Prof. Dr. Obiyathulla
Ismath Bacha
Professor of Finance,
INCEIF
A: INCEIF-The Global University of Islamic Finance
Lorong University A,
59100 Kuala Lumpur
Malaysia
T: (603) 7651 4000
F: (603) 7651 4071
E: marketing@inceif.org
W: www.inceif.org

Debt appears to be at the root of every financial/ banking crises. In a now famous study, Rogoff and Reinhart (2010) show that every single financial crisis in the last hundred years has been caused by excessive debt. That, governments of not just poor countries but the biggest and mightiest economic super powers have been brought to their knees, shows how risky an overreliance on debt can be. The huge social costs and negative externalities of debt induced crises is now abundantly clear. Notwithstanding the huge costs that societies have had to pay for their excesses with debt, global addiction to debt appears unabated.

In a recent paper, Adair Tuner and Susan Lund argue that since the 2008 crisis, global debt has grown by US$57 trillion, a growth rate exceeding GDP growth. Government debt alone has increased by US$25 trillion with most of it in developed countries. The debt to GDP ratio is higher today than on the eve of the crisis in 2007. Worryingly, even in the developing world the buildup in debt is at record levels. This is clearly untenable.

In the absence of fiscal surpluses, governments have had to rely on unprecedented monetary easing to avoid a downward tailspin. While we may have avoided the abyss, we have little to show in terms of growth. Slow growth and minimal returns, we are told, may be the new normal.

What the world needs is growth without leverage (debt). For this, we need new thinking, outside the realm of conventional economics. And this may be where, Islamic finance can help, specifically the risk-sharing contracts Mudarabah and Musharakah.

The Mudarabah in particular is a hybrid instrument sharing the features of both debt and equity. What makes it particularly suited for today’s conundrum is that, it has the risk-sharing features of equity but not the leverage inducing feature of debt. Unfortunately, the Mudarabah story has not been well-told. At least, not in a way that will make corporate treasurers see how the debt-equity trade off they have been manacled to, becomes irrelevant with Mudarabah. Similarly policy makers in governments are not aware that financing infrastructure without leverage could be possible with Mudarabah-based sukuk.

For corporations, debt, though riskier is more attractive than equity because it’s cheaper and more importantly avoids earnings and ownership dilution. The dilution which is also perpetual is probably the most painful part of equity issuance. In Mudarabah, a financier (rab-ul-mal), provides funding to a mudarib based on a predetermined PSR (profit sharing ratio). In an 80/20 PSR, the mudarib keeps 80% of profits earned and the 20% goes to the funder. Like dividends he does not pay if there are no profits. When a corporation in need of funding an investment, considers Mudarabah in-lieu of debt, a number of benefits arise. First and foremost there is no increase in financial leverage as there are no fixed charges. As a result, the corporation’s overall riskiness may actually be lowered because there is now lower propotion debt in the capital structure. However, given the PSR, there will be earnings but not ownership dilution. There are two reasons for this. First, only profits accruing from the newly funded project is to be shared, not all earnings. This is unlike new equity which has a claim on all earnings, not just that of the new project.

Second, the Mudarabah funder only has ownership claims on the asset he funded, not the other assets of the firms, as is the case with new equity. Furthermore, the claim is terminal, like debt. Existing equity holders continue to own all the assets they currently own and take the bigger share of the profits accrued from the newly funded project. Viewed this way, Mudarabah financing effectively changes the debt-equity tradeoff, makes debt much less attractive and would be best suited to get the world out its current rut.

Indeed, in its earlier evolution, as the commenda in medieval Europe, Mudarabah funded the renaissance and in a later form, as venture capital in Silicon Valley. Given its risk sharing features, Mudarabah could yet again, in a revised form, offer the world a potential way out.