Why fixed return contracts predominate in Islamic banking

An enquiry from a PhD student led me to write a short article explaining how unattractive profit participating contracts are to Islamic banks, and also to their customers.

Summary

I received an interesting enquiry from a PhD student in Germany.
He expected Islamic banks to primarily use profit participating contracts.
He found that, in practice, fixed return contracts overwhelmingly predominate in Islamic banking.
I already knew this and explained to him that fixed return contracts are used for commercial reasons.
Profit participating contracts are actually very unattractive to Islamic banks, and also to their customers.

Over the years, I have received many interesting enquiries. Below is an anonymised extract from an email I received in June:

The only problem is that while this is very attractive from a theoretical perspective, whenever Islamic banks have prioritised using profit participating contracts they have lost money. Instead they overwhelmingly use fixed return contracts such as murabaha and ijarah.

I used my email exchange with the PhD student as the basis for my August 2016 monthly column in the magazine Islamic Finance News. While the magazine is only available to subscribers, you can read my column below.

Letter from Amin - 10 August 2016

I was recently contacted by a European PhD student researching in Islamic finance. He asked why Islamic banks provide relatively little finance using profit sharing contracts such as musharaka and mudaraba, instead providing most of their finance using fixed return contracts such as murabaha and ijarah.

As a simple illustration, the 31 December 2015 accounts of The Bank of London and the Middle East plc, which describes itself as the largest Islamic bank in Europe, can readily be downloaded from its website. The balance sheet shows customer financings of £613,753,000. From note 21, after adjusting for sukuk holdings and impairment provisions, I computed that 99.1% of the customer financings were murabaha, while only 0.9% were musharaka and mudaraba combined.

The key point which many often forget is that Islamic banks are, first and foremost, banks. That means that their purpose is to make a profit for their shareholders by receiving money from one set of customers and using that money to provide finance to other customers.

While many advocates of Islamic banking are keen on having banks take genuine equity participation risk when financing projects, that is not normally the objective of the banks concerned. Providing finance with genuine equity participation is a much riskier proposition than providing finance which has the economic characteristics of debt finance. In practice such equity participation risk is not wanted by either banks or their customers.

Banks do not want equity participation risk because it exposes them to the risk of serious loss. Furthermore, regulators will require a higher level of bank capital to be allocated against equity based financings than against debt based financings. Also, in countries where fiduciary standards are low, it is not uncommon for customers to falsify their accounts when what they have to pay to the bank is directly linked to the results of their business.

Most customers also do not want financing on the basis of genuine equity participation. Because of the higher levels of risk, anyone providing finance on genuine equity participation terms requires a much higher rate of return than someone providing finance on debt-based terms. That higher rate of return obviously represents an increased cost to the customer is being financed.

Accordingly, notwithstanding the regular entreaties of advocates of Islamic finance, Islamic banks in the real world remain incredibly reluctant to provide finance to customers on terms that involve genuine equity participation. In practice, almost all Islamic finance provided by banks uses contracts such as murabaha that have debt-based (fixed return) characteristics.

The above behaviours are not a failing of Islamic banks; they are an essential consequence of them being banks, and it is just how conventional banks also behave. In conventional finance, equity based finance comes from other providers such as individual high net worth individuals, venture capital funds, and other investment companies. They in turn typically have permanent or semi-permanent capital, owned by people who can afford the losses that may arise, instead of being financed by deposits from people who will want their money back, in full, in a relatively short timescale.

To the extent that the Islamic finance community requires equity based finance, it needs to develop Islamic equity capital providers mirroring those found in conventional finance. Indeed, many already exist. However, providing equity based finance is simply not the commercial purpose of Islamic banks, regardless of how much some people want it to be.