By Saiful Azhar Rosly, PhD, Professor INCEIF
Islamic banking is established based on the fundamental Quranic injunctions that “Allah has allowed al-bay but prohibited riba” (al-baqarah 275).
Al-bay which means trade and commerce signifies the importance of the real economy as opposed to the riba-based money lending system. Real economy necessitates production activities by firms which require capital and labour as inputs that generates new goods and services which is the gross domestic product.
However, risks in production are usually high. It therefore poses great challenges to deposit-taking Islamic banking to promote real sector financing. Non-real sector financing on the other hand is associated with financialisation which involves the financing of investments such as stocks, mutual funds and derivatives. It does not lead to the increase in the gross domestic product and is often the cause of asset bubbles.
Generally, firms obtain loans from banks to finance production. These loans are usually funded by deposits which is also debt that banks owe depositors. Risks in loans such as default, market and operational risk are thus carried by banks since interest-bearing deposit funds are risk-free. For this, banks are expected to be prudent in making loans as they are using risk-free deposits instead of their own capital funds to provide loans.
This means loans must be supported with adequate collaterals that reduce loss to banks when default occurs. Under a loss event, banks are required to absorb these losses. For these reasons, banks are required to make loss provisions and also have capital against potential defaults. The higher the risks in loans, the more loss provisions and capital must be put aside by banks.
Alternative solution to bank loans
Financing real production can be highly challenging for deposit-taking Islamic banks which derive its philosophy from trade and commerce (al-bay). This will put Islamic banks in a difficult position as financing the real economy by using deposit funds is a formidable task. Using risk-fee deposits to finance risk-laden production activities are pure mismatches of risk-appetites. It requires Islamic banks to hold more capital against the real-sector based financing thus, posing stress of capital adequacy requirement of the bank.
Alternative funding is desperately needed to overcome the mismatching of risks. One such product is investment account funds. Risks in real-sector finance will be assumed by the investment account holders which will free Islamic banks from holding capital against these exposures.
But banks are often seen as a safe haven for money. It is not a place for making risky investments. In fact, many Islamic banks offer tawarruq fixed deposits that provide equivalent incentives to interest-bearing depositors such as fully protected savings and fixed income. This is mainly due to the Muslims’ savings behavior that remains unaffected despite the new IA product offerings.
For this reason, Islamic investing behavior must be explained well enough to convince Muslims that investing is one form of al-bay. Therefore, it is a Quranic injunction. When al-bay is contrasted to riba in the Quran (2:275), it invites one to reflect that for savings to earn profits, it should be put into real transactions as opposed to money lending.
An illustration is given below:
- Disposable income ($10,000) = Consumption ($8,000) + Savings ($2,000)
- Savings ($2,000) can be used:
- For lending purposes where the surplus money is used to make loans with interest that gives surplus money a guarantee of capital appreciation. This is riba that the Quran prohibits.
- For investing purposes, where the surplus money is put at risk, such that there is a possibility of profit and loss. This is al-bay as enjoined by the Quran. Investing means putting money in merchandise trade. But it can also mean to buy in equity products such as shariah-compliant stocks, mutual funds as well as investment accounts offered by Islamic banks.
Importance of Islamic crowdfunding
While al-bay is generally translated as sale which is trading, it must be understood that capital is required to execute a sale, which merchants use to buy goods from wholesalers. This is different from portfolio-based investing activities as merchandise trading is immediate compared to portfolio investing which requires longer duration to realize profits. In the world of finance, investing is the purchase of securities, real estate and other items of value in the pursuit of capital gains or income.
Investing in a business venture in contrast to a financial portfolio is more directly associated with al-bay. This is where Islamic equity crowdfunding (ICF) can be positioned as a significant manifestation of al-bay since capital is directly injected into the real sector. Ordinary people with surplus funds can thus participate in real sector investing activities to fulfill the Quranic commandment of al-bay as opposed to riba.
Sadly, investing in shariah-compliant financial assets today is not explained from the standpoint of al-bay. Much focus is given to shariah asset screening and this has produced a serious gap in the understanding of Islamic investing behavior. The legal maxim “al-ghorm bil ghonm” which means that profit is accompanied with loss is a fundamental principle that Islamic finance should leverage to incentivize Muslims to put their surplus money in the rightful places, which includes both Islamic banking investment accounts and Islamic equity crowd-funding.
Read more about Equity Crowdfunding