% 26.3% 26.2% 27.2% 31.8%
Oil and gas 4.5% 6.2% 2.7% 4.1% 3.2% 5.9% 5.4% 5.1% 3.2%
Healthcare 0.0% 3.8% 3.5% 7.7% 7.7% 6.8% 8.1% 7.4% 5.7%
Technology 5.2% 2.9% 1.4% 1.1% 0.0% 1.7% 1.5% 1.2% 0.7%
Transportation/shipping 8.1% 6.1% 4.8% 8.0% 9.4% 8.5% 7.1% 7.5% 13.0%
Others 16.4% 8.7% 13.3% 14.4% 10.5% 19.7% 22.4% 28.4% 26.5%
Total 100% 100% 100% 100% 100% 100% 100% 100% 100%
Source: created by authors based on the annual reports of VCBB during 2007 and 2016
 Anatomy of Islamic venture capital 89
stood at US$ 334.3 million at 30 June 2016 compared to US$ 90.9 million at
30 June 2006, and shareholders’ equity stood at US$ 224.3 million at the end of
financial year 2016 vs. US$ 79.8 million at the end of financial year 2006. Lever-
age ratio and return on capital also show moderate trends over their life spans.
This indicate that VC bank tries to strengthen its footstep first.
It has shown that, during its first five years of journey, VCBB concentrated on
the real estate sector but the negative externality by the US subprime loan crisis
and the subsequent Arab Spring in the MENA region and political unrest in Bah-
rain lost their profit base, then VCBB seemed to be forced to change its invest-
ment strategy. VCBB has started to build expertise in healthcare, oil and gas, and
shipping to diversify its portfolio and to go beyond the MENA region (i.e. Turkey,
the UK and the US) as a strategy to mitigate the geographical risk. This strategy
seems to have proven well and VCBB maintains a steady profit margin since 2013.
Also we should note that VCBB has reduced its investment on bank and financial
institutions which may have partly contributed to the two-step loans to real estate
projects.
Regarding the business model of VCBB we can say that VCBB was still looking
for a suitable market niche to survive. It is observed from VCBB’s last 10 years of
investment policy that initially it focused on real estate sector. Later it concentrated
on the retail and healthcare sectors in the MENA region and some real estate sec-
tors in the UK to ensure guaranteed return at the end of the financial year and a
safe investment exit strategy which reflects VCBB’s risk-averse attitude. However,
VCBB seems to have resumed its focus on the real estate sector. Meanwhile, it is
reported that VCBB reshuffled its human resources as a cost reduction strategy
during the period 2010 and 2011 and it focused on building its own human capi-
tal expertise to enter in a stable market like Turkey. However, although VCBB has
committed to invest in new ventures, it is observed that VCBB has focused on
later-stage enterprises which have a previous transaction record and track record
of performance. We can say that the VCBB model can be considered a conserva-
tive form of venture capital that seeks reasonable returns while avoiding the genu-
ine project risk embedded in new ventures.

6.2  PT PNM Ventura Syariah

Small- and medium-sized enterprises (SMEs) have been proven to contribute sig-
nificantly to driving the real sector economy and absorbing many employees in the
Indonesian economy. Based on Statistic of Micro and Small and Medium Enter-
prises Year 2008–2009 (Ministry of Cooperative and Small and Medium Enter-
prise 2010), there were at least 52 million SMEs including microenterprises in
2009 which accounted for 99.99 percent of the number of business units in the
economy. Furthermore, SMEs absorbed 96 million employees (97.3 percent of
total employees) and contributed 58.27 percent of the Indonesian GDP (Ministry
of Cooperative and Small and Medium Enterprises, 2010; Dewi and Kasri, 2011).
Nevertheless, there exist obstacles which hinder the improvement of the com-
petitiveness of microenterprises and SMEs (MSMEs) in Indonesia. The MSMEs’
90  Yasushi Suzuki et al.
limited access to finance and capital sources is raised as one of the major obstacles
(Bank Indonesia 2016). To ease their funding constraint, a state-owned enter-
prise, namely PT Permodalan Nasional Madani (Persero or PNM), was estab-
lished based on Government Decree of Republic Indonesia No. 38/99 dated 29
May 1999. PNM was expected to play its strategic roles in supporting MSMEs
through training the management skills and facilitating their financial access. The
following contributions are reported by PNM (2016): (1) conducting financ-
ing through a cooperative microfinance institution with more than 1,200 coop-
eratives and rural banks (Bank Perkreditan Rakyat/BPR); (2) conducting direct
financing to the micro and small enterprises through the Micro Capital Services
Unit (Unit Layanan Modal Mikro/ULaMM); and (3) developing the Mekaar
unit (Membina Ekonomi Keluarga Sejahtera/Developing Prosperous Families’
Economy) as a group-based empowerment service for underprivileged women of
micro business practitioners.
In this chapter we are more concerned with how PNM have contributed to
incubating new ventures. In 2000, PNM established a VC firm as its subsidiary
known as PT PNM Venture Capital (99.99 percent of the shares are owned by
PNM). Then, in 2002, PT PNM Venture Capital established PT PNM Ventura
Syariah (99.995 percent of the shares are owned by PT PNM Venture Capital) as
a VC firm which is operated under the Shari’ah principles.
Table 5.3 shows the comparison of total asset and total financing of the banking
industry, venture capital companies (VCC), and PNM, respectively, in selected
years. We can see the marginal magnitude of the fund from VCC and PNM com-
pared to that of the banking industry.
Figures 5.2, 5.3, and 5.4 present the total asset, the total financing, and the
total revenue of PNM, PNM Venture Capital (PNM-VC) and PNM Ventura Sya-
riah (PNM-VS), respectively, in 2015 and 2016. These figures clearly show that
the magnitude of the VC vehicles (PNM-VC and PNM-VS) in the PNM Group
was still marginal. Besides, we can see that the size of PNM-VS was around half or
one-third of that of PNM-VC.

Table 5.3 Comparison of total asset and total financing of the banking industry, Ven-
ture Capital Company and PNM in selected years (in trillion Rp)

YEAR Total asset Total financing

Banking Venture PNM Banking Venture PNM

Capital Capital
Company Company
(VCC) (VCC)

2010 3,055 3.0 3.3 2,810 3.0 1.6

2015 6,198 9.5 6.0 6,051 6.8 4.1
2016 6,844 12.0 7.7 6,680 8.8 5.4
Source: created by authors upon Financial Services Authority (2016a, 2016b, 2017a, 2017b)
and Bank Indonesia (2016)
Figure 5.2 Comparison of total asset of PNM, PNM Venture Capital, and PNM
Ventura Syariah in 2016 and 2015 (in million Rp)
Source: authors, constructed from annual reports of each company, respectively

Figure 5.3 Comparison of total financing of PNM, PNM Venture Capital, and PNM
Ventura Syariah in 2016 and 2015 (in million Rp)
Source: authors, constructed from annual reports of each company, respectively

Figure 5.4 Comparison of total revenue of PNM, PNM Venture Capital, and PNM
Ventura Syariah in 2016 and 2015 (in million Rp)
Source: authors, constructed from annual reports of each company, respectively
92  Yasushi Suzuki et al.
Table 5.4 presents the selected financial performance of PNM, PNM-VC
and PNM-VS, respectively, in 2015 and 2016. We can see that the profitability
(ROE and Profit Margin Ratio) of PNM-VS was in a lower level among the PNM
group, though the Operating Ratio of PNM-VS suggested a better performance
in efficiency.
We conducted interviews on 9 and 13 October 2017 with a senior officer and
member of the Shari’ah Supervisory Board (SSB) of PNM-VS. The following
interviewee’s comments are suggestive; first, the interviewee considers that the
limitation in funding is the main obstacle for PNM-VS to expand its business.
According to the interviewee, the PNM group is, in general, exposed to the more
severe competition for raising the necessary funds, even though the group has
been financially supported by the government (as we recognized that in the period
1999–2014, PNM group was appointed as credit management of ex-Credit Pro-
gram Liquidity of Bank Indonesia (Bantuan Likuiditas Bank Indonesia/BLBI)).
The increase in the cost of fund forces the company to cut the cost of operating
for improving the efficiency. Nevertheless, it is worth noting that currently, in
order to have a lower cost of fund, management of PNM-VS has taken an ini-
tiative to perform a strategic alliance with Indonesian Waqf Board (Badan Wakaf
Indonesia/BWI) in utilizing waqf funds as a financial source in financing Muslim
entrepreneurs’ business projects. Second, the interviewee realizes that PNM-VS
is facing the difficulty of training the professionals in effectively managing the VC
fund. As a result, the skills and knowledge of screening and incubating innova-
tive start-ups have not yet been accumulated in PNM-VS. Third, the interviewee
considers that PNM-VS is facing the difficulty of diversifying and socializing the
risk embedded in the participatory mode of financing (for instance, musharaka
mutanaqisa (diminishing musharaka) which is expected to be utilized for incu-
bating innovators-entrepreneurs.
We are not sure how much of the VC fund would be necessary for meeting the
demand by innovative start-ups and ventures in Indonesia. However, we should

Table 5.4 Comparison of selected financial performance of PNM, PNM Venture Cap-

ital, and PNM Ventura Syariah in 2016 and 2015

Financial 2015 2016

performance
PNM PNM PNM PNM PNM PNM
Venture Ventura Venture Ventura
Capital Syariah Capital Syariah
Return on 3.79% 3.94% 1.67% 3.95% 9.51% 0.66%
equity (ROE)
Liquidity ratio 510.83 % 532.31 % 16,935.05% 618.00% 487.00% 17,444.18%
Profit margin 8.93% 5.17 % 3.69% 6.31% 9.24% 1.33%
ratio
Operating ratio 67.29% 105.44 % 43.79% 77.05% 107.64% 44.87%
Source: authors, constructed from annual reports of each company, respectively
 Anatomy of Islamic venture capital 93
note that even though 15 years have already passed since its establishment in
2002, the size and performance of PNM-VS has been quite marginal. Perhaps
the PNM group has been focusing on financing to MSMEs, rather than financ-
ing the start-ups and ventures. It seems that PNM-VS as an Islamic VC firm,
despite being financially supported at least indirectly by the government, fails to
accumulate the skill and knowledge necessary to incubate and support innovative
ventures, consequently losing its raison d’être in the market.

6.2.1  Typology of VC firms

Based on the discussions in this chapter on historical trend of venture capital and
two cases on Islamic venture capital, we wish to offer a theoretical framework
for the typology of Islamic venture capital. In our model, we are mapping each
domain of following four types, taking into account each strategy for challenging
risks and expected return (see Figure 5.5). Each domain may be overlapped in
practices.

1 Typical VC in matured economies: In the relationship between risk (with

uncertainty) and returns, typical VC firms particularly in matured economies
are expected to explore innovative venture seeds, challenging ‘high risk’ but
expecting ‘high return’-type profit opportunities. The domain of typical VC
particularly in matured economies is drawn as in Figure 5.5.
2 Commercial banks (including Islamic commercial banks): In contrast, the
basic preference of credit portfolio selection by commercial banks is quite
conservative, mainly because they are responsible as depository corporations
for ensuring the returns to the depositors.

Expected return

High

Typical VC

VC with the focus

on real estate

VC as
Commercial
governmental
bank-led VC
agent

Risk
Low High

Figure 5.5  Typology of Islamic financial institutions including Islamic venture capital firms
94  Yasushi Suzuki et al.
3 VC with the focus on real estate projects: Due partly to the lack of skill and
knowledge in screening and monitoring innovative seeds or the weak demand
for incubating high-end industries in pre-matured economies, this type of
Islamic VC may prefer a conventional strategy to seek relatively higher returns
upon the mortgage over the real estate projects by mitigating the project risk.
VCBB can be categorized into this type.
4 VC with governmental support: This type of VC plays the role as ‘agent’ for
facilitating governmental funds (policy lending) for the purpose of incubating
innovative SMEs which have the limited access to the credit/loan markets.
PNM takes the role as the agent of mediating governmental funds. PNM
itself does not necessarily seek higher returns.

7.  Concluding remarks

In fact, Islamic venture capital is the newest wing of the Islamic finance industry.
In this chapter we begin with the clarification of the difference between Islamic
microfinance and Islamic venture capital. We reviewed the contemporary litera-
ture on venture capital and the historical background of Silicon Valley, then dis-
cussed about the dilemmas facing Islamic VC firms. In addition, we discussed
about two different types of Islamic VC firms.
We should note that the role and strategy of Islamic VC firms are not identi-
cal. In the case of Bahraini Islamic VC firm (VCBB), their strategy is, by nature,
considered still conservative for focusing on the real estate projects backed by the
mortgage, though VCBB is now diversifying their credit portfolio and mitigating
the geographical risk, as well as accumulating the skill and knowledge of screen-
ing and monitoring innovative start-ups. In the case of Indonesian Islamic VC,
PNM-VS is expected to play the role as ‘agent’ for facilitating governmental funds
(policy lending) for the purpose of incubating innovative (or sick) SMEs which
have the limited access to the credit/loan market by commercial banks. However,
it seems that PNM-VS as an Islamic VC firm, even though it has been financially
supported, at least, indirectly by the government, has failed to accumulate the
skill and knowledge necessary to incubate and support innovative ventures, con-
sequently losing its raison d’être in the market.
As mentioned earlier, VC cannot grow if there are no entrepreneurial activities
or entrepreneurial spirit in society. Entrepreneurs have to build up the degree of
confidence of venture capitalists in their projects through commitment, and open
and free communication can be considered a catalyst in building a strong relation-
ship between both of them. This leads us to ask: How are Islamic VC firms ready
to build up the degree of confidence in entrepreneurs? It might be a bit too early
to judge it. However, we are afraid that what Islamic VC firms particularly in the
stage of developing can do for contributing to entrepreneurial activities in society
would be very limited.
6 
Sukuk environment and
challenges in Bangladesh
and Malaysia (with the
supplement of the
Japan-sukuk case)
S. M. Sohrab Uddin, Nahid Afroz
and Yasushi Suzuki

1. Introduction
Sukuk (Islamic bond) is an alternative financing instrument that represents undi-
vided ownership of an underlying asset, specific project or investment activities
based upon the principles of Islamic Shari’ah (Islamic law). The main concept
of Sukuk stands on the Islamic principle of prohibition of riba (interest). Before
the origination of Sukuk, the Muslim community used to have a few choices for
investment in interest-free instruments. They either had to invest their funds in
real assets or in Shari’ah-compliant stock market securities (Tariq and Dar, 2007;
cited in Ahmed et al., 2015). The income from such investment was highly risky
and irregular in nature and accordingly Muslims required some low-risk fixed
income from their investment. The issuance of the first Sukuk in Malaysia in the
1980s has been able to meet the demand of the Muslim community. The net out-
standing amount of world Sukuk stood at $349.1 billion in 2016, a 576 percent
growth in 10 years (Bank Negara Malaysia and Surahanjaya Sekuriti, 2009; Sura-
hanjaya Sekurity, 2017a). Such an upsurge indicates the potential of the Sukuk
industry for attracting investors around the world.
A number of countries are joining the list of Sukuk issuers every year. Start-
ing in 1980, Malaysia has continued to be the market leader in the Sukuk indus-
try for almost three decades. The successful position of Malaysia is grounded on
its planned infrastructure. In addition, the combined effort of the government
of Malaysia, Bank Negara Malaysia (central bank of the country), Surahanjaya
Sekurity (Securities Commission Malaysia), and National Shari’ah Board is the
strength of the Sukuk industry in Malaysia. On the other hand, Bangladesh started
its voyage in this industry in 2004. However, the absence of required infrastruc-
ture and the mechanism for Islamic securities have been causing hindrance to
further issue of Sukuk securities. The success of Islamic banking in Bangladesh,
currently one-fifth of the banking sector as a whole indicates that there exists high
potential for further acceleration of Sukuk instruments.
Even though a significant number of studies are conducted on Sukuk, very few
of them concentrate on cross-country comparison. At this backdrop, this chapter
96  S. M. Sohrab Uddin et al.
aims at examining the Sukuk environment and challenges in Bangladesh and
Malaysia by analyzing the Sukuk instruments available in both countries, by iden-
tifying the areas in which the Sukuk market of Bangladesh is different from that of
Malaysia, by portraying the potential of Bangladesh for Sukuk issuance to a greater
extent, and by highlighting the obstacles of the Sukuk market in Bangladesh.
The latter part of the chapter is divided into six sections. Section 2 focuses on
the literature review. Section 3 offers an overview of existing Sukuk instruments
of Bangladesh and Malaysia. Section 4 highlights the purposes for investment in
Sukuk instruments in both countries. Section 5 provides a summary of the legal
and regulatory framework for Sukuk in Bangladesh and Malaysia. Section 6 intro-
duces the potential for further acceleration of the Sukuk industry in Bangladesh.
In parallel, Japan is an evolving case showing how a form of financial praxis origi-
nally based in the identity and ethical concerns of Islam has acquired new appeal
and is thereby expanding into regions of the global economy that is lacking large
Muslim populations (Morrison, 2013). Section 7 aims to review the J-sukuk issu-
ance scheme and the tax measures regarding J-sukuk, and to draw the dilemmas
and challenges in J-sukuk. The last section concludes the paper with some policy
recommendations.

2.  Literature review

Sukuk represents certificates of equal value characterized by undivided claims on
the income of underlying Shari’ah-compliant assets or investment activities or
projects. According to Islamic Financial Services Board (IFSB), Sakk (singular
form of Sukuk) as understood in its contemporary form1 means Islamic bonds
or certificates with “a proportional undivided ownership right in tangible assets
or a pool of predominantly tangible assets or a business venture”. These assets or
business activities must comply with Shari’ah principles. In addition, Accounting
and Auditing Organization of Islamic Financial Institutions (AAOIFI) describes
Sukuk as “certificates of equal value representing undivided shares in ownership
of tangible assets, usufruct and services or in ownership of the asset of a particular
project or a special investment activity” (AAOIFI, 2003, p. 299).
The term Sukuk has come into existence to replace conventional debt instru-
ments. However, many scholars mark Sukuk as a combination of conventional
stock (equity) and bond (debt). Similar to bonds, Sukuk has a fixed term to
maturity, regular income, and a final payment at the end of maturity. Again, the
profit-sharing nature and uncertainty in amount of profit resembles some features
of stock. These resemblances to conventional securities emphasize the necessity
to distinguish Sukuk from other instruments. A Sukuk must meet three criteria
to be Shari’ah compliant: must represent ownership (not a claim of indebted-
ness), payments should come from after-tax income (not payable in case of loss,
unless stated otherwise), and the payment at the end of maturity should reflect
the market value of the underlying asset (not the original amount of investment)
(Godlewski et al., 2013). Basically, Sukuk is a debt instrument. However, longer
tenors, perpetual bonds, and ‘hybrid capital’ issues allowing a mix of debt and
 Sukuk environment and challenges 97
equity are all now commonplace among Sukuk instruments (HSBC Bank Malay-
sia Berhad, 2015). We should note that a type of Sukuk has a ‘hybrid’ characteris-
tic of debt and equity.
As an emerging area, literature on Sukuk studies is yet to assume a mature shape.
Zulkhibiri (2015, pp. 247–248) describes this situation as an “underdeveloped
state of research”. He argues that absence of historical, related, and consistent
data along with the insignificant number of journals attributed to Islamic finance
are the principal reasons for such a situation.
The existing literature on Sukuk can be divided into three categories. The first
category intends to introduce Sukuk and its securitization process. This category
focuses on the ways in which Sukuk complies with the Shari’ah law and the opin-
ions of scholars on this subject. Other studies in the same category focus on the
areas in which Sukuk differs from conventional debt instruments. Godlewski
et al. (2013) show that stock market investors react differently to announce-
ments of Sukuk and conventional bonds. Using multivariate analysis and event
studies, they find the stock market is neutral to announcements of conven-
tional bond issues while it shows negative reactions to announcements of Sukuk
issues. Nagano (2016) has performed comparative analysis to identify the differ-
ence between Sukuk issuers and conventional debt and equity issuers. Based on
firm-based micro-level data, he provides empirical evidence to the fact that low
financial constraints and undervalued stock in pre-issuance periods stimulate the
Sukuk issuance. Klein and Weil (2016) have examined the factors inducing firms
to choose Sukuk instead of conventional bonds. According to them, information
asymmetry and moral hazard have significant impact on the selection of Sukuk
issuance.
The second category focuses on the standardization, pricing, rating, and inno-
vation on the structuring of Sukuk. Wilson (2008) reveals the necessity of special
purpose vehicles (SPV) in the issuance and management of Sukuk. He suggests
gross domestic product (GDP) growth rate as an alternative pricing benchmark
for sovereign Sukuk, instead of benchmarks such as the London interbank offer
rate (LIBOR). Ahmed et al. (2015) extend the study of Wilson (2008) with a
discussion on pricing mechanisms and credit rating in Malaysia. Wedderburn-Day
(2010) addresses the impact of changing opinions of Shari’ah scholars and the
financial crisis of 2007 on the issuance of Sukuk. According to his findings,
the existing Sukuk market was adversely affected by both phenomena whereas the
sovereign Sukuk market remained impassive to these factors.
The final category concentrates on globalization of Sukuk, the Sukuk environ-
ment in particular countries or regions, and comparison of various aspects of Sukuk
across different countries. Grassa and Miniauoi (2017) analyze the issuers’ choice
between Sukuk and conventional bonds particularly in Gulf Cooperation Council
(GCC) countries. They identify that issuers favor Sukuk over conventional bonds
in case the issuance is of large size and tenure. They also give evidence to a posi-
tive correlation between quality of credit and issuance of conventional bonds and
negative correlation between quality of credit and issuance of Sukuk. Kamarudin
et al. (2014) focus on Sukuk defaulter profiles in Malaysia and prove that defaults
98  S. M. Sohrab Uddin et al.
and potential defaults are triggered by creditworthiness of the issuer rather than
by faulty structure.

3. Sukuk instruments available in Bangladesh and

Malaysia
The Sukuk market in Bangladesh is comprised of various Bangladesh Government
Islamic Investment Bonds (BGIIB) issued under mudaraba (profit-and-loss shar-
ing) principle. In 2004, these BGIIBs were issued for the first time with maturi-
ties of six months, one year, and two years. Later, the circulation of one-year and
two-year bonds was suspended and the circulation of three-month BGIIB began
on January 1, 2015 after making an amendment to the guidelines on BGIIB rules
2004. The net outstanding amount of BGIIB stood at BDT 85.14 billion in 2016
and increased by 34 times during the last five years (Bangladesh Bank, 2016). The
Islamic capital market in Bangladesh also comprises Shari’ah-compliant mudara-
bah perpetual bonds issued by one of the Islamic banks in Bangladesh, namely
Islami Bank Bangladesh Limited. However, there is argument on whether this
Islamic bond should be considered Sukuk. Wilson (2008) argues that Sukuk has
to be for a fixed tenure rather than perpetual. Nevertheless, Sarkar (2009) terms
this perpetual bond as Sukuk. Due to such confusion, we keep this bond out of the
discussion. Currently, a new issuance of corporate Sukuk of BDT 1 billion is in the
pipeline as a result of an agreement reached between Pran-Foods Limited (PFL)
and Green Delta Capital Limited in April 2016 (The Financial Express, 2016).
Islamic banks, financial institutions, and resident and non-resident Bangla-
deshis who have agreed to profit–loss sharing according to Islamic Shari’ah are
eligible to purchase BGIIB. On a pre-specified date, banks and financial institu-
tions directly and individual investors through banks or financial institutions in
an open bid file their bid forms. The amount of each purchase should be in BDT
100,000 or multiples of BDT 100,000. Islamic banks purchase this instrument as
part of their statutory liquidity ratio (SLR). As per Section VI of the Guidelines
for Conducting Islamic Banking 2009, the excess liquidity of Islamic banks or
Islamic branches/windows of conventional banks needs to be invested in BGIIB.
In case of a liquidity crisis, Islamic banks may collect funds against liens of invest-
ment bonds. In effect, Islamic banks, Shari’ah-compliant financial institutions, or
any other institution who have agreed to follow Shari’ah compliance in line with
instructions from the government may borrow from special Islamic bond fund
accounts for not more than 180 days against demand promissory (DP) notes.
Table 6.1 offers a summary of BGIIB’s performance during the last eight fiscal
years and reflects a gradual pattern of progression over the years. The sale of these
BGIIBs has increased by 7.5 times between 2009 and 2016. Interestingly, in fiscal
year 2013, the sale of BGIIB experienced more than 240 percent growth from
the previous year. This extraordinary change occurred due to liquidity mopping
up needs of Bangladesh Bank for sterilization of its intervention in the foreign
exchange market (Bangladesh Bank, 2016). Before 2013, a major portion of the
fund collected from issuance of BGIIB was distributed to Islamic banks as loans.
 Sukuk environment and challenges 99
Table 6.1  Sale, financing, and net outstanding amount of BGIIB

Particulars 2009 2010 2011 2012 2013 2014 2015 2016

Sale 16.4 23.4 25.3 31.48 107.13 121.34 135.84 122.94

Financing 12.1 15.4 22.8 31.26 67.78 24.37 25.40 37.80
Net outstanding 4.3 8.0 2.5 0.22 39.35 96.97 110.44 85.14
Source: constructed by authors based on Bangladesh Bank (various years)
Note: amounts are in billion BDT

Malaysia is the issuer of the first Sukuk security and the third largest bond mar-
ket in Asia, and accounts for almost half of the new issuance of the global Sukuk
market. Moreover, the first global Sukuk issuance also came out from the Malay-
sian government in 2002 (Jabeen and Javed, 2007). The Malaysian market has
experienced exponential growth over the years and accounted for 52.6 percent
of the world Sukuk outstanding (Bank Negara Malaysia, 2016). The Malaysian
Sukuk market contains both government and corporate Sukuk securities. The top
issuance comes from the financial services, government, power and utilities, and
transportation sectors. Since its inception, the Islamic financial market in Malaysia
has been continuing its operation side by side with the conventional debt market.
However, the outstanding amount of Sukuk has gradually outstripped the out-
standing amount of conventional debt securities. In addition, the government
Sukuk securities market faces competition from the growing private sector. The
corporate Sukuk market in Malaysia has captured 75 percent of the total Sukuk
outstanding almost 10 years ago in 2008 (Bank Negara Malaysia and Surahanjaya
Sekuriti, 2009). In 2016, the aggregate amount of 32 new corporate Sukuk issu-
ances was RM 64.82 billion leading to a total corporate Sukuk outstanding of RM
393.45 billion (Surahanjaya Sekurity Malaysia, 2017a). The major government
and corporate Sukuk securities are shown in Table 6.2.
Government Sukuk in Malaysia includes both short-term and long-term securi-
ties issued by the Malaysian government and Bank Negara Malaysia. These securi-
ties are of the highest class and act as the standard for evaluating and pricing of
other securities. although the Malaysian securities market is getting more private
market driven, government Sukuk issuance still accounts for 49 percent of total
Sukuk issuance. GIIs are long-term dividend-bearing Sukuk instruments based on
Bai’Al-Inah (sale with immediate repurchase) principle with maturities of 3, 5,
7, and 10 years. According to Bai’Al-Inah, the government will sell a particular
asset and afterwards buy that back at purchase price plus a profit percentage. The
commitment to pay the price agreed on in the tender process is securitized in the
form of GII securities. The profits are payable semiannually and the nominal value
of securities are payable at maturity. GIIs are issued through competitive auction
and traded in the Islamic interbank money market. Unlike GII, MITBs are short-
term Sukuk securities based on the Bai’Al-Inah principle with an original maturity
of one year. Securities are issued through a closed auction on each Thursday and
the actual issuance is made on Friday. MITBs are tradable in the secondary market
100  S. M. Sohrab Uddin et al.
Table 6.2  List of major government and corporate Sukuk securities in Malaysia

Government Sukuk Corporate Sukuk

Government Investment Issues (GII) Khazanah
Malaysian Islamic Treasury Bill (MITB) Sandat ABBA Cagamas (SAC) or
Sukuk Bank Negara Malaysia Ijarah CAGABAIS
(SBNMI) Sandat Mudarabah Cagamas (SMC)
Merdeka Savings Bonds (MSB) Asset Backed Securities (ABS) on
Sukuk Simpanan Rakyat (SSR) Islamic principle
Source: constructed by authors based on different reports published by Bank Negara Malaysia
and Surahanjaya Sekurity Malaysia

on a yield basis based on remaining days to maturity. The funds collected by GII
and MITB are used to finance the development projects and operational activities
of the Malaysian government.
On the other hand, SBNMIs are issued by Bank Negara Malaysia on the Al-
Ijarah (sale and lease back) concept. An SPV oversees the issuance of this Sukuk.
MSB is a scrip-less Shari’ah-compliant instrument designed for older citizens
(56 years and above) or any Malaysian citizen retired on medical grounds. Each
investor must invest at least RM 1,000 to a maximum range of RM 50,000.
The MSB instrument is distributed on a first-come-first-served basis with a
monthly profit. Finally, SSR are scrip-less investment instruments issued on
a first-come-first-served basis. Malaysian citizens of 21 years or above are eligible
to make investments in this instrument in a range from RM 1,000 to RM 50,000
per investor. The profit on SSR is payable on a quarterly basis to holders’ accounts
through the agent bank.
The co-existence of the conventional bond market and Sukuk market in the
Malaysian economy calls for open competition. The corporate Sukuk market in
Malaysia is gradually wining the competition by snatching away the market share
from its conventional counterpart. The recent statistics shows that corporate
Sukuk issuance stands at 75.68 percent of total corporate bonds and Sukuk issu-
ance, and Sukuk outstanding stands at 73.85 percent of total corporate bonds and
Sukuk outstanding in 2016 (Surahanjaya Sekurity Malaysia, 2017a). The major
corporate Sukuk securities include the Khazanah bond, which is a long-term zero-
coupon bond based on the Murabaha principle and issued by Khzanah Nasional
Berhad, the investment wing of the government. With maturity periods of 3, 5, 7,
and 10 years, Khazanah bonds include bullet repayment of face value at maturity.
SAC or CAGABAIS is a semiannual dividend-bearing Sukuk security based upon
the principle of Bai’Bithman Ajil (deferred payment sale). SAC is used to support
the purchase of Islamic housing loans and hire purchase contracts. Along with the
semiannual dividend distribution provision, this security involves payment of par
value with dividends due upon maturity. SMC is similar to CAGABAIS except
that it is based upon the principle of the Mudaraba. It also supports the purchase
of Islamic housing loans granted on the basis of Bai’Bithman Ajil and Islamic hire
purchase under the principle of Ijara Thumma Al-Bai (lease to purchase). Along
with the semiannual profit distribution at a pre-specified rate, this security involves
 Sukuk environment and challenges 101
140 129.4
117.7
120 103.02
100 80.94 77.27
80
60
40
20
0
2012 2013 2014 2015 2016

Figure 6.1 Malaysian Sukuk issuance

Source: constructed by the authors based on Bond Pricing Agency Malaysia (2015) and Ramli (2015)
Note: Amounts are in billion RM

payment of par value upon maturity unless there is any demission of value. Finally,
ABS is a basic form of Sukuk security and is backed by house purchase.
A comparative picture of government and corporate Sukuk issuance during
the period 2012–2016 is shown in Figure 6.1. Since Malaysia leads the Sukuk
industry, its market walks in line with the global market or, in a more precise way,
Malaysia draws the line of the global market. In 2012, the global Sukuk issu-
ance reached its peak. Malaysian Sukuk issuance also experienced an upsurge in
the same year contributing towards the major portion of this expansion. After a
gradual decline, the Sukuk market in Malaysia has experienced recovery and 2016
was termed a record year.

4. Purposes for investment in Sukuk instruments

in Bangladesh and Malaysia
BGIIB is issued as a means for Islamic banks and financial institutions to invest
their excess funds for short terms. BGIIB also acts as part of the SLR requirement.
The profit earned on this instrument falls far below the rate of other interest-
bearing instruments and deposit rates (Sarkar, 2015). Thus, the sole reason for
investment in the Sukuk instrument in Bangladesh is to fulfill the requirement of
liquidity by investing in a Shari’ah-compliant instrument as per the guidelines of
the central bank. However, the resident and non-resident Bangladeshi citizens
eligible for investment in BGIIB may do so for religious cause, as profit potential
is very low for the instrument.
The financial market in Malaysia is loaded with bundles of different Sukuk secu-
rities along with different classes of investors. These investors, both institutional
and individual, choose Sukuk instruments for investing their surplus funds to
serve a variety of purposes. The investors who choose government Sukuk prefer
low-risk investments to high-risk volatile corporate Sukuk instruments. Among
government and Bank Negara Malaysia issues, GII acts as a long-term source of
investment. Individuals and investors with idle funds, pension funds, and Islamic
institutions seeking long-term benefit with considerable low risk invest in GII.
102  S. M. Sohrab Uddin et al.
On the other hand, MITB meets the need of financial institutions for short-term
investment of surplus funds. MSB and SSR provide regular income to old and
young investors respectively, acting as the social welfare arm of the Malaysian gov-
ernment. The investors of corporate Sukuk usually invest in them for earning a
rate of profit higher than that of government instruments. Another class of Sukuk
investors exists in the market place that invests in Shari’ah-compliant debt secu-
rities for strict religious purpose either as a personal standard or as compulsory
institutional requirement for Shari’ah compliance.

5. Legal and regulatory framework for Sukuk in

Bangladesh and Malaysia
Bangladesh Bank as the central bank of the country formulates regulations on
issuance, pricing, distribution, and redemption of government Sukuk. It also
maintains and utilizes funds collected from the investors of BGIIB by provid-
ing them as loans to Islamic banks and Shari’ah-compliant financial Institutions.
Bangladesh Bank conducts issuance and dealings of BGIIB as per the guidelines
on BGIIB Rules 2004 and the guidelines on BGIIB Amended Rules 2014. In
addition, Section VI of the Guidelines for Conducting Islamic Banking is also
applied by Bangladesh Bank to deal with the instructions on BGIIB from the
perspective of liquidity management of Islamic banks. Any issuance of corporate
Sukuk also requires the permission of the central bank. Table 6.3 provides a sum-
mary of basic aspects covered by the different guidelines.
Central Shari’ah Board for Islamic Banks of Bangladesh (CSBIB) is a non-profit
research-oriented national body of Islamic banks and Islamic banking branches/
windows of conventional banks registered under Bangladesh Bank. The board
was formed on August 16, 2001 to ensure uniform guidelines for all Islamic banks
and to provide fatwa (decision) and implementation of such decisions regarding
Shari’ah compliance. Shari’ah scholars, Islamic economists, and members of the
Shari’ah council of Islamic banks are the members of CSBIB. Currently the board
has 65 members and 21 member organizations. The main objective of CSBIB is
to advise the government, Bangladesh Bank, regulatory organizations, and mem-
ber banks, and to supervise the work of Islamic banks in terms of Shari’ah. The
board holds regular meetings and discussions, and acts under the supervision of
Bangladesh Bank to formulate the guidelines in conducting Islamic banking in
Bangladesh. Though the board primarily deals with Islamic banking, it plays an
advisory role in case of the issuance and allotment of BGIIB. Figure 6.2 represents
the Sukuk mechanism in Bangladesh.
Figure 6.3 exhibits the Sukuk mechanism in Malaysia. Bank Negara Malaysia
is entrusted with the responsibility of supervision of issuance, registration, dis-
tribution, settlement, and redemption of government Sukuk securities under the
Government Funding Act 1983. This act empowers the bank to raise funds on
behalf of the government of Malaysia through Shari’ah compliance and National
Shari’ah Advisory Council-approved instruments including GII and MITB. Bank
Negara Malaysia performed its role as principal regulator of the Sukuk market until
Table 6.3  Basic aspects covered by the guidelines

BGIIB Rules 2004 • The guideline is applicable in cases of Islamic banks and financial institutions and persons or their representatives
(originated by issuing who will buy or hold this bond and Islamic banks and financial institutions and other institutions approved by the
circular number FRTMD Bangladesh government and Bangladesh Bank, which will use the fund collected by issuance of this bond.
(PDS) 146/2004–16 • The issuance and payment will be conducted by the respective office of Bangladesh Bank.
by Bangladesh Bank on • A non-resident Bangladeshi who agrees to share profit–loss according to Shari’ah should collect this bond through
15.09.2004) a non-resident foreign currency deposit account (NFCD) in any Bangladeshi Bank opened in his name.
• The eligible institutions and persons may transfer this bond among themselves and use it as collateral. In all cases, it
should be recorded with the issue office.
• The holder of an Islamic bond will receive profits at the end of a six-month, one-year and two-year maturity period
at, respectively, 2 percent, 1.5 percent, and 1 percent less from the average realizable profit rate. At maturity, the
face value (after adjustment of loss) and profit on BGIIB is paid from the issue office.
• The proceeds from the bond fund are disbursed among Islamic banks and financial institutions for 180 days against
collateral and the monthly profit on such a loan is equal to the profit rate on the Mudaraba deposit account of the
respective Islamic bank.
BGIIB Amended Rules • The guideline has suspended the circulation of one-year and two-year bond and begun the circulation of a three-
2014 (originated by month Islamic bond.
issuing circular number • The amended guideline extends the purview of holders and investors of BGIIB to Islamic banking branches of
08.036.014.00.003. conventional banks.
2004–128 by Ministry of • The eligibility for participation in open bid is restricted to Shari’ah-compliant banks and financial institutions and
Finance on 18.08.2014) Islamic banking branches of conventional banks.
• Islamic bond is circulated through open bid on the basis of profit-sharing ratio (PSR) and Bangladesh Bank
determines the rules of auction from time to time.
• The government may also circulate Islamic bonds of different maturities on specific Shari’ah-approved sector or
assets.
• The fund of Islamic bonds is deployed only against demand promissory note issued by respective institutions.
• The nominee clause is excluded in these rules and no mention has been made on the same in any other place of
these rules.
Section VI of the Guidelines • Islamic bonds have to be the first source of investment of excess liquidity and first line of defense to face liquidity
for Conducting Islamic crisis of Islamic banks and Islamic banking branches of conventional banks.
Banking (issued by • In times of liquidity crisis, loans can be availed from Islamic bond funds against liens of Islamic bonds.
Bangladesh Bank in • The Islamic banks and Islamic banking branches of conventional banks may borrow from Bangladesh Bank at a
November 2009) provisional rate on its respective mudaraba short notice accounts even if the bank has no surplus investment in
BGIIB at that time.
Source: constructed by the authors based on respective guidelines
104  S. M. Sohrab Uddin et al.

Bangladesh Bank

Rules and
Guidelines
CSBIB issued by Ministry
of Finance and
Bangladesh Bank

Figure 6.2  Sukuk mechanism in Bangladesh

Source: constructed by the authors

Bank
Negara
Malaysia

Surahanjaya National
Shari’ah
Sekuri
Council

Regulations
Regulations
on
on corporate
government
Sukuk
Sukuk

Figure 6.3  Sukuk mechanism in Malaysia

Source: constructed by the authors

2000, when the corporate Sukuk market came under the supervision of Surahan-
jaya Sekuriti (Bank Negara Malaysia and Surahanjaya Sekuriti, 2009). The bank
still plays its supportive role to ensure stability and growth of the Sukuk market as
well as the overall financial structure of Malaysia. On the other hand, Surahanjaya
Sekuriti acts to ensure a fair, efficient, secure, and transparent capital market from
its origination on March 1, 1993 under the Securities Commission Act 1993. It is
a self-funding and self-regulatory statutory body entrusted with the responsibility
of regulating the capital market participants and ensuring proper conduct of mar-
ket institutions and licensed persons through circulating a number of guidelines,
regulations, and practice notes.
The National Shari’ah Advisory Council, the highest Shari’ah authority in
Islamic finance in Malaysia, is an authoritative body of Shari’ah scholars, jurists,
and market practitioners. Under the regulation and supervision of Bank Negara
 Sukuk environment and challenges 105
Malaysia, the council started its operation in May 1997. It acts as the reference
body and advisor of the central bank in matters relating to Islamic banking,
Takaful (Islamic insurance), the Islamic financial business, and the Islamic devel-
opment financial business. It also validates Islamic banking and Takaful products,
and advises on any issuance of Islamic instruments for Shari’ah compliance. The
ruling of it shall prevail over any contradictory ruling of any other Shari’ah body
or committee in Malaysia. The court is also required to take the advice of the
National Shari’ah Advisory Council in any issues relating to Islamic finance after
the Central Bank of Malaysia Act 2009. The body of the council currently con-
sists of ten members who are qualified individuals and experienced in matters of
Islamic banking, finance, economics, and Shari’ah rulings on economic activities.
Bank Negara Malaysia is responsible for issuing guidelines and regulations on
government Sukuk instruments dealing. Islamic banks, commercial banks, and
investment banks registered and licensed under the central bank may deal with
government securities. The trading of such securities falls under the purview
of the Capital Markets and Services Act 2007. On the other hand, Surahanjaya
Sekuriti has acted as the principal regulator of the corporate securities market since
July 2000. Surahanjaya Sekuriti publishes guidelines on the issuance of Islamic
securities, oversees trading, and performs joint investigations with Bank Negara
Malaysia. The following guidelines, practice notes, and regulations of Surahanjaya
Sekuriti displayed by Figure 6.4 deal with Sukuk.

Guidelines on trust deeds (2011)

Guidelines on registration of credit

rating agency (2011)
Guidelines on the offering of ABS
(2004)
Practice note 1 - special requirements
and disclosure (2008)
Guidelines on allowing a person as
trustee (2001)
Practice Note on Registration as a
bond trustee (2006)
Guidance note on secondary trading
of foreign currency denominated
Islamic securities (2005)

Figure 6.4  List of significant guidelines and practice notes on Sukuk

Source: constructed by the authors based on the information collected from Surahanjaya Sekuriti
(2017b)
106  S. M. Sohrab Uddin et al.

6.  Potential for the Sukuk industry in Bangladesh

The underdeveloped financial market of Bangladesh presents huge potential for
turning the wheel of financial innovation in any particular area. In addition, more
than 80 percent Muslim population and continuous rise of Islamic banking make
a suitable combination for issuance of Islamic securities in Bangladesh. The grow-
ing and highly competitive lease financing industry faces strong competition in
raising required funds. These leasing companies currently operating in Bangla-
desh are also surrounded by only a few investment choices. The issuance of Ijarah
Sukuk may present these financial institutions an avenue for investment for their
funds. Furthermore, the non-bank financial institutions may launch Ijara Sukuk
or Mudaraba Sukuk for raising sufficient funds. Government institutions may also
raise their needed financing for large projects by issuing Sukuk instruments under
the principle of Bai’Bithman Ajil, Bai’Inah or Murabaha. The private–public
partnership of Bangladesh government presently accounts for $4,549 million
of investment in 56 projects. The issuance of government Sukuk will enable the
government to reduce dependence on high-cost foreign loans and protect the
national economy from the burden of public debt.

7.  In parallel: potential of the Sukuk industry in Japan

There has yet to be any Sukuk issued in Japan, despite the so-called J-sukuk issu-
ance having been legally possible since April 2012. J-sukuk is defined as “a finan-
cial instrument which enables an issuer to raise capital from not only conventional
investors but also from Islamic investors. It is legally not a bond itself, but it
treated as if it were a bond for tax purposes” (FSA, 2012, p. 1). Japan is an evolv-
ing case showing how a form of financial praxis originally based in the identity and
ethical concerns of Islam has acquired new appeal and is thereby expanding into
regions of the global economy that are lacking large Muslim populations (Mor-
rison, 2013). This section aims to review the J-sukuk issuance scheme and the tax
measures regarding J-sukuk, and to draw the dilemmas and challenges in J-sukuk.
Financial Services Agency of Japan (FSA) describes the merits of Japanese com-
panies’ issuing of Sukuk as follows: (1) Because issuers can issue Sukuk and raise
capital from Islamic investors, to whom they have never had access, they can diver-
sify their financing measures. (2) By issuing Sukuk compliant with Islamic law,
favorable attention to the issuers in the Islamic world is expected. Thus, the issuers
are expected to gain favorable positions in marketing in the Islamic world (FSA,
2012). As is mentioned earlier, J-sukuk is defined as a financial instrument which
is structured using a quasi-bond beneficial interest of a specified purpose trust
prescribed in the Act on Securitization of Assets of Japan. A quasi-bond benefi-
cial interest is an interest-receiving pre-fixed amount like interest on a bond. It is
legally not a bond, but is treated as if it were a bond for tax purposes by the 2011
tax reform (FSA, 2012).
As an illustration, FSA (2012) explains Ijara Sukuk as an example of the J-sukuk
issuance scheme: [I] At the time of the issuance of J-sukuk: (1) the issuer entrusts
 Sukuk environment and challenges 107
its owned real estate to the trustee of the special purpose trust; (2) the investors
pay the issue price of J-sukuk to the issuer; (3) the issuer issues J-sukuk to the
investors. [II] From the issuance until the redemption of J-sukuk: (4) the issuer
leases the entrusted real estate from the trustee; (5) the issuer periodically pays
rental fees to the trustee; (6) the trustee periodically pays distribution amounts
funded by the rental fees to the investors. [III] At the time of the redemption
(maturity) of J-sukuk: (7) the issuer purchases back the entrusted real estate from
the trustee; (8) the issuer pays the purchase price of the real estate to the trustee;
(9) the trustee pays the redemption amounts funded by the purchase price of the
real estate to the investors.
In a case where real estate is entrusted on issuing J-sukuk, registration and
license tax on the real estate transfer registration and real estate acquisition tax
are not imposed. In addition, the repurchase of the real estate is neither subject to
registration and license tax nor real estate acquisition tax, if the following require-
ments are mainly satisfied (FSA, 2012): (1) On entering into the specified pur-
pose trust (SPT) agreement, the issuer grants an option to sell back the entrusted
real estate to the trustee. (2) The issuer treats such real estate as its fixed asset
for accounting purposes in between the effective time of the SPT agreement and
its ending time (on-balance transaction). (3) The issuer continuously owns part
of the principal of the beneficial interest of the SPT from the effective time of
the SPT agreement. (4) The issuer leases the entrusted real estate. (5) The issuer
repurchases such real estate at the ending time of the SPT agreement. (6) The
redemption period of J-sukuk is within 20 years.
Besides, taxes on the distribution amounts by foreign investors (as well as
domestic financial institutions) are being exempted. In order for the distribu-
tion amounts of J-sukuk to be treated as pay-through payments for tax purposes,
it is necessary for J-sukuk to be publicly offered (with an aggregate issue price
of 100 million yen or more) or subscribed by institutional investors only (FSA,
2012). The tax exemption for the distribution amounts of J-sukuk received by for-
eign investors will expire on March 31, 2019. Also, the exemption of registration
and license tax on the repurchase of the real estate, along with the J-sukuk issuance
scheme, will expire on March 31, 2019.
A Samurai-sukuk is considered a type of J-sukuk issued in Japan by a foreign gov-
ernment or foreign company. A Samurai-bond is a yen-denominated debt security
issued in Japan by a foreign government or foreign company. One of the uses of
J-sukuk is that foreign governments or foreign companies in the Islamic world use
J-sukuk as financing measures in Japan. In this case, J-sukuk economically have
the same function as Samurai-bonds have. To be specific, various schemes may be
taken into consideration. For example, it is considered that a foreign government
or foreign company in the Islamic world would entrust its own Sukuk (originated
in its jurisdiction) to the trustee of the specified purpose trust and issue J-sukuk
(FSA, 2012).
Interestingly, there has yet to be a Sukuk issued in Japan, despite J-sukuk issuance
having been legally possible since April 2012. Bedi Gunter Lackmann, Nomura
Institute of Capital Markets Research, raises possible reasons: (1) when using a
108  S. M. Sohrab Uddin et al.
basic scheme such as Ijara, the issuance amount is limited by the market value
of the underlying assets; (2) not many companies own the Shari’ah-compliant
assets needed to back a Sukuk issuance; (3) there is a lack of companies with the
necessary expertise (legal, accounting, and Shari’ah-compliance assessment) to
issue a Sukuk or to provide consulting services (in Japanese) on issuing Sukuk;
(4) Sukuk have higher issuance costs than conventional bonds, and their issuance
process takes longer (generally 12 to 20 weeks); and (5) domestic investors have
no incentive to invest if Sukuk yield is not set higher than conventional bond yields
because the dividends received from a J-sukuk get the same tax treatment as the
interest on a bond, and thus issuers who want to raise yen funds with a Sukuk wind
up being reliant on finding Islamic investors overseas with a desire to invest in a
yen-denominated Sukuk. Thus issuing corporate Sukuk in Japan remains difficult
for several reasons (Lackmann, 2015).
This entails further investigation and discussions. As for the yield, traditionally,
Islamic finance in general and Sukuk in particular has been more expensive than
conventional loans and bonds. But it is worth noting that the gap between the
two, especially in the fixed income sector, such as Sukuk and bonds, has narrowed
during the last few years and may, for now, disappear completely (Bakar, 2017,
p. 69; IFSB, 2017). Bakar (2017) raises the case of Emirates Airline as an exam-
ple. In January 2013, Emirates Airline issued a 12-year conventional amortizing
bond of US$ 750 million at 300 basis points over a seven-year mid-swap. A few
months after that, it issued a Sukuk of US$ 1 billion at a cheaper cost of fund.
He points out that this reflected that the liquidity for Sukuk was deeper, having a
wider investor base.2

Sukuk’s rise is driven by the growing influence of consumers who want invest-
ment and savings products compliant with Shari’ah laws and principles. Inter-
est is strong in the Gulf Cooperation Council member states and in growing
economies such as Malaysia and Turkey. For those seeking finance, offering
Shari’ah-compliant debt offers access to the large pool of capital in oil-rich
countries in the Middle East and Southeast Asia.
(HSBC Bank Malaysia Berhad, 2015, p. 1)

There has yet to be a Sukuk (J-sukuk) issued in Japan, though “Japan’s Financial
Services Agency is right to promote the growth of its Shari’ah-compliant finance
sector” (HSBC Bank Malaysia Berhad, 2015, p. 1). In contrast, outside of Japan
there have been Sukuk issues from Japanese corporations in recent years, although
actual Sukuk issuances by Japanese corporations are still few. According to Lack-
mann (2015), Aean Credit Service (issued in 2007)3 and UMW Toyota Capital’s
(issued in 2008)4 intent in issuing Sukuk in Malaysia was likely in order to (1)
diversify their funding methods, (2) obtain funding in local currency, (3) fund
Shari’ah-compliant businesses, and (4) increase their acceptance by, and expand
their customer base among, local Islamic consumers.
On the other hand, global financial institutions like Nomura Holdings (issued
in 2010)5 and The Bank of Tokyo-Mitsubishi UFJ (Malaysia) (issued in 2014)6
 Sukuk environment and challenges 109
are motivated to enter this market to (1) diversify their funding sources by region
and currency, (2) raise funds aimed at providing Shari’ah-compliant financial ser-
vices to the local market, (3) improve their franchise value and name recognition
in the Islamic world, (4) gain access to investors in Southeast Asia and the Mid-
dle East, (5) assume the role of an arranger for future Japanese Sukuk issuances
(a longer-term objective of accumulating expertise and helping other Japanese
companies obtain funding through Sukuk), and (6) strengthen their relationships
with governments seeking to develop Islamic financial markets and with major
market players.
Japan’s Financial Services Agency has given the green light for banks to move
into Islamic financing. In spite of it, we have to ask: Why has J-sukuk been never
materialized? There must be widespread sentiment that issuing Sukuk is (still) too
complex, time consuming, and costly. We should continue to watch the dilemmas
and challenges in J-sukuk.

8. Conclusion
Bangladesh started its journey in the Sukuk industry almost 13 years ago. In spite
of the stellar growth of the Islamic banking sector, the country still trades on a
single government Sukuk instrument. Nevertheless, Malaysia is considered the
pioneer of the global Sukuk market, possessing both government and corporate
Sukuk instruments. Keeping all these issues in mind, this chapter aimed at evaluat-
ing the Sukuk environment in both of these countries supplemented by the case
of J-sukuk. It is evident from the findings that Malaysia and Bangladesh portray
completely different pictures in terms of the existing Sukuk instruments available,
the legal and regulatory framework, and the participation of different stakeholders
of the industry. In spite of the high potential for growth, Bangladesh has failed to
make any significant progress. The future of the industry largely depends on firm
planning and co-ordination among regulatory authorities, Islamic banks, Islamic
financial institutions, Shari’ah scholars, and other markets participants. Most
importantly, the Malaysian success story can be the mantra for Bangladesh and
Japan for achieving the pace of the growing global Shari’ah-compliant securities
market. In addition, the Malaysian case may show the other two countries how
they may board into the fastest growing train of Sukuk keeping their conventional
capital market growth on track.

Notes
1 The name ‘Sukuk’ is derived from the word of ‘Sakk’ which means a legal instru-
ment, deed, and check. In lisan al-Arab, the meaning of Sakk is ‘to strike one’s seal
on a document’ or ‘imprint one’s mark on a clay tablet’. However, the Sukuk, as
understood in its contemporary form, lies in a decision of the Islamic Jurisprudence
Council in February 1988 which provided that “any combination of assets (or the
usufruct of such assets) can be represented in the form of written financial instru-
ment which can be sold at a market price provided that the composition of the
group of assets represented by the Sukuk consists of a majority of tangible assets.”
110  S. M. Sohrab Uddin et al.
The main function of Sukuk is to provide an alternative for conventional bonds, in
other words, to provide the benefits associated with conventional bonds but in a
Shari’ah-compliant manner (Abduh, 2016).
2 Although many reports and analyses tend to attribute the lower pricing of Sukuk to a
bigger and wider investor base, Bakar (2017) also points out that this is not the case
all the times. He refers to two Indonesian government Sukuk which were priced a
few bps more than their conventional bonds. In the end, it is entirely dependent on
market forces and market conditions. “A wider investor base will surely help but it
will not guarantee that the sukuk issuance will always be cheaper when it is issued by
the same issuer with the same rating and tenor” (Bakar, 2017, pp. 69–70).
3 The issued amount is 400 million ringgit through the musharaka scheme with a
maturity of seven years. The underwriters are BTMU Malaysia, CIMB Investment
Bank, and ASEAN Bankers Malaysia.
4 The issued amount is 1 billion ringgit through the musharaka scheme with a matu-
rity of seven years. The underwriters are BTMU Malaysia and CIMB Investment
Bank.
5 The issued amount is US$ 100 million through the ijarah scheme with a maturity
of two years. The underwriter is Kuwait Finance House (KFH, Malaysia). The yield
is LIBOR + 1.6 percent.
6 The issued amount(s) are JPY 2.5 billion and US$ 25 million through the wakala
scheme with a maturity of one year. The underwriter is CIMB Investment Bank.
7 A comparative study
between the Grameen
and Islamic modes of
microfinance in Bangladesh
with reference to Islamic
microfinance in Pakistan
Yasushi Suzuki, Helal Uddin and Mohammad
Dulal Miah

1. Introduction
The importance of microcredit in our society cannot be ignored by any means.
It creates self-employment opportunities (McKernan, 2002; Erhardt, 2017);
increases income and consumption (Zeller, 2001); improves health, education,
and women’s empowerment etc. (Nader, 2008; Swain and Wallentin, 2009).
Microfinance contributes to development at both the individual and national
levels. For instance, Raihan et al. (2015) mention that microfinance has a posi-
tive effect on GDP. In general, it contributes to both micro and macro levels of
the economy by creating new employment and empowerment. According to the
United Nations (UN) General Assembly Report 2004, microcredit can contrib-
ute to the achievement of the Millennium Development Goals, in particular the
goal of poverty reduction, gender equality, women’s empowerment, and commu-
nity development. To emphasize the importance of microfinance that has global
importance and ramifications, the year 2005 was declared the ‘Year of Micro-
credit’ by the UN and in 2006 Professor Muhammad Yunus and Grameen Bank
(GB) together won the Nobel Peace Prize.
The Grameen mode of microcredit mechanism (group lending) has been rep-
licated in Bolivia, Chile, China, Ethiopia, Honduras, India, Malaysia, Mali, the
Philippines, Sri Lanka, Tanzania, Thailand, the US, and Vietnam. Suzuki et el.
(2011) have found that the Grameen mode of microcredit, without much modifi-
cation, has been prevailing all over the world. Microfinance spreads quickly across
the globe because few other tools promise to fight poverty as effectively as micro-
finance can do (Morduch, 2000). A good volume of research in the existing litera-
ture can be found which focuses on several dimensions of microfinance including
its effects on the national economy. For example, Schuler et al. (1997), Pitt and
Khandker (1996), Imai et al. (2010), Montgomery and Weiss (2011), Deloach
and Lamanna (2011), Imai et al. (2012), and Mazumder and Lu (2015) find that
the Grameen mode of microfinance has a positive impact on poverty eradication
as well as employment creation.
112  Yasushi Suzuki et al.
Despite the marvelous growth of conventional microfinance having its sweep-
ing impact on the development of the individual and national levels, a segment
of the target population remains out of the touch of this magic wand. Specially, a
large number of Muslim populations are reluctant to accept finance from conven-
tional microcredit providers because these financiers deal with interest which is
prohibited in Islam. Despite this setback involved with the conventional microfi-
nance institute (MFI), mainstream Islamic financial institutions do not show ade-
quate interest in catering to the financing needs of these marginal borrowers. In
particular, the unprecedented growth of mainstream Islamic finance is unrivalled
to the sluggish growth of Islamic microfinance. For instance, the Islamic financial
market has been growing at a significant pace since its beginning in the 1970s. It
was estimated that the annual growth rate hovered around 40.3 percent between
2004 and 2011. It is further predicted that the annual growth rate will be about
19.7 percent until 2018 (Suzuki and Miah, 2015).
The rise of the Muslim population on the one hand and the reluctance of main-
stream Islamic financial institutions to support small and marginal borrowers on the
other have created a huge gap between the demand and supply of Islamic microfi-
nance. For instance, Islamic microfinance has a total estimated global outreach of
only 380,000 customers served by 126 institutions in 14 countries, and accounts
for only an estimated 1.5 percent of total microfinance outreach (CGAP, 2008).
According to the Center of Islamic Banking and Economics Report 2014, the size
of Islamic finance reached $2 trillion whereas the contribution by Islamic microfi-
nance accounts for 1 percent in the total assets held by Islamic financial institutions.
Despite huge potential for Islamic MFI, this model has failed to emerge.
Although the contemporary literature pays much attention to the conventional
mode of microfinance, the domain of what Islamic MFI can learn from the suc-
cess story of conventional MFI has largely remained unexplored. This research
thus aims to fill this gap. In so doing, the research analyzes the factors hindering
the growth of the Islamic microfinance industry vis-à-vis the success factors of
conventional MFI in Bangladesh. In this regard, the research analyzes how Gra-
meen Bank, the largest microfinance provider in Bangladesh, has overcome typi-
cal obstacles involved with microfinancing including asymmetry of information,
moral hazard, and transaction costs. Then a detailed analysis of the Rural Devel-
opment Scheme (RDS), the largest Islamic microfinance provider in Bangladesh,
is offered along with identifying the critical hindrances restricting its growth.
A comparative analysis of these two MFIs is helpful in the sense that they are
working in the same macroeconomic environment but with different success tra-
jectories. Thus, the differences between them can be attributed to their respective
functions, strategies, and management systems.
The chapter has been structured as follows. Section 2 elaborates the obstacles
hindering the growth of Islamic microfinance whereas Section 3 details the cur-
rent practices of Islamic microfinance in Bangladesh. Section 4 compares and
contrasts between Grameen Bank and the Rural Development Scheme. Section 5
analyzes the current state of Islamic microfinancing in Pakistan. This is followed
by the conclusion and policy prescriptions.
 Grameen and Islamic modes of microfinance 113

2.  Challenges to the growth of Islamic microfinance

The existing literature has identified several key obstacles that are hindering the
expected growth of MFI. For example, Wulandari and Kassim (2016) identify
the issues and challenges of Baitul Mal-wat Tamil (BTM) and find four types of
challenges: sources of finance, collateral status, mode of financing, and the default
cases faced by BTM. Rahman and Dean (2013) find that the low market penetra-
tion, the fragility of MFIs due to lack of funds and high administrative costs, and
the expected role in alleviating poverty are the main reasons for its growth con-
straint. Ali (2015) highlights that most of the microfinance providers are managed
not for profit but for social development. Also, a large number of MFI depends
on donor, government, and individual funds to carry out their businesses. The
current mechanism for channeling those funds, especially government and donor
funds, has been proved inefficient. The cost of materializing donor funds is exor-
bitant if administrative costs are accounted for (Ahmed, 2009). It is difficult to
say how much of initially allocated funds actually reach the poor. According to
Yunus and Jolis (1999) only 10–25 percent of donor funds actually reach the bor-
rower while the rest is spent on administration, overhead, and training purposes.
Therefore, MFIs, in general, are facing a barrier to expanding their operation
because of their limited resources. Suzuki and Miah (2015) conclude that there
is a huge demand for Islamic microfinance across the globe. However, the supply
side, especially the lack of loanable funds, has apparently failed to meet the needs
of rising demand.
We can roughly categorize the obstacles towards the growth of MFI into
four broader classes: (I) lack of loanable funds (Haque and Yamao, 2011; Riwa-
janti, 2015; Glaubitt et al., 2008; Ahmed, 2009); (II) asymmetry of informa-
tion between MFIs and their clients (Boateng and Agyei, 2013); (III) improper
regulatory framework (for incubating the infant microcredit industry)/failure
to incubate the managers (human resources) who would well-manage MFIs
(Muhammad, 2010; Ahmed, 2009; Dogarawa, 2011; Mirghani et al., 2011;
Ashraf and Ibrahim, 2013); and (IV) insufficient infrastructure (transport, utility,
and so on) as well as dominance of conventional MFIs (lack of scale efficiency in
Islamic MFI) (Boateng and Agyei, 2013; Ali, 2015).
Though these explanations seem to have their own merit, we raise some cri-
tiques to these explanations. First, insufficiency of loanable funds might be one of
the causes of the marginal outreach of microcredit. However, it would be naïve to
simply assume that MFIs would increase the exposure to the micro-clients if the
availability of loanable funds is increased. This is because their marginalized clients
are not necessarily credible and their business is not always commercially viable.
Second, we note that the asymmetry of information between MFIs and their cli-
ents is severe. The efforts of attenuating the asymmetry of information through
initiating closer monitoring might accelerate the flow of more financial resources
to their clients. However, this explanation also understates that the business of
marginalized clients is always exposed to high risk and fundamental uncertainty.
Closer monitoring does not necessarily guarantee the attenuation of risk and
114  Yasushi Suzuki et al.
uncertainty associated with the business of clients. Third, failure to incubate the
managers who would well-manage MFIs is agreeable. However, this explanation
insufficiently explains how we can create an appropriate incentive for the manag-
ers to develop their skill and knowledge of credit risk management. Also, these
explanations understate that the business by marginalized clients is always exposed
to (not bankable) risk and uncertainty. It would amount to a risky strategy to
expect too much for the MFI managers to tackle the ‘not bankable’ level’s risk
and uncertainty. Finally, the development of infrastructure would reduce the cost
of screening and monitoring. However, this explanation also understates that the
business by marginalized clients is always exposed to high risk and fundamental
uncertainty. The lower transaction cost of monitoring does not necessarily reduce
the risk and uncertainty associated with the business by marginalized clients.
This postulates that while these factors are important, the literature has paid
much less attention to how the fundamental risk and uncertainty involved with
marginalized borrowers can be adequately tackled for materializing the potential
of Islamic microfinancing. In other words, mitigating these challenges may be the
necessary conditions for incubating the Islamic microfinance industry but not suf-
ficient on their own. Thus, we first evaluate the GB and RDS through the lens of
these criteria, and second, we add the uncertainty dimension to evaluate the slow
growth of Islamic microfinance.

3. Current practices of Islamic microfinance in

Bangladesh
Among the 165 million population of Bangladesh, 36 percent live in the urban
area and the remaining live in the rural and suburban areas. An estimation by the
Asian Development Bank (ADB, 2017) shows that 31.5 percent of the total pop-
ulation live under the national poverty line (income $1.25 per day) and 73.5 per-
cent of the total population live below $1.90 purchasing power parity per day. The
majority of the population depend on agriculture whereas a tiny portion of them
is employed in the service sector which contributes the lion share of the GDP.
According to the available statistics, the service sector accounts for 56.3 percent
of the GDP followed by industry (28.6 percent) and agriculture (15.1 percent).
Bangladesh is viewed as a synonym to microfinance. The concept of modern
microfinance was born in Bangladesh by the introduction of Grameen Bank (GB).
GB is a special type of bank owned by the borrowers whom it serves. Borrowers
of the bank own 95 percent and the remaining 5 percent is owned by the govern-
ment. It was initiated by professor Dr Muhammad Yunus, a professor of Econom-
ics at the Chittagong University, Bangladesh. GB provides small loans to the poor
people who are excluded from formal financial institutes. The formal financial
institutes provide loans backed by collateral assets but GB provides loans without
any collateral. GB started its operation in the eastern part of Bangladesh with
a fund of US$ 27; now its total asset is estimated to be US$ 2,803 million and
its cumulative disbursement has amounted to BDT 1,531.24 billion as of 2017.
 Grameen and Islamic modes of microfinance 115
Table 7.1  Performance of Grameen Bank

Particulars 2011 2012 2013 2014 2015

Active borrowers 6.58 6.71 6.74 7.03 7.18

(in millions)
Gross loan portfolio 75,294 80,317 84,381 87,491 96,422
(BDT millions) [+13.48] [+6.67] [+5.06] [+3.69] [+10.21]
[changes from the
previous year: %]
Branches 2,565 2,567 2,567 2,568 2,568
(a) Total assets (BDT 140,441 158,952 178,937 200,961 220,885
billions)
(b) Net profit (BDT 12597.56 27180.79 24424.90 8339.88 485.95
billions)
ROA [(b) / (a)] (%) 8.97% 17.10% 13.65% 4.15% 0.22%
Source: created by the authors upon GB, 2015

Now GB serves 81,392 villages through 2,568 branches which cover 97 percent
of the total Bangladesh landscape (see Table 7.1).
The microfinance industry in Bangladesh is composed of NGOs, Grameen
Bank, state-owned commercial banks, private commercial banks, and specialized
programs of some ministries of Bangladesh government. As of June 2015, there
were 659 NGO-MFIs in Bangladesh. To monitor and supervise this growing sec-
tor, the Government of Bangladesh (GoB) has established ‘Microcredit Regula-
tory Authority Act 2006’ by which a new independent authority ‘Microcredit
Regulatory Authority’ (MRA) was established to stimulate and foster the sustain-
able development of the microfinance sector. According to MRA (2015), total
loan disbursement was BDT 634 billion in 2015, the double of BDT 303.18 bil-
lion in 2011 (see Table 7.2). According to Bangladesh Bank (the central bank of
Bangladesh) statistics, by the end of June 2016, there were 680 licensed MFIs and
191 provisional licensed MFIs serving over 26.3 million clients.
Despite its sharp growth in terms of outstanding loan and disbursement, this
sector is far behind achieving its objective. According to ADB (2017) about
31.5 percent (50.37 million) of the Bangladeshi population still lives under the
national poverty line. If it is assumed that all MFIs serve only the clients who live
under the national poverty line there are still 24.07 million people living under
the poverty line and are unbanked (BB, 2016). Suzuki and Miah (2016) mention
that religious faith is one of the critical reasons for low microfinance outreach in
Bangladesh.
Bangladesh is the world’s third largest Muslim country and its official religion
is Islam. Therefore, Muslim people hesitate to engage in any activities that are
prohibited by their religion. Conventional microfinance engages with interest in
both deposit and loan markets. The Muslim population in Bangladesh consti-
tutes 90 percent of the total population and Islam plays a significant role in their
social and economic lives. A portion of the Muslim population was not always
116  Yasushi Suzuki et al.
Table 7.2 Loan disbursement and outstanding trend in MF sector (amount in billion
BDT)

Particular 2011 2012 2013 2014 2015

Loan outstanding 173.79 211.32 257.01 282.20 352.41

Loan disbursement 303.18 456.02 432.28 462.00 634.00
Source: MRA, 2015

satisfied with conventional microfinance services because they are involved in

interest (riba). To serve this market niche, some MFIs came into being with some
financial products which are compliant with Islamic Shari’ah. Even though some
Islamic MFIs (currently seven Islamic MFIs are operating in Bangladesh) come to
serve this niche market, their outreach is still very low. In fact, the Rural Devel-
opment Scheme (RDS) being the market leader covers only 5 percent of total
microfinance outreach.
Islami Bank Bangladesh Ltd. (IBBL) is the largest Islamic commercial bank
in Bangladesh. It was established with an objective of establishing a balanced
economic growth by ensuring balance between rural and urban markets. Com-
mercial banks provide loans to their clients backed by collateral while there are
many potential clients particularly in rural areas without collateral. IBBL as a
commercial bank feels it is very difficult to provide loans to these potentially un-
bankable clients. To mitigate this dilemma, IBBL introduced a special scheme of
microfinance in 1995 named ‘Rural Development Scheme’. Basically RDS was
introduced to fulfill the financial or investment needs in the agriculture and rural
sectors which would create more employment opportunities and generate income
that would reduce poverty.
RDS is the first scheme that facilitates Islamic microfinance in Bangladesh. The
main funding sources of RDS are its clients’ voluntary and forced deposits in addi-
tion to the fund allocated from IBBL. RDS imitates the GB mode of group lending.
However, one of the salient features of this scheme is that RDS does not provide
any funds directly to the client but sells the goods the client needs to get on a
deferred payment condition. RDS does so to comply with Shari’ah principles. After
eight weeks of observation by the group member as well as field officers on his/her
regular attendance in center meetings, each member becomes eligible to apply for
a loan. Upon receiving the application, the field officer and the investment com-
mittee thoroughly review the loan proposals. Before receiving the loan, each mem-
ber must attend the training for skill development, environmental awareness, and
entrepreneurship development to improve proper utilization of funds as well as
efficient management and investment.
RDS provides loans in nine sectors with the maturity period ranging from one
year to a maximum of three years and the investment from BDT 20,000 to a maxi-
mum of BDT 50,000. Initial investment starts with BDT 10,000 (US $125) and
regular repayment increases the loan amount from BDT 2000 to BDT 5000 for
every next time up to the ceiling of every sector (see Table 7.3). The rate of return
of RDS investment is 12.5 percent and the timely repayment rebate is 2 percent.
 Grameen and Islamic modes of microfinance 117
Table 7.3  Purpose, period and ceiling of investment

Sl. Sector of investment Duration Ceiling of

investment (BDT)

1 Crop production 1 year 25,000/-

2 Nursery and commercial production of 1 year 50,000/-
flowers and fruits
3 Agriculture implements 1 to 3 years 50,000/-
4 Livestocks 1 to 2 years 50,000/-
5 Poultry and duckery 1 year 35,000/-
6 Fisheries 1 to 2 years 50,000/-
7 Rural transport 1 year 20,000/-
8 Rural housing 1 to 5 years 50,000/-
9 Off-firm activities 1 year 50,000/-
Source: RDS website

Table 7.4  RDS performance from 2012–2016

Particular 2012 2013 2014 2015 2016

Villages 15,507 17104 18086 18615 19418

Centre 24,883 26887 27874 28822 28960
Members 733,520 836227 911470 947305 999140
Total savings 3,323.15 4531.46 5727.15 6932.89 7952.64
(BDT mil)
Total outstanding 10,390.71 13730.92 17379.97 20798.82 24476.99
inv. (BDT mil)
Recovery rate (%) 99.72 99.70 99.50 99.47 99.54
Source: IBBL 2016

Every member must maintain a Mudaraba Saving Account (MSA-RDS) in

their individual name. The minimum compulsory deposit amount is BDT 20 per
week. Out of 318 IBBL branches, 228 branches carry out RDS activities in 64 dis-
tricts of the country and total loan outstanding has become BDT 24,476.99 mil-
lion (see Table 7.4).

4. Comparison between Grameen Bank and the Rural

Development Scheme
As we discussed in Section 2, the existing literature raises the following explana-
tions of the slow-paced penetration of the Islamic microfinance industry: (I) lack
of loanable ‘microcredit’ funds, (II) improper regulatory framework, (III) infor-
mation asymmetry between MFIs and their clients, and (IV) failure to materialize
the economies of scale. This section argues how well the GB has mitigated these
obstacles and why the RDS has yet to address these challenges.
118  Yasushi Suzuki et al.
4.1  Lack of loanable ‘microcredit’ funds
The GB is one of the largest MFIs in the world. It started its operation in the east-
ern part of Bangladesh with an amount of US$ 27 which rose to US$ 2,803 mil-
lion and its cumulative disbursement amounted to BDT 1,531,244.85 million by
2017. As for the RDS, total outreach is estimated to be BDT 47,757.25 million
which is 35 times less than that of GB. If we have a closer look at the financial
statements of GB and RDS, GB receives four concessional soft loans. The Inter-
national Fund for Agricultural Development (IFAD) provided SDR equivalent
of BDT 6,200,000 on 8 January 1990 at a 2 percent interest rate with a grace
period of 2 years which is to be repaid within a maximum of 80 years. Norwegian
Agency for International Development (NORAD) provided Norwegian Kroner
55,000,000 on 4 August 1986 at a 2 percent interest rate with a grace period of
10 years, repayable in 30 years. Swedish International Development Authority
(SIDA) funded SEK 60,000,000 on 30 November 1986 at a 2 percent interest
rate with a grace period of 10 years, repayable in 30 years. Dutch Grant Loan
provided a loan to GB of DFL 2,000,000 equivalent of BDT 44,283,298 in 1986
at a 2 percent interest rate with a one-year grace period, repayable in 15 years.
Japan International Co-operation Agency (JICA) provided GB with an amount
of Yen 2,986,000,000 in March 1996 repayable in 30 years including a 10-year
grace period. GB places fixed deposits amounting to BDT 93,917.20 million with
27 Bangladeshi conventional banks on an average 10 percent interest (Suzuki et
al., 2011), which provides GB with an opportunity to make smart deposit interest
spread on an average of 8 percent upon its funding cost of around 2 percent from
the concessional loans.
GB also keeps high spread margins on their loans and advances on an aver-
age 15.6 percent (Suzuki et al., 2011). This opportunity to earn high interest
incomes may have encouraged the GB to expand its business outreach in Bangla-
desh. Another funding source of GB is the deposit from non-members. The GB
opens a depository scheme for non-members who can deposit their funds in GB.
By the end of 2014, the total non-members’ fund amounted to BDT 64,138 mil-
lion. Recently GB also started to issue corporate bonds when it faces shortage of
funds. These bonds are guaranteed by the Government of Bangladesh.
On the other hand, the funding of RDS depends solely on the budget alloca-
tion by IBBL, though some Islamic charity funds such as zakat and waqf are con-
tributing to its funding. Only an independent organization is eligible to borrow
from Islamic Development Bank (IDB) or other Islamic multinational financial
institutions. Therefore, it is difficult for RDS which is solely subsidized by IBBL
to diversify its funding sources. Besides, RDS is not allowed to receive any soft
loan from the official development aid providers such as IFAD, NORAD, SIDA
and JICA because of their involvement with interest which is strictly prohibited
in Islam. Issuing Sukuk (Islamic bond) is one way by which RDS can raise their
funds. But according to Bangladesh Security and Exchange Commission Act, for
issuing any kind of stock, bond, or debenture, the issuer should be an independ-
ent organization. RDS is not a separate or independent organization from IBBL.
 Grameen and Islamic modes of microfinance 119
Therefore, it is not publishing its own annual report. As a result, RDS is not eligi-
ble for issuing any kind of bond in the Bangladeshi capital market.

4.2  Improper regulatory framework

Regulatory framework is the key to financial stability and development. A well-
designed regulatory framework would help to incubate an infant industry. It
provides the economic players in the industry with appropriate incentives and
sanctions leading to its development and further innovation. A well-organized
regulatory framework is necessary for microfinance industry for its development.
Rural Economics Program (the initial name of GB) worked to help the poor
by providing small loans. Subsequently, it was converted to an independent bank
called ‘Grameen Bank’ by the government ordinance on October 2, 1983, which
is known as Grameen Bank Ordinance, 1983. This ordinance provides a full regu-
latory framework for GB. In 2013, the Bangladesh Parliament passed ‘Grameen
Bank Act’ which replaces the Grameen Bank Ordinance, 1983, authorizing the
government to make rules for any aspect for the smooth running of this institute.
For smoother operation of other microcredit organizations in Bangladesh, the
government passed a microcredit act known as ‘Microcredit Regulatory Authority
Act 2006’. This law has been enacted in order to establish an authority and for-
mulate rules and related matters for efficient regulation of microcredit programs
ensuring transparency and accountability in the activities of microcredit organi-
zations operating in Bangladesh. By this act, Microcredit Regulatory Authority
(MRA) was born which is the prime authority of all microcredit organizations of
Bangladesh. MRA is the regulatory authority that monitors and supervises micro-
finance operations. License from the Authority is mandatory to operate as micro-
finance provider in Bangladesh.
RDS is a unique microfinance organization in Bangladesh, operating directly
neither under the Bangladesh Bank nor the MRA. RDS is a subsidiary of IBBL,
that is, the only microfinance organization run by a commercial bank. RDS is
also unique in the light of their operation because it has neither central body to
monitor and supervise its operation nor does it have an independent or central
Shari’ah board to ensure the compliance with Shari’ah. IBBL also faces some
dilemmas when it plays its role as a monitoring and supervisory authority because
the operation of a commercial bank is totally different from that of a microfinance
organization.

4.3  Information asymmetry between MFIs and their clients

Asymmetric information problems or ‘lemon’ problems arise from the differences
in information held between lenders and borrowers (Healy and Palepu, 2001).
Boateng and Agyei (2013) and Ahmed (2002) suggest that information asym-
metry is one of the reasons that would limit the growth of Islamic microfinance.
Here, we are going to analyze how information asymmetries would restrain the
growth of RDS and how well GB has overcome this particular problem.
120  Yasushi Suzuki et al.
Development of microfinance is one of the main innovations in the past
25 years (Servin et al., 2012) which changed the concept of financial intermedia-
tion. GB shows that all the segment of the population is bankable including the
poor households who were excluded from the formal financial market. Formal
financial institutions excluded them because of their lack of collateral status. For
the commercial banks, the collateral condition is essential for maintaining a cer-
tain level of the loan recovery. On the other hand, GB provides loans to the poor
without any collateral and achieves a recovery rate of about 98 percent, a standard
which the mainstream financial institutions find it difficult to achieve. The secret
of this remarkable recovery rate is the ‘group lending model’ or what Besley and
Coate (1995) call “joint liability”.
Initially, GB made many trials and errors in their delivery and recovery method.
After a considerable period of trial and error, GB has finally discovered that the
formation of group lending method is crucial to the success of its operations
(Yunus and Jolis, 1999). To be eligible for applying for a loan from GB, every
borrower must become a member of a group. Every group consists of 5 mem-
bers and 2 to 10 groups operate under one center. These groups are formed
in a mechanized way such that every group member is jointly liable for any of
the member’s default. If any member in the group defaults the whole group is
liable to repay the remaining amount. If not, GB’s policy is not to extend any
credit to any member of the group in the future (Suzuki et al., 2011). This group
lending model helps GB in two ways; first, it works as a sanction mechanism for
the poor borrower; and second, it reduces information asymmetry and potential
moral hazard. It is difficult for GB to monitor its borrowers because monitoring is
costly and time-consuming because of information asymmetry. Also, it is difficult
to screen good borrowers from bad borrowers. Wydick (2001) mentions that
self-select membership helps mitigate potential adverse selection effects. Besley
and Coate (1995) also identify that joint liability improves the willingness of loan
repayment.
RDS has adopted the GB lending mechanism with some modification. They
also provide small loans based on groups and if one member defaults the whole
group will be liable to recover that loan and the default member is to be expelled
from the group as well as restricted from further benefits provided by RDS as
well as the IBBL1 (Al-Mubarak, 2011). In such a circumstance, the whole group
is not considered default and credit can be extended to other members of that
group. The condition of RDS in dealing with default members is completely dif-
ferent from that of GB. Based on the profit–loss sharing (PLS), Islamic financial
institutions are not allowed to penalize any defaulter or late payers (Parker, 2010).
A survey was conducted by Hossain et al., (2008) about RDS problems and pros-
pects by taking an interview of 36 IBBL employees from different branches. Of
the respondents, 78 percent have mentioned that monitoring of RDS clients is
costly. RDS employees physically inspect at least two client locations every week
to identify if the promised goods for which finance is sought have been actually
purchased and are in possession of the client (Obaidullah, 2007).
 Grameen and Islamic modes of microfinance 121
4.4  Economies of scale
Infrastructure is the basic or fundamental feature of a system or organization
that facilitates smooth operation. Every industry requires its basic infrastructure
to grow. Different industries require different infrastructure and the same infra-
structure can be used by different industries. As such, the microfinance industry
requires some basic infrastructure for its smooth operation. The main infrastruc-
ture for the MFI is its communication facility. It can be a branch network, roads,
communication skill etc.
In terms of branch network, GB has a total of 2,568 branches serving over
81,000 villages constituting about 97 percent of the country’s landscape. This
means that it covers almost the whole country. On the other hand, RDS is falling
behind the GB because it is unable to establish its own branch network. But rather,
it operates through the IBBL branches. RDS runs it operation through 252 IBBL
branches that cover 19,418 villages constituting only 23 percent of the country.
This is one of the major disadvantages for RDS which is presumably restricting the
growth of Islamic microfinance in Bangladesh.

5. A glimpse of current practices of Pakistani Islamic

microfinance
Pakistan is a Muslim-dominant country where Islamic microfinance has been
struggling to grow responding to the emerging demand of the country. In this
section, we attempt to reflect the current status of Islamic microfinance in Pakistan
and what Islamic MFIs can offer or learn from similar institutes in other countries.
We should note that the state of financial inclusion in Pakistan, as a whole, still
depicts a dismal picture. Only 16 percent of the adult population has access to the
banking system and 23 percent of the population use formal financial services.
The statistics are worse in the rural areas where only 14 percent of the adult popu-
lation are banked. In the case of women, only 11 percent are banked. Pakistan
continues to lag behind other Indian sub-continental countries. According to the
Global Findex Database 2014 of World Bank, the share of formal savings reached
only 3 percent in Pakistan (compared to 7 percent in Bangladesh) and the share
of formal borrowings reached only 2 percent (compared to 10 percent in Bang-
ladesh) (PMN, 2016).
Despite these setbacks, microfinance industry in Pakistan, as a whole, witnessed
continuous growth and expansion in outreach in the year 2015 (see Table 7.5).
Pakistan Microfinance Network [PMN] (2016) points out that the major devel-
opment took place in the policy and regulatory fronts such as the launch of the
National Financial Inclusion Strategy (NFIS) and the introduction of a regula-
tory framework for Non-Bank Microfinance Institutes (NBMFI) by the Securities
and Exchange Commission of Pakistan (SECP) in 2015. In addition, results of
the second Access to Finance Survey were launched. With the launch of NFIS, a
roadmap for achievement of financial inclusion in the country has been laid out.
122  Yasushi Suzuki et al.
Table 7.5  Microfinance industry in Pakistan

2012 2013 2014 2015 2016

Active borrowers (in millions) 2.0 2.4 2.8 3.6 4.2

Gross loan portfolio (PKR 33.1 46.6 61.1 90.2 132.0
billions) [changes from the [+33.46] [+40.78] [+31.11] [+47.62] [+46.34]
previous year: %]
Branches 1,460 1,606 1,747 2,754 2,367
(a) Total assets (PKR billions) 61.9 81.5 100.7 145.1 225.3
(b) Total revenue (PKR billions) 12.5 17.3 24.3 32.8 41.8
ROA [(b)/(a)] (%) 20.19 21.22 24.13 22.60 18.55
Source: created by the authors upon PMN (2016, 2017)

Now with the introduction of the rules and regulations for NBMFI a level playing
field has been created in the industry which provides an opportunity for non-
bank players to scale up their businesses. Despite sustained efforts having been put
forth by the policymakers, regulators, and donors a lot more needs to be done for
an enviable microfinance environment in Pakistan (PMN, 2016, p. 3).
Second, we should note how poorly Islamic MFI has contributed to the micro-
finance industry in Pakistan. Here we look at NRSP Microfinance Bank Limited
(‘NRSP Microfinance Bank’), headquartered in Bahawalpur which commenced
its operation in March 2011 as a national-level microfinance provider. NRSP is
one of the leading players of the microfinance sector in Pakistan. According to
its website, the bank has endeavored to offer cutting-edge banking services to
its customers with the launch of Islamic microfinance operations. Being the first
Islamic micro-lending institution, the bank intends to cater to the greater demand
of Shari’ah-compliant solutions and services to the microfinance industry of Paki-
stan. The bank builds on the experience of its parent institution, the National
Rural Support Program (NRSP), to alleviate poverty and promote financial inclu-
sion in the country. Its capital has been contributed by highly reputed organiza-
tions including the International Finance Corporation, Acumen, KFW, and the
National Rural Support Program. Through a network of 108 branches across 32
districts, NRSP bank offers a range of financial services including deposits, micro-
credit, and micro-insurance to the financially excluded individuals living in both
urban and rural areas of Pakistan (see Table 7.6).
We observe that the share of Islamic advances provided by NRSP-MB is in
increasing trend. However, the share of Islamic advances in the Microfinance
Bank is still at a marginal level compared to that of conventional microcredit (see
Table 7.7).
Third, we should note the limited effect of various microfinance industry initia-
tives by the government. According to PMN (2016), the Government of Pakistan
(GoP) launched an interest-free microloan scheme (‘Prime Minister Interest Free
Loan Scheme’) in 2014 to address the issues of poverty and rising unemployment
in the country. Under the scheme, PKR 3.5 billion were allotted from the federal
 Grameen and Islamic modes of microfinance 123
Table 7.6  Performance in NRSP-MB

2012 2013 2014 2015 2016

Active borrowers 126,717 171,718 194,489 258,444 325,521

Gross advances 3.06 4.85 5.19 9.09 13.27
(PKR in billions)
Profit before 148 338 286 650 960
taxation (PKR in
millions)
Source: NRSP-MB (2016)

Table 7.7  Share of Islamic advances in NRSP-MB (percentage in parentheses)

Loan type 2015 2016

No. of loan Amount outstanding No. of loan Amount outstanding

outstanding Rupees (in millions) outstanding Rupees (in millions)

Microcredit 257,240 9,008.18 318,750 12,863.57

[99.53] [99.15] [97.91] [96.93]
Islamic 1,204 77.33 6,771 407.47
advances [0.47] [0.85] [2,08] [3.07]
Total 258,444 9,085.51 325,521 13,271.04
[100.0] [100.0] [100.0] [100.0]
Source: NRSP-MB (2016, p. 48)

budget to facilitate the poor and destitute segments of the population for gear-
ing up their livelihood. However, in order to safeguard the interests of the MFPs
it was decided that the funds under this scheme would be routed through the
national apex, PPAF, and would only be extended in Union Councils that have a
low or no penetration of conventional microfinance. As of December 2015, PKR
2.25 billion have been disbursed under the scheme to approximately 110,000
beneficiaries, out of which 66,000 were female and 44,000 were male applicants.
These interest-free loans are being made available to men and women from house-
holds with a score of up to 40 on the Poverty Score Card (PSC) and with little or
no access to banks or microcredit institutions. Most of the loans have been utilized
in the livestock sector, followed by business and trading, services, and agriculture.
As was observed, NRSP Microfinance Bank is focusing more on the conven-
tional mode than the Islamic one. According to an ex-staff member of NRSP
Microfinance Bank, in the case of transacting the Islamic mode of microcredit
with the government, the borrower pays back only the principal amount without
interest, then the government pays 16 percent profit margins to NRSP Microfi-
nance Bank. Nevertheless, as reported in Table 7.7, the disbursement rate for the
Islamic mode has been very low because the applicants cannot meet the NRSP
Microfinance Bank’s credit criteria.
124  Yasushi Suzuki et al.
Lastly, we should note that financing against gold-backed loans by Microfinance
Banks (MFBs) have gained widespread popularity in the last few years in Pakistan.
According to PMN (2016), it has allowed MFBs to move from traditional group
lending to individual lending and also increase their loan sizes. PMN (2016)
points out that this mode of financing drew its strength from the fact that gold
and gold ornaments have been a traditional mode of savings among the masses
which in times of emergency is liquidated often at a deep discount. Obtaining a
loan against this gold without having to liquidate may provide a better alternative
to potential borrowers. This product effectively transformed gold from a non-
liquid asset into a liquid and earning asset. Pioneered by Tameer Microfinance
Bank (TMFB), it was soon adopted by other MFBs. At this time up to five MFBs
are dealing in this product and the percentage of the gross loan portfolio financed
against gold ranges from 20 percent to 55 percent.
The issue is whether the loans were being utilized for consumption purposes
rather than for productive ones (PMN, 2016). Also, the concern as to whether the
loan amounts being determined based on the value of the gold or based on the
repayment capacity of the client led to strengthening the belief that gold-backed
loans were against the spirit of microfinance which promotes lending without
physical collateral. It is reported that overall group lending methodology contin-
ues to dominate the industry. However, individual lending is gaining popularity
(PMN, 2016). Presumably, financing against gold-backed loans may be related to
the share of individual lending.
The direction of Islamic finance must be in conformity with the maqasid
­al-shari’ah, which has been defined as the “purpose and wisdom behind the enact-
ment of all or most of the Shari’ah rulings” (Çizakça, 2011, p. 240). Simultane-
ously, Çizakça (2011) points out that mudaraba/musharaka investments demand a
totally different management approach than ordinary banking. Whereas the former
involves a style of management that requires a very personal and often hands-on
approach, for the latter a hands-off approach would suffice. Indeed, conventional
bankers as well as Islamic bankers with conventional banking backgrounds are
trained to detach themselves from the business of the entrepreneurs they finance. By
contract, mudaraba/musharaka investments demand a constant cooperation and
support for the entrepreneur. Çizakça (2011, p. 246) argues that “Islamic bankers
with a conventional mindset are simply not prepared for this sort of management.”
This leads us to ask: Can his claim be held for Islamic microfinance? Probably, Islamic
bankers with a conventional mindset are simply not prepared for the MFI manage-
ment, either. This may explain a cause of extremely low rate of Islamic advances in
the Pakistani MFI and, on the contrary, higher portfolio of financing against gold-
backed advances. Though this entails further investigations, the MFI bankers’ mind-
set and the market for gold-backed advances might be raised as the factors which
hinder the development of the Islamic microfinance industry in Pakistan.

6.  Conclusion and recommendation

There is a huge demand for Islamic MFIs around the globe but the outreach is
very marginal compared to the demand. This chapter has explored its reasons
 Grameen and Islamic modes of microfinance 125
and possible remedies. In so doing, we have analyzed and compared Grameen
Bank as a successful conventional MFI with IBBL-RDS as an emerging Islamic
MFI in Bangladesh. We also have provided the current status of Islamic MFIs in
Pakistan.
We have identified potential obstacles for MFIs mainly from four dimensions:
lack of loanable ‘microcredit’ funds, improper regulatory framework, informa-
tion asymmetry between MFIs and their clients, and the economies of scale. Our
analysis suggests that GB has gained a competitive advantage in the microfinance
industry which helps it overcome these obstacles successfully whereas RDS has
been in a trap of these obstacles. We also have identified several structural prob-
lems facing RDS. First, RDS has the limitation in raising the loanable funds.
The funding of RDS as the subsidy of IBBL depends solely on its parent com-
pany. Besides, it is structurally difficult for RDS to diversify its funding sources
to tap Islamic multinational financial institutions (due to the lack of eligibility
criteria) or multinational and bilateral donor agencies (facing the Shari’ah-com-
pliant issue). Second, RDS is less recognized under the governmental policy for
enhancing the microfinance compared to the GB which has been fully supported
by the government. Third, under the current Islamic mode of profit–loss sharing
(PLS), RDS is in a disadvantageous position to discipline its clients, even though
RDS follows the same ‘group lending’ model developed by GB for mitigating
potential moral hazard problems. Fourth, it is not easy for RDS to seek its scale
efficiency to compete with GB which has gained the wider branch network in
Bangladesh.
We further provide a glimpse of the current practices of Islamic MFIs in Paki-
stan. Here we have observed how poorly Islamic MFI has contributed to the
microfinance industry in Pakistan. Even though this argument entails further
investigations, this chapter has pointed out the limited effect of various microfi-
nance industries initiated by the Pakistani government. Also we are concerned that
financing against gold-backed loans by Microfinance Banks (MFBs) has gained
widespread popularity in the last few years in Pakistan, which has allowed MFBs to
move from traditional group lending to individual lending and also increase their
loan size. We should watch the evolution of the Pakistani Islamic microfinance
industry, too.
Before closing, we wish to draw some policy options for incubating and enhanc-
ing the Islamic microfinance industry:

• To develop and diversify the funding sources for Islamic MFIs, the role and
scope of Islamic multinational financial institutions such as Islamic Develop-
ment Bank (IDB) should be expanded to meet the demand of loanable funds
by Islamic MFIs. Development of financial schemes (for instance, through
the issuance of Islamic bonds) to get multinational and bilateral donor agen-
cies engaged with the Islamic microfinance industry should be promoted.
• The current mode of PLS should be reviewed from the perspective of pro-
tecting the lenders’ rights in the credit agreement and effectively disciplin-
ing the borrowers. Otherwise, commercially sustainable Islamic microfinance
business is not feasible.
126  Yasushi Suzuki et al.
• The government has to consider the ‘level playing field’ for incubating
Islamic MFIs by giving the opportunity (time) of learning the skill of moni-
toring microenterprises and of expanding their branch network for gaining
the economies of scale. If fair competition between Islamic and conventional
MFIs is ensured, MFIs are expected to bring growth-enhancing effects to
society.

Note
1 According to Parker (2010), an Islamic financial institution is obliged to try to
resolve defaults or late payments through refinancing or restructuring, and any
imposition of late payment charges and fines should be a last resort and should con-
sider the customers’ financial capability and motives.
8 An impact assessment of
Islamic Saving–Loan and
Financing Cooperatives in
Indonesia
Preliminary findings from
the artificial neural networks
technique
Yasushi Suzuki, Saiful Anwar, Sigit Pramono
and Trisiladi Supriyanto

1. Introduction
Currently, the debate on the similarities between Islamic and conventional financial
products has shifted to a more fundamental question – how does Islamic finance
contribute to promoting welfare, building social-cohesion, and realizing social
justice as an ultimate goal of Islamic economics? Abu Zaharah (1997) classifies the
main objectives of Islamic laws into three categories: educating people, establish-
ing justice, and promoting welfare. Many Islamic scholars are concerned about
the so-called Maqasid al-Shari’ah Index as a socio-economic mixture based index
to measure the Islamic bank’s performance comprehensively reflected in financial,
social, material, and spiritual aspects. Imam Satibi is a well-known Islamic scholar
who initially explains the Maqasid al-Shari’ah as a clear vision in practicing Islamic
law. Maqasid al-Shari’ah reflects the holistic view of Islam which has to be looked
at as a whole not in parts as Islam is a complete and integrated code of life and
its goal encompasses the whole life, individual, and society, in this world and the
Hereafter (Abozaid and Dusuki, 2007). According to Imam Satibi, there are five
main objectives of practicing Islamic law: safeguarding the value of faith, rights
and stake-holding, self, intellect, and social entity.
The argument behind this fundamental criticism is to clearly differentiate the
paradigm of doing business in the financial industry following Islamic teaching
in a holistic way. This leads us to ask: Should Islamic banks focus on how to cre-
ate profit as much as possible resulting from Shari’ah-compliant products? Or
should Islamic banking also consider how to narrow down the gap between the
rich and the poor? According to the Islamic economics ‘idealist’ view, Shari’ah
compliance as the ultimately distinguished parameter of Islamic financial institu-
tions (IFIs) means that the IFIs (including Islamic banks) operate not only fol-
lowing the Islamic forms but also following the Islamic spirit or substance. Such
paradigm gives direction and guidance on how to frame the ultimate goals in the
128  Yasushi Suzuki et al.
IFIs according to the spirit and value behind Islamic finance. The idealists respect
Qur’an Surah 59 Verse 7:

Whatever God restored to His Messenger from the inhabitants of the vil-
lages belongs to God, and to the Messenger, and to the relatives, and to the
orphans, and to the poor, and to the wayfarer; so that it may not circulate
solely between the wealthy among you. Whatever the Messenger gives you,
accept it; and whatever he forbids you, abstain from it. And fear God. God is
severe in punishment.

In the idealist view, the operation of Islamic banking should follow the Maqasid
al-Shari’ah in which the ultimate goal is to promote human well-being reflected
on economic and sustainable development, social justice, and social investing-
oriented principles (Asutay, 2012; Chapra, 1992). Some scholars attempt to
measure the unsatisfactory achievement (Martan et. al., 1984; Asutay and Harn-
ingtyas, 2015). The idealists, however, ignore the important dimension such that
banks as depository corporations are expected to pay the best effort to protect the
interest (welfare) of their general depositors to maintain financial stability. For the
purpose of avoiding the potential accumulation of non-performing credits which
may trigger financial instability, in general, banks require the pledge of collateral
for securing their financing. On the other hand, society should consider that poor
people in general are categorized as unbankable or not-credible persons, thus the
collateral condition becomes a serious constraint for poor people to access financ-
ing or credit from banks. Rahim (2007) implies that Islamic microfinance is still
underdeveloped in Islamic finance.
This chapter aims to shed an analytical light on the current impact of Islamic
microfinance – with the case of Islamic Saving–Loan and Financing Cooperatives
in Indonesia – on poverty alleviation. Also this chapter aims to make a meth-
odological contribution to the existing scientific method of impact assessment of
microfinance by introducing the concept of ‘artificial neural networks’. The out-
line of this chapter is as follows: Section 2 has a glimpse of the realities of Islamic
microfinance in Indonesia. Section 3 reviews the limitations of the existing meth-
ods of impact assessment of microfinance. Section 4 describes the methodology in
our analysis and proposes a methodological contribution to the existing scientific
method. We discuss the concept of artificial neural networks. Section 5 argues and
interprets the result of our analysis. Section 6 finally concludes.

2.  The realities of Islamic microfinance in Indonesia

In Indonesia with the largest Muslim population in the world, the government
requires Islamic banks to provide credit or financing facilities to micro-, small- and
medium-sized enterprises (MSMEs) in a minimum amount of 20 percent of the
total credit or financing (Bank Indonesia (BI) Regulation No. 17/12/PBI/2015
dated on June 25, 2015, as the amendment of BI Regulation No. 14/22/
PBI/2012 dated on December 21, 2012). Banks which would fail to fulfill the
 An impact assessment 129
required credit ratio are to be given administrative sanctions by the central bank.
This regulation, however, may have given an ill-incentive for Islamic banks not to
challenge the MSMEs credit risk beyond the minimum ratio (Figure 8.1).
As mentioned earlier, in general, banks as depository corporations have to
pay the best effort to protect the welfare of their depositors. Under the cur-
rent mode of profit-and-loss sharing (PLS), Islamic banks should be kept away
from undertaking very high risk and uncertainty typically associated with the
MSMEs financing. In exchange, society needs another type of IFIs so as to incu-
bate MSMEs for the purpose of poverty alleviation. The main players in the
Islamic microfinance sector in Indonesia include two types of financial institu-
tions, namely ‘Islamic rural banks’ (Bank Pembiayaan Rakyat Syariah, BPRS)
and ‘Islamic microfinance cooperatives’ also known as Baitul Maal wat Tamwil
(BMT) (Bappenas, 2014).
BPRS as the micro-bank institution is regulated and supervised separately from
Islamic commercial banks by Indonesian Financial Services Authority (FSA). The
latter has two forms in its legal entity of Islamic microfinance cooperative, namely
Islamic Financial Services Cooperatives (Koperasi Jasa Keuangan Syariah/
KJKS) which is under the supervision of Ministry of Cooperatives and Small and
Medium Enterprises, and Islamic Micro Financial Institution (Lembaga Keu-
angan Mikro Syariah/LKMS) which is under the supervision of FSA. Islamic
Financial Services Cooperatives are replaced by Islamic Saving–Loan and Financ-
ing Cooperatives (Koperasi Simpan Pinjam dan Pembiayaan Syariah/KSPPS)
based on Decree of Ministry of Cooperatives and Small and Medium Enterprises
No. 16 Year 2015.
As of December 31, 2015 there were 163 BPRSs which operate in all areas
of Indonesia. Meanwhile, there were only 18 units of Islamic Micro Financial
Institution with total asset amounting to Rp 71 billion. In parallel, the number of
Islamic Financial Services Cooperatives was 150,223 units including 4,000 units
of Islamic-based cooperatives consisting of 1,197 units of Islamic Financial Ser-
vices Cooperatives (Koperasi Jasa Keuangan Syariah/KJKS) and 2,163 units of
Islamic Financial Services Unit/Windows (UJKS).

Figure 8.1  Portion of MSME financing in Indonesia’s Islamic Banks

Source: FSA’s Indonesian Banking Statistics
130  Yasushi Suzuki et al.

3. Limitations of existing impact assessment

methodologies of microfinance
Hulme (2000) classifies three paradigms of impact assessment: the scientific
method, the humanities tradition, and participatory learning and action (PLA).
This classification was derived from the literature to improve the standard of
measurement, sampling, and analytical technique. In fact, the existing literature
has resulted in quite diverse conclusions on impact assessment of microfinance.
For instance, Holcombe (1995), Hossain (1988), and Khandker (1998) conclude
that microfinance gives benefits to both economic and social aspects. On the other
hand, Adams and Von Pischke (1992), Buckley (1997), and Montgomery (1996)
assert a different conclusion, that microfinance creates negative impacts on both
the economic and social lives of people. There are researchers such as Hulme and
Mosley (1996) and Mosely and Hulme (1998) who conclude that microfinance is
beneficial economically but somehow does not benefit the poor through poverty
alleviation.
Each paradigm of impact assessment has its own challenges. First, the scientific
method is used to observe the parameters that microfinance could give impact to
economic and social elements through experimentation. Hulme (2000) explains
that this method lies under a specific condition which is perfectly under control.
The statistical method that could be used is multiple regression, however, this
method is rarely being used since the method requires a huge amount of data and
strict assumptions. Otherwise, the research could experience problems of sample
selection bias and misuse of parameters that fail to represent the population. The
second problem lies in the humanities aspect. Hulme (2000) describes that the
humanities tradition method initially belongs to the subjects of geography, rural
sociology, and anthropology. This method is the opposite of the scientific method
since it has nothing to do with statistics, probability, and samples. Due to the high
intention of process involvement, the validity of the humanities tradition method
relies on logical consistency, rigorous material, documents presented as evidence,
degree of triangulation used to validate the evidence, and the quality of methodol-
ogy and researchers. Therefore, the humanities tradition method seems to be quali-
tative, which needs a subjective approach to measure the quality of the research.
The participatory learning and action (PLA) approach of impact assessment
strongly, on the other hand, relies on the side of the poor as the center of study.
The assumption of this method is to cover the connection of parameters in the
complex web. The scientific method is considered failed as it neglects the com-
plexity, diversity, and contingency of winning livelihoods by reducing the com-
plexity to unidirectional connections (Hulme, 2000). However, the problem
addressed in this method is three-fold: (I) subjectivity on conceptualization in
explaining the impact; (II) subjectivity on choosing and using data as parameters
to observe the impact; (III) the condition of variation of a set of parameters used
in different conditions which do not allow the drawing of a comparison.
Needless to say, there is no perfect way to conduct an impact assessment of
microfinance. However, we should continue to challenge the improvement of
 An impact assessment 131
impact assessment in fulfilling Maqasid al-Shari’ah in terms of poverty alleviation
to realize ‘social justice’. Here we attempt to contribute to the scientific method.
First, we adopt a conventional model of impact chain proposed by Hulme (2000)
which assumes that the Islamic microfinance institution acts as an intervention
instrument to change the economic behavior of the poor and practice it some-
how to achieve the desired outcome. We look at the internal variables of agents
being intervened by microfinance institutions, following the work of Schreiner
(2012). These variables include number of household members, education level,
health condition, and economic condition in order to classify which parameters
give the significant impact on poverty alleviation following business development
and community empowerment program in the institution.
This method like other models has the weakness in regard to its assumption.
Schreiner (2012) as the inventor of this method explains that a certain bias could
be occurred since the future relationship between parameters and poverty is
assumed to remain unchanged. However, as Desiere et al. (2015) explain, the
bias could be reduced if the target parent population is not so specific and/or if
the relationship between parameters and poverty is reasonably updated.

4. Methodology
To perform an impact assessment of microfinance on poverty alleviation, this
research utilizes data consisting of 2,440 respondents among 136,675 members
(as of September 2017) of an Islamic-based cooperatives namely KSPPS Benteng
Mikro Indonesia as a case study. The data collection through its five branches is
based on the stratified sampling method in calculating the necessary number of
respondents in accordance with the population in several villages in each specific
district which each branch is covering, so that the assessment may overcome the
self-selection bias problem.

4.1  PPI scorecard

Measuring the impact on poverty alleviation is very complicated mainly because
setting up the criteria for measuring it – how an ‘absolute’ criterion on the poverty
line should be sought and how long we should monitor any positive or negative
impact on poverty alleviation within a certain time frame – is extremely difficult.
Needless to say, the data collection is time-consuming and very costly. In Indone-
sia, the government together with Mark Schreiner developed the Indonesian Pro-
gress out of Poverty Index (PPI) Scorecard as a tool for measuring the national
poverty condition, mainly looking at four variables; the number of household
members, the education level of the family head, the health condition, and the
economic condition of each household (Schreiner, 2012). The scorecard is pre-
pared using the national 2010 socio-economic survey conducted by the national
statistical bureau of Indonesia. This scorecard is widely used as rules of thumb by
Indonesian individuals or organizations to measure the poverty rates in targeted
groups and parent population.
132  Yasushi Suzuki et al.
Schreiner (2012) explains the characteristics of the scorecard which uses ten
parameters in four variables as follows: first, the parameters are selected, taking
into account the cost for data collection, the clarity and coherence of setting the
Q&As, and verifying them and the correlation with the changes in poverty status.
Second, each parameter is quantified using a non-negative-integer score rang-
ing from 0 (suggesting the significant correlation with living most likely below
a poverty line) and 100 (least likely below a poverty line). Third, the parameters
are selected and the score is given for each answer in each parameter according
to the transformed function of statistical Logit coefficient which addresses the
discriminatory power. The higher point is given to the answer which is its power
in distinguishing the poor from the non-poor household is higher or otherwise
(Desiere et.al., 2015) [For instance, for the parameter of ‘number of household
members’, six answers are prepared; (a) six or more, (b) five, (c) four, (d) three,
(e) two, (f) one, then the point to each answers is assigned such as 0 to (a), 5 to
(b), 11 to (c), 18 to (d), 24 to (e), 37 to (f), respectively. As for the parameter of
‘level of education of family head’, seven answers are prepared: (a) never go to
school, (b) elementary school, (c) junior high school, (d) no family head/wife, (e)
senior high school, (f) high school with special package, (g) diploma or bachelor
and above, then the point to each answers is assigned as 0 to (a), 3 to (b), 4 to (c),
4 to (d), 4 to (e), 6 to (f), 18 to (g), respectively. As for the parameter of ‘own-
ership status of a motorcycle/motor boat’, all or nothing answers are prepared,
0 to ‘no’ and 9 to ‘yes’. The details are available at ‘Simple Poverty Scorecard®
Indonesia’]. The parameters are similar to those used in the model introduced by
Noreen (2011) and Goetz and Gupta (1996).
Finally, the total score (PPI Score) is linked to the so-called percentage of pur-
chase power parity (PPP) (see Table 8.1). The linkage of PPI score with the PPP
exhibits the probability of a household that lives below the poverty line. The
Indonesian PPI scorecard shows that, for example, a member in the category
(Layer 3) of 10–14 PPI Score lives, with the probability of 98.3 percent, below
the poverty line upon the US$ 2.50 income per day standard using the 2005
purchase power parity (US$ 2.50–2005 PPP) issued by the World Bank.

4.2  The process of poverty alleviation analysis

The analysis of the member’s poverty status is very important especially for
Islamic Saving–Loan and Financing Cooperatives including KSPPS Benteng
Mikro Indonesia, since the cooperative has set its target for alleviating poverty so
as to make the minimum income per day for each member reach Rp 30,000 or
US$ 2.20. As discussed earlier, the survey of impact assessment on poverty alle-
viation is time-consuming and costly. Therefore, KSPPS Benteng Mikro Indone-
sia is very concerned about the rules of thumb for measuring the poverty rate of
its members.
We calculate each PPI score of 2,440 respondents collected from the members
of KSPPS Benteng Mikro Indonesia to check the member’s poverty rate upon
three criteria for the poverty line: (I) the international standard income of US$
 An impact assessment 133
Table 8.1  PPI scorecard for Indonesia

Layer PPI score PPP (in percentage)

$2.50 100% national

Year 2005 (Indonesian

standard)

 1  0–4 99.6 66.3

 2  5–9 99 60
 3 10–14 98.3 48.4
 4 15–19 96.5 34.1
 5 20–24 95.2 25.2
 6 25–29 91.5 17.3
 7 30–34 87.7 10.3
 8 35–39 79.7 5.8
 9 40–44 68.4 3.2
10 45–49 54.7 1.4
11 50–54 40.1 0.6
12 55–59 26.9 0.2
13 60–64 17.6 0.1
14 65–69 9.1 0
15 70–74 6.9 0
16 75–79 3.7 0
17 80–84 0.2 0
18 85–89 0 0
19 90–94 0 0
20 95–100 0 0
Source: created from Indonesian PPI scorecard

2.50 per day, (II) the national poverty line standard as portrayed in 100 percent
national purchase power parity, (III) the target income level of Rp 30,000 or
US$ 2.20 by using the extrapolated version of PPI scorecard upon the US$
2.50–2005 PPP (we adjust the US$ 2.50–2005 PPP to the scale by [(US$ 2.5 *
Rp 13,630) - (US$ 2.20 * Rp 13,630))/(US$ 2.50 * Rp 13,630)]1 or 14 per-
cent down.
Furthermore, we attempt to apply the method of ‘artificial neural networks’
(or the ANN method) to investigate how the individual factors are affecting pov-
erty alleviation in the members of the cooperative. The cooperative is very con-
cerned with which parameters (factors) would be more contributing to poverty
alleviation for the members. Financial support to a household might be trickled
down to society. Besides, the ANN method is expected to diagnose the hidden
parameters which would be more contributing to alleviating the poverty of mem-
bers in particular.
As mentioned earlier, we follow Schreiner (2012) in selecting input parameters
as follows: number of household members (X1), all members aged 6 to 18 go to
school (X2), level of education of family head (X3), material of the floor (X4),
toilet arrangement (X5), main cooking fuel (X6), ownership status of gas cylinder
134  Yasushi Suzuki et al.
12 Kg (X7), ownership status of freezer (X8), ownership status of a motorcycle/
or motor boat (X9), and the main employment of family head (X10). On the
other hand, we look at the PPI score (Y) as the proxy of life condition in each
household. In passing, it is worth noting the statistical description of each param-
eter’s score collected from 2,440 respondents (see Table 8.2).

4.3  Artificial neural networks

Here we wish to discuss the essence of artificial neural networks. This method
is an early type of machine learning technique which simulates the way of the
human brain in learning and understanding information. The human brain con-
sists of billions of neurons that are interconnected. Specifically, the technique fol-
lows the function of the interconnection of neurons in receiving, processing, and
transferring the valuable information to other neurons. Accordingly, the artificial
neural networks technique is then designed in accordance with the information
structure of neurons which consists of input function, weighted function, sum-
mation function, transformation function, and output function.
The designed structure supports the technique to analyze information result-
ing in pattern recognition which initially comes to input functions. The abil-
ity of this technique in understanding some patterns and translating them into
information depends on the number of training given into the networks. This
optimum number of training process is needed to develop data generalization
and to enhance the potency of networks in improving the performance. Finally,
the generalization ability can be used to perform powerful prediction and clas-
sification tasks.
The process of artificial neural networks in performing either prediction or
classification tasks is as follows: First, there are some inputs coming to the neuron
j marked with symbol x1j, x2j, x3j to xij. Each input that comes into the neuron j has
its different number of weight which differentiates its level of importance. Subse-
quently, the input is processed in the neuron using the activation function. The
function calculates all inputs by summing up all the input value which the initial
value has been multiplied with its respective weight. Furthermore, the calculation
results will be compared to the threshold value which indicates minimum value
that is allowed to be forwarded to other neurons as an output Yj. This threshold

Table 8.2  Statistical description of parameters

Statistical X1 X2 X3 X4 X5 X6 X7 X8 X9 X10 Total PPI

descriptive score score

Minimum 1 0 0 0 0 0 0 0 0 0 6 0%
Maximum 6 2 18 5 4 5 6 8 9 6 64 60%
Median 4 2 3 5 4 5 0 8 9 1 40 3%
Std. deviation 1.2 1 2.6 1.3 1.5 0.9 1.77 3.35 2.85 1.13 8.0 8%
Average 4.03 1.2 4 4.61 3.1 4.84 0.58 6.19 7.98 1.66 38.1 7%
 An impact assessment 135
value is unique for each neuron when the net value originated from the sum-up
calculation is bigger than the threshold value; therefore, the neuron will be acti-
vated to transfer the information as an output to other neurons. Currently, vari-
ous types of activation function can be used in analysis, namely linear, sigmoid,
and logistic.
The utilization of artificial neural networks in research is mostly in the form
of multilayers which comprise sets of neurons (West et.al., 1997). The group of
neurons is then designed to become a specific structure to enhance the power of
prediction making, and more often for doing classification tasks.
There are many techniques which can be used to do classification tasks includ-
ing traditional statistical techniques such as linear discriminant analysis and logis-
tic regression, and data-mining techniques such as artificial neural networks and
support vector machine (Maroco et al., 2011). Specifically, Nur Ozkan-Gunay
and Ozkan (2007) argue that artificial neural networks outperform other statis-
tical techniques such as Multi Discriminant Analysis (MDA) because the tech-
nique has adaptive capabilities in making adjustment of behavior changes of data
distribution in the so-called nonlinear approach by transforming the data into a
linearly separable feature space. Therefore, the technique results in better approx-
imation by adaptively modifying the weighted function to promptly respond to
the changes of data distribution behaviour. Meanwhile, the traditional statistic
technique has limitations since the technique is conducted according to pre-
assumptions that data are distributed in a linear behaviour, so-called multivari-
ate normally distributed. Therefore, most of the traditional statistical techniques
such as MDA will benefit the researchers if the parameters and basic underlying
relationship are always in stable condition.
This is due to the fact that the utilization of artificial neural networks to do
classification tasks has been extensively practiced in many fields (Yang, 2010). For
Islamic banking research, Anwar and Ismal (2011) compare both techniques to
predict the rate of return of Islamic banks’ deposit products which conclude that
artificial neural networks perform better in the context of capturing all patterns of
data. Furthermore, Anwar and Mikami (2011) compare the pattern recognition
ability to do predictions in Islamic banking between traditional statistical tech-
niques and artificial neural networks and conclude that artificial neural networks
result in better abilities in making predictions. The comparison is based on total
classification accuracy and error rate.
To optimize the power of classification, artificial neural networks are con-
structed into multi stages comprising the input layer, the hidden layer functions
as processing the weighted information coming from the input layer, and the
output layer, whereas each layer consists of multi-units of neurons to enhance the
power of classification.
Specifically, the input layer is a set of neurons which perform to collect infor-
mation from outside. Subsequently, the collection of information is then feed
forwarded into the hidden layer which detects the input signal and releases it to
the output layer as an output. The output signal is actually the accumulation of
the activation function of all neurons creating the hidden layer. Mathematically,
136  Yasushi Suzuki et al.
the feed forward multi-layer structure of artificial neural networks is depicted in
the following formula:
yˆt = f ( x , θ ) + ε

where: ŷt is an output value so-called target variable that is intended to be fore-

casted or classified at observation time t. Meanwhile, x is the input variable vector
which functions as an explanatory variable, θ is a weighted parameter of the input
variable, and ε the component of random error. There are two types of activation
functions which can be used to utilize feed forward artificial neural networks,
namely the linear activation function and logistic activation function, both of
which function as classifiers, which is located in the hidden layer. This research
employs the linear activation function due to the output value being modeled
being a numeric value which is formulated as:

f (x ) = x

The classification resulted from this research is evaluated by following the work of
Maroco et.al., (2011) when he classifies mild cognitive impairment among 400
people using two instruments namely sensitivity and specificity. Sensitivity means
the ability to predict the condition when the condition is present meanwhile the
specificity means the ability to predict the absence of the condition when the
condition is not present.
In other words, this research empowers the ability of artificial neural networks
to perform as classifier discriminant to measure the significance of the input
parameters, which would be really contributing to alleviating poverty, in deter-
mining the PPI score as the proxy of life conditions in each household. Finally,
the output value as the classification result is to be evaluated using some statisti-
cal techniques such as R2, correlation coefficient, and actual vs. output graph to
validate that the algorithm fits the data well enough.
This research utilizes the application Alyuda Neuro Intelligence which is
widely used by many big companies for data mining and forecasting needs such
as Microsoft, Hewlett-Packard, Boeing, Coca-Cola, General Electric etc. The
application is used to develop the classifier algorithm which is initially trained in
a certain number of iterations or epochs for a subset of the data, the so-called
train set. The remaining subset of the data is categorized as the validation set
and the test set. In the process of classifier algorithm development, the incre-
ment number of iteration will upgrade the value of weight as an adjustment
process to increase the correction rate of classification power at the same time
to minimize the classification error. There are five subsequent steps conducted
in this research to apply an artificial neural networks-based analysis using Aly-
uda Neuro Intelligence software such as data preparation, data preprocessing,
designing the architecture of the network, training the networks, and testing
the networks.
 An impact assessment 137

5.  Results and discussion

Islamic Saving–Loan and Financing Cooperative (KSPPS) Benteng Mikro Indo-
nesia was established in June 2003 upon the modified Grameen microcredit
model. Later, it officially started its operation upon the Islamic-compliant con-
tract on March 20, 2013 and received its legal entity approval of Islamic Financial
Services Cooperatives by the decree of the Minister of Cooperatives and MSMEs
No. 486/BH/MENEG.I/V/2014.
We had an interview with the president director of KSPPS Benteng Mikro
Indonesia (KSPPS-BMI) on October 27, 2017. According to the primary source,
the number of cooperative members has reached 136,675 persons. KSPPS-BMI
operates to serve those people living in Banten Province and West Java Prov-
ince through five branches. The members of this cooperative are dominated by
women (around 95 percent) and MSMEs entrepreneurs who are engaged mainly
in running retailers, housing, and small restaurants. Basically, KSPPS-BMI offers
its saving and investment accounts to members under the Islamic financial con-
tracts of mudharabah (mudharabah muqayayadah or mudharabah mutlaqha).
Additionally, KSPPS-BMI also channels funds from Islamic commercial banks
and other Islamic microfinance institutions.
On the other hand, the asset side of the cooperative is accumulated mainly
through the Islamic financial contracts of murabaha and ijarah in facilitating the
demand of working capital from the members. The total financing was increased
to Rp 486,221 million as of September 2017, increased by 26 percent from that
in December 2016. Meanwhile, the ratio of non-performing financing (NPF)
stays at about 0.4 percent.

5.1  Poverty rate analysis

The research collects the data from 2,440 respondents to calculate the PPI score
of each household, classifying each of them into 20 categories (layers) according
to PPI scorecard Indonesia. As discussed in Section 4, we check the member’s
poverty rate upon three criteria for the poverty line: (I) the international standard
income of US$ 2.50 per day, (II) the national poverty line standard as portrayed
in 100 percent national purchase power parity, (III) the target income level of Rp
30,000 or US$ 2.20 by using the extrapolated version of PPI scorecard upon the
US$ 2.50–2005 PPP.

5.2  Poverty rate analysis of international standard

KSPPS-BMI’s members are only classified into 12 layers of PPI Score (Table 8.3).
In the highest layer (60 to 64), there are 15 respondents (representing 0.61 per-
cent of the total) who are assumed to live, with the probability of 17.60 percent,
under the poverty line upon the international standard. In contrast, in the lowest
layer, there are 14 respondents or 0.57 percent who are assumed to live, with the
probability of 99 percent, under the poverty line.
138  Yasushi Suzuki et al.
Table 8.3  KSPPS-BMI members’ PPI score and PPP upon the international standard

LAYER PPI score PPI table Number of Portion Average

index respondents of total income/
respondents day
1 60–64 17.60% 15 0.61% 547.533
2 55–59 26.90% 30 1.23% 208.186
3 50–54 40.10% 57 2.34% 254.824
US$ 2.5 2005 PPP

4 44–49 54.70% 288 11.80% 189.204

5 40–44 68.40% 872 35.74% 203.359
6 35–39 79.70% 522 21.39% 182.355
7 30–34 87.70% 310 12.70% 171.266
8 25–29 91.50% 186 7.62% 146.550
9 20–24 95.20% 94 3.85% 131.566
10 15–19 96.55% 38 1.56% 99.647
11 10–14 98.30% 17 0.70% 81.617
12 5–9 99% 14 0.57% 103.000

This result suggests that the majority of the members (representing around
84 percent categorized into Layer 5 and above) are still likely to live under the
poverty line upon the international standard. Also, we should note that the core
members of the KSPPS concentrate on Layer 4 to 7. It is possible that the mar-
ginalized members categorized into Layer 8 and above, who are likely with the
probability of more than 90 percent to live under the poverty line, have very
limited access even to KSPPS.

5.3  Poverty rate analysis of national standard

The Indonesian government defines the poor as people who earn their income
below Rp 374,500 or US$ 27.5 per month upon the latest exchange rate.
According to Indonesian Statistic Bureau, nearly 30 million people are starving
and living below the national poverty threshold. Table 8.4 shows KSPPS-BMI
members’ PPI Score and PPP upon the national standard. There are only 11 per-
sons or 0.5 percent of the population (Layer 12) who have more than 50 percent
probability to live under the poverty line upon the national standard.
It is worth noting here that the income per day of respondents in Layer 12 is higher
than respondents in Layer 10 and 11. Table 8.5 shows the comparison of statistical
description for each parameter. Looking at the difference in the score of X9 (owner-
ship status of a motorcycle/or motor boat) between Layer 10 and 12, this anomaly
might be explained by the hypothesis that the respondents in Layer 12 have to pay
more expenses on public transportation despite earning higher income. However,
explanation of the anomaly between Layer 12 and 11 entails further investigation.

5.4  Poverty rate analysis of KSPPS standard

Table 8.6 shows KSPPS-BMI members’ PPI Score and PPP upon the KSPPS
standard. An income of more than Rp 30,000 or US$ 2.20 per day should be
 An impact assessment 139
Table 8.4  KSPPS-BMI members’ PPI score and PPP upon the national standard

LAYER PPI PPI table Number of Portion Average

score index respondents of total income/
respondents day

1 60–64 0.1% 15 0.6% 547,533

2 55–59 0.2% 30 1.2% 208,187
3 50–54 0.6% 57 2.3% 254,825
4 44–49 1.4% 288 11.8% 202,033
100% national

5 40–44 3.2% 872 35.7% 203,360

6 35–39 5.80% 522 21.4% 182,355
7 30–34 10.3% 310 12.7% 161,525
8 25–29 17.3% 186 7.6% 188,543
9 20–24 25.2% 94 3.9% 131,567
10 15–19 34.1% 38 1.6% 99,647
11 10–14 48.4% 14 0.6% 81,618
12 5–9 60% 11 0.5% 103,000

Table 8.5  Comparison of statistical description for each parameter

Statistical X1 X2 X3 X4 X5 X6 X7 X8 X9 X10
descriptive

Minimum 1.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 LAYER 10
Maximum 6.00 2.00 4.00 5.00 4.00 5.00 6.00 8.00 9.00 3.00
Median 4.00 0.00 3.00 5.00 0.00 5.00 0.00 0.00 0.00 1.00
Std. deviation 1.46 0.92 1.44 2.52 1.73 2.44 0.97 1.81 4.02 0.91
Average 3.92 0.58 2.08 2.76 1.21 3.16 0.16 0.42 2.37 1.24
 
Minimum 1.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 LAYER 11
Maximum 6.00 0.00 3.00 5.00 0.00 5.00 0.00 0.00 0.00 1.00
Median 2.50 0.00 0.00 2.50 0.00 0.00 0.00 0.00 0.00 0.50
Std. deviation 1.58 0.00 0.95 2.64 0.00 2.42 0.00 0.00 0.00 0.53
Average 2.60 0.00 0.30 2.50 0.00 1.50 0.00 0.00 0.00 0.50
 
Minimum 1.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 LAYER 12
Maximum 6.00 0.00 3.00 5.00 0.00 5.00 0.00 0.00 0.00 1.00
Median 2.50 0.00 0.00 2.50 0.00 0.00 0.00 0.00 0.00 0.50
Std. deviation 1.58 0.00 0.95 2.64 0.00 2.42 0.00 0.00 0.00 0.53
Average 2.60 0.00 0.30 2.50 0.00 1.50 0.00 0.00 0.00 0.50

earned by its members. We find that KSPPS-BMI is still far away from achieving
the target. As depicted in the table, there are only 520 respondents or 21.31 per-
cent among the population who have below a 50 percent probability of living
under the poverty line.

5.5  Artificial neural networks

As mentioned earlier, the utilization of artificial neural networks is addressed to
classify the variables that give the most significant impact on determining the
140  Yasushi Suzuki et al.
Table 8.6  KSPPS-BMI members’ PPI score and PPP upon the KSPPS standard

LAYER PPI score PPI table Number of Portion of total Average

index respondents respondents income/day

1 70–74 6.9% 12 0.49% 614,999

2 65–69 9.10% 21 0.86% 231,742
3 60–64 17.60% 22 0.90% 176,986
4 55–59 26.90% 89 3.65% 246,602
US$ 2.5 extrapolated

5 50–54 40.10% 376 15.41% 197,815

6 44–49 54.70% 742 30.41% 204,889
7 40–44 68.4% 522 21.39% 182,355
8 35–39 79.70% 257 10.53% 166,055
9 30–34 87.70% 204 8.36% 188,305
10 25–29 91.50% 97 3.98% 130,535
11 20–24 95.20% 57 2.34% 114,722
12 15–19 96.50% 19 0.78% 76,342
13 10–14 98.3% 13 0.53% 80,348
14 5–9 99% 8 0.33% 116,250

probability of KSPPS-BMI’s members of living below the poverty line. In this

regard, the data has been partitioned into three sets using random method as
follows: the training set (a set of data that is used for training the networks)
amounted to 68 percent of data, the validation set (a set of data that is used to
validate the training process) amounted to 16 percent of data, and the test set
(a set of data that is used to test the learning process of networks) amounted to
16 percent of data. In this preparation step, we set up 10 variables (X1, X2, X3,
X4, X5, X6, X7, X8, X9, X10) as numeric and the others as categorical (Name,
Villages, and Branches).
Further, we performed the preprocessing step to transform both the numerical
and categorical variables into scaled-encoded numeric columns. This step also
helps to encode the date and time variables to transfer source data into a con-
venient form for artificial neural networks analysis. As a result, we encoded 255
columns with scaling range of [-1,1]. Subsequently, we design the networks to
perform further learning and adaptation processes. In this step, some parameters
are set up as follow: (I) The input activation function is a linear function. (II) The
output name is Score PPI. (III) The output error function is a sum-of-squares
function. (IV) The output activation function is linear. The result of this step is
a design of artificial neural networks architecture that consists of 342 neurons
in the input layer, 2 neurons in the hidden layer, and 1 neuron in the output
layer. The specific network to do PPI score classification is selected according
to the proper fitness parameters of networks architecture as follows: (I) fitness
value (0.860982), (II) train error value (0.044511), (III) validation error value
(0.043639), (IV) correlation value (92.80 percent), and (V) R-squared value
(86.09 percent).
 An impact assessment 141
The next step is training the networks. In this step, we trained the artificial neu-
ral networks to adapt and learn the behavior changes of data distribution. In this
regard, we set up some training parameters as follows: (I) The training algorithm
used is quick propagation in which parameters are set using 1.75 of quick propa-
gation coefficient and 0.1 of learning rate. (II) The training process is stopped
under certain conditions which are: Network MSE is 0.0000001 or 20.000 itera-
tions, whichever comes first, and data set error is 0.0000001 or 20.000 iterations,
whichever comes first.
Accordingly, the networks are trained; the process is depicted in Figure 8.2. The
network error and R-squared figure describe the speed of networks in improving
its forecasting ability. The ability actually shows us how good the networks are
in adapting and learning the behavior changes of data distribution which brings
the consequence that the networks will be able to make forecasts accurately. The
networks successfully achieve the smallest network error at 12.000 iterations,
meanwhile the best R-squared value is achieved before 2.000 iterations which
depicts the goodness of fit in performing classification assignment. The training
process is stopped when the value of R-squared almost reaches the threshold (1).
It means that the variance of input variables will be correctly reproduced over
learning processes.
The training process is crucial since it produces the input importance rate that
indicates which variables give the strongest influence on the networks, as follows:

 1 Ownership status of motorcycle or motor boat (X9) with the importance

rate of 31.08 percent.
  2 Ownership status of freezer (X8) with that of 25.80 percent.
  3 Level of education of family head (X3) with that of 10.53 percent.
  4 Number of household members (X1) with that of 8.89 percent.
  5 Material of the floor (X4) with that of 8.20 percent.
  6 Toilet arrangement (X5) with that of 7.02 percent.
  7 Main cooking fuel (X6) with that of 2.54 percent.
  8 The main employment of family head (X10) with that of 2.29 percent.
  9 Ownership status of gas cylinder 12 Kg (X7) with that of 0.72 percent.
10 All members age 6–18 go to school (X2) with that of 0.19 percent.

As the final step, the networks testing process is to validate the classification
process which results in the significant variables which determine the PPI Score.
As shown in Figure 8.3, the result is convincing enough to say that artificial neural
networks have performed very well in learning and adapting the changes of 2,440
data collected from the respondents according to correlation value (94.88 per-
cent), R-squared value (88.99 percent), and mean absolute error (0.038009).

6. Conclusion
This chapter aimed to shed an analytical light on the current impact of Islamic
microfinance – with the case of an Islamic Saving–Loan and Financing Cooperative
Figure 8.2  The networks training process
Figure 8.3  The validation evidence of artificial neural networks performance
144  Yasushi Suzuki et al.
in Indonesia – over poverty alleviation. We calculated the PPI Score represent-
ing their life condition from the respondents of the members of KSPPS Benteng
Mikro Indonesia to estimate how many of their clients are likely to live under the
poverty line upon the international standard, the national standard in Indonesia,
and the KSPPS target, respectively. First of all, we should say that the national
standard is a bit indulgent. In other words, it is applauded that KSPPS-BMI has
set its target line which is closer to the international standard. Simultaneously, we
find that even upon the KSPPS standard, around 78 percent of the respondents
are likely to live under the poverty line (around 84 percent upon the interna-
tional standard). We should be worried that the outreach of Islamic Saving–Loan
and Financing Cooperatives to marginalized clients is perhaps very limited in
Indonesia, though further examination on other KSPPS is required to make our
hypothesis more conclusive.
This chapter also aimed to make a methodological contribution to the exist-
ing scientific method of impact assessment of microfinance by introducing the
concept of ‘artificial neural networks’. The training process in the ANN method
is to produce the input importance rate that indicates which variables give the
strongest influence on the networks. In this case of the respondents of KSPPS-
BMI, we find that the variables of ‘ownership status of motorcycle or motor boat’
and ‘ownership status of freezer’ contribute on the networks much more greatly
than the variables of ‘number of household members’ and ‘level of education of
family head’ which are considered critical factors in the conventional methods
like the PPI scorecard.
We may point out that the ANN method identifies a certain bias in the PPI
scorecard utilization in KSPPS, though these preliminary findings entail further
clarification. The ‘all or nothing’ scale for the variables of ‘ownership status of
motorcycle or motor boat’ and ‘ownership status of freezer’ in the PPI score-
card should be reviewed. On the other hand, taking into consideration that the
median values of these variables have reached the assigned maximum values (see
Table 8.2), we could say that further improvement of these ownership statuses
may contribute less to the PPI Score. In the parent population of this survey, we
may hypothesize that the answers to the variables of ‘number of household mem-
bers’ and ‘level of education of family head’, which are considered critical factors
in the conventional method, might be narrowly distributed. If this hypothesis
cannot be rejected, the lower importance rate indicated by the ANN method may
suggest a higher potential for alleviating the poverty rate further. The interpreta-
tion of the result upon the ANN method entails further testing. To facilitate the
discussion on how well or poorly Islamic finance could contribute to poverty
alleviation, the method of impact assessment should be critically assessed for its
improvement.

Note
1 We refer to the Rupiah/US$ exchange rate on November 2, 2017.
Part III

Dilemmas and challenges

in governance structure
9 Anatomy of governance
structure in the mode of
Islamic finance
An emphasis on the governance
over Shari’ah boards
Yasushi Suzuki, Sigit Pramono and Oni Sahroni

1. Introduction
There is little doubt that the role of the board members and advisors in the
Shari’ah Supervisory Board (SSB) or the Shari’ah Committee, called in general
‘Shari’ah board’ (SB), is inevitable in Islamic finance. Islamic Financial Institu-
tions (IFIs) are usually governed by two boards; Board of Directors (BoD) and
SB. The BoD has the same roles and characteristics of any traditional board,
but the SB has a unique role of ensuring that all the IFIs are Shari’ah compliant
(Garas and Pierce, 2010; Ginena and Hamid, 2015; Hassan, 2012). All the busi-
ness and financial contracts in the framework of Islamic finance have to conform
to the Shari’ah rules with the objective of helping to achieve Maqasid (objectives)
al-Shari’ah. Shari’ah refers to a code of law or divine injunctions that regulate the
conduct of human beings in their individual and collective lives (Ayub, 2007).
The idea is having an SB to provide a third-party assurance – a proper ‘check and
balance’ – that Shari’ah compliance is not being compromised. Besides, an SB
is expected to provide the Shari’ah endorsement of the products dealt by IFIs
(Bakar, 2016).
What are the expected duties and responsibilities undertaken by the SB mem-
bers? For instance, the Shari’ah Governance Framework for the Islamic Financial
Institutions 2010 (BNM, 2010) introduced by Central Bank of Malaysia (Bank
Negara Malaysia) provides a comprehensive guidance to the Shari’ah Committee
members in discharging their duties and responsibilities for matters relating to
Shari’ah. Their main duties and responsibilities are as follows: (a) to be respon-
sible and accountable for all Shari’ah decisions, opinions and views provided by
them. (b) To advise the board and provide input to the IFI on Shari’ah mat-
ters in order for the IFI to comply with Shari’ah principles at all times. (c) To
endorse Shari’ah policies and procedures prepared by the IFI and to ensure that
the contents do not contain any elements which are not in line with Shari’ah.
(d) To endorse and validate relevant documentations including the terms and
conditions contained in the forms, contracts, agreements or other legal docu-
mentations used in executing the transactions; and the product manual, market-
ing advertisements, sales illustrations and brochures used to describe the product
148  Yasushi Suzuki et al.
comply with Shari’ah principles. (e) To assess whether the works carried out by
Shari’ah review and Shari’ah audit are in order and compliance with Shari’ah
matters which form part of their duties in providing their assessment of Shari’ah
compliance and assurance information in the annual report. (f) To assist related
parties of the IFI such as its legal counsel, auditor or consultant who seeks advice
on Shari’ah matters from the Shari’ah Committee. (g) To advise on Shari’ah
matters to be referred to the Shari’ah Advisory Council (SAC, Malaysian two-tier
Shari’ah governance structure is discussed later) that could not be resolved. (h)
To provide written Shari’ah opinions in circumstances where the IFI make refer-
ence to the SAC for further deliberation, or where the IFI submits applications to
the Central Bank of Malaysia (Bank Negara Malaysia) for new product approval.
Lewis and Algaoud (2001) opine that the SB has a vital role in the Islamic bank’s
corporate governance structure for two reasons. First, to ensure that the bank’s
operations are in accordance with Shari’ah principles and to maintain this com-
pliance at all levels of the bank’s organization. Second, the adherence to Islamic
principles in conducting their business will become a response to the potential
incentive problem and the agency theory issues in Islamic banks.
Nevertheless, it is worth noting that the position and role of SB has been
changed in accordance with the development of Islamic banking and finance.
As Nienhaus (2007) points out, at the primitive stage in development, SB was
perceived, in general, as strictly conservative. However, as recent technological
changes and intensifying uncertainty make the management of Islamic banking
more complex, the practices by SB are increasingly being criticized as very per-
missive. Under this circumstance, it is becoming more important to review and
well-design the SSB’s duties and responsibilities for ensuring Shari’ah compliance
in IFIs’ business operations, while avoiding a ‘merely procedural’ adherence to
Islamic principles.
To ensure that all these duties and responsibilities are carried out accordingly,
many scholars have admitted that SB must be independent (Nienhaus, 2007; Sya-
fei, 2010; Garas and Pierce, 2010; Othman et al., 2013). According to Govern-
ance Standard for Islamic Financial Institutions No. 5, independence is defined
as “an attitude of mind which does not allow the viewpoint and conclusions of its
possessor to become reliant on or subordinate to the influences and pressures of
conflicting interests. It is achieved through organizational status and objectivity”
(AAOIFI, 2002, p. 44). Mautz and Sharaf (1961) refer to a categorization of
independency as a “supervisory and audit function”, pointing out that the SB’s
independence should include practitioners’ independence in terms of performing
their duties and responsibilities based on proper competence and capability. In
addition, they point out that SB should have professional independence in order
to make their decision-making unbiased and objective. Simultaneously we should
be aware of the necessity of preparing a number of mechanisms in Shari’ah gov-
ernance, including its members’ appointment, composition, function and remu-
neration, to maintain SB’s independence in the mentioned multiple contexts.
On the other hand, there exist potential conflicts of interest as well as “a huge
paradox” (Bakar, 2016) between Shari’ah scholars and the other stakeholders
 Anatomy of governance structure 149
under the situation that the SB is appointed and remunerated by the financial
institutions. This chapter aims to shed an analytical light on this paradox and to
draw a prescription for it.
Section 2 aims to overview the multiple principal–agent structure in the mode
of Islamic finance. Section 3 argues the current practices in nominating and
decision-making process of the SB in Malaysia and Indonesia. Section 4 looks
at an inside story of an SB member. Section 5 aims to draw a prescription upon
the essence of the UK Corporate Governance Code. Section 6 presents the
conclusion.

2. Anatomy of governance structure in the mode of

Islamic finance
In the theory of microeconomics, the principal (P)–agent (A) problem of causing
various types of ‘market failure’ such as moral hazard, adverse selection and credit
crunch, may arise in the structure where (i) P cannot perfectly monitor A’s activi-
ties, and/or (ii) P tends to think that the information held by P is too coarse for
P’s decision-making compared to that held by A (this is called as the asymmetry
of information between the economic players).
To begin with, let us overview the multiple principal (P)–agent (A) structure
in the mode of Islamic finance (see Figure 9.1); [1] Depositors (P)–Islamic banks
(A): In the profit–loss sharing (PLS) mode of Islamic finance, the depositors are
expected to share the risk and uncertainty which the Islamic banks are under-
taking and sharing with their borrowers. Under the P–A structure where the
depositors face the difficulty of screening and monitoring the skill of credit risk
management in each Islamic bank, the depositors would have hesitated to place
their funds as deposits to any bank. In practice, however, the depositors are not
often asked to share the loss that the Islamic banks made. The banks would
rather not lose their reputation which would be lost by sharing the loss with their
depositors. The so-called displacement commercial risk by the depositors to with-
draw their deposit from the banks that lost the reputation and confidence would
discourage the banks to share any loss even if they made it. In this customary

P A
Regulator(s) [5] Shari’ah Board

P P

[3] [4]

P [1] A A A P [2] A

Depositors Islamic Banks Client firms

(lenders) (borrowers)

Figure 9.1  Multiple principal–agent structure in the mode of Islamic finance

150  Yasushi Suzuki et al.
practice, it appears that many depositors are not ready to share the loss. In this
context, the typical problems from the P–A structure between depositors and
banks would not often occur. Most depositors do not have strong incentives to
monitor the banks on their own. Basically, it is considered in this mode that the
depositors delegate the role of monitoring Islamic banks to the regulator and the
Shari’ah board. On the other hand, the customary practice mentioned earlier in
this chapter may have given a certain bias on the credit policy undertaken by the
Islamic banks.
[2] Islamic Banks (P)–Client firms (A): In the PLS mode of Islamic finance, the
Islamic banks as lenders are expected to share the profit and loss with the client
firms as borrowers. Under the P–A structure without any condition of mitigating
the information asymmetry or supporting the lender’s limited capacity of moni-
toring, the banks would hesitate to invest in the borrowers, which may cause the
‘credit crunch’ situation. As was argued earlier, Islamic banks are, in practice,
discouraged to share losses with their depositors. The ‘displacement commercial
risk’ makes the banks’ policy of portfolio selection ‘risk-averse’. The so-called
murabaha syndrome is due partly to this structure. Besides, the PLS structure
may give the borrowers an ill-incentive of causing ‘moral hazard’. For instance,
in the current mode of Islamic banking, the banks are not allowed to charge any
penalty as a threat on the borrowers for avoiding the occurrence of their delayed
payment, because that situation calls for the loss sharing in accordance with a core
principle of Islamic banking. This limited ‘sanction’ mechanism in contracting
for protecting the lender’s right may have given the banks and the borrowers an
ill-incentive of causing ‘credit crunch’ and ‘moral hazard’. Therefore, the regula-
tor is expected to design an appropriate institutional framework for reasonably
protecting the lender’s right in contracting.
[3] Regulator (P)–Islamic Banks (A): Basically, the regulator tends to think
that the regulator cannot perfectly monitor the regulated banks’ activities. There-
fore, it is intrinsically difficult for the regulator to find such an appropriate regu-
lation that is not too severe as well as not too relaxed so as to avoid giving any
ill-incentive to the regulated banks. If the regulation on banks is too severe,
it would discourage the banks to mediate financial resources to the borrowers.
If the regulation on banks is too gentle, for instance, the regulator’s commit-
ment to bail any bank out of any dismal portfolio, it would give a moral hazard
effect on the banks to challenge high risk–high return-type investments even
upon non-prominent monitoring skills, perhaps accumulating non-performing
loans (NPL), consequently triggering the contagious runs by the bankruptcy of
the troubled bank as a result of the accumulation of NPL. This is a systemic risk
embedded in the banking industry.
[4] Shari’ah Board (P)–Islamic Banks (A): In the mode of Islamic finance,
how the regulated banks comply the Shari’ah rules should be monitored. The
regulator’s limited capacity for supervising the regulated Islamic banks, particu-
larly in the dimension of Shari’ah compliance, may urge the regulator to expect
the role of SB. The idea of having an SB is to provide a third-party assurance – a
proper ‘check and balance’ – that Shari’ah compliance is not being compromised.
 Anatomy of governance structure 151
Besides, an SB is expected to provide the Shari’ah endorsement of the products
dealt by Islamic financial institutions (Bakar, 2016). However, in theory, the SB
members tend to think that they cannot perfectly monitor the Islamic banks’
activities. Besides, there exist potential conflicts of interest as well as ‘a huge para-
dox’ between Shari’ah scholars and the other stakeholders under the situation
that the SB is appointed and remunerated by the financial institutions (Bakar,
2016). This leads us to ask, how can a proper check and balance be institutionally
ensured?
[5] Regulator (P)–Shari’ah Board (A): According to Bakar (2016), there
are two approaches in regulating SBs by regulators. In some jurisdictions like
Malaysia, Sudan, Bahrain and Oman, the respective regulator will take the lead
in providing the framework governing the SBs, either at the central bank or at
the individual banks. These regulators would apply the same standard of robust-
ness and due diligence on SB members as applied to other organs of the Islamic
financial institution, such as the Board of Directors, appointment of the CEOs,
the appointment of external auditors etc. Other regulators, on the other hand,
would expect the individual Islamic financial institution to have their own inter-
nal standards and governance in dealing with their SB. (Bakar, 2016, p. 43). In
the case of Malaysia, the National Shari’ah Advisory Council at the Central Bank
(as well as the Securities Commission Malaysia) also needs to engage with the
respective court of law quite actively, particularly when the courts refer Islamic
finance to the Council to get its Shari’ah views. In essence, the Shari’ah Advisory
Council will go through all the affidavits and submissions by both parties, namely
the plaintiff and defendant, to identify the Shari’ah issue (if any) that needs a
Shari’ah view (Bakar, 2016, p. 44).
As pointed out by a Shari’ah scholar, Dr Mohd Daud Bakar, at this point
in time, in general, the Shari’ah advisors are not governed by any specific reg-
ulation. Therefore, “checks and balances, which is integral to any governance
requirement may be lacking” (Bakar, 2016, p. 69). Though there is a standard
by AAOIFI on the administrative procedures for the appointment of Shari’ah
scholars and its related matters, “it is void of any governance language to provide
a kind of checks and balances for the Shari’ah scholars” (ibid., p. 69).

3. Current practices in nominating and decision-making

process in the Shari’ah board
This section aims to describe the current practices in nominating and decision-
making process in the Shari’ah board in Malaysia and Indonesia, respectively. The
characteristics in each mode are summarized in Table 9.1.

3.1 Malaysia
As is mentioned earlier, Central Bank of Malaysia (CBM) has introduced a two-
tier Shari’ah governance infrastructure comprising two vital components, (i)
the Shari’ah Advisory Council (SAC) which is a centralized Shari’ah advisory
152  Yasushi Suzuki et al.
Table 9.1 Comparison of the governance mode over the Shari’ah board between
Malaysia and Indonesia

Malaysia Indonesia

Governance Two-tier Shari’ah Two-tier Shari’ah

structure governance: Shari’ah governance:
Advisory Council at National Shari’ah Advisory
Central Bank and Council (Dewan Syariah
Shari’ah Committee in Nasional, ‘DSN’) at the
each IFIs. Indonesian Ulama Council
(Majelis Ulama Indonesia/
MUI) and Shari’ah
Supervisory Board
(Dewan Pengawas Syariah,
‘DPS’) in each IFIs.
Nominating Appointed by the Appointed by the DSN
process BoD upon the upon the recommendation
recommendation of its and nomination from
Nomination Committee, BoD of each IFIs. The
subject to prior written appointment shall be valid
approval of the Central for a renewable term of
Bank. The appointment four years.
shall be valid for a
renewable term of two
years.
Number of SB Five in most of the IFIs. At least three members in
members each IFI.
Decision-making Voting by majority. Consensus among the SSB
process Opinions of the minority members and voting for
are to be written in the last alternate decision-
fatwa. making procedure.

body at CBM and (ii) the Shari’ah Committee which is an internal Shari’ah
body formed in each respective IFI. This is important in ensuring that the over-
all Islamic financial system in Malaysia operates in accordance with the Shari’ah
principles (Othman et al., 2013). In 2010, CBM developed, introduced and
issued the Shari’ah Governance Framework for the Islamic Financial Institutions
with the primary objective of enhancing the role of the Board of Directors
(BoD), the Shari’ah Committee and the management in relation to Shari’ah
matters, including enhancing the relevant key organs having the responsibility to
execute the Shari’ah compliance and research functions aimed at the attainment
of a Shari’ah-based operating environment.
BNM (2010) has mentioned clearly that the Shari’ah Committee members shall
be appointed by the BoD upon the recommendation of its Nomination Commit-
tee. The appointment and reappointment of a Shari’ah Committee member shall
obtain prior written approval of Bank Negara Malaysia. The appointment shall
be valid for a renewable term of two years. In approving the appointment and
reappointment, Bank Negara Malaysia may impose necessary conditions it deems
 Anatomy of governance structure 153
fit in addition to the requirements in these guidelines. The failure to comply with
any of such conditions shall nullify the approval.
The members of the Shari’ah Committee shall be persons of acceptable reputa-
tion, character and integrity. Bank Negara Malaysia reserves the right to disqual-
ify any member who fails to meet the requirements. In particular, any member
may be disqualified due to any of the following breach of corporate governance:
(i) he has acted in a manner which may cast doubt on his fitness to hold the posi-
tion of a Shari’ah Committee member; (ii) he has failed to attend 75 percent of
meetings scheduled for Shari’ah Committee in a year without reasonable excuse;
(iii) he has been declared a bankrupt, or a petition under bankruptcy laws is filed
against him; (iv) he was found guilty for any serious criminal offence, or any other
offence punishable with imprisonment of one year or more; or (v) he is sub-
ject to any order of detention, supervision, restricted residence or banishment.
Whereupon the discovery of any fact that any member of a Shari’ah Committee
becomes subject to any ground of disqualification or otherwise becomes unfit to
hold such appointment as provided in these guidelines and/or in the letter of
approval from Bank Negara Malaysia, the Islamic financial institution shall termi-
nate the appointment of the Shari’ah member.
The number of Shari’ah Committee members to be appointed must not be less
than three. Othman et al. (2013), through their research by distributing and col-
lecting the questionnaire to the respondents who are involved in IFI industries,
report that most of the institutions have five members of Shari’ah Committee.
Additionally, 75.3 percent of the respondents mention that they have five mem-
bers, 16.0 percent of the respondents have more than five members while only
8.6 percent of respondents have fewer than five members. This is a very good
indication as about 92.4 percent of the institutions have achieved the required
numbers of the Shari’ah Committee members.
It is also the requirement of BNM (2010) that the majority of Shari’ah Com-
mittee members must possess strong knowledge in Shari’ah and be backed by
the appropriate qualifications in that area. In this regard, every IFI is required
to establish a Shari’ah Committee of which the majority shall comprise persons
with appropriate qualifications and experience in Shari’ah. The competency and
credibility of the Shari’ah Committee members provide the assurance that the
IFI’s operations are being monitored by a credible and competent committee.
A member of a Shari’ah Committee shall be an individual. A company, insti-
tution or body shall not constitute a Shari’ah Committee for the purpose of
these guidelines. The proposed member of the Shari’ah Committee shall at least
either have qualification or possess necessary knowledge, expertise or experience
in the following areas: (i) Islamic jurisprudence (Usul al-Fiqh); or (ii) Islamic
transaction/commercial law (Fiqh al-Mu’amalat). It should however be noted
that paper qualification on these subjects will not be mandatory as long as the
candidate has the necessary expertise or experience in the areas specified in the
qualifications list.
According to the survey by Othman et al. (2013), among the IFIs that have
five Shari’ah Committee members (N=59), 44.1 percent (26 IFIs) assign five
154  Yasushi Suzuki et al.
Shari’ah Committee members who possess Shari’ah qualification, 40.7 percent
(24 IFIs) do four, 15.2 percent (9 IFIs) do three. The requirement that each of
the IFI must have a majority of Shari’ah Committee possess Shari’ah qualifica-
tion was fulfilled. From another point of view, we may say that almost half of IFIs
does not diversify the composition of SB to non-Shari’ah professionals.

3.1 Indonesia
In 1999, for the purpose of setting up the Shari’ah governance arrangement,
the Indonesian Ulama Council (Majelis Ulama Indonesia, ‘MUI’) established
the National Shari’ah Board (Dewan Syariah Nasional, ‘DSN’) in accordance
with the Decree No. 754/MUI/II/1999. MUI is an organization of Islamic
scholars (Ulama) in Indonesia which has its mission in empowerment, education
and Islamic preaching programs for Muslim people. MUI was founded on 26
July 1975 in Jakarta upon the agreement in a convention that was attended by a
large number of Islamic scholars and Muslim leaders who came from the majority
of provinces over the nation. This event was known as ‘the National Congress of
Ulama I’ and it released ‘MUI establishment charter’. Specifically, MUI became
an advisory body that takes a guiding role by giving religious decrees (fatwa)
dealing with all the Shari’ah issues related from the individual life to the nation’s
matter. In this sense, MUI is perceived as a quasi-autonomous non-governmental
organization in which it has been transformed to be a channel of aspiration for
Muslim groups to influence government policies and benefitted from a special
connection with the state (Lindsey, 2012; Choiruzzad and Nugroho, 2013).
The main responsibility of the National Shari’ah Board is to prepare Shari’ah
regulatory support to the Islamic banking and finance industries (DSN-MUI and
BI, 2006). Thus, the National Shari’ah Board has an important role in creating
public trust and awareness of the Shari’ah compliance matters of the Islamic
banking industry. It is worth noting that the National Shari’ah Board is an inde-
pendent body from Bank Indonesia (Central Bank) or Financial Service Author-
ity (FSA) interventions. This mechanism is different from the Shari’ah regulatory
arrangement practiced in a number of other countries in support of Islamic bank-
ing. For instance, in Malaysia, the National Shari’ah Advisory Council (NSAC)
as Shari’ah standards and regulatory body is placed under the control of Bank
Negara Malaysia (BNM, the central bank) so that the NSAC seemingly is not an
independent body from which the BNM’s policy intervenes.
Similar to the Shari’ah governance structure in Malaysia, Indonesia has imple-
mented a two-tier Shari’ah governance infrastructure through (i) the National
Shari’ah Board as the Shari’ah opinion/fatwa-issuing body and comprehensively
supervisory body for Shari’ah adherence in all IFIs, and (ii) Shari’ah Supervisory
Board (SSB) as a Shari’ah compliance supervisory body which internally func-
tions in each respective IFI.
In accordance with the Decree No. 3 Year 2000 of DSN (DSN-MUI and BI,
2006), each IFI in Indonesia should assign at least three members of their SSB.
SSB members have to be approved by the DSN upon the recommendation and
 Anatomy of governance structure 155
nomination from the BoD of each IFI. The remuneration of SSB is paid by each
IFI. Some scholars and practitioners cast doubt on this mechanism which may
cause conflicts of interest. Syafei (2010) reports that many Islamic bank managers
consider that an alternative remuneration mechanism, for instance, fully remu-
nerated by the regulator (e.g. Bank Indonesia, the central bank) would avoid the
potential conflict of interest to improve the independence of the SSB.
The appointment for SSB members shall be valid for a renewable term of four
years. Related to the concurrent position as member of SSB, this decree has
arranged that every member of SSB in IFIs is only allowed to hold the maximum
position in two Islamic banks and two non-bank Islamic financial institutions
simultaneously. In the SSB’s decision-making process, it is worth noting that
seeking consensus among the SSB members is outweighed and voting is the last
alternate in practice.

4.  An inside story of a Shari’ah scholar

If the Shari’ah advisors are not governed by any specific regulation, as pointed
by Bakar (2016), the performance would depend on the morale of the board
members. Now, let us look at an inside story of a Shari’ah scholar. Dr Mohd
Daud Bakar published a book in 2016, titled Shariah Minds in Islamic Finance.
Having reflected on the author’s 20 years of experience as a member as well as the
chairman of many Shari’ah boards around the globe, this book offers an insight-
ful work to shed light on the inner workings of ‘Shari’ah minds’ in dealing with
Shari’ah advisory, and how Shari’ah scholars respond to innovation as well as
bottlenecks in a contemporary regulatory framework (Bakar, 2016).
In this book, the author begins with the explanation of what is the minimum
quality and quantity of the knowledge that would make a person a Shari’ah
scholar in Islamic finance (Bakar, 2016, Chapter 1). While admitting certain con-
tributions in various ways by non-Shari’ah qualified or trained members of the
SB, the author insists that only qualified and trained Shari’ah scholars or the
majority of the Shari’ah minds are eligible to undertake the great responsibility
of issuing any fatwa. The author raises three rules to be a Shari’ah scholar: First,
to acknowledge that he/she is working in an environment that is not perfect and
still requiring Shari’ah solutions. Second, to be cognisant that Shari’ah scholars
do not work in isolation. Lastly, the most important aspect is to possess ‘humil-
ity’. Good intellectual knowledge of both the Shari’ah and modern finance, as
well as a good personality, are emphasized here. Then, he describes the roles of
Shari’ah scholars in the industry of Islamic finance. The main function of the
scholars is to provide assurance on Shari’ah compliance. The author describes
the real working process of Shari’ah boards to draw the description of Shari’ah
compliance as an apparatus of ‘prevention’ (Chapter 2). The author insists that
the idea of having a Shari’ah board is to provide a third-party assurance – a
proper ‘check and balance’ – that Shari’ah compliance is not being compromised.
Besides, a Shari’ah board is expected to provide the Shari’ah endorsement of
the products dealt by Islamic financial institutions (Chapter 4). He explains the
156  Yasushi Suzuki et al.
Shari’ah minds which need to deal with both Shari’ah rulings (which are Divine)
and fiqh rulings (which are human in character). The author refers to the process
of ijtihad, using one’s best endeavours to arrive at the intended rulings of Allah
the Almighty (Chapter 7). He also mentions the Shari’ah scholars’ contributions
to the Islamic finance industry. These contributions include: to install general
‘confidence’ by all the stakeholders in the industry, to establish a more robust
Shari’ah compliance due diligence process, to brand Islamic finance by undertak-
ing the role as ‘global ambassadors’ (Chapter 10).
Meanwhile, as mentioned earlier, the author describes potential conflicts of
interest as well as ‘a huge paradox’ between Shari’ah scholars and the other stake-
holders under the situation that the Shari’ah board is appointed and remunerated
by the financial institutions (Chapter 8). He also refers to the concept of Shari’ah
governance for Shari’ah scholars themselves (Chapter 3). He answers the ques-
tion on how a Shari’ah scholar understands and scrutinizes financial products.
Shari’ah advisory is, in his view, a daily learning process but all the experiences are
stored in their brain for future use, consequently contributing to reach a Shari’ah
solution for the development of the industry of Islamic finance (Chapter 5). The
author raises a counter argument against the view of labelling the Shari’ah schol-
ars as the ‘Shari’ah-compliant’ proponents of mimicking conventional products.
The author insists that the Shari’ah scholars would welcome and praise the move
towards developing totally new structures and behaviours of Islamic financial
products as ‘Shari’ah based’ (Chapter 6).
Unlike conventional banks, Islamic banks have to absorb not only the credit
risk but also the risk associated with the compliance of Shari’ah. In theory, the
profit (the margin for security) earned by Islamic banks has to cover the neces-
sary time and effort, what the economists call ‘transaction cost’, for seeking the
compliance to maintain their reputation as prudent Shari’ah compliant lenders.
In economics textbooks ‘transaction cost’ is defined as the economic equivalent
of ‘friction’ in physical systems. His insight tells us how Shari’ah scholars, with
the proper Shari’ah minds upon solid resolution and realism, play the important
role as ‘lubricant’ for running the ‘nervous system’ in Islamic finance. However,
it appears that the mechanism for monitoring the quality of lubricant is lacking
in the industry. Shari’ah scholars, the regulatory authority and other profession-
als need to design an appropriate financial architecture which can create socially
acceptable levels of margin opportunities for Islamic banks to avail the benefit
from the variety of Islamic financing as declared by Shari’ah. ‘Shari’ah minds’
must be a key for this design. However, the excess reliance on the morale in the
board seems vulnerable.

5.  A hint from the UK Corporate Governance Code

As argued earlier, there exist potential conflicts of interest as well as a huge para-
dox between Shari’ah scholars and other stakeholders under the situation that
the Shari’ah board is appointed and remunerated by the financial institutions.
How can the potential conflicts of interest be avoided?
 Anatomy of governance structure 157
One strategy is to pay the salary of the board members from the government’s
account to ensure the independence of the board. This strategy seems to be
inspired by the practices that occur in various countries as an effort to maintain
the independence of auditors of the public accountant firm who perform audits
for the financial statements of banking and financial institutions. In this con-
text, the remuneration paid to the Shari’ah Committee members will be charged
to the government or regulator account (i.e. Central Bank, Financial Services
Authority, Ministry of Finance) which may be sourced from the tax fund or mem-
bership contribution of each financial institution in the industry. Nevertheless,
we should note that this strategy possibly will not resolve the basic dilemma of
governance and decision-making process in the Islamic banking industry. As we
discussed in Section 1, in the profit–loss sharing (PLS) mode of Islamic finance,
the depositors are expected to share the risk and uncertainty which the Islamic
banks are undertaking and sharing with their borrowers. Under the P–A struc-
ture, the depositors face the difficulty of screening and monitoring the skill of
credit risk management in each Islamic bank. In particular, as Archer and Karim
(2006) point out, a severe conflict of interest between the shareholders and the
Investment Account Holders (IAH) may occur when Islamic banks mobilize the
fund of IAH for the mudaraba and musharaka investment. Under the condition
that IAH have no voting right at the Board of Directors (BoD) as well as the
shareholders meeting, Islamic bank managers are able to shirk taking reasonable
care of the IAH’s interest by seeking profit opportunities only for the sharehold-
ers. This is a case of moral hazard. To avoid the case, some scholars suggest that
a representative for IAH should be prepared in the BoD or the SSB (Nienhaus,
2007; Archer and Karim, 2007).
In the discussion with Prof. Mohammad Hashim Kamali, the founding CEO
of International Institute of Advanced Islamic Studies (IAIS Malaysia) in Novem-
ber 2016, he was supportive for the remuneration strategy to be paid by the
government. In the so-called Muslim countries such as Malaysia, the strategy
would be politically supported and, to some extent justifiable, partly because the
majority of the country would be benefited from the sound governance upon the
independence of the SB over the Islamic banking industry. However, in our view,
there exists a political hurdle to justify the strategy of using the national budget,
because the government has to consider the utility of non-Muslim tax payers as
well. Of course, as pointed out by Professor Kamali, the sound development of
the Islamic banking industry would benefit not only the Muslim customers but
also non-Muslim customers. In spite of it, the government has to ensure the
‘level playing field’ for the fair competition in the industry including the conven-
tional banks within the country. Governmental support only to the Islamic banks
would cause another dilemma.
Is there any other strategy to draw a prescription for the sound governance
without using the national budget? For contributing to this argument, here we
aim to get a hint from the essence of the UK Corporate Governance Code.
The UK Corporate Governance Code (‘the Code’) is a part of UK Company
Law with a set of principles of good corporate governance aimed at companies
158  Yasushi Suzuki et al.
listed on the London Stock Exchange. It is overseen by the Financial Reporting
Council (FRC) and its importance derives from the Listing Rules by the Financial
Conduct Authority. The Listing Rules themselves are given statutory authority
under the Financial Services and Markets Act 2000 and require that publicly
listed companies disclose how they have complied with the code, and explain
where they have not applied the code – in what the code refers to as ‘comply
or explain’.1 The Code adopts a principles-based approach in the sense that it
provides general guidelines of best practice. This contrasts with a rules-based
approach which rigidly defines exact provisions that must be adhered to.
The purpose of corporate governance is to facilitate effective, entrepreneurial
and prudent management that can deliver the long-term success of the company.
FRC (2016) refers to the first version of the Code (its paragraph 2.5) which was
produced in 1992 by the Cadbury Committee as the classic definition of the
context of the Code:

Corporate governance is the system by which companies are directed and

controlled. Boards of directors are responsible for the governance of their
companies. The shareholders’ role in governance is to appoint the directors
and the auditors and to satisfy themselves that an appropriate governance
structure is in place. The responsibilities of the board include setting the
company’s strategic aims, providing the leadership to put them into effect,
supervising the management of the business and reporting to shareholders
on their stewardship. The board’s actions are subject to laws, regulations and
the shareholders in general meeting.

Corporate governance is therefore about what the board of a company does

and how it sets the values of the company. It is to be distinguished from the
day-to-day operational management of the company by full-time executives.
The Code is a guide to a number of key components of effective board practice.
It is based on the underlying principles of all good governance: accountability,
transparency, probity and focus on the sustainable success of an entity over the
longer term. The Code has been enduring, but it is not immutable. Its fitness for
purpose in a permanently changing economic and social business environment
requires its evaluation at appropriate intervals. The new Code applies to account-
ing periods beginning on or after 17 June 2016 and applies to all companies with
a premium listing of equity shares regardless of whether they are incorporated in
the UK or elsewhere (FRC, 2016).
Following the 2014 Code amendments, which focussed on the provision by
companies of information about the risks which affect longer-term viability, the
FRC will continue to monitor compliance with these changes.

One of the key roles for the board includes establishing the culture, values
and ethics of the company. It is important that the board sets the correct
‘tone from the top’. The directors should lead and ensure that good stand-
ards of behaviour permeate throughout all levels of the organisation. This
 Anatomy of governance structure 159
will help prevent misconduct, unethical practices and support the delivery of
long-term success.
(Preface 4, FRC, 2016)

For the purpose of improving the governance, FRC emphasizes ‘diversity’ on the
board.

One of the ways in which constructive debate can be encouraged is through

having sufficient diversity on the board. This includes, but is not limited to,
gender and race. Diverse board composition in these respects is not on its
own a guarantee. Diversity is as much about differences of approach and
experience, and it is very important in ensuring effective engagement with
key stakeholders and in order to deliver the business strategy.
(Preface 3, FRC, 2016)

FRC raises ‘Non-Executive Directors Main Principle’. The principle requires

that as part of their role as members of a unitary board, non-executive directors
should constructively challenge and help develop proposals on strategy.

Non-executive directors should scrutinise the performance of management

in meeting agreed goals and objectives and monitor the reporting of perfor-
mance. They should satisfy themselves on the integrity of financial informa-
tion and that financial controls and systems of risk management are robust
and defensible. They are responsible for determining appropriate levels of
remuneration of executive directors and have a prime role in appointing and,
where necessary, removing executive directors, and in succession planning.
(Section A.4, FRC, 2016)

FRC requires the board to appoint one of the independent non-executive direc-
tors2 to be the senior independent director to provide a sounding board for the
chairman and to serve as an intermediary for the other directors when necessary.
The senior independent director should be available to shareholders if they have
concerns which contact through the normal channels of chairman, chief execu-
tive or other executive directors has failed to resolve or for which such contact is
inappropriate (Code Provisions A.4.1, FRC, 2016).
FRC supports for ‘The Composition of the Board Main Principle’ in which the
board and its committees should have the appropriate balance of skills, experi-
ence, independence and knowledge of the company to enable them to discharge
their respective duties and responsibilities effectively.

The board should include an appropriate combination of executive and non-

executive directors (and, in particular, independent non-executive direc-
tors) such that no individual or small group of individuals can dominate the
board’s decision taking. The value of ensuring that committee membership
is refreshed and that undue reliance is not placed on particular individuals
160  Yasushi Suzuki et al.
should be taken into account in deciding chairmanship and membership of
committees.
(Section B: Effectiveness B.1, FRC, 2016)

Drawing a hint from the UK Corporate Governance Code, we propose that

the role of independent non-executive (non-Shari’ah or non-Muslim but profes-
sional) members in the SB be strengthened; at least, their job description should
be clarified to ensure the independence of the SB. AAOIFI has offered some
descriptions of a Shari’ah supervisory board:

a Shari’ah supervisory board is an independent body of specialised jurist

of fiqh al-mu’amalah (Islamic commercial jurisprudence). However, the
Shari’ah supervisory board may include a member other than those special-
ised in fiqh al-mu’amalah, but who should be an expert in the field of Islamic
finance and with knowledge of fiqh al-mu’amalah.
(Bakar, 2016)

However, it seems that the expected role of non-Shari’ah members in the board
is not yet clearly designated from the governance perspectives over the board.
According to Bakar, there are many different practices of admitting non-
Shari’ah qualified personnel into Shari’ah supervisory boards.

While some non-Shari’ah trained members would have voting rights in some
practices and jurisdictions, they do not have this voting right in other prac-
tices and jurisdictions. In some other jurisdictions where they have voting
rights, it is prescribed that majority of the Shari’ah supervisory board mem-
bers must be Shari’ah-trained members.
(Bakar, 2016, p. 8)

It seems that Bakar is conservative for the role of non-Shari’ah members:

The Shari’ah minds must prevail in any potential conflict of perspectives. In

short, only qualified and trained Shari’ah scholars or the majority of Shari’ah
minds are eligible to undertake this great responsibility of issuing any fatwa.
It would be damaging for a beginner in Islamic commercial law to embark
on this assignment.
(Bakar, 2016, p. 8)

His view from the Shari’ah scholar’s viewpoint is understandable. However, it

would be also damaging to put aside the diversity on the SB.

6.  Concluding comments

The main objective of the paper is to shed an analytical light on the existence
of potential conflicts of interest and ‘a huge paradox’ between SB and the other
stakeholders under the ‘client-patronage’ independency since the SB is appointed
 Anatomy of governance structure 161
and remunerated by the client financial institutions. In order to tackle various
potential problems which may be caused under the multiple principal and agent
structure, we should continuously seek a better mechanism for ensuring the
proper ‘check and balance’ role and responsibility of the SB, which will contrib-
ute to the sound development of Islamic banking and finance industry. In this
sense, a good Shari’ah governance must be attributable to the independence of
SB. The independency of SB should be designed and monitored in various levels
in the process of appointing its members and of determining its composition,
scope and remuneration.
To design a perfect governance structure might be impossible. However, we
should continuously seek it through a trial-and-error process. The strategy to
compensate the remuneration for the SB members from the regulator’s or gov-
ernment’s account is one option for enhancing the independence of SB. How-
ever, as argued in the previous section, governmental support only to the Islamic
banks would cause another dilemma. The strategy to assign independent and
non-Shari’ah (but professional) members into the SB for its diversity would be
another option. However, it is not so easy to designate the role and scope of non-
Shari’ah qualified members in the SB in the light of strengthening the Shari’ah
compliance. Again, to design a perfect governance structure might be impossible.
However, we believe that seeking an appropriate governance structure will con-
stitute the exercising of ijtihad.

Notes
1 FRC (2016) explains the comply or explain approach as follows: 1. The ‘comply
or explain’ approach is the trademark of corporate governance in the UK. It has
been in operation since the Code’s beginnings and is the foundation of its flex-
ibility. It is strongly supported by both companies and shareholders and has been
widely admired and imitated internationally. 2. The Code is not a rigid set of rules.
It consists of principles (main and supporting) and provisions. The Listing Rules
require companies to apply the Main Principles and report to shareholders on how
they have done so. The principles are the core of the Code and the way in which
they are applied should be the central question for a board as it determines how it
is to operate according to the Code. 3. It is recognized that an alternative to fol-
lowing a provision may be justified in particular circumstances if good governance
can be achieved by other means. A condition of doing so is that the reasons for it
should be explained clearly and carefully to shareholders, who may wish to discuss
the position with the company and whose voting intentions may be influenced as
a result. In providing an explanation, the company should aim to illustrate how its
actual practices are consistent with the principle to which the particular provision
relates, contribute to good governance and promote delivery of business objec-
tives. It should set out the background, provide a clear rationale for the action it
is taking and describe any mitigating actions taken to address any additional risk
and maintain conformity with the relevant principle. Where deviation from a par-
ticular provision is intended to be limited in time, the explanation should indicate
when the company expects to conform with the provision. 4. In their responses
to explanations, shareholders should pay due regard to companies’ individual cir-
cumstances and bear in mind in particular the size and complexity of the company
and the nature of the risks and challenges it faces. While shareholders have every
right to challenge companies’ explanations if they are unconvincing, they should
162  Yasushi Suzuki et al.
not be evaluated in a mechanistic way and departures from the Code should not be
automatically treated as breaches. Shareholders should be careful to respond to the
statements from companies in a manner that supports the ‘comply or explain’ pro-
cess and bearing in mind the purpose of good corporate governance. They should
put their views to the company and both parties should be prepared to discuss the
position. 5. Smaller listed companies, in particular those new to listing, may judge
that some of the provisions are disproportionate or less relevant in their case. Some
of the provisions do not apply to companies below the FTSE 350. Such companies
may nonetheless consider that it would be appropriate to adopt the approach in the
Code and they are encouraged to do so. Externally managed investment companies
typically have a different board structure which may affect the relevance of particu-
lar provisions; the Association of Investment Companies’ Corporate Governance
Code and Guide can assist them in meeting their obligations under the Code.
6. Satisfactory engagement between company boards and investors is crucial to
the health of the UK’s corporate governance regime. Companies and shareholders
both have responsibility for ensuring that ‘comply or explain’ remains an effective
alternative to a rules-based system. There are practical and administrative obstacles
to improved interactions between boards and shareholders. But certainly there is
also scope for an increase in trust which could generate a virtuous upward spiral in
attitudes to the Code and in its constructive use.
2 According to NASDAQ Rule 4200 a(15)) “independent director” is defined as a
person other than an executive officer or employee of the company or any other
individual having a relationship which, in the opinion of the issuer’s board of direc-
tors, would interfere with the exercise of independent judgment in carrying out
the responsibilities of a director. The following persons shall not be considered
independent: (A) a director who is, or at any time during the past three years
was, employed by the company or by any parent or subsidiary of the company;
(B) a director who accepted or who has a family member (‘family member’ means
a person’s spouse, parents, children and siblings, whether by blood, marriage or
adoption, or anyone residing in such person’s home) who accepted any compensa-
tion from the company in excess of $60,000 during any period of 12 consecutive
months within the three years preceding the determination of independence, other
than the following: (i) compensation for board or board committee service; (ii)
compensation paid to a family member who is an employee (other than an execu-
tive officer) of the company; or (iii) benefits under a tax-qualified retirement plan,
or non-discretionary compensation. Provided, however, that in addition to the
requirements contained in this paragraph (B), audit committee members are also
subject to additional, more stringent requirements under NASDAQ Rule 4350(d).
(C) a director who is a family member of an individual who is, or at any time during
the past three years was, employed by the company as an executive officer; (D) a
director who is, or has a family member who is, a partner in, or a controlling share-
holder or an executive officer of, any organization to which the company made, or
from which the company received, payments for property or services in the current
or any of the past three fiscal years that exceed 5 percent of the recipient’s consoli-
dated gross revenues for that year, or $200,000, whichever is more, other than the
following: (i) payments arising solely from investments in the company’s securities;
or (ii) payments under non-discretionary charitable contribution matching pro-
grams. (E) a director of the issuer who is, or has a family member who is, employed
as an executive officer of another entity where at any time during the past three
years any of the executive officers of the issuer serve on the compensation commit-
tee of such other entity; or (F) a director who is, or has a family member who is,
a current partner of the company’s outside auditor, or was a partner or employee
of the company’s outside auditor who worked on the company’s audit at any time
during any of the past three years.
10 A comparative study
on Shari’ah compliance
frameworks
Is the integrated or separated
model well suited to Bangladesh?
S. M. Sohrab Uddin, Asif Nawaz Chowdhury
and Yasushi Suzuki

1. Introduction
Besides Islamic countries, a handsome number of non-Islamic countries through-
out the world use Islamic finance as a distinct approach of finance where Islamic
Shari’ah (Islamic law) acts as the pivotal guiding element. However, there is evi-
dence showing the breach of Shari’ah compliance due to lack of knowledge and
awareness among employees, absence of an interest-free economy, government’s
inability to provide supportive rules and regulations, and adequate infrastructure
for further development (Ullah, 2014). Some of these factors can be consid-
ered internal factors and some others external. Corresponding to the increasing
demand for Islamic finance products and the rapid growth of Islamic banks and
other financial institutions worldwide, Shari’ah compliance has received signifi-
cant attention during the last few decades.
The Shari’ah compliance mechanism checks whether Islamic Shari’ah governs
the process of origination of products and services, the execution of operations,
and the reporting of financial and non-financial activities to the stakeholders of
Islamic banks and financial institutions. Interestingly, Shari’ah compliance mech-
anisms differ from country to country based on the authority and delegation of
responsibility of the central Shari’ah board. The existence of two fundamentally
different compliance structures can be observed, namely the ‘separated’ model
upon a very high degree of independence of the Shari’ah board, which is applied
in Gulf Cooperation Council (GCC) countries including Kuwait, Saudi Arabia,
Bahrain, Qatar, and the UAE, and in some other countries including Jordan,
Yemen, and Gambia; and the ‘integrated’ model upon harmonizing with bank-
ing regulations, which is applied in Malaysia, Sudan, Pakistan, and Indonesia
(Gintzburger, 2011; Hamza, 2013; Rahajeng, 2013). In the same way, Grassa
(2013) categorizes the distinct available Shari’ah-compliance mechanisms as the
Southeast Asian model and GCC model. On the other hand, it is quite unique to
see that the existence of the Shari’ah board is not seemingly a prerequisite in Iran
(Gintzburger, 2011, p. 314). Even deviations can be found in compliance prac-
tices among countries reported under the same compliance structure. According
to Khan (2007, p. 288), the disparity in the opinions concerning Shari’ah creates
164  S. M. Sohrab Uddin et al.
unease among participants which, in turn, leads to profit-seeking behavior at the
expense of misplacing the spirit of Islamic finance infrastructure.
Besides, some international bodies working on Islamic finance such as Account-
ing and Auditing Organization for Islamic Financial Institutions (AAOIFI), Islamic
Development Bank (IDB), International Islamic Ratings Agency, International
Islamic Centre for Reconciliation for Commercial Arbitration for Islamic Finance,
Institute of Islamic Banking and Insurance (IIBI), International Institute of Islamic
Finance (IIIF), and Islamic Financial Services Board (IFSB) provide guidelines and
benchmarks on Shari’ah compliance, which largely influence the Shari’ah compli-
ance mechanism. Malkawi (2013) categorizes various Shari’ah compliance struc-
tures as the internal Shari’ah board, the external Shari’ah board, and the regulatory
and supervisory agency. The Shari’ah board of a particular Islamic bank or financial
institution is regarded as the internal Shari’ah board. The external Shari’ah board
is further divided into the national Shari’ah board, international Shari’ah board
including AAOIFI and IDB, and consultant Shari’ah board including IIBI and
IIIF. Finally, the IFSB is considered the regulatory and supervisory agency with
a predominant aim to support the industry as a whole by promulgating adequate
regulation and guidelines and by undertaking proper training and research.
The urgencies and rapid development of Islamic finance worldwide have ena-
bled Bangladesh to operate Islamic finance activities throughout the country
since 1983 with huge acceptability by its citizenry. Bangladesh Bank, the central
bank of the country, has issued necessary guidelines to structure the Shari’ah
compliance mechanism but it fails to provide the required solution whenever a
conflict of interest occurs among participatory parties (Amanullah, 2015). Ullah
(2014) finds a high degree of anomalies in Shari’ah compliance status of the
Islamic banks in Bangladesh. With a variant approach, this chapter aims at iden-
tifying the Shari’ah compliance framework used by Islamic banks in Bangladesh
and at examining the nonconformity in the compliance framework by linking the
existing practice with the available compliance structures in the global arena and
under the AAOIFI guideline.
The latter part of this chapter is divided into four segments. Section 2 high-
lights the literature review by demonstrating the Shari’ah compliance structures
available in the international arena. Section 3 provides an overview of the Islamic
banking sector of Bangladesh. Section 4 introduces the current Shari’ah compli-
ance practices of Islamic banks and tries to identify an appropriate structure for
Bangladesh. Section 5 concludes the paper with some policy recommendations
for designing the future shape of the Shari’ah compliance framework.

2.  Literature review

Shari’ah is an Arabic word which refers to Law of Allah used as religious pre-
cepts of Islam. Every aspect of a Muslim’s life is required to be conducted as per
Shari’ah.

There are four sources of Islamic Shari’ah: (i) interpretations of the Qur’an
(The Holy Book of the Muslims consisting of the revelations made by God
 A comparative study 165
to the Prophet Muhammad (peace be upon him) during his Prophethood of
about 23 years); (ii) interpretations of the Sunnah/Hadith (after the Qur’an,
the Sunnah is the most important source of the Islamic faith and refers essen-
tially to the Prophet’s example as indicated by his practice of the faith); (iii)
Ijma, consensus amongst scholars (consensus of the jurists on any issue of
fiqh after the death of the Prophet (peace be upon him)/collective reason-
ing); and (iv) Qiyas/Ijtihad analogical deduction (individual reasoning).
(Ullah, 2014, p. 184)

All the activities must comply with at least any of these four sources in order to
be considered Islamic. At the same time, activities have to be free from elements
such as riba (interest), maysir (gambling), and gharar (uncertainty) (Adam and
Bakar, 2014; Gintzburger, 2011).
Shari’ah compliance is a comprehensive issue which deals with a number of
instruments including the Shari’ah supervisory board (SSB) and the Shari’ah
governance framework. With the help of these instruments, Shari’ah is imple-
mented by Islamic banks in designing their products and services, and in execut-
ing their operations. SSB is an independent body consisting of Shari’ah scholars
who are specialized in fiqh al-mu’amalat (Islamic commercial law) and relevant
proficiencies associated with the nucleus of Islamic finance mechanisms (Gintz-
burger, 2011; Hamza, 2013). The activities of SSB were first initiated in 1976
by the Faisal Islamic Bank in Egypt followed by Jordan and Sudan in 1978,
Kuwait in 1979, Malaysia in 1983, and UAE in 1999 (Malkawi, 2013, p. 546).
The members of SSB possess the right to interpret, review, and approve when-
ever there is a gap of opinions concerning any issue of Shari’ah. The process of
interpretation is done through ijthihad, which refers to independent reasoning in
finding a solution to a specific problem. Thus, SSB is predominantly responsible
for reviewing, supervising, and directing the legal, contractual, and operating
activities of Islamic banks. It provides guarantee and assures credibility to stock-
holders, stakeholders, and other related authorities that all activities of Islamic
banks are performed as per Shari’ah, which is fundamental to the development of
Islamic finance including Islamic banking since any non-compliance leads to the
rise of Shari’ah risk and hampers the credibility of the sector as a whole (Hamza,
2013). Such non-compliance may violate market discipline too, as indicated by
Khan (2007). SSB also plays a significant role in the process of constructing
Shari’ah-compliant products besides pure Shari’ah-based products. In doing all
of these, SSB considers the guidelines and benchmarks provided by international
Islamic finance regulatory bodies including AAOIFI and IFSB. On the other
hand, the Shari’ah governance is an organizational arrangement conducted by
SSB for ensuring Shari’ah compliance and for conducting the Shari’ah audit in
Islamic banks in order to identify any deviations of the Shari’ah rules. Of course,
the Shari’ah governance framework is a part of corporate governance of Islamic
banks, which is rather a complex blending of how firms are to be directed, gov-
erned, and controlled.
Two prominent models, the stockholder model and stakeholder model, are
used to define the corporate governance structure in conventional finance.
166  S. M. Sohrab Uddin et al.
The stockholder model suggests that a firm has one core objective, which is to
maximize shareholder wealth. Thus, stockholders have the right to interfere in
strategic decisions to maximize their wealth. On the other hand, the stakeholder
model suggests maximizing both shareholders’ and stakeholders’ wealth. Here,
‘stakeholder’ is meant in a broader sense where stockholders along with other
related entities are benefited. Hence, firms following the stakeholder model tend
to have more responsibility to society. As an analogy, we can see the types of
Shari’ah compliance structure; the ‘separated’ framework and the ‘integrated’
one in the light of the degree of independence of Shari’ah boards. The former
puts the highest priority to the issue of Shari’ah compliance, while the latter
intends to harmonize it with banking regulations at the centre.
Under the ‘separated’ model, SSB of each of the Islamic banks has the supreme
power of authority. In this model, there is no powerful authority at the national
level to structure and monitor institutional SSB. That is, SSBs in the institutional
level are independent of the central bank and decisions taken by them concern-
ing Islamic Shari’ah are deemed to be accepted without any external resistance in
the case of the permissibility of contracts, Shari’ah-compliant financial products,
and Shari’ah practices (Hamza, 2013). The GCC countries and Jordan, Yemen,
and Gambia are the followers of the separated model as the Shari’ah compli-
ance framework. However, anomalies exist among these followers of the sepa-
rated model. For instance, even though there is no effective national authority
in the level of the central bank in GCC countries, few of these countries such as
Kuwait, Qatar, and UAE have higher Shari’ah authority. In Kuwait, the authority
is known as the Ministry of Awqaf and Islamic Affairs; in Qatar, it is recognized
as the Ministry of Awqaf; and in UAE, the authority is known as Higher Shari’ah
Authority. Similarly, the decision of SSBs can only be influenced by Islamic Fiqh
Academy (IFA) in the case of Saudi Arabia and by the National Shari’ah Board
in the central bank in the case of Bahrain. Nevertheless, the higher authority can
only advise if there are conflicts of opinion between or among the SSBs of Islamic
banks or cases of Shari’ah interpretations or necessities for new Shari’ah issues
(Grassa, 2013). As a result, with regard to fatwa (a scholarly opinion on a mat-
ter of Islamic law), inconsistencies may occur among the SSBs of Islamic banks
or within the same SSB of an Islamic bank over the years. Table 10.1 provides a
summary of the key issues associated with the separated model practiced by dif-
ferent GCC countries.
In contrast, the ‘integrated’ model assigns the essential authority to the central
bank to pattern, control, advice, and follow up the Islamic banks on the conform-
ity of Shari’ah in their products and services, procedure, and activities through a
central SSB. Malaysia, Pakistan, Sudan, and Indonesia adopt, as Hamza (2013)
calls it, the centralized Shari’ah framework (Hamza, 2013). In addition, evidence
proves that Indonesia also follows the model (Rahajeng, 2013). In fact, under
this model dual authority exists where the central authority at the national level
guides, advises, and resolves Shari’ah issues related to Islamic banking. Individual
SSB of respective Islamic banks are responsible for ensuring the compliance of the
issues fixed by the central SSB at the institutional level. Thus, it is likely to observe
 A comparative study 167
Table 10.1  Separated model in GCC countries

Issues Bahrain Kuwait UAE Qatar Saudi Arabia

Authority for National Ministry of Higher Ministry of IFA

resolving Shari’ah Awqaf and Shari’ah Awqaf
Shari’ah Board in Islamic Authority
conflict the central Affairs
bank
Responsibility Issuing fatwa.
of SSB in Ensuring Shari’ah review through a committee.
Islamic Nomination of Shari’ah scholars.
bank Allowing the presence of scholars in more than one Islamic bank.
Shari’ah risk Inconsistencies among fatwas of different SSBs or in the same SSB
over the period due to the absence of an integrated SSB for all
Islamic banks.
Source: constructed by the authors based on Hamza (2013, p. 232–233)

a harmonized Shari’ah compliance practice under the integrated model, which is

relatively free from inconsistencies concerning fatwas at the institutional level. In
this regard, Hamza (2013) mentions that the integrated model ensures consist-
ency of fatwas and explanations within the Islamic banking sector as a whole,
though coordination among central SSB and SSBs of Islamic banks is still an issue.
He asks for the formation of a council of all SSBs of Islamic banks in collaboration
of the central bank for ensuring the harmonization of Shari’ah compliance. How-
ever, variations exist among countries practicing the integrated model, which are
shown in Table 10.2. For instance, the members of central SSB are not allowed to
be members of any SSB of an Islamic financial institution in Malaysia and Indo-
nesia whereas it is allowed in Pakistan and Sudan. Yet again, unlike Sudan, the
members of central SSB can be nominated as members of SSB of only one Islamic
financial institution in Pakistan. In this regard, Malkawi (2013) argues that the
situation of representing multiple SSBs leads to the erosion of perception by cre-
ating conflicts of interest and accordingly legal revisions are needed for prohibit-
ing such sitting. In addition, the presence of Shari’ah scholars in more than one
Islamic bank is allowed in Pakistan and Sundan but not in Malaysia and Indonesia.

3.  Overview of the Islamic banking sector of Bangladesh

The Islamic banking sector of Bangladesh consists of full-fledged Islamic banks,
Islamic banking branches of conventional banks, and Islamic banking counters or
windows of conventional banks. Full-fledged Islamic banks refer to the institu-
tions where all the products and activities are offered in such a way that complies
with the Islamic Shari’ah. When one or more branches of a conventional bank
offer Islamic banking they are regarded as Islamic banking branches of conven-
tional banks, and when a conventional bank has an Islamic banking counter or
window in its branches besides the conventional banking counter or window
then it is called an Islamic banking window of a conventional bank. Table 10.3
Table 10.2  Integrated model in Malaysia, Pakistan, Sudan, and Indonesia

Issues Malaysia Pakistan Sudan Indonesia

Fatwa issued by central Yes Yes Yes Yes

bank
Review and audit of Yes Yes Yes Yes
Shari’ah compliance
are done by Islamic
banks
Appointment of Shari’ah Yes, subject to the Yes Yes, subject to the Yes
scholars by Islamic approval from the approval from the
banks financial authorities. central SSB.
Presence of scholars in No Yes Yes No
more than one Islamic
bank
Members of central SSB Cannot be a member of Can be a member of Can be a member of Cannot be a member of
any Islamic financial only one Islamic any Islamic financial any Islamic financial
institution. financial institution. institution. institution.
Authority for resolving Central SSB in the name Central SSB in the name High Shari’ah Majelis Ulama Indonesia
Shari’ah conflict of Shari’ah Advisory of Shari’ah board at Supervisory Board (MUI) (Indonesian
Council (SAC) at the the central bank, State (HSSB) at the Ulema Council or
central bank, Bank Bank of Pakistan. central bank. known as Dewan
Negara Malaysia. Syariah Nasional –
DSN) is responsible
for supporting the
central bank, Bank
Indonesia.
Shari’ah risk Due to the absence of coordination among central SSB and SSBs of Islamic banks.
May slow down the process of new product development.
Source: constructed by the authors based on Gintzburger (2011), Hamza (2013, pp. 233–235), and Rahajeng (2013)
 A comparative study 169
provides a summary of different types of banks involved in Islamic banking. It
indicates that eight banks are engaged in Islamic banking services fully, which
includes two banks that started their journey as conventional banks and later
converted into full-fledged Islamic banks in 2004 and 2008, respectively. All of
the full-fledged Islamic banks are under private ownership. In addition, 16 con-
ventional banks are offering Islamic banking branches or windows out of which
eight banks including seven private banks and one foreign bank are maintaining
branches; and eight banks including three state-owned banks, three private banks,
and two foreign banks are holding windows for such services. Most importantly,

Table 10.3  Initiation of and experience in Islamic banking by different types of banks

Bank Type of Year of Initiation Experience

ownership inauguration of Islamic up to 2016
banking

Full-fledged Islamic banks

Islami Bank Bangladesh Ltd. Private 1983 1983 34
ICB Islamic Bank Ltd. Private 1987 1987 30
Social Islami Bank Ltd. Private 1995 1995 22
Al-Arafah Islami Bank Ltd. Private 1995 1995 22
Shahjalal Islami Bank Ltd. Private 2001 2001 16
Union Bank Ltd. Private 2013 2013 4
Converted Full-fledged Islamic Banks
EXIM Bank Ltd. Private 1999 2004 13
First Security Islami Bank Private 1999 2008 9
Ltd.
Conventional Banks with Islamic Banking Branches
Prime Bank Ltd. Private 1995 1995 22
The City Bank Ltd. Private 1983 2003 14
Dhaka Bank Ltd. Private 1995 2003 14
Premier Bank Ltd. Private 1999 2003 14
Southeast Bank Ltd. Private 1995 2003 14
Jamuna Bank Ltd. Private 2001 2003 14
AB Bank Ltd. Private 1982 2004 13
Bank Alfalah Ltd. Foreign 1997 2003 14
Conventional Banks with Islamic Banking Windows
Sonali Bank Ltd. Govt. 1972 2010 7
Agrani Bank Ltd. Govt. 1972 2010 7
Pubali Bank Ltd. Govt. 1972 2010 7
Trust Bank Ltd. Private 1999 2008 9
Bank Asia Ltd. Private 1999 2008 9
Standard Bank Ltd. Private 1999 2009 8
HSBC Bank Ltd. Foreign 1996 2010 4*
Standard Chartered Bank Foreign 1972 2004 13
Ltd.
Source: constructed by the authors based on different annual reports of respective banks
Note: *HSBC Bank Ltd. closed all Islamic banking operations by the end of 2013
170  S. M. Sohrab Uddin et al.
initiation of the Islamic banking sector in different time periods portrays the gap
of experience of these banks varying from the highest experience of 34 years to
the lowest of 4 years.
According to Bangladesh Bank (2016), the full-fledged Islamic banks contain
19.3 percent and 21.9 percent of the banking sector deposits and credits, respec-
tively. On the other hand, banks with Islamic banking branches and windows
hold 1.1 percent of deposits and 1.4 percent of credits of the sector. In aggregate,
the marker share of the Islamic banking sector in terms of deposits and credits are
20.4 percent and 23.3 percent, respectively.
The full-fledged Islamic banks make a report concerning Shari’ah compliance
in their published annual reports. All of these banks ensure the presence of at least
three Shari’ah scholars in their SSB during the period 2012–2016. However, only
Islamic Bank Bangladesh Ltd. has become the member of international bodies
such as AAOIFI and IFSB. Variations are also observed among these full-fledged
Islamic banks in terms of the number of meeting held of their SBBs and change
in members of SSBs during the period 2012–2016, as shown in Table 10.4.

4.  Shari’ah compliance in Bangladesh

Bangladesh is prevailed to have its own Islamic bank as the first Islamic bank in
the name of Islami Bank Bangladesh Ltd., which started its operation in 1983.

Table 10.4 Number of meetings and change in members of SSB of full-fledged Islamic

banks

Bank 2012 2013 2014 2015 2016

Number of meetings of SBB

Islami Bank Bangladesh Ltd. NR 5 10 12 10

ICB Islamic Bank Ltd. 4 NR NR NR NR
Social Islami Bank Ltd. NR NR 5 6 6
Al-Arafah Islami Bank Ltd. NR NR NR NR NR
Shahjalal Islami Bank Ltd. 9 4 5 5 6
EXIM Bank Ltd. NR NR NR NR 6
First Security Islami Bank Ltd. 7 NR NR NR NR
Union Bank Ltd. NR NR 8 10 NR
Change in members of SSB
Islami Bank Bangladesh Ltd. No No Yes Yes Yes
ICB Islamic Bank Ltd. Yes Yes Yes Yes Yes
Social Islami Bank Ltd. Yes Yes No No Yes
Al-Arafah Islami Bank Ltd. NR NR NR NR NR
Shahjalal Islami Bank Ltd. Yes Yes Yes Yes Yes
EXIM Bank Ltd. NR Yes Yes Yes No
First Security Islami Bank Ltd. No No No No No
Union Bank Ltd. NR NR No No No
Source: constructed by the authors based on different annual reports of respective banks
Note: ‘NR’ stands for not reported
 A comparative study 171
For ensuring Shari’ah compliance in Islamic banking products and service, Bang-
ladesh has arrangements at both the national and institutional levels. At the
national level, there is a central Shari’ah board known as Central Shari’ah Board
for Islamic Banks of Bangladesh (CSBIBB). At the same time, Bangladesh Bank
has issued Guidelines for Conducting Islamic Banking. At the institutional level,
every Islamic bank has its own SSB. Though there is a CSBIBB, it is not backed
by sufficient authority needed to harmonize, control, and rule over Islamic banks.
According to Section III of the Guidelines for Conducting Islamic Banking issued
in November 2009 by Bangladesh Bank:

It will be the responsibility of the board of directors of the respective banks

to ensure that the activities of the banks and their products are Shari’ah com-
pliant. The Board of the Islamic banks/subsidiary company/conventional
commercial banks having Islamic branches, therefore, is constituted with
directors having requisite knowledge and expertise in Islamic Jurisprudence.
The Board may form an independent Shari’ah Supervisory Committee with
experienced and knowledgeable persons in Islamic Jurisprudence. However,
the Board shall be responsible for any lapses/irregularities on the part of the
Shari’ah Supervisory Committee.
(p. 10)

CSBIBB started its journey in 2001 mainly to assist and provide necessary advice
to member banks following the similar procedure and unanimous action of
Shari’ah principles and to supervise the implementation of Shari’ah principles in
the activities and operations of member banks. Table 10.5 highlights the regis-
tered members of CSBIBB during the period 2012–2016. It shows that seven
full-fledged Islamic banks have been the members of CSBIBB during the period
2012–2016. In 2012, the registered number of conventional banks with Islamic
branches or windows was 10, which rose to 13 in 2016. However, one full-fledged
Islamic bank and two conventional banks offering Islamic banking still remain
unregistered in CSBIBB. In aggregate, it includes 7 full-fledged Islamic banks, 8
conventional banks having Islamic banking branches, 5 conventional banks having
Islamic banking windows, and 1 Islamic financial institution, leading to a total of
21 registered institutional members. CSBIBB also has 65 individual members. The
board organizes trainings, workshops, capacity building, and knowledge-sharing
programs for Islamic banking practitioners of the country on a regular basis.

Table 10.5  Number of banks registered in CSBIBB

Types of bank 2012 2013 2014 2015 2016

Full-fledged Islamic banks 7 7 7 7 7

Conventional banks with Islamic 10 10 13 13 13
banking branches/windows
Source: constructed by the authors based on different annual reports of Bangladesh Bank
172  S. M. Sohrab Uddin et al.
Table 10.6 provides involvement of the 52 individual members (for whom data
are available) of CSBIBB in banks offering Islamic banking services. According
to the table, 22 members engage in full-fledged Islamic banks; 14 in banks with
Islamic banking branches; 11 in banks with Islamic banking windows; 1 in banks
with Islamic branches and banks with Islamic windows; and 1 in Islamic banks,
banks with Islamic branches, and banks with Islamic windows. Only three of
them are independent as they are not involved in any Islamic bank or financial
institution. On the other hand, 12 members are involved in SSB of banks offering
Islamic banking, 36 engage in management of banks offering Islamic banking,
1 participates in both SSB and management, and 3 of them are not involved in
either of the two roles (see Table 10.7). Among 12 members engaged in the SSB
of Islamic banks, 10 are involved in an individual bank, one concurrently serves
the SSB of six banks, and 1 is associated with five banks simultaneously. However,
Malkawi (2013) urges limiting the number of seats that Shari’ah scholars can
hold simultaneously even though he acknowledges the shortage of experienced
scholars as a shortcoming to be resolved quickly.
There are a few differences between the integrated model and the model prac-
ticed in Bangladesh. For instance, CSBIBB as the central SSB does not have
the sole authority to issue fatwa. At the same time, it is not mandatory to fol-
low CSBIBB’s rulings for Islamic banks, which is a fundamental issue under the

Table 10.6 Involvement of the members of CSBIBB in banks engaging in Islamic

banking

Member of Only Only in Only in Banks with In Islamic Not in

CSBIBB in full- banks with banks with Islamic banks, banks banks
fledged Islamic Islamic branches with Islamic offering
Islamic branches windows and banks branches, Islamic
banks with Islamic and banks banking
windows with Islamic
windows

52 out of 22 14 11 1 1 3
65
Source: constructed by the authors based on different annual reports of respective banks

Table 10.7 Nature of involvement of the members of CSBIBB in banks offering

Islamic banking

Member of Member of Engage in Engage in Not engage

CSBIBB SSB of banks management of SSB and in SSB or
offering Islamic banks offering management management
banking Islamic banking of banks of banks
offering Islamic offering Islamic
banking banking

52 out of 65 12 36 1 3
Source: constructed by the authors based on different annual reports of respective banks
 A comparative study 173
integrated model. On the other hand, like the separated model, SSBs enjoy the
power of authority in Islamic banks of Bangladesh and are independent from the
central bank concerning decision-making based on Shari’ah. Some other basic
features of the separated model including fatwa issued by Islamic banks, review
of Shari’ah compliance done by Islamic banks, and presence of scholars in other
Islamic banks are also observed in the model used by Islamic banks. However,
unlike the separated model, there is no specific authority to resolve Shari’ah con-
flict in Bangladesh. Table 10.8 makes a summary of the issues associated with the
Shari’ah compliance framework practiced by Islamic banks. Interestingly, it is a
bit confusing as it follows the shared features of both separated and integrated
models. At the same time, nonexistence of specific authority for solving the con-
flicts of interest among SSBs and the involvement of the members of CSBIBB in
any number of banks ranging from a minimum of one bank to a maximum of six
banks can be regarded as country-specific issues. Seemingly, a hybrid model with
the features of both separated and integrated models along with some country-
specific issues exists in the Shari’ah compliance framework practiced by Islamic
banks of Bangladesh.
In order to assess if banks in Bangladesh follow the guidelines set by AAOIFI,
an analysis is made on all full-fledged Islamic banks during the period 2012–2016
based on the contents mentioned in Table A2 in the Appendices. It is observed

Table 10.8 Issues associated with the Shari’ah compliance framework of Islamic banks
in Bangladesh

Separated • Responsibility of providing necessary Shari’ah advice to

member banks delegated to CSBIBB.
• Fatwa issued by the SSB of Islamic banks.
• Islamic banks are responsible for ensuring that all activities
comply with the Islamic Shari’ah.
Integrated • Members of central SSB, that is, CSBIBB, are allowed to
participate in the Shari’ah compliance of Islamic banks and
financial institutions.
• Members of CSBIBB can be involved with more than one
bank.
• Islamic banks are authorized to appointment Shari’ah
scholars in their SSBs as per the criteria including educational
qualification; experience and exposure; track record; solvency
and financial integrity; and integrity, honesty, and reputation
set by Bangladesh Bank. The details of these criteria are
reported in Table A1 in the Appendices.
Bangladesh • Authority for resolving Shari’ah conflict is not clearly specified
specific within the system.
issues • Members of CSBIBB can be involved with any number of
banks, ranging from a minimum of one bank to a maximum of
six banks.
• Members of CSBIBB are allowed to take part in the
management of Islamic banks and financial institutions.
Source: constructed by the authors
174  S. M. Sohrab Uddin et al.
that all of the banks follow the guidelines such as composition of SSB including
maximum five years of members as experts, existence of full members, and mini-
mum of three members; selection of SSB members at an annual general meeting;
reporting regarding remuneration provided to SSB members; periodic meetings
with the management; and inclusion of title, opinion paragraph containing an
expression of opinion about the compliance of the Islamic financial institution
with Islamic Shari’ah rules, and signatures of the members of SSB in the SSB
report. On the other hand, appointment and dismissal mechanisms of SSB mem-
bers are not clearly mentioned by these banks in their annual reports. However,
inconsistencies are found concerning the issues including invited members in
the SSB; no dual position with SSB and management of other Islamic banks and
financial institutions; and addressee, opening or introductory paragraph, scope
paragraph describing the nature of the work performed, and date of the SSB
report.

5. Conclusion
This chapter has intended to provide insights regarding Shari’ah compliance of
Islamic banks in the international arena along with Bangladesh. It is found that
the compliance mechanism practiced by the Islamic banks in Bangladesh is dif-
ferent from the two broad categories followed by the GCC countries and the
Southeast Asian countries. Interestingly, the model of Bangladesh consists of a
few country-specific features such as the absence of the authority for resolving
Shari’ah conflict, involvement of the members of CSBIBB with any number of
banks, and allowance of the members of CSBIBB to take part in the management
of Islamic banks and financial institutions. Moreover, CSBIBB does not have the
right to issue fatwa and Islamic banks are not bound to follow rulings issued by
the CSBIBB. The findings reveal that Bangladesh needs to establish a powerful
central SSB with the authority to pattern the Shari’ah compliance structure, deal
with the disagreement of opinions, lead the increasing trend of Islamic banking
throughout the country, and provide sufficient direction and necessary rulings
for Islamic banks and financial institutions. At the national level, the CSBIBB
structure should be reviewed and necessary steps should be taken so that it can
act as an authoritative central board with sufficient power to issue fatwa and con-
trol the SSB at the institutional level. There should also be operational mecha-
nism regarding the committee member selection and for dealing with conflicts of
interest among SSBs in CSBIBB. At the institutional level, Islamic banks should
follow the international standard both in Shari’ah compliance and in Shari’ah
reporting.
Appendices

Table A1  Criteria for selecting members for SSB of Islamic banks

Qualification Issues

Educational • Graduate and postgraduate degrees in Islamic studies, Arabic,

qualification Islamic law, Islamic economics, or Islamic banking with
insightful knowledge in the Arabic language.
Experience and • Must have at least three years of experience in teaching or
exposure research work in Islamic jurisprudence/Islamic law/Islamic
banking-related subject.
• Three years of experience as a member of any fatwa board
in giving Shari’ah rulings on Islamic trade and commerce/
banking and financial matters or publication of three exclusive
articles on Islamic trade and commerce, Islamic banking,
Islamic economics, and Islamic commercial jurisprudence in
any recognized journal or publication of three books on the
same subjects.
Track record • Must have an impeccable record of accomplishment in social,
economic, and financial dealings.
• Has not been terminated or dismissed in the capacity of an
employee or director/chairman from any institution, firm, or
company.
Solvency and • Has not been involved in any illegal/improper activity
financial particularly relating to banking business.
integrity • Has not been in default of payment of dues owed to any bank
or financial institution and/or default in payment of any taxes
in an individual capacity or as a proprietary concern.
Integrity, • Has not been convicted in any civil/criminal offence or
honesty, and involved in financial impropriety and moral turpitude.
reputation • Has not been subject to any adverse findings or any
settlement in civil/criminal proceedings particularly, in regard
to investments, financial/business, misconduct, fraud etc.
• Has not contravened any of the requirements and standards
of the regulatory system or the equivalent standards of
requirements of any regulatory authority.
• Has not been debarred from giving religious rulings by any
religious institution/body.
Source: constructed by the authors based on Section III of the Guidelines for Conducting
Islamic Banking issued by Bangladesh Bank
Table A2  AAOIFI compliance items

AAOIFI: IFSB independence elements of SSB members

Appointment mechanism
Maximum five years among the experts
Composition and competencies:
Full member
Invited member
Minimum three members
Selection at an annual general meeting
Dismissal mechanism recommended by the board of directors
No dual position with other Islamic financial institution and with board, e.g. as
director
Remuneration
Periodical meetings with the management
AAOIFI: basic elements of the SSB’s report
Title of the SSB
Addressee
Opening or introductory paragraph
Scope paragraph describing the nature of the work performed
Opinion paragraph containing an expression of opinion concerning the compliance
of the Islamic financial institution with the Shari’ah rules and principles
Date of report
Signatures of the members of the SSB
Source: constructed by the authors based on Rahajeng (2013) and Vinnicombe (2010)
11 Alternative views upon
the ‘division of work’ and
‘specialization’ towards a
new mode of profit–loss
sharing
Yasushi Suzuki and Mohammad Dulal Miah

1. Introduction
It is observed that exorbitant dominance of murabaha financing has remained
unchanged over the years. This is alarming as per the explanation of major Islamic
finance literature. Many studies state that at the beginning of Islamic finance,
jurists were a bit lenient in endorsing murabaha concentration on the pretence
that such a practice might help infant Islamic finance grow rapidly. Once this
model of finance reaches a competitive stage it may strive to shift gradually from
the mark-up based/Shari’ah-compliant financing to participatory/trust-based
financing upon the pure mode of ‘profit–loss sharing’ (PLS) (Ahmad, 1993).
Contrary to this expectation, Islamic financial institutions have been maintaining
their financing dominance on murabaha. Many Islamic scholars insist that being
Shari’ah compliant does not automatically embody the spirit of Islamic finance.
Thus, they are very critical about the current practice of Islamic banks (Kuran,
1995; El-Gamal, 2006; Çizakça, 2011).
The literature, however, provides some explanations as to why Islamic banks
do not readily participate in PLS. Iqbal and Molyneux (2005) identify moral
hazard and adverse selection problems as the key to murabaha concentration
of Islamic banks. They further emphasize that the monitoring cost required for
resolving these problems functions as an obstacle towards PLS-based financing.
Aggarwal and Yousef (2000) contend that banks’ attempts to avoid agency prob-
lems rationalize their preference for debt-like finance. Similarly, Chong and Liu
(2009) argue that reducing the mark-up dominance of Islamic banks calls for the
mitigation of agency problems. Some studies however emphasize entrepreneurs’
moral hazard problem associated with ex post information asymmetry (Mills and
Presley, 1999; Dar and Presley, 2000; Hamza, 2016). Farooq (2007), on the
other hand, argues that the reason for not materializing the expected growth of
PLS lies with the nature of partnership. He provides evidence showing that part-
nership is the least common form of business organization because of some legal
predicaments involved with it. Khan (2010) lists several obstacles that discour-
age banks from engaging in PLS. He insists that entrepreneurs’ moral hazard,
particularly their tendency to hide critical information as well as non-cooperative
attitude, fades Islamic banks’ interest in participatory finance.
178  Yasushi Suzuki and Mohammad Dulal Miah
We argue that these issues are important but secondary only as far as Islamic
banking is concerned. The primary issue cements the question of whether Islamic
banks should ideally be allowed to deal with risk and uncertainty embedded in
participatory/trust-based financing and/or with the financing towards marginal
clients under the current mode of loose PLS. Banks, regardless of whether they
are Islamic or conventional, are special and sensitive because they are entrusted
with the use-power of people’s savings for commercial purpose. If incentives for
commercial banking are tightly aligned with banks’ higher risk-appetite, deposi-
tors’ interest would be at stake. Thus, depository corporations have to put their
best effort in protecting the welfare of the depositors by avoiding high risk and
uncertainty in lending activities. As long as financial instruments of asset-backed
financing are Shari’ah compliant, it is surprising why Islamic banks are criticized
so much for their focus on this technique. Second, conventional banks are tightly
regulated for many credible reasons including the avoidance of systemic financial
catastrophe. If so, how far is it logical to suggest Islamic banks to assume higher
risk involved with participatory financing or financing for marginal clients?
Our analysis in this chapter rests on the following understanding. An expan-
sion of the mode of PLS is essential to materialize the social justice sought in the
Shari’ah norm. However, banks regardless of their philosophical orientation are
not in a position to solely perform this task. Islamic banks are still expected to
mobilize the ‘safety’ fund from the risk-averse depositors who are not yet willing
to engage in the mode of PLS. At the same time, Islamic banks should protect the
welfare of these depositors which requires that Islamic banks should minimally
be involved with participatory financing and/or financing for marginal clients.
Other financial institutions including Islamic venture capital and microfinance
institutions can be developed and supported to greatly contribute to the PLS
mode of finance because these institutions possess comparative advantage in deal-
ing with PLS compared to depository corporations. Banks’ appetite for higher
risk stemming from participatory financial contracts and/or financing for mar-
ginal clients may lead financial institutions to financial fragility. Therefore, Islamic
banks like their conventional counterparts should be conservative for the risk and
uncertainty embedded in the participatory mode of finance.
The chapter has been structured as follows: Section 2 describes the feasibility
of Islamic banks to finance PLS-based projects under the existing financial and
regulatory framework. Section 3 offers an alternative model based on the speciali-
zation and division of work of Islamic financial institutions to enhance PLS. Sec-
tion 4 focuses on other contemporary issues discussed in the existing literature
as obstacles towards PLS finance and the possible ways to address them. This is
followed by a brief conclusion.

2.  Participatory finance and bank’s risk exposure

Many Islamic finance scholars ask: Why do Islamic banks not actively partici-
pate in equity-like financing instead of their current debt-like financing? This is
a right question but wrongly directed because suggesting that banks take more
 Alternative views 179
risk associated with participatory finance is contrary to the long-standing practice
of the banking industry, though there is a debate on how equity-like financing
would prevent banks from undertaking excess credit risks.
It is rational for the greater stability of a financial system that Islamic banks
simply should not be encouraged to accept high risk because bankruptcy of a
single bank can lead a country-wide bank run which in turn, through its ripple
effect, may trigger financial and economic crisis (Krugman, 2012). In the case
of bankruptcy of a depositary corporation it is usually the depositors who lose
their deposited money beyond the amount insured under the deposit insurance.
On the other hand, they are ultimately the tax payers who would pay the socio-
economic cost for insurance. Even worse, once it happens, depositors lose their
confidence on the financial system, which would often lead to the disinterme-
diation of financial resources resulting in economic slowdown. Evidence shows
that the failure of financial institutions results in macroeconomic instability and
bail out costs (Caprio and Klingebiel, 2002; Englund, 1999; Angkinand, 2009).
Honohan and Klingebiel (2003) show that the cost of cleaning up financial mess
accounts for on average 12.8 percent of national GDP in their sample of 40 epi-
sodes. The calculated cost is higher (14.3 percent) for developing countries and
some crises have claimed much larger outlays of about 40–55 percent of GDP.
Because of huge social cost involved with the bankruptcy of depository corpora-
tions, they are rescued during the time of their financial distress by injecting tax
payers’ money. This external social cost justifies tight regulation on the banking
industry for preventing banks from undertaking excess credit risks.
One may insist that banks’ limited liability and the existence of ‘quasi’ flat rate
deposit insurance could encourage banks to assume more risk which is termed
in the literature as ‘moral hazard’. However, there arises confusion in this story
between the rescue of a bank (or depositors) and the rescue of the owners or
managers who are responsible for the creation of the situation which creates the
need for a rescue.

To the manager, it is not much of a consolation that his/her firm is saved by

the government, if the rescue operation involves the termination of his/her
contract. So, if a manager knows that his/her job would be in jeopardy if the
firm performs badly, there is little moral hazard.
(Chang, 2000, p. 782)

In the incentive approach, solvency regulations are modeled as solutions to prin-

cipal–agent problems between a public insurance system and private banks. Since
regulators’ insurance is costly, solvency regulations are required to create incen-
tives that limit the potential cost in terms of public funds being used to bail out
depositors, by way of keeping banks away from excess credit risks.
If the conventional banking system is regulated tightly to avoid potential finan-
cial catastrophe and to maintain depositors’ confidence in the financial system,
it is equally rational to ask Islamic banks to keep away from dealing with high
risk and fundamental uncertainty involved with participatory financing (or the
180  Yasushi Suzuki and Mohammad Dulal Miah
financing to marginal clients) under the current mode of PLS. If Islamic banks
fail to share the loss incurred from the accumulation of non-performing credit,
it is ultimately the tax payers who are supposed to pay the socio-economic cost
under the deposit insurance for protecting the general depositors (in particular,
saving account holders). Under the PLS-based contract, banks’ function is con-
fined merely to financial intermediaries. Ideally they bear no risk of clients because
they can transfer the risks associated with the borrowers to the depositors (for
instance, investment account holders). This structure would, however, cause seri-
ous principal–agent problems between depositors (investors) and Islamic banks,
which actually drain the ‘risk fund’ as resources that are needed for participatory
financing. Under the existing banking model, capital owners (investment account
holders) appoint Islamic banks as their agent for making various decisions such
as determining the PLS ratio, re-investment prospects and terms of funds, liqui-
dation of projects etc. Banks have their own shareholders who represent in the
board of a bank. In such a circumstance, it is uncertain how far banks strive to
protect the right of the investment account holders instead of maximizing the
welfare of shareholders of the bank.
More importantly, the depositors of Islamic banks like their conventional coun-
terparts are mostly small savers who are assumed to be risk-averse (Muljawan et
al., 2004; Nienhaus, 2007). A wholesale transfer of risk may keep this group of
depositors away from the formal financial system. The fact is that we should not
view Islamic and conventional banks as competitors to each other. But rather,
the operation of Islamic banks can be seen as complementary, to a great extent,
to the conventional banking model at least, in regard to financial inclusion and
financial stability.
We do not deny the claim that PLS-based Islamic finance is associated with
greater potentials. Our point of departure from the ‘idealist’ Islamic economists
is that promoting participatory financing (or the financing to marginal clients)
under the current mode of PLS upon the risk-averse nature of small investors
would be problematic to the banks. As Chapra (2002, p. 222) states, “there may
be nothing basically wrong in a reasonable amount of short-term debt that is
used for financing the purchase and sale of real goods and services.” From this
perspective, let the Islamic banks finance on the basis of mark-up at a reasonable
amount. Participatory financing (or financing for marginal clients) needs can be
satisfied by other Islamic financial institutions like Islamic venture capital firms
and microfinance institutions.

3. Alternative views upon division of work and

specialization in Islamic finance
Most studies of Islamic ‘idealist’ literature attribute the rise of murabaha concen-
tration to agency problems. As a result, policy prescriptions for shifting from a
debt-like financing to PLS-based financing centers on resolving agency problems
(Maurer, 2002; Khalil et. al, 2002; Farooq, 2007). In so doing, the literature,
however, treats agency problems embedded in musharaka and mudaraba in the
 Alternative views 181
same manner although the nature of agency problems is different for these two
contracts. For instance, musharaka is a partnership contract where agency prob-
lems are evident. In contrast, mudaraba is a trust-based contract which does
not entail agency risk ostensibly, because the rab-ul-mal (financier) trusts the
mudarib (entrepreneur).
Here, we support the view that Islamic banks should be kept away from trust-
based financing because they are responsible for paying the best effort to protect
the welfare of their depositors. In a mudaraba contract, financiers ‘trust’ the
entrepreneurs in regard to their sincerity and dedication to the project’s success
as well as honesty in dealing with financial information that affects the contract.
Khalil et al. (2002) find that project attributes, the quality of the entrepreneur,
and religious considerations are the three most important agency-contractual
problems in mudaraba financing. These attributes while critical for mudaraba
contract are unobservable. Islamic banks as depository corporations cannot sim-
ply rely on these intangible attributes of entrepreneurs given the fact that indi-
viduals vary greatly in terms of their belief in the omnipotence. Also, individuals’
dedication to religious and spiritual belief fluctuates over time. Hence Islamic
banks find it difficult to extend depositors’ funds to finance projects based on
mudaraba.
Islamic banks may show similar conservative behavior in financing small and
medium enterprises. It is reported in many studies that firms at their infant stage
find it difficult to access the capital market for their necessary financing (Cosh
and Hughes, 2003; Fraser, 2005; Cowling et al., 2012). This can be attributed
to the firms’ lack of sufficient information and a proper track record of busi-
ness which are considered the prerequisites for accessing finance (Berger and
Udell, 1998; Revest and Sapio, 2012). These start-ups tend to rely heavily on
bank-based financing besides their limited self-financing. Given various modes of
finance offered by Islamic banks, these start-ups may prefer participatory financ-
ing which does not essentially meet the conditions of collateral. Moreover, newly
established firms look for partners so that the associated risks and uncertainties of
projects can be shared. Islamic banks on the other hand have their own business
strategies in terms of risk-appetite and profitability. They may perceive young
and small firms to be highly risky. At the same time, they may be dubious about
the personal attributes of the entrepreneur. Thus, Islamic banks tend to be very
conservative in engaging with young and small enterprises.
While we support Islamic banks’ conservative behavior for financing mudaraba
as well as start-up projects, we however argue that financing needs of these pro-
jects can be met by other financial institutions which possess a comparative
advantage over Islamic banks in financing these enterprises. Islamic venture capi-
tal (VC) is one among them. Many Islamic VC firms are established by Islamic
banks as their venture capital wing dedicated to venture capital financing. How-
ever, this should be modeled after special purpose entity (SPE/SPV) so that the
depositors of mainstream Islamic banking operations remain unaffected by the
economic outcome of the SPE/SPV. It is logical to assume that some risk-neutral
investors devoted to the Islamic faith live in society and prefer higher returns at
182  Yasushi Suzuki and Mohammad Dulal Miah
the exchange of higher risk. These investors are unlikely to be tapped by the tra-
ditional Islamic banking system that offers benchmark returns to the investment
account holders. Thus, independent VC firms are expected to become the effec-
tive vehicle to bring these risk-neutral investors into Islamic financial systems.
We consider this strategy a less cumbersome alternative to a strategy of naively
expecting Islamic banks to expand participatory financing, although the emer-
gence of a large and diversified base of risk-neutral investors which are willing to
sufficiently absorb various types of risk and uncertainty embedded in innovative
start-ups is a prerequisite for the strategy (see Chapter 5 of this book for the real-
ity in the Islamic VC industry).
Islamic banks are also facing the difficulty of sharing risk and uncertainty embed-
ded in microfinance towards marginal clients. Recently, microfinance institutions
(MFIs) such as Grameen Bank have got widespread coverage in empowering the
poor. They appear to possess some comparative advantage in mitigating risks
and uncertainties associated with their marginal clients. One of the important
institutional settings for successful MFIs is to be able to raise concessional funds
from the donors and NGOs enough to absorb the associated risk and uncertainty
(see Chapter 7 of this book for the details). Although microfinance entails a
huge potential and can simply be accommodated to the Shari’ah principles, the
sector did not grow expectedly. Suzuki and Miah (2015) identify some critical
constraints that restrict the growth of Islamic microfinance. They argue that the
key constraint to the development of this segment of small-scale finance is the
inadequate supply of funds. Although many Islamic microfinance institutes work
under the auspices of Islamic banks, the supply of funds is very scanty vis-à-vis the
demand (Suzuki and Miah, 2015).
Traditionally, financing needs of start-up firms were satisfied by the venture
capitalists, while financing needs of marginal clients were nurtured by the initia-
tives of MFIs. In the same way, it would make sense to seek the ‘division of work’
and ‘specialization’ in Islamic finance. Islamic VC firms are expected to mobilize
more ‘risk funds’ from a relatively large and diversified base of investors who are
willing to absorb risk and uncertainty embedded in innovative start-ups. On the
other hand, Islamic MFIs are expected to mobilize more ‘concessional funds’
from waqf/zakat or Islamic multinational financial organizations or donors who
are ready to contribute to poverty alleviation by empowering the poor.
Given the nature of commercial banks as depository corporations, it makes sense
for Islamic banks to concentrate on the mark-up based financing on their attempt
to protect the welfare of depositors. This ‘division of work’ and ‘specialization’
strategy by Islamic banks would contribute to mediate more ‘safety’ idle money
from the general risk-averse depositors who are limitedly willing to absorb risk
and uncertainty, as well as meet the still-strong demand of asset-based investment,
partly contributing to further economic development through the credit multiplier.
An expansion of participatory financing undertaken by Islamic VC or an
increased participation of MFIs for catering to the financing needs of small and
marginalized borrowers requires some issues, discussed in the following section,
to be properly addressed.
 Alternative views 183

4. Issues to be resolved for expanding participatory

financing

4.1  Mitigating agency problems

The genesis of agency problems is the asymmetry of information and moral haz-
ard problems. Thus, the key to mitigating agency problems lies in how to reduce
these twin problems. In the developed countries, credit rating agencies reduce
information asymmetry to a greater extent. Developing countries where most
Islamic financial institutions are based lack this particular institution because the
system would be excessively costly. This calls for an alternative mechanism to
be devised. A national system of information repository can be maintained par-
ticularly for small and medium enterprises (SMEs), what can be called the ‘SME
Foundation’. This foundation would aim to keep record of relevant information
about SMEs, especially their financing structure and the history of debt repay-
ment habit. Moreover, the success of projects initiated by a particular entrepre-
neur can be accounted for.
Although this information is difficult to retrieve, cooperation among and
between different branches of the state may facilitate necessary information col-
lection. For instance, a start-up is required to receive a license from the con-
cerned office of the country or region; it needs clearance from the central banks
for applying for a loan; it is also supposed to acquire tax certificates for the busi-
ness purpose. Digitalization of these systems can automatically track an entrepre-
neur and can generate some necessary information for any financiers to consider.
An SME Foundation can be digitally linked to the information database of a
particular entrepreneur. Based on different criteria, the SME Foundation can
rank an individual’s financial traits in a transparent manner which can be used
by financial institutions such as VC or MFIs (also Islamic banks in financing
musharaka) in deciding if it is logical to partner with an entrepreneur or finance
the marginalized borrowers. Financial institutions would seriously consider the
provided information because they can share the fortune of a successful project
whereas entrepreneurs would be willing to provide data because doing so would
enhance their chance of being financed.
Of course, the system mentioned earlier in the chapter is unlikely to check
entrepreneurs’ moral hazard once the project is financed. It is to be noted that
asymmetry of information does not harm the contract if parties do not behave
opportunistically. Williamson (1985) epitomizes the contracting problem
admitting two important aspects of human behavior: bounded rationality and
opportunism. If we assume that the human brain possesses unlimited calcula-
tive power, problems stemming from opportunism can be tackled by writing a
comprehensive contract ex ante. Also, ex post opportunism can be averted by tak-
ing every future contingency into account. Similarly, if human behavior is non-
opportunistic, contracting problems arising ex post due to bounded rationality
can be overcome because parties have agreed to cooperate and disclose all the
relevant information that affects the contract. Since human-bounded rationality
184  Yasushi Suzuki and Mohammad Dulal Miah
should be admitted, effective PLS contracting requires that contracting parties
do not behave opportunistically.
Moral hazard of entrepreneurs that hurts the interest of financiers, in most
instances, may take the form of underreporting of profit or over invoicing of
costs. These instances can be safeguarded by initiating an interim audit of the
project. Financiers should have the discretion to initiate surprising audit as and
when they deem fit. Provisions for imposing severe penalties can be prescribed
in case the audit finds any anomalies in the profit or expense items which nega-
tively affect the interest of financiers. A sincere and honest entrepreneur should
have no objection to this provision. This arrangement would protect the interest
of both parties in the contract. Also, two other necessary steps can be useful in
mitigating the actor’s moral hazard. First, strategies are to be made to reduce the
unaccounted cash flow of any project; and second, attempts are to be made so
that the level of discretionary cost is minimized. These strategies are believed to
squeeze entrepreneurs’ scope of over or underreporting of cash flows.

4.2  Trust and relation-based contracting

Islamic finance during the time of the Prophet and the subsequent Caliphates
was based on mudaraba. Agency problems were not highly pronounced because
most transactions were accomplished based on trust and morality. Abdul-Rahman
et al. (2014) contend that trust was developed from the financier’s knowledge of
the entrepreneur’s conviction to noble values and his esteemed personality. This
informal institution reduces the designing and implementing cost of formal rules
and regulations. Abdul-Rahman et al. (2014) further note that formal institu-
tions are unlikely to replace the deep-seated trust developed through interactions
between financiers and entrepreneurs. The Muslim community, besides creating
wealth in business, should be striving to achieve rewards for the life hereafter by
being moral and honest. If so, entrepreneurs would be more compelling by put-
ting their sincere efforts into making the project successful and revealing the true
performance of firms.
Although trust is an intangible attribute and difficult to ascertain, lending and
borrowing activities relying on trust and relation in the modern world are not
rare either. For instance, Japan and Germany during their economic and financial
heyday practiced a distinct financial system known as a ‘relation-based’ system.
Unlike the Anglo-American market-based financial system in which the capital
market meets the major financing needs of corporations, firms in the bank-based
system rely extensively on the banking system to meet their financing needs. In
Japan, a specific bank worked as a lead bank called the main bank (hausbank in
Germany) that supplied the major share of a client’s total external financing need.
A tightly knit relationship between the main bank and a borrower facilitated
the free flow of information as well as reduced moral hazard of the borrower.
The system was incentive compatible in the sense that clients during their finan-
cial distress received financial and advisory assistance from the lending banks.
In exchange, the lending banks used to enjoy ‘rent’ or more than competitive
 Alternative views 185
market rates during the high profit period of clients’ firms. The foundation of the
system relied on trust and cooperation between the interacting parties. They were
committed to honor and respect the trust regardless of business outcome. Any
breach in trust resulted in serious social and economic repercussion.
This trust-based relationship system is highly compatible with the participa-
tory Islamic banking model. Toriqullah Khan (1995) argues that the contractual
relationships and trust between parties are the two fundamental building blocks
of an Islamic economic system. It is mentioned in the Holy Qur’an (Chapter 23,
Verses 1 and 8) that “successful are the believers those who are faithfully true to
their amanat (all the duties which Allah has ordained: honesty, moral responsi-
bility, and trust) and to their covenants.” Although cultural artifacts significantly
influence the level of trust held by the members of a society, the Islamic mode of
finance has the greater possibility to adapt to this system because the contract-
ing parties themselves share similar characteristics, notably a common faith that
affects their economic and financial behavior. Clients believing in the Islamic faith
should disclose relevant information that affects the contract. If Islamic banks can
build the trust exemplified by the Prophet and his companions, agency problems
can be reduced to a greater extent.
Although less revealed and formally analyzed, trust- and relation-based financ-
ing are practiced in some instances. Abalkhail and Presley (2002) show that Saudi
informal financiers rely heavily on the trust of their clients. Their study shows that
among the top five entrepreneurial criteria, ‘trust’ ranks second after the entre-
preneur’s success in ventures in the past. Karim (2002) presents a case of Bank
Muamalat showing that the bank has been successful in initiating mudaraba and
musharaka financing through a cooperative financing system in which the bank
has emphasized reducing the non-observable cash flow as well as discretionary
expenses. Similarly, Sadr and Iqbal (2002) have investigated the nature of trust-
based investment undertaken by Agriculture Bank of Iran (ABI). The authors
argue that through continuous and frequent supervision, the ABI has established
a very solid and trusting relationship with the partners. By investing in supervi-
sion, the bank seems to be able to learn about profitable investment opportu-
nities in various agricultural regions and about the entrepreneurial and moral
characteristics of its partners. They show that in 1996, an 80 percent recovery
rate of the total outstanding debt was left over to the borrowers. Recovery rate
on Islamic contracts is impressive and ranges between 95 and 99 percent. An
insightful analysis of these cases is necessary to disintegrate the elements of trust
contained in them for an expansion of Islamic participatory finance.
No doubt, trust and relations are intangible features of human beings which
are susceptible to be exploited by any opportunist entrepreneur. Like the prov-
erb ‘good fences make good neighbors’, strict formal regulations force people
to be loyal and trustworthy. Thus, the level of trust in society is the function of
its formal and informal rules. Formal rules should be updated and implemented
effectively. On the other hand, there should be a system of informal punishment
for breaking trust. The genesis of formal rules should start with the protection
of one’s rights.
186  Yasushi Suzuki and Mohammad Dulal Miah
4.3  Efficient structure of property rights
Well-defined property rights are a prerequisite for PLS contracts. Lenders or
financiers’ rights are at stake due to the lack of legal protection under the current
mode of PLS. As hinted earlier, man-made rules are required because honesty
and faith in the life hereafter are unobservable traits of human beings. The foun-
dation of any man-made institution should be the institution of efficient property
rights. Although Islamic tradition believes that the sole ownership of property
remains to Allah and property owners in this world are simply the custodians,
there is no prohibition of owning private property for the purpose of generating
profit, creating employment, increasing investment and prosperity (Azid et al.,
2007). Strong property rights tend to provide financiers with a sense of security
about the return of their investment and if possible with some addition. If finan-
ciers find ex post that entrepreneurs are shirking or hiding information that may
hurt the interest of the financiers in the project, financiers can resort to the court
to protect their interest. Strong enforcement of contracts may accompany the
reduction of the moral hazard problem.
PLS contracts are deemed to be less attractive because property rights in most
Muslim countries are not properly defined or protected (Farooq, 2007). It is not
enough that the rules and regulations of a country are prevalent. It is important
to ensure that these rules are pragmatic and implemented at the lowest cost. In
the context of Islamic finance, there are many issues which may seem to be new
or not historically practiced by the legal system in many societies. Thus, Islamic
jurists should be equipped well with fiqh knowledge and modern financing tech-
niques to clearly understand the respective rights in a contract. It is not uncom-
mon that in many developing countries winding up or bankruptcy procedures of
firms take years to be finished. Such a cumbersome legal system even if strong
may not render expected services due to legal inertia or exorbitant costs. Thus, a
strong and simplified nature of property rights should supplement the Shari’ah
principles in this particular regard for expanding PLS-based finance.

4.4  Islamic jurisprudence on risk-hedging tools

Chapter 3 has outlined in detail the existing debate in regard to acceptable lim-
its of gharar. Islam encourages participatory financing which is associated with
fundamental uncertainty of entrepreneurs. On the other hand, Shari’ah rules
prohibit economic agents from dealing with excessive gharar. Although Islamic
jurists have distinguished between major or excessive gharar (El-Gamal, 2006),
the problem is that the extent of uncertainty which makes any transaction haram
has not been clearly defined (Ayub, 2007). Although this excuse should not be
put forward to justify the current accumulation of mark-up financing of Islamic
banks, non-clarity in regard to acceptable gharar may provide Islamic banks a
moral ground to shun away from PLS-based financing.
Moreover, PLS-based financing is embedded in risk which financial institu-
tions may wish to hedge through using some available financial mechanisms.
 Alternative views 187
The conventional derivative products are unsuitable because they are most often
involved with maysir (gambling). Although Aurbun is an allowed hedging tech-
nique, some Madhabs disagree on some clauses of Aurbun. It is essential that the
Islamic Fiqh Council initiates an in-depth research on the analysis of Qur’anic terms
and Prophetic Sunnah to arrive at a consensus in regard to issues which are cur-
rently not clearly understood by the general practitioners of Islamic finance. Gharar
is one example of these blurred issues. At the same time, the Fiqh Council should
come into a consensus through seeking experts’ opinions on the suitable nature
of derivatives permissible for Islamic financial institutions. If currently practiced
derivatives are unsuitable for them the new risk-hedging tools should be invented.
Moreover, sustainable development of participatory finance requires long-
term vision of developing Islamic scholars with the knowledge of finance. Morais
(2007) reports that about 20 Shari’ah scholars are available worldwide who have
the necessary stature to certify something as Shari’ah compliant. He further
reports that these scholars sit on 40–50 Shari’ah boards each. Perhaps because of
time constraints of these Shari’ah scholars, Khan (2010, p. 817) argues that they

are satisfied if the IBF (Islamic Banking and Financial) institutions convince
their customers that they are partaking in something exclusively Islamic,
something that reinforces the borrower’s ‘Islamic identity’ rather than in
ensuring that the financial products on offer are truly different.

This requires international governing bodies to formulate policies on how to

equip qualified Islamic scholars with financial knowledge.

4.5  Profit management

The current mark-up financing mode of Islamic banking is criticized on the
ground that it is a costlier alternative to the conventional banking model
(Kuran, 1996) in the sense that the model serves the same purpose as does
the conventional banking model but the former incurs additional transaction
costs because multiple parties’ involvement is required to accomplish a single
transaction. Despite this criticism, the mark-up financing is Shari’ah compliant
whereas the conventional bank lending is not. In this sense, the mark-up model
is better than a state of no-Shari’ah compliance financing for clients devoted to
the Islamic faith.
Islamic banks have to compete with conventional banks in both the deposit
and lending markets. While it is true that depositors and investors having faith
in Islamic teaching should strive to comply with Islamic principles instead of
looking for conventional alternatives, it is not clear whether this judgement can
remain valid if the mainstream conventional alternatives offer higher returns on
deposit and thinner interest on lending compared to Islamic banks. This compels
Islamic banks to focus on mark-up financing which is considered less risky than
the PLS financing in the sense that the return on debt-contracts is fixed whereas
return on participatory financing is variable and uncertain.
188  Yasushi Suzuki and Mohammad Dulal Miah
As hinted earlier, given the risk-neutral characteristics of the depositors of
Islamic banks, it is infeasible on the part of banks to function simply as inter-
mediary between the depositors and the entrepreneurs so that banks can simply
transfer the risk involved with the projects to the depositors. Although some
studies find that Muslim depositors do not really care about a promised return
for deposit (Abdullah et al., 2016), the fact is not universal. Erol and El-Bdour
(1989) find that religious motives did not stand out as being the major sig-
nificant motive for depositors in considering motives responsible for selecting
Islamic banks as depository institutions. This indicates that Islamic banks should
offer depositors competitive rates in commensuration with conventional banks.
Most Islamic banks thus stabilize the rate through managing profit. They cre-
ate profit equalization reserves (PER) and investment risk reserves (IRR). Dur-
ing economic upturn which is expected to bring above average profit, Islamic
banks retain a portion of this earning and distribute to the depositors in a year
of comparatively bad returns on investment. Banks benchmark to the market
interest rate in deciding an appropriate percentage on investment to be paid to
depositors. Thus, it is not surprising that the return on deposits of Islamic banks
coincides with the market rate.
Although this policy may hypothetically help banks avoid displaced commercial
risk, such a profit management mechanisms is redundant at best because more
than 90 percent of Islamic banks’ financing is based on fixed or mark-up return.
While the demand side of funds remains dominated by fixed returns, it is rather
irrational to see neutralizing the fluctuation of return in the supply side. We
argue that profit management mechanisms would be worth more if a reasonable
amount of investment in Islamic banks takes place in the form of PLS such as
musharaka. This implies that the current practice of profit management is irrel-
evant which would make great sense if Islamic banks participate reasonably in
the participatory financing mode. Thus, Shari’ah boards should carefully permit
PER and IRR of Islamic banks unless their PLS-based financing reaches a certain
threshold.

5. Conclusion
Scholars of Islamic finance are in consensus that the true spirit of Islamic finance
lies in the widespread use of PLS. The existing practice thus falls short of this
expectation. In the equity-based Islamic financing model, banks as financial inter-
mediaries can do very little to change the dominance of mark-up-based practices
because the risk banks undertake by extending finance to investors can be shifted,
in an ideal case, to the depositors if they are risk neutral. Islamic banks should
face no difficulty in transferring the risk at this circumstance. On the contrary, if
depositors are risk-averse, direct transfer of risk is infeasible. Here comes the role
of banks. They absorb part of the investors’ risk before shifting it to the deposi-
tors. Banking as an industry is very special and sensitive which means that banks
possess only limited capacity for absorbing risk. Thus, it is logical for them to
avoid risky investments to such an extent that does not defy the existing legal
 Alternative views 189
system. Since debt-like or murabaha financing is endorsed by the Shari’ah board
as Shari’ah compliant, concentration of Islamic banks to this mode is rather a
rational choice.
We have further argued that Islamic banking is a demand-driven industry which
claims enormous popularity in Muslim-majority countries. Thus, any regulatory
changes aiming to curb banks’ reliance on murabaha financing may adversely
affect the industry in different ways. For instance, any restriction on murabaha
financing is likely to compel banks to gorge higher risk involved with participa-
tory financing which may result in overall financial catastrophe. On the other
hand, banks’ strategy to transfer the risk to depositors may end up with losing
the deposit base. Either way, the scarce fund will be dried up from the formal
financial system. Based on this argument, we propose the division of work and
specialization of Islamic banks in which the mainstream operations will remain
mark-up dominant to protect the welfare of depositors whereas independent ven-
ture capital firms and microfinance institutes would dedicate themselves to cater-
ing to the equity financing needs of entrepreneurs and the financing of marginal
clients, respectively.
Of course, Islamic banks can increase their participation in equity-based finance
to a reasonable extent through musharaka contracts. However, some institutional
settings are required to encourage banks as well as VCs and Islamic MFIs towards
this end. Salient among them are instituting a strong property right so that all
the parties’ interests in the contract are adequately protected. We believe that a
strong legal system should supplement the moral sentiment of financiers which
may facilitate trust- and relation-based participatory finance. Furthermore, it is
essential for Islamic scholars to endorse some risk-hedging financial tools. Since
equity-based financing of Islamic banks is accompanied with higher risk, banks’
risk-hedging strategy is vital to encourage Islamic banks for musharaka financing.
Conclusion
Yasushi Suzuki and Mohammad Dulal Miah

The phenomenal growth of Islamic finance in the last couple of decades has
attracted considerable attention from scholars and policymakers alike. Various
issues including the distinctive nature of Islamic finance, its impact on the devel-
opment and stability of the financial system, the long-term sustainability of the
model and its competitive advantage over the conventional counterpart occupy
the center of academic discussion. One of the distinct characteristics of Islamic
finance is risk sharing. The financier and the entrepreneur mutually absorb the
risk involved with a project through equity and/or equity-like participation. This
in turn results in the spread of venture firms leading to larger business activi-
ties and economic progress. While these expected benefits cannot be neglected,
a large segment of the Muslim population has not yet fully embraced Islamic
finance as a way of their economic lives due to various reasons. According to
some scholars, the current practice of Islamic finance conforms less to the sub-
stance of Islamic teaching because Islamic finance is dominated by the banking
industry that prefers debt-like financing over PLS contracts, although diversity in
Islamic financial products, to some extent, very recently can be noted.
The book has attempted to explain the logic of murabaha or mark-up bias of
Islamic banks. In so doing the book takes the view of modern banking theories
which explain the sensitive nature of banks and the repercussion that may result
from financial intermediaries’ excessive risk appetite. An analysis of banking and
financial fragility supports the proposition that most financial crises precede an
event of excess risk-taking. In this sense, risk-neutral behavior of financial inter-
mediaries augurs well for the economy. Just criticizing murabaha concentration
or conservative behavior of Islamic banks is unfair at best.
On the other hand, conservative behavior of Islamic banks creates an obvious
challenge as to how the Islamic financial system should be designed to expand
equity-like PLS-based finance where Islamic banks, being the dominant players in
the Islamic financial system, shy away from investing in the participatory mode.
Unfolding this challenge occupies the central theme of the book. In the exist-
ing debate it has been argued that as long as murabaha is allowed without limit,
Islamic banks are unlikely, and rationally so, to be engaged with equity-like PLS-
based financing. The reason is that murabaha is an incentive-compatible mode
of finance for Islamic banks in terms of risk–return tradeoff. At this circumstance,
 Conclusion 191
any attempt to increase the PLS-based Islamic finance may require regulatory
authority either to emphasize other types of Islamic financial institutions or to
impose an outright restriction on the use of murabaha.
The latter view is not economically convincing because there is no guaran-
tee that a restriction on the use of murabaha is accompanied by an increase in
PLS. Although murabaha contracts specify pre-agreed fixed returns it is the sale-
based transaction which is allowed in Islamic Shari’ah. The asset-backed mura-
baha financing facilitates and supports the economic activities of, in particular,
the merchants in the Muslim economy. In this perspective, restricting murabaha
entails financial disintermediation which may prove to be welfare-reducing for
the economy.
Thus, the general arguments of this book echo the proposition that an alterna-
tive mode of PLS system is welfare enhancing. In this regard, we have put our
views towards a new mode of Islamic finance in the previous chapter. It is not an
easy task to design an alternative mode of achieving a delicate balance in mobiliz-
ing funds from risk-averse depositors while creating and accumulating the wealth
in society enough for incubating risk-neutral investors or donors who would be
willing to absorb various types of risk and uncertainty exposed to innovative start-
ups or to empower marginalized people. Now it is time to conclude our argu-
ment, which can be summarized as follows.
First, safety of the banking industry is utmost important for the greater stability
of a financial system. Islamic banks as depository corporations have to pay the best
effort to protect the welfare of their general depositors. As a consequence, sug-
gesting Islamic banks to assume higher risk involved with trust-based mudaraba
finance is less compelling. Due to their economic and social role of interme-
diating depositors’ funds, the ethical mode of trust-based finance is unsuitable
for Islamic banks. On the other hand, the participatory form of financing or
musharaka would be feasible in accordance with the effective power retained by
Islamic banks to monitor and discipline the clients or partners. However, under
the current regulation for encouraging the mode of PLS, Islamic banks are not
given adequate incentives to develop the ‘hands-on’ skill and knowledge neces-
sary for the effective monitoring of entrepreneurs. This implies that under the
current mode of PLS, Islamic banks are to be discouraged to engage in participa-
tory musharaka financing, too.
Second, Islamic venture capital (VC) firms are expected to engage in participa-
tory finance. However, the Islamic VC industry is still underdeveloped. Several
cases of Islamic venture capital operating in different Muslim countries have been
analyzed to show their contribution to the economy measured by various yard-
sticks. Also, the future prospects of these funds as well as the impediments that
may come across their growth have been examined. The success of this industry
depends on how to diversify and absorb the risk and uncertainty embedded in the
innovative start-ups. It is mentioned that Islamic virtues of altruism and reciproc-
ity urge wealthy individuals to help the fellow entrepreneurs who lack necessary
financial strength to start a project. However, due to the difficulty of observing
one’s dedication to the religious belief, financiers who subscribe to a strong sense
192  Yasushi Suzuki and Mohammad Dulal Miah
of reciprocity may be reluctant to finance the entrepreneurs. While individuals’
moral commitment should be emphasized and respected, the book endorses the
view that there is a need for designing institutions to protect the financier’s rights
in the contracts. In particular, the national system of property rights should be
effectively implemented and simplified so that transaction costs remain low.
Third, Islamic banks show very little interest in financing small and marginal-
ized borrowers. Since deposits are the major source of funds for banks, they must
place all sorts of feasible attempts in securing assurance from the entrepreneurs
that the promised amount will be recovered. Small borrowers, in most instances,
fail to provide such reliable and feasible assurances because they lack tangible col-
lateral or proven business track records. Taking these facts into account, the book
portrays the role of Islamic microfinance institutes (MFI) to assess if they can
cater to the needs of small and marginal borrowers. The success factors of con-
ventional MFI have been singled out and examples have been presented showing
how Islamic MFI can be remodelled for accomplishing this goal. One critical
constraint highlighted in the book is that, unlike their conventional counterparts,
Islamic MFI suffers from being short of funds. This has been attributed to the
failure of these MFIs in their attempts to convince the potential donors about the
distinct features as Islamic MFIs. There is a dilemma in which many Islamic MFIs
are operated under the patronage of Islamic banks that are not always willing to
undertake the credit risk of marginalized borrowers.
Apart from an idealistic view, the Islamic financial system should, in our view,
take a trial-and-error process to evolve upon the ‘specialization’ and ‘division of
work’ in credit risk screening activities and monitoring functions. In this context,
Islamic banks should play a specialized function as depository corporations and
fund providers mainly for small- and middle-sized merchants and manufacturers,
Islamic VC firms should act as incubators, and Islamic MFIs should act as finan-
cial intermediaries for empowering marginalized clients. A policy prescription
requiring tax advantages for incubating Islamic VC and microfinance industries
should be paid more attention.
The book has also stressed the need for some key institutional design for
mitigating multiple principal–agent problems embedded in Islamic finance. For
instance, the book is unequivocal in suggesting the independence of Shari’ah
boards. The current practice of the appointment and remuneration system may
compromise boards’ independence, at least ‘in appearance’ if not ‘in practice’.
The book has explicitly mentioned the feasibility of arranging payment to board
members facilitated by the state mediators like the central bank or other such
centrally governed enterprises, though governmental support only to the Islamic
banks would cause another dilemma because the government has to ensure the
‘level playing field’ for fair competition in the industry including the conventional
banks within the country. The governance system also entails a trial-and-error
process to evolve.
The book emphasizes that there is no ready-made solution to the expansion
of Islamic participatory finance and Islamic microfinance. It requires a concerted
effort from the concerned stakeholders including market participants, regulatory
 Conclusion 193
authority, and Shari’ah boards. Participants’ understanding on the divine reward
and punishment as well as the moral and spiritual advantage derived from adopt-
ing the sacred concept of PLS and seeking for social justice is essential. At the
same time, it is duly acknowledged that such institutional design for the expan-
sion of PLS requires costs. The innate benefit derived from facilitating participa-
tory finance, empowering the poor, and strengthening the governance structure
is expected to outweigh the costs even in the economic sense.
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Index

Note: Page numbers in italic indicate a figure and page numbers in bold indicate a
table on the corresponding page.

adverse selection 2, 82, 120, 149, 177 banking see conventional banking;

altruism 2, 4; in Islam 65 – 69, 75 – 76; Islamic banks
trust and 64 – 65; and venture capital behaviour 48, 49; see also opportunism;
61 – 62, 73, 83, 191 trust
angel investors 2 bonds 5, 86, 118 – 119, 125; see also
animal spirits 52, 52 Sukuk
Arab Spring 86, 89 borrowers 2, 6, 8, 55, 112, 192; see also
artificial neural networks see impact interest; microfinance; profit-and-loss
assessment sharing (PLS); riba
asymmetry of information 6; and agency
problems 183; and governance capitalism 3, 20 – 22, 26; see also Marxian
structure 149 – 150; and microfinance economics
112, 113, 117, 119 – 120, 125; and collateral 2, 6; in financing small
moral hazard 177; and Sukuk; and and medium enterprises 181; in
venture capital 61, 82 microfinance 113, 114, 116, 120,
awaqaf (perpetual charity) 66 124; in musharaka financing 55; and
poor people 128; and Sukuk 103; in
Bahrain 4; musharaka mode of financing venture capital 69
in 71; Shari’ah-based financing in 34, conventional banking 23, 28 – 29, 32,
35, 36; Shari’ah board in 151, 163, 40, 167, 169, 187
166, 167; venture capital in 77, 84, cooperative modes 6, 69, 86, 90, 129,
85, 86 – 89, 87, 88, 94 185; see also Islamic Saving-Loan and
bai bithman ajil 1, 28, 29, 33 Financing Cooperatives (KSPPS);
bai muajjal, 28, 29, 33, 34 microfinance
bai salam (forward sale contract) 1, credit see microfinance
28, 34 creditworthiness 6, 98
Bakar, Dr Mohd Daud 41, 84, 108,
110n2, 160; see also Shari’ah Minds in debt-contracts 2
Islamic Finance decision-making 25, 48 – 49, 149; see
Bangladesh: bai bithman ajil in 33; also Shari’ah board
Islamic banking sector in 167 – 170, deferred installment 3, 30, 33, 100, 116
169, 170; microfinance in 6, 112, depositors: and credit portfolio
114 – 121, 115, 125; murabaha in selection by commercial banks 93;
29, 34, 37, 39, 70; Shari’ah boards in and Islamic banks 23, 191; and
7; Sukuk markets in 5, 95 – 102, 99, microfinance 118, 128 – 129; and
103, 104, 106, 109; venture capital possibility of exploitation in lending
in 84, 85 relationship 26; and profit-and-loss
 Index  213
sharing 28, 31, 41 – 42, 149 – 150, and 30; social enterprise 70; and
157; and prohibition of gharar 51, venture capital 80, 82 – 83, 89 – 90;
54; protection of 4, 178 – 182; and see also microenterprises; small- and
Shari’ah compliance 187 – 188; and medium-sized enterprises (SMEs)
uncertainty 25 entrepreneurial activity: and corporate
deposits 2; and Islamic banks 23, 170, governance 158; in Islamic
188; and microfinance 116, 118, convention 70, 75; and lending
122, 192; and profit-and-loss sharing relationship 26; moral hazard and
40, 149; and the prohibition of riba 184; and risk sharing 190; and trust
24, 26 185; and uncertainty 2; and venture
development: development aid 118; capital 61, 77, 79 – 83, 94; see also
of Islamic finance 2, 39, 148, mudaraba; musharaka; venture capital
156 – 157, 161, 164 – 165; and the equity see profit-and-loss sharing (PLS);
Maqasid al-Shari’ah 128, 131; and venture capital
microfinance 111 – 116, 120, 124, ex ante 44, 47, 61 – 63, 69, 71, 73,
125, 182; of participatory finance 75, 183
187; and regulatory framework 119; exploitation 14, 17, 20, 25 – 26, 54
and Shari’ah board 168; and Sukuk ex post 50, 63, 67, 73; and information
100; and venture capital 72, 81, 82, 75, 177, 186; and opportunism 47,
86; see also entrepreneurial activity; 69, 183
venture capital
distribution: and altruism and fatwa 56, 74; and governance structure
reciprocity 68; in capitalist mode 102, 152, 154, 155, 160; and
26; in Marxian analysis 3, 16; and Shari’ah compliance frameworks
microfinance 78, 79; and murabaha 166 – 167, 167, 168, 172 – 173, 173,
concentration 41; opinions among 174; and venture capital 84
Imams regarding 44n1; and financialization 19, 24 – 25
regulatory framework 102; and Sukuk first-come-first-served 100
100, 107; and venture capital 79 fiqh 56, 156, 165, 186; fiqh scholars 86;
division of work 8, 180 – 182, 189 see also Islamic Fiqh Council
donor funds 113 fiqh al-muamalat 85, 153, 160, 165
functionless investors 11 – 12, 17, 20,
economics: heterodox school of 11 – 12, 23, 25
16; Islamic principles of 15, 41, 52, fund providers 22, 25, 31, 42,
54, 127; microeconomics 149; see 72 – 74,  83
also Keynesian economics; Marxian funds recovery method 6
economics; New Institutional
Economics (NIE); Post-Keynesian gharar (uncertainty) 1, 3, 4, 71; and
Economics; Transaction Cost Islamic jurisprudence 186 – 187;
Economics (TCE) linkage between theory and
Emirates Airline 108 practice of prohibition of 55 – 57;
employment 3; in impact assessment and murabaha syndrome 23;
134, 141; interest and 18 – 19, 22, 26; prohibition of 11 – 12, 13, 15, 25;
microfinance and 111, 116, 122; and scope of acceptable 24, 45 – 46;
property rights in Islamic tradition trans-disciplinary framework for
186; and venture capital 61, 70, 53 – 55; and Shari’ah compliance
74, 83 165; and venture capital 84; see also
enterprise: cooperative 6; distinguished incomplete contracting; uncertainty
from speculation 51 – 53, 52; financing governance structure 3, 7; independent
of 2, 181; interest and 16 – 18; in director 162n2; in Islamic finance
Islamic mode of investment 15; and 149 – 151, 149, 160 – 161; UK
profit-and-loss sharing 73; uncertainty Corporate Governance Code
in 4, 24, 54 – 56, 61; musharaka 156 – 160; see also Shari’ah board
214 Index
Grameen Bank (GB) 6, 111 – 112, bai bithman ajil; bai muajjal; bai
114 – 115, 115, 117 – 121, 125, 182 salam (forward sale contract); ijarah
Guidelines for Conducting Islamic (leasing); istisna (commissioned or
Banking 98, 102, 103, 171, 175 contract manufacturing); mudaraba
(trust-based finance); murabaha
healthcare 89 (mark-up); musharaka (participatory
heterodox see under economics finance)
Islamic bond see Sukuk
idle money 3, 22, 24, 182 Islamic Fiqh Council 187
ijarah (leasing) 1, 28, 28, 41, 57, 137 Islamic Saving-Loan and Financing
impact assessment 6; artificial neural Cooperatives (KSPPS) 6, 129,
networks 134 – 136, 139 – 144, 142, 131 – 132, 137 – 140, 138, 139, 144
143; limitations of 130 – 131; of istisna (commissioned or contract
microfinance on poverty alleviation manufacturing) 28, 33 – 34, 43
131 – 136, 133, 134, 137 – 144, 138, ithar 65 – 67,  71
139, 140;
incomplete contracting 4, 46 – 47, 61 J-sukuk 5, 106 – 109
Indonesia 4; financial structure of jurisprudence: and governance structure
Islamic banks in 34, 37, 39, 57n4; 153, 171, 175; and participatory
and gharar 55; Shari’ah board in financing 42 – 43, 44; on risk-hedging
151 – 155, 152; Shari’ah compliance tools 186; and Sukuk 109n1; see also
in 163, 166 – 167, 168; and Sukuk fiqh al-muamalat
110n2; and venture capital 77,
85 – 86, 89 – 94, 90, 91, 92; zakat in Keynesian economics 3; compatibility
73; see also Islamic Saving-Loan and with Islamic prohibition of interest
Financing Cooperatives (KSPPS) and uncertainty 11, 16, 25 – 26; on
industry: industrial capital 16 – 18, 22, the demand for money 27n1; on
24 – 25; industrialization 3; industrial interest and uncertainty 18 – 19, 22;
sectors 52 – 54, 56 – 57 see also animal spirit; post-Keynesian
information asymmetry see asymmetry of Economics
information Knight, Frank 21, 25, 42, 48 – 49, 79
interest 2, 11; challenges to Islamic
and heterodox views of 22 – 25; labor see labour
in current financial world 20 – 21; labour 24, 30, 55
heterodox view of 11 – 12, 15 – 20; level playing field 122, 126, 157
interest-bearing capital 3, 16, 22, 24; liquidation 2
see also interest-free; rate of interest; liquidity: and interest 18 – 19, 21, 22;
riba (interest) and Sukuk 5, 98, 101, 102, 103, 108
interest-free 12: challenges to 26 – 27;
and exploitation 14, 25; in Marxian maisir (gambling) 13
theory 22; and microfinance Malaysia: asset portfolio of Islamic banks
122 – 123; and poverty 26; and in 57n4; and gharar 28 – 29, 33 – 34,
Shari’ah compliance 163; and 38, 39; and microfinance 111; and
Sukuk 95 Shari’ah board 147 – 149, 151 – 154,
Islami Bank Bangladesh Ltd. (IBBL) 6, 152, 157; and Shari’ah compliance
37, 98, 116 – 121, 125, 169, 170 163, 165 – 167, 168; and Sukuk 5,
Islamic banks: compared to 95 – 102, 100, 101, 104 – 105, 104,
conventional banking 28 – 29; 108 – 109; and venture capital 84 – 85;
criticism of financial products of see also National Shari’ah Advisory
43 – 44; financial products of 28 – 29; Council
financing income of 36; increased Maqasid al-Shari’ah 124, 127 – 128, 131
popularity of xii; lending structures Marxian economics 3; compatibility
of 33 – 39, 35; safety of 191; see also with Islamic prohibition of interest
 Index  215
and uncertainty 11, 25 – 26; on 180 – 181, 183, 185, 188 – 189; and
interest and uncertainty 16 – 19, Shari’ah board 157; and Sukuk 110;
22, 24 see also venture capital
microcredit see microfinance musharakah see musharaka
microenterprises 2, 78, 89, 126
microfinance 2 – 4, 6, 61, 111 – 112, 192; National Shari’ah Advisory Council
challenges to growth of 113 – 114, 102, 104 – 105, 151, 152, 154
117 – 121, 124 – 126; current New Institutional Economics (NIE)
practices in Bangladesh 114 – 117, 4; and venture capital 62; view on
115, 116, 117; current practices incomplete contracting 46 – 47
in Pakistan 121 – 124, 122, 123; non-governmental organization 154
Islamic microfinance and Islamic
VC compared 77 – 79, 78; and opportunism 61 – 65, 67, 73, 75
poverty alleviation 128; realities in
Indonesia 128 – 129, 129; shortage Pakistan 6; microfinance in 112,
of funding for 73; see also Grameen 121 – 125, 122; and moral hazard
Bank (GB); impact assessment; Rural 84; and murabaha 29, 33 – 34, 38,
Development Scheme (RDS) 39; and Shari’ah compliance 163,
Millennium Development Goals 111 166 – 167,  168
modeling 19 – 20,  21 participatory finance 2, 4; and bank’s
money capital 16 – 17, 22, 24 risk exposure 178 – 180; issues to
moral hazard 2, 42; charity and 73; be resolved concerning 183 – 189;
and governance structure 149 – 150, see also microfinance; musharaka
157; and microfinance 112, 120, (participatory finance); profit-and-loss
125; and profit-and-loss sharing 177, sharing (PLS); Sukuk; venture capital
179, 183 – 184, 186; and Sukuk 97; in post-Keynesian Economics 4, 21, 25,
venture capital 61, 82, 84 46, 47 – 54,  56
moral virtues see altruism; reciprocity; poverty alleviation 2, 6, 61, 70, 73, 128;
trust see also under impact assessment
mudaraba (trust-based finance) profit-and-loss sharing (PLS) 1,
1 – 2, 3 – 4, 28, 20 – 31, 42, 57n2; 177 – 178, 190 – 193; policy framework
concentration on in GCC countries for Islamic banks 7 – 8; see also division
33 – 39; in light of prohibition of of work; mudaraba (trust-based
gharar 49 – 53; see also profit-and-loss finance); musharaka (participatory
sharing (PLS); venture capital finance); specialization
murabaha (mark-up) 1 – 4, 26, 28,
31 – 33, 190 – 191; and altruism Qatar 5, 35, 36, 86, 163, 166, 167
and reciprocity 70 – 72, 74; classical Qur’an: and altruism and reciprocity
position on 57n3; concentration on 65 – 67, 69, 75; difficulties decoding
in GCC countries 33 – 39, 37, 38; and 42 – 43, 187; on riba 1, 13 – 14;
microfinance 137; on naïve critics of and scope of acceptable gharar 53,
39 – 43; percent of financing of Islamic 55 – 56; and Shari’ah compliance 128,
banks 29, 57n4; and profit-and-loss 164 – 165; and trust 185
sharing 177, 180, 189; and Shari’ah
board 150; and Sukuk 100, 106; see rate of interest 3, 13, 26, 48, 188; and
also murabaha syndrome; tawarruq concentration on murabaha 40;
murabaha syndrome 4, 23, 54, 56 – 57, heterodox perspective on 16 – 19, 22;
72, 150 and microfinance 118
musharaka (participatory finance) 1, rationality 49, 62 – 63, 66, 75, 183
28, 30; concentration on in GCC real estate 5, 39; and Sukuk 107; and
countries 29, 33 – 39; and gharar 55; venture capital 86, 88, 89, 93, 94
and microfinance 124; and murabaha reciprocity 2, 75 – 76; in Islam 65 – 69;
41 – 44; profit-and-loss sharing and venture capital 61 – 62, 72 – 74
216 Index
regulatory infrastructure 6; and venture available 98 – 101, 99, 100, 101; in
capital 74; and Sukuk 102 – 105, 103, Japan 106 – 109; legal and regulatory
104, 105 framework for 102 – 105, 103, 104,
rentier 3, 19, 20, 25 105; literature review 96 – 98; potential
riba (interest) 1, 54; and microfinance for Sukuk industry 106 – 109; pricing
116; prohibition of 11 – 15, 25; and of 110n2; purposes for investment in
Shari’ah compliance 165; and Sukuk 101 – 102; see also J-sukuk
95; and venture capital 69, 71, 84; see
also interest-free tawarruq 29, 33, 34
Rural Development Scheme (RDS) 6, transaction cost 63 – 64; see also
112, 116 – 124 Transaction Cost Economics (TCE)
Transaction Cost Economics (TCE) 46,
sale-based transactions 3 62, 71
Saudi Arabia 5, 71, 163, 166, 167 trust 4, 62 – 65, 75 – 76; see also altruism
scarcity value 3, 19 trust-based finance see mudaraba
self-interest 62 – 63; see also
opportunism UAE: equity-based financing in 71;
Shari’ah 1; compliance in Bangladesh financing income of Islamic banks
170 – 174, 171, 172, 173; compliance in 36; lending structures of Islamic
frameworks 163 – 167, 167, 168, 174, banks in 35; and Shari’ah compliance
176; Shari’ah scholars 5, 155 – 156; 163, 165, 166, 167; Sukuk markets in
see also Maqasid al-Shari’ah; 5; and venture capital 86
Shari’ah board UK Corporate Governance Code 7,
Shari’ah board 7, 160 – 161; criteria for 156 – 160, 161 – 162n1
selecting members of 175; current uncertainty 2; challenges to Islamic and
practices in Indonesia 152, 154 – 155; heterodox views of 22 – 25; in current
current practices in Malaysia financial world 20 – 21; heterodox
151 – 154, 152; independence of view of 15 – 20; and modern capitalism
192; integrated vs. separated 7; and 26; post-Keynesian perspective on
UK Corporate Governance Code 47 – 53; and venture capital 61
156 – 160; and venture capital 74 unemployment see employment
shirkah 30, 49
small- and medium-sized enterprises venture capital (VC) 61, 77, 191 – 192;
(SMEs) 6; financing of 181; and altruism and reciprocity in Islamic
information 181, 183; and interest VC 61 – 62, 69 – 75, 71, 76; case
15, 24; and microfinance 128 – 129; studies of Islamic VC 86 – 94, 87, 88,
and uncertainty 54, 57; and venture 90, 91, 92, 93; dilemmas of Islamic
capital 61, 89 VC 83 – 86; and entrepreneurship
social justice see altruism; exploitation; 79 – 82, 94; Islamic VC and Islamic
Maqasid al-Shari’ah; poverty microfinance compared 77 – 79, 78;
alleviation; Shari’ah; Qur’an nature of 82 – 83
sovereign debt 5
specialization 8, 180 – 182, 189, 192 waqf 61, 70, 92, 118, 182
speculation 4, 17, 20; see also enterprise; wealth distribution see distribution
gharar; uncertainty
Sukuk (Islamic bond) 4, 5, 95 – 96, zakat (almsgiving) 66, 73 – 74, 78, 79,
109, 109 – 110n1; instruments 118, 182