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Tuesday, 27 December 2011

Islamic Finance Role in Equity Markets

by Salman Ahmed Shaikh

It is a well documented and known fact that equity financing is regarded as more just and close to Islamic principles than debt based financing. Almost all of academic literature on Islamic Banking and Finance obtains its legitimacy and support by the mention of preferable equity modes of financing like Mudarabah and Musharakah. Irony is that if they are preferable modes, why they are not used and not used at all!

Not only, Islamic banks do not use Mudarabah and Musharakah in their asset side operations, the Islamic financial institutions have showed no inclination to develop an equity market with Islamic investment banks facilitating IPOs through bridge, seed and venture capital financing using preferable equity modes. Not only this has not happened, nobody seems to be thinking on those lines. This makes the claim of going towards egalitarian and redistribution objectives all the more meaningless.

With surplus liquidity at their disposal, Islamic banks could have provided financing using preferable equity modes to facilitate new IPOs in the market and hence encourage equity financing to be used in the economy. But, what they are doing with their surplus liquidity makes one very uncomfortable. Islamic banks currently in Pakistan use their excess liquidity to provide funds to the conventional banks who by way of this provide interest based loans to the people. Is this the kind of economy Islamic scholars and practitioners are promoting and had in mind?

There is a stock exchange in Karachi where around 700 companies are listed and they opted to finance themselves with equity. The point is that bankers think, they are the only ones who are or can provide finance. Islamic banking is supported sometimes on the premise that if not it, then what will suffice and fulfill the needs. What about thousands of private companies incorporated in the country, what about the thousands of public unlisted and listed companies who generated most of their financing through equity and went through their most difficult phase of business with own equity? What about mega housing and construction projects worth millions of dollars which are financed through private equity in the city of Karachi?

With important covenants in place, equity financing can be used and is used widely. It is interesting to study the size of debt and equity market in developing countries. For instance, in Pakistan, corporate bond market hardly exists, whereas equity financing is more prevalent and widely used.

Equity financing through shares will forever deny the claims of bankers in general and Islamic bankers in particular who hide behind trust deficit and documentation problems. Why people invest in shares of companies without any guarantee over par value let alone dividend? Even when they do, Islamic scholars have put a restriction which even denies people the right to participate in equity markets flexibly and this we discuss next. 

Analysis of Screening Principles for Equity Investments

Islamic scholars have put a cap on how much interest based debt could be used to finance total assets. In Pakistan, if the ratio of interest based debt to total assets is 37 percent or more, then, Islamic scholars disallow investment in ordinary shares of such a company. 

Lamentably, this restriction is mentioned in neither Quran nor Hadith and is referred to as an ‘operational restriction’ by Islamic scholars. A company which has used an Islamic debt based mode of finance to finance a fixed asset or used an interest based debt to finance the same asset, then, the company will be rendered non-Compliant for investment in its ordinary shares if it has used interest based financing mode. But, from the perspective of leverage, it will have the same nature of liability and same leverage position. It is incorrect to say that this principle discourages leveraging. Fixed installments will be payable in both cases from economic point of view. But, with higher Islamic banking spreads, fixed installments to Islamic banks will be higher than conventional!

While small investors are deprived of equity investments in such companies, these companies will be provided with finance by Islamic banks with priority. Hubco, Kapco, Nishat Mills, Engro, Fauji Fertilizer Bin Qasim Limited, DGK Cement, Attock Petroleum etc are some of the companies whose shares had performed well in recent past and they had been provided with Finance by Islamic banks. But, for small investors, investment in ordinary shares of these companies was not allowed solely due to an ‘operational restriction’ and on the premise of discouraging ‘leverage’ and promoting ‘Islamic debt based mode of finance’. 

Islamic banks would earn exorbitant profits by providing debt based Islamic mode of finance to these companies, but Islamic scholars by way of their self-imposed restriction have deprived small investors to invest in the ordinary shares of these companies. 

Small investors already earn negative real interest rate in Pakistan since Islamic banking spreads are 8.80 percent and more than 6.90 percent for the conventional banks (Source: SBP Islamic Banking Bulletin, Apr-Jun 2011). Hence, Islamic financial institutions have not only deprived small investors of a useful way to earn inflation beating returns through equity investments, but with this rent seeking mentality, also deprived their depositors by paying them lower profit rates and maintaining world’s highest banking spreads among major countries.


If Mudarabah and Musharakah are deemed ideal alternatives by Islamic banking experts and scholars favoring it; then, they would have been better off entering into investment banking and supported new IPOs before they entered into commercial banking. 

Ironically, Islamic values like justice, equality, truth, trust, kindness, honesty and responsibility are often discussed in literature and seminars on Islamic Economics; whereas, in reality, the lack of these values in practice in Muslim countries specifically is the major reason why preferable participatory equity based modes of financing remain unusable!

(By Salman Ahmed Shaikh, a researcher in Islamic Economics. He is author of "Proposal for a New Economic Framework Based on Islamic Principles". He has also written 20 papers and more than 60 articles on Islamic Economics. He can be contacted at


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