Probably the oldest debate in Islamic finance regards equity vs. debt. What is preferable from an Islamic point of view and what is permissible or not? Clearly, Muslim economists propagate the profit/loss sharing model as the core application for the economy, while Shariah scholars rightly claim that instalment purchase (Murabaha), leasing (Ijara) and other modes are all likewise permissible. There is no dispute that debt is potentially dangerous: It is made clear to us Muslims that whoever dies with unsettled debts will not enter paradise, so we have to avoid so-called situations with negative equity that leave us unable to settle debts. From a qualitative perspective, equity is superior, but do we really have to have more equity than debt? Or is it good enough just being ready to settle outstanding debts?
Another question is: Does banking interest really makes the rich richer and the poor poorer? If so, why are real estate funds for high net worth investors highly leveraged and why does microfinance alleviate poverty? My best guess: The rich get richer with leverage and the poor normally do not get any finance at all. When the poor do get Ribawi/interest-bearing loans, 90 percent of them do better, while possibly up to 10 percent suffer worse misery of vicious circles of debt. If a poor entrepreneur has a brilliant idea, he does not receive any loan finance and has to give away 90 percent of his company to a rich guy for some equity finance, while the rich guy with a good idea would borrow and only invest a small portion of his equity. Unfortunately, that is business life, and without charity and Zakat, the gap would widen all the time. Cooperative banking and saving and loans have done a great deal in a number of European countries to reduce this as well.
The Debate
But still, why does Islamic banking focus so overwhelmingly on debts? This question came again to my mind in reading two different books on endowments: One was written by Murat Cizakca on the history of philanthropic foundations and the other is Pioneering Portfolio Management by David F. Swensen, Chief Investment Officer of the Yale Endowment Fund. It was astonishing to learn that the Ottoman Cash Waqf used a method called Istiglal, a sort of sale/lease-back transaction to generate fixed income, rather than the Mudaraba (profit sharing/loss bearing) already recommended by Imam Zufar at the time. This discussion is very familiar to modern-day Islamic banking, isn't it? Nowadays we justify our low exposure to equity modes because of the moral hazard that can occur when the bank client uses his information advantage to the disadvantage of the bank and negative selection of projects. Therefore, Islamic banks prefer debt-based modes of finance.
However, David F. Swensen, who manages probably the most successful endowment fund in modern times, writes that he does not like to invest in debt instruments because of the moral hazard and prefers equity. This is the exact opposite view of the prevailing one and is clearly food for thought. Mr. Swensen rightly claims that the debtor always tries to increase his debt level to leverage his equity position further, a problem which bankers have to deal with and for which they demand certain covenants. Still, Mr. Swensen prefers equity, which he is more comfortable scrutinizing.
Numbers Talk
So, who is right? In the long run, equity has higher returns than fixed income and therefore should be ideal for investment by endowments with their long perspective. Mr. Swensen gives empirical proof on this common thesis: From December 1802 to December 1998, gold became worth 12 times the 1802 one-dollar note and inflation amounted to 14 modern notes for one old one. Treasury bonds had 9,950 times more value and large capitalized stocks were worth 9,856,849 times more. The long-term difference is mind-blowing. Wealth gets created by productive investments. Hoarding is meaningless and fixed income unattractive.
The evidence and common logic suggest that any long-term investor would need to be into equity, and only investors with short and medium-term goals need some fixed income. Historically, US endowments have not invested that way, but that changed along with the "legal infrastructure," meaning that initially, a trustee was held responsible if one single investment failed (the prudent man rule), but much later, a portfolio approach was adopted advocating prudent management for a diversified portfolio. The broadening of that view made investment strategies like that of Yale's Endowment Fund possible and successful.
Why Not Equities?
That does not yet answer the question of why Islamic banks are not more favourable towards equities. My personal favourite argument is this: It is the infrastructure. Commercial banking is made for debt business, regulated as a debt business, driven by commercial bankers who have learned the debt business their entire lives. A stronger focus toward investment banking, private equity and venture capital will come from dedicated entities managing those funds; it appears that the seed is being planted and the next five to 10 years will produce more of this.
Coming up in April 2008, The Harvard Forum on Islamic Finance will be tackling the hot topics of Islamic finance, equity and debt specifically and will be a valuable resource to those interested in exploring this area.
Michael Saleh Gassner is Division Head for Product Development in the Islamic Banking Group at Bank AlJazira. He writes often about Islamic finance issues in leading industry magazines and is the founding editor of the "IslamicFinance.de - Executive News" newsletter. He speaks frequently at Islamic finance conferences and is a member of the editorial team for the International Journal of Islamic and Middle Eastern Finance and Management. He holds a master's degree in business administration from the University of Siegen.
By Michael Saleh Gassner
© Business Islamica 2007
