So the question then is – should Islamic banking be the conduit for this sort of financing model? When the business climate is good then the answer is yes – but in an environment where certain sectors decline significantly such as the property market, it could adversely  4  BIS Review 49/2010  impact Islamic finance institutions, that could that suddenly finds itself saddled with assets that it cannot sell. There are ways to minimize such inventory risk – but we are making a big assumption here that ALL Islamic banks will behave rationally at all times. Although clearly Mudharaba and Musharaka should be in the Islamic Bank’s toolbox, in taking a wholesale view to move towards asset based financing – it is imperative to look at the overall implication of such a shift. For the purpose of discussion, let’s consider for the moment that the entire economy is premised on asset based financing. We must ask ourselves, in that scenario – would a financial system purely based on profit from equity based financing be necessarily more efficient than one based on asset financing or debt? Does it benefit the entire Ummah? Consider this possibility – who would have better information on business climate – the Entrepreneur, the Bank or the Client? Remember the asymmetry of information? A shift from the debt based financing to equity based financial system does not, necessarily lead to a better equitable outcome to society; instead, if not properly implemented it could cause uneven benefits to various stakeholders.
Or is it a natural phenomena? Are players in the industry not aware of the benefits? Or are they aware of the benefits, weighed it against the potential risks and decided not to pursue this strategy because of business and operational reasons? First let’s analyze the potential benefit. For example, a Bank enters into a joint venture with a housing developer. The financing of the project in the form of equity can yield a lucrative return when the development is completed and then sold. Margin for profit upon sale can be high, as Bank enters into the development at the earliest chain of production. The Bank can still provide financing for the home purchasers, the difference this time – the homes are the Bank’s own asset. Those are direct impact; there are positive impacts in other key areas as well. What happens to the profit from sales and financing? It gets channeled back to Depositors (giving them higher returns on the deposits). This concept would, completely, according to equity-based financing proponent, move Islamic banks away from mimicking conventional products and would truly operate as the shariah had wanted it. Is this true, are there any other factors to be considered? In terms of risk assessment, such a transaction will necessarily inject greater market discipline among industry players. This business model is premise on a few fundamental assumptions.