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Failure and potential of prot-loss sharing

contracts: A perspective of New Institutional,

Economic (NIE) Theory

Aisyah Abdul-Rahman a,, Radziah Abdul Latifb,Ruhaini Muda c, Muhammad Azmi Abdullah a

a Faculty of Economic and Management, National University of Malaysia (UKM), 43600, Bangi, Selangor, Malaysiab National University of Malaysia (UKM), 43600, Bangi, Selangor, Malaysiac Universiti Teknologi MARA, 40450 Shah Alam, Selangor Malaysia

a r t i c l e i n f o a b s t r a c t

Article history:

Received 24 November 2013

Accepted 24 January 2014

Available online 2 February 2014

This paper theoretically evaluates why protloss sharing (PLS) contracts

in Islamic banking fails andits potential for improvement withinthe scope

of the New Institutional Economic Theory (NIE). The objective of the

evaluation is to draw conclusive theoretical arguments of whether Islamic

banking institutions in Malaysia should act as eithernancial intermedi-

aries or entrepreneurs. Further, we analyze thisissue fromthe perspective

of agency theory, nancial intermediation theory and entrepreneurship

theory with four economic agents in the Islamic banking sector, namely

entrepreneurs, depositors, shareholders, and the Islamic banks. Speci-

cally, the rst three economic agents represent the asset (equity-based

nancing), liability, and equity of the Islamic banks, respectively; while

the latter is the Islamic banks, which act as a separate legal entity. Finally,

we suggest that PLS contracts would best be positioned if Islamic banks

play the role of genuine entrepreneurs.

2014 Elsevier B.V. All rights reserved.

JEL classication:

G210

L80

D210

L20

M210

I000

F37

P51

Keywords:Prot loss sharing

New Institutional Economic

Islamic bank

1. Introduction

Theoretical literature on Islamic banking strongly supports the notion that the adoption of protloss

sharing (PLS) contracts would increase the value of Islamic banks and make them resilient to crisis. The

Pacic-Basin Finance Journal 28 (2014) 136151

Corresponding author. Tel.: + 60 19 2864377 (hp), + 60 3 89213007 (ofce); fax: +60 3 89213163.

E-mail address:[email protected](A. Abdul-Rahman)

0927-538X/$see front matter 2014 Elsevier B.V. All rights reserved.

http://dx.doi.org/10.1016/j.pacn.2014.01.004

Contents lists available atScienceDirect

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adoption of PLS in the opinion of some scholars is in the real spirit of Islam. This is because the

reward-sharing element in PLS is related to the risk-sharing between the transacting parties, a bank as a

capital provider and its clients (on the asset-side), and this risk can be passed on to the liability-side of the

Islamic banks (between depositors and investment account holders). In general, PLS is dened as a

contractual agreement between two or more executing parties. PLS enables the contractual parties to

combine resources as capital in a project and in return they share the prots and losses based on a

pre-agreed ratio. The Islamic banks in Malaysia currently employs three forms of PLS contracts. They are

mudaraba, musharaka and diminishing musharaka. While mudaraba and musharaka can be applied to

either the asset-side or liability-side of the bank, diminishing musharakais only applied to home nancing

(asset-side). PLS contracts in this paper refer to the rst two. To-date, PLS nancing is not the dominant

form ofnancing, comprising of less than 3% of the average of total nancing for the Malaysian banks, even

though its benet and its closeness to the Islamic spirit are well acknowledged. Majority of Islamic banks

offer trade and projectnancing on mark-up pricing or on lease basis. Hence, this paper aims to explore what

makes the Islamic banks behave that way through the lens of the New Institutional Economics (NIE) theory

and conceptually proposes what should be done to encourage them to adopt PLS contracts. The scope of this

study is related to agency theory, intermediation theory and entrepreneurship theory of a rm.

2. Theoretical framework

2.1. Evolution of the Old Institutional Economics (OIE) to the New Institutional Economics (NIE) Theory

An institution is an important element in understanding Institutional Economic theory. So, what do

institutions mean? Institutions have several different denitions according to the scholars in economics and

social science. According toPotts (2007), institutions are coordinating mechanisms between the individual

and the social process of the creation of economic value, and that these process-structures of coordination are

just as important in explaining economic activity as the relative endowments of factors of production.

The term institution broadly refers to the formal rule set (North, 1990), ex- ante agreements (Boncheck

and Shepsple, 1996), less formal shared interaction sequences (Jepperson, 1991), and taken for-grantedassumptions (Meyer and Rowan, 1991) that the organizations and individuals are expected to follow.

These are derived from rules such as regulatory structures, governmental agencies, laws, courts,

professions, and scripts and other societal and cultural practices that exert conformance pressures (DiMaggio

and Powell, 1983, 1991). One may wonder then what Institutional Economics is all about? Institutional

economics focuses on understanding the role of the evolutionary process and the role of institutions in

shaping economic behavior.

According to Veblen (1908:37), institutional economics is becoming substantially a theory of the

process of consecutive change, which is taken as a sequence of cumulative change, realized to be

self-continuing or self-propagating and to have no nal term. Institutional economics focuses on

understanding the role of the evolutionary process and the role of the institutions in shaping economic

behavior. Its original focus lays in Veblen's instinct-oriented dichotomy between technology on the oneside and the ceremonial sphere of society on the other. Institutional economics emphasizes a broader

study of institutions and views markets as a result of the complex interaction of these various institutions

(e.g. individuals, rms, states, social and norms).

From the denitions above, it can be concluded that the institutional economics is the coordination

process between the individual and social processes in creating economic value by taking into account the

value of certain regulations. Institutional theory is traditionally concerned with how various groups and

organizations better secure their positions and legitimacy by conforming to the rules and norms of the

institutional environment (Meyer and Rowan, 1991). From the economists' point of view, this is known as

the Old Institutional Economic (OIE). As the economics develops and evolves, there is a group of

researchers who support the New Institutional Economic (NIE).

The arguments of the proponents of NIE are as follows:

(1) OIE focuses on collective rather than individual action;

(2) OIE prefers an evolutionaryrather than a mechanistic approach to the economy;

(3) OIE emphasizes on empirical observation over deductive reasoning.

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Level 3 is the point where the game is played by the government and contracts become dominant in the

institutional system. The role of contract administration is to craft order, thereby reducing conict and

realizing mutual gains. This involves complex rules and procedures arising in achieving the goals of the

institutions. Finally, Level 4 is the point where neoclassical economics operate. Under Level 3 regulations

transactions occur and prices adjust. Basically, this is the role of the market to mold the institutions.

According to Williamson (2000), NIE concerns itself primarily with levels 2 and 3, but for the case of

Islamic Banks to grow on a totally different footing from the conventional banks (that is to focus more on

equity nancing as compared to debt nancing), we suggest that every level should be examined.

2.2. The current practice model: Islamic banks asnancial intermediaries

According tode la Cuesta-Gonza'lez et al. (2006), banks in general have four important functions as

nancial intermediaries:

1. The bank intermediates between economic units with excess and decient nancial resources.

2. It also adapts terms, from borrowing on a short-term basis to lending on a long-term basis.

3. It manages money spatially, taking nancial savings in the form of deposits and other liabilities in someregions in order to nance loans in other regions.

4. It acts as a risk evaluator, efciently producing valuable information regarding the protability and risk

involved in many operations and investments.

By exercising the rst and the fourth roles as nancial intermediaries, banks are expected to perform the

functions of reducing transaction costs, minimizing inefciencies due to asymmetric information and aligning

incentives through active monitoring. Inefciency of the intermediary functions due to asymmetrical

information could eventually increase the cost ofnding opportunities among the investors and entrepreneurs.

This gives rise to search costswhich can be identied as a part of transaction cost (Coase, 1960).

In this regards it is believed that Islamic banks are able to provide quality information through signals

at lower costs by playing the role of a nancial intermediary. Due to this reason, banks are incline to offerdebt-based contracts, which by design, require minimum information from investors when performances

of the projects are not observable (Khan, 1986). Therefore, debts-based contracts are dominant in nancial

intermediation. Notwithstanding the fact that Islamic banking in principles promotes PLS contracts, it is

often claimed by critics of the Islamic banking that in the presence of transaction costs and asymmetrical

information, PLS or equity-based contracts are subjected to higher degree of adverse selection and moral

hazard (Sadr and Iqbal, 2002). In the debt-based contracts, the entrepreneurs are obliged to pay back the

total amount of capital obtained from banks, regardless of the performances of the projects. On the other

hand, in equity-based contracts, bank and entrepreneurs share the prots and losses according to the pre

agreed prot ratio, as formusharakahcontract and bank will bear the loss, if any, in the case ofmudarabah

contract. Therefore, in the equity-based contract additional monitoring and supervision are required to

minimize asymmetric information and transaction costs (Muda and Ismail, 2010).

2.3. Agency theory in banking institutions

There are two types of relationship between nancial intermediaries and nancial market. It is the

bankborrowers and the banklenders relations. These relationships can be analyzed from the asset and

liability side of the bank's balance sheet, respectively. For the bankborrowers relation, bank lending

activities can be distinguished through transactions-based lending (sale-based nancing) and relationship

lending (equity-based nancing). From the asset-side, the information is relatively easily available at the

time ofnancing origination. In the latter relation, data are gathered over the course of the relationship

with the borrowers. Several studies discuss the bankborrowers (asset-side) relation issues arising from

the ex-ante information asymmetric; the screening and monitoring function of banks (Diamond, 1984andKing and Levine, 1993), the adverse selection problem (Akerlof, 1970), credit rationing (Stiglitz and Weiss,

1981), the moral hazard problem (Stiglitz and Weiss, 1983) and the ex post verication problem (Gale and

Hellwig, 1985). On the other hand, a strand of studies on the banklenders (liability-side) relation issues

of deposit taking activities are; bank runs (Diamond and Dybvig, 1983), the competitions between banks

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for deposits on their lending policy and the probability that banks fulll their obligations (Boot and

Thakor, 2000; Diamond and Rajan, 2003).

Generally, as proposed by Ahmed (2002), models of conventional banks can be classied into three.

Firstly, the classications are based on the asset-side approach, where banks act as a monitoring agent that

minimizes asymmetric information (Diamond, 1984 and; Ramakrishnan and Thakor, 1984). Secondly, on the

liability-side approach, issues on deposits taking activities are focused (Diamond and Dybvig, 1983 and

Gangopdhyay and Gurbacha, 2000). Finally, an integrated approach can be taken from both the asset- and

liability-side (Bhattacharya et al, 1998). Most of the aforementioned studies suggest that the issue of

asymmetric information arise on the assets-side approach. In the environment of market imperfection, the

ability of banks to make optimal nancing decisions is decreased due to asymmetrical information (moral

hazard problem), since the entrepreneurs have better knowledge on the projects, relative to the banks. On the

other hand, Diamond (1984) also argued that an ex-post's information asymmetry arise (moral hazard

problem), when banks do not know how much the entrepreneur has produced. Thus, banks are expected to

reduce information asymmetry in order to achieve the optimal returns. This would suggest that additional

monitoring and supervision by the banks to minimize asymmetric information are able to maximize their

returns and create value.

In Islamic banking, monitoring and supervision are essential due to asymmetric information. Fromthe liability-side, Ahmed (2000) claims that depositor's preferences for using Islamic banks may be

due to religious or ethical reasons, while the investors of these banks do not necessarily have this

motive. This is also reected in the xed-income murabahah contracts of the asset-side. To deal with

the slackness and dishonesty of the clients inmudarabahcontracts, a ne is imposed by Islamic bank in

cases where arrears repayment arises (Usmani, 1999). With the concept of universal banking,

nancing under musharakah, would mean that the capital owner has a right to enter into the

management and hence has some control over the problems created by the informational asymmetry.

The roles of an Islamic bank as an entrepreneur (mudharib) on the liability-side and as a capital

provider (rabbul mal) on the asset-side provide unique and different implications on the borrowing

and lending relations (Aggrawal and Yousef, 2000and;Ahmed, 2002). It shows that PLS contracts are

able to minimize asymmetrical information and reduce transaction costs, through supervision,monitoring and alignment of incentives. Consequently, Islamic banks maximize their net prots and

create value to their shareholders.

3. Analysis and discussions

Our following discussion of the failure of PLS contracts is based on four levels of NIE by Williamson

(2000).

3.1. L1 Embeddedness of customs, traditions, norms, religion

Whatever is the degree of success of individual Islamic banks, they have so far failed in adopting PLSbased nancing in their business (on the asset-side). Even the long-established full-edged Islamic Banks

such as Bank Islam Malaysia Berhad (BIMB) and Bank Muamalat Malaysia, which are supposed to be

functioning heavily on a PLS basis, have a negligible proportion of their funds invested on a mudarabah or

musharakahbasis. According to theInternational Association of Islamic Banks (1996), PLS covered less

than 20% of investments made by Islamic banks world-wide and as mentioned earlier, even lower in

Malaysia (less than 3%). On the liability-side, even though there are deposits based on mudarabah

contracts, in substance they are reported as liability, and with or without the creation of prot

equalization reserve (PER), it appears that earnings of banks are managed so that depositors almost

always earn prot.1

In one way the reluctance of the Islamic banks to fully operate on PLS basis, could be understood from

the customs, traditions and norms that are embedded in society (even in Muslim countries), as discussedearlier in Section 2.3 regarding information asymmetric issues. The existence of conventional banks

1 In June 2012, Bank Negara Malaysia has withdrawn the requirement of Islamic banks to hold PER for income smoothing to shield

depositors from losses. Hence, afterwards, Islamic banks have a choice whether to continue imposing PER or not.

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preceded many of that of Islamic banks. For example in Malaysia, the turn of the twentieth century saw the

arrival of foreign banks as Malaysia became the main producer of various commodities (i.e. tin and

rubber). To name a few, Standard Chartered Bank, Hongkong Bank and Overseas Chinese Banking

Corporation made their presence to cater for plantation and mining companies (BankRakyat, 2010). It is

expected that the subsequently incorporated local banks, which were initially conventional, would adopt

the nancial intermediary practices of those foreign banks, even with the existence banks such as Bank

Agong (what is now Bank Kerjasama Rakyat Malaysia) which was formed strongly with social objectives

of assisting farmers, the rural poor and civil servants who were in the lower income group. It can be safely

assumed that the societal expectations of what is a bank, primarily as a source for borrowing money as

oppose to a business partner to share prots and loss, is thus formed early on in that period. As depositors

there is an expectation of earning interest on deposits, and especially, a certain return of capital. Such

expectations were detached from religious doctrine of avoiding ribafor instance.

Prior to the seventies Muslims in Malaysia and elsewhere were quite comfortable to accept and pay

interest. This is in part due to a lack of an appreciation of Islam as a way of life. Islamic virtues and

principles should govern every aspect of a person's life and not just daily rituals such as prayers, fasting

and performingHaj. The society was very much secular in nature. The halal and haram narratives only

dominate the banking scene in Malaysia in the eighties with the rising Islamic fundamentalism2. The rstIslamic bank, Bank Islam Malaysia Berhad was formed in the early eighties to meet the need of ever

increasing Muslims who desired halalform ofnancial dealings.

The increasing desire in society for halal nancial dealings does not over the years, match with

increasing desire to share in prots and especially losses with banks. The expectation to earn prots

persists. This is evident in the way Islamic banks shield depositors from losses, through PER or other

methods of managing income, and the way Islamic banks are mainly involved in xed income and

mark-up based nancing. It seems that most Islamic banks adopt the nancial intermediary structure of

the conventional banks and that an Islamic bank operates as a legal person who could contract, hold assets

and sue/be sued in its own name with the broad mandate from shareholders to maximize prots.

Management performs an executorial role. It is conceivable, although a conjecture, that management is

playing safe by providing xed return or mark-up nancing, knowing depositors' aversion for risk andlosses, to ensure a certain return. Thus management is willing to forego a potentially higher return from

PLS project nancing, fully aware of its repercussion on management's own emoluments or job security in

case the project turns losses. Nonetheless, it could be different if the depositors as individuals provide

nancing to a known individual with a well-known reputation and values. Individual ( rabul mal) could

take more risk than average and putting his own resources at stake. On the other hand, the management of

a bank could only take the risk as he believes depositors are willing to take. In other words the bank

management behavior is an expression of the general society's or depositors' risk behavior.

As is widely reported during the Prophet's (pbuh) time, mudarabah contracts were the norm.

Individuals such as the Prophet's (pbuh) rst wife Khadijah, provided the capital for another trusted

individual, in Khadijah's case the Prophet (pbuh), to trade. The whole arrangement was based on trust.

The trust was developed from the rabul malknowledge of the mudharib's conviction to noble values andhis esteem personality. What is seen in modern banking is that the assurance to the depositors as rabul mal

is the extensive rules and regulations established for banks to follow i.e. for the management to execute.

However, such assurances could not replace the deep seated trust developed through interaction between

individuals which provides therabul malknowledge of themudharib. The same applies for banks asrabul

mal, as previously discussed inSection 2.3for issues in asymmetric information.

It should also be noted that, the Shariah governs terms of contracts and the conduct of contracting

parties inmurabahah,mudarabahand musharakahcontracts. An Islamic bank as a legal person and as an

intermediary as it has always existed, is an alien concept in the Islamic tradition. Yet the proponents of the

theory of Islamic bank almost always refer to an ideal Islamic bank in terms of the way it sources its fund

and mobilizes it (Greuning and Iqbal, 2007). The desirable way in both cases is through PLS contracts.

However, in practice Shariah compliance is assessed on contracts that collectively form a product. Perhaps,in practice a bank is not judged less Islamic if it is involved less in PLS nancing. Given such belief, it is

2 Fundamentalism simply refers to the desire to return to the Quran and Sunnah as a source of guidance.

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expected for Islamic banks in Malaysia and elsewhere to continue with non-PLS based nancing. Unless

there is a compelling argument fromShariahperspective for the ideal Islamic bank, the consideration for

accepting nancial products that are non-PLS is mainly economic or business in nature. Hence, many

nancial products such as Islamic credit cards, personal nancing, etc., which mimic conventional ones as

contract by contract, they, are judged as Shariahcompliant.

One argument for the ideal Islamic bank is that it is more towards the achievement of the maqasid of

shariah.3 However, these issues are too broad as many actions could easily fall within them especially

when judgment is based on maslahahmafsadaharguments.4

3.2. L2institutional environment: Formal rulesconstitutions, laws and property rights

For the PLS contracts to grow, the legal environment of the Islamic banking system must be right. An

effective regulatory framework should have the following features (ISRA, 2011):

A supporting nancial landscape that promotes and assists the development of the industry.

A legal framework that has a vivid, procient and comprehensive system that supports the

implementation of Islamic banking contracts. A forum that has high credibility and reliability for the clearing of legal disputes resulting from Islamic

nance transactions.

These characteristics may look straightforward; nonetheless they are complicated when it comes to

practice. In the real world, Islamic banking transaction permits sophisticated parties to enforce their

pre-agreed risk distributions with regards to market uctuation. This requires precise information as well

as agreement between the parties upon those risk allocations and execution tool that honors and provides

impact to it (ISRA, 2011). An effective legal framework is not just a code of conducts, but also a group of

inter-related fundamental doctrinal legal regulations and stable legal institutions, comprising the entirety

of rule of law (McMillen, 2008). For instance, there should be a complete legal framework for central

banking, commercial banking, investment banking, securities trading, accounting and auditing practices.

In fact, each institution that supports those activities must apply the principle of disclosure,transparencyand accountabilityfor the whole system to work effectively.

In addition, a comprehensive Islamic banking legal framework contains various components, namely

civil law, common law,Shariah law, tax law, business law, property law, insolvency law, securities law and

employment law. With regards to enactment, for the case of Malaysia, the Islamic Banking Act 1983 (IBA)

was the rst act enacted to provide the infrastructure of Islamic banking followed by the Government

Investment Act (GIA) 1983 to assist on interest-free liquidity and statutory reserve requirements. Next,

the Banking and Financial Act (BAFIA) 1989 was amended in 1996 to permit banks under BAFIA to

introduce the Islamic windows. In 2003, IBA was amended, which mentioned that an Islamic bank may

seek advice of theShariahAdvisory Council (SAC) onShariahissues. In 2009, the Central Bank of Malaysia

Act 1958 was amended, saying that it is mandatory for the Islamic banks to conform to the advice given by

the SAC if needed (ISRA, 2011). This implies that the SAC has advisory powers over the Islamic banks.Notwithstanding the aforementioned acts to rule Malaysian Islamic banking activities, it is

disheartening to realize that the adoption of PLS contracts, which is supposedly in the true spirit of

Islam, is still minimal. Islamic banking in Malaysia still need supports from other laws in order for the PLS

contract to be feasible and sustainable. For instance, PLS contracts entail well-dened property rights to

function efciently. However, under the current circumstances, property rights are not accurately dened

and related issues of it are not well-protected. In addition, the unfair taxation treatment could also be one

of the unattractiveness of PLS contracts. From the perspective of the demand-side, interest (in debt-based

nancing) is tax allowable as it constitutes a cost item, whereas prot paid (in equity-based nancing) is

not a tax allowable expense. Perhaps, this contributes to the general public/customers' reluctance to be

parties to PLS. Also, it can be understood within the development of the rule and regulations. As describe

earlier, the regulations are mainly to facilitate the nancial intermediary's type of institution, which areparallel to the conventional banking system.

3 Maqasid of Shari'ah: protection of faith (Din), life (Nafs), posterity (Nasl), property (Mal), and reason ('Aql).4 Maslahahrefers to benets/goodness whilemafsadahrefers to evil/wickedness.

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Against this background, the whole regulatory system needs to be enhanced to get the institutional

environment right. It should to some extent address the fear of public/clients to enter PLS contract. Then,

the next question is how? Among others, these include the following:

Tax law that gives incentives to promote PLS contracts, especially with respect to prot gain,

documentation and process-ow. Business law that allows Islamic banks to contribute in real economic activities like trading of assets,

properties and investment activities for the true essence of PLS contracts.

Property law that permits Islamic banks to hold properties as assets or get properties as collaterals.

Insolvency law that empowers Islamic banks to protect itself against creditor (liability-side of banks) or

impose its claims against debtors (asset-side of banks).

Employment law that guards against brain-drain and encourage inows of international employees to

accommodate the high demand of talented human capital to manage, execute and monitor PLS

contracts.

A dispute resolution framework which comprises competent lawyers, judges and other experts to

generate accurate decision-making when dealing with PLS contracts.

3.3. L3 Governance

In general, governance is dened as the inter-link between public and private regulations, which

involves management, board of directors (BOD) and stakeholders (Rosenberg, 2004). For banking,

governance is a mixture of regulation, law and relevant voluntary private-entity that governs banks to

attract fund and human capital, perform efciently, and nally produce sustainable economic value for

its shareholders, but at the same time do not ignore the interest of the stakeholders and society as a

whole (Weil and Manges, 2002).

For Islamic banking, the Accounting and Auditing Organization for Islamic Institutions (AAOIFI) and the

Islamic Financial services board (IFSB) were established to strengthen the governance of the Islamic banks.

IFSB-3 describes governance as follows:

A set of organizational arrangement whereby the actions of the management of institutions

offering Islamic nancial services are aligned, as far as possible, with the interest of its

stakeholders; provision of proper incentives for the organs of governance such as the BOD,

Shariah Supervisory Board and management to pursue objectives that are in the interests of

stakeholders and facilitate effective monitoring, thereby encouraging Islamic Financial Services

(IIFS) to use resources more efciently; and comply with the IslamicShariahrules and principles.

(IFSB, 2006, p.33)

From the denition above, we can see that the role of governance in Islamic banking can be threefold;

1) to provide assurances that the activities not only fully comply with the Shariah principles, but are

carried out towards achieving Maqasid al-Shari'ah, 2) to improve growth, efciency and credibility of

Islamic banking (Grais and Pellegrini, 2000) andnally, 3) to address various types of risk such as duciary

risk, operational risk, transparency risk, reputational risk andShariahrisk (Iqbal and Mirakhor, 2007). In

summary, Islamic governance should be both Shariahcompliant and simultaneously should acknowledge

the prot-motive of the stakeholders' wealth (Akhtar Aziz, 2007). To successfully play its role, the spirit of

Islamic bank's governance must be based on Tawhid(concept of vicegerency) and the Shariahrules and

principles.Tawhidhere is in the sense that all stakeholders have the same goal of the oneness of Allah and

the objective of living in to achieve falah and everyone is accountable to Allah for his own deeds. Allah

(s.w.t) says in the Quran:

Those who remember Allah standing, sitting, and lying down on their sides, and think deeply about the

creation of the heavens and the earth, (saying): Our Lord! You have not created this without purpose,glory to You! Give us salvation from the torment of there.(Al-Quran, 3:191)

Chapra (1992) mentioned that Tawhid in Islamic governance must be applied via the concept of

consultation (shura) as Allah (s.w.t) says in the Quran (3:159):

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So pass over (their fault), and ask for (God's) forgiveness; and consult them in affairs (of the moment)

then, when you have taken a decision, put thy trust in God.

Shura invites involvement of the stakeholders in the banking activities, either directly or indirectly. The

shura'sgroup (i.e. shareholders, depositors, management, BOD and employees) play an important role in

doing check-and-balance that all activities are consistent with the Islamic banks' objectives as well as in

line withShariahprinciples without ignoring the society as a whole.

The ideal Islamic banking governance model should be based on stakeholders-oriented approach (Iqbal

and Mirakhor, 2004) and with the aim of equitably safeguarding the rights of all stakeholders irrespective

of whether they hold equity or not (Chapra and Ahmed, 2002). The common Islamic banking governance

issues are often related to property rights and commitment to both direct and indirect contracts that rule

the economy and societal conduct of individuals, citizen and government. In respect to property rights (be

it the rights of ownership, acquisition, usage and disposition), majority Islamic jurists are of the opinion

that usufruct (mana') and rights (huquq) constitute a property, thus must be protected. For the

ownership rights, Islam believes the sole owner goes to Allah and a property is given as amanah, whilst

human beings are just custodians to manage property in accordance with the Shariah. This implies that the

right to own private property is just to generate prot, employment, increase investment and prosperity(Azid et al., 2007) with the goal of obtaining al-falah, which should also benet the society at large.

Governing the stakeholders needs a proper contractual framework. This contractual framework

strengthen the scope of stakeholders of the Islamic banks since it is not only refers to the shareholders, but

also refers to those who are both actively or non-actively involved in the policy-making process. Allah

(s.w.t) vividly requires Muslims to accomplish each of their contractual obligations as in Al-Quran (5:1):

O you who believe, fulll contracts

This verse provide basic underpinning on contract, in which all individuals, institutions, society and the

state are bound by their contract that denes the rights and obligations of each. Taken together, each

stakeholder has its own role: the shareholders have a role to play as capital providers and hire proper BOD,auditors andShariahboard; BOD has to set the bank's direction and policy; management has to manage the

banking activities; employees have to accomplish their designated task, Shari'ah board has to ensure Shari'ah

compliance and protect the rights of depositors and other stakeholders; investment account holders (IAH)

have to monitor the investment performance; andnally, regulators have to warrant effective enforcement of

the contracts. Notwithstanding the known role of each stakeholder, the most important phase is to ensure

that the process and ow of each run smoothly as desired. For instant, the BOD is supposed to be

professionally competent in all aspect of risk, strategic management, banking business and capable to

comprehend and value Masaqid al-Shari'ah. In contrast to BOD, the management is responsible to implement

the strategies and policies set by the BOD. Hence, it is crucial for the management to be really conscious (both

in practice and spirit) of the concept ofMaqasid al-Shari'ah so that all stakeholders concern are secured while

carrying out their roles. However, in reality, this scenario is yet to occur. (Abu-Tapanjeh, 2009)The most crucial component in Islamic governance is the Shariah board (ISRA, 2011). At least three

members of the Shariah board for each bank are needed to monitor (both as advisory the supervisory

body) the enforcement of Islamic banking governance by working together with the management and

Audit committee (IFSB, 2006).

Another aspect of Islamic banking governance is the role of corporate social responsibility (CSR). Islam

conjectures CSR as religious obligations, motivated by the concept ofTaqwa from the principle ofTawhid. CSR

can be categories into four aspects, namely the environmental, human capital, philanthropic and human right.

The implementation of CSR can be either mandatory or voluntary. Investment screening,Shariah compliance

earnings,zakat, equitable treatment to employees and responsible transactions with clients are the examples

of the mandatory CSR. Meanwhile, the voluntary ones are benevolent loans, environmental-investment

quota, social-impact based investment quotas, clients screening, excellent customer service, charitableactivities, etc.

Effective governance requires high transparency, accountability and integrity to safeguard its

stakeholders besides nurturing market efciency (Rosenberg, 2004). However, to ensure the enforcement

of those aspects for each contract, especially PLS contracts, is not as easy as it sounds. For instance, the


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limited role of shareholders (investors) in management makes them non-participatory in nature. This

would be similar to a sleeping partnership. In practice, Islamic banks and entrepreneur (asset-side of

bank) are not sharing risk in a real sense; instead, they share capital without participatory decision making

(Choudhury, 1998).

In summary, the governance structure of Islamic banks needs to be strengthened, especially in terms of

enforcement.Dar and Presley (2000)suggest that imbalance between the management and control needs

to be removed in order to increase market appeal of PLS. How? For example, the Malaysia Islamic banks

can adopt venture capital nancing as practiced in USA, UK and other European countries. Venture capital

in spirit is in line with Islamic teachings and provides a balance between managers and nanciers in terms

of control of business decisions. Venture capital approach with some modications, customized to banking

role needs to be further explored since in venture capital, the entrepreneur does not have to worry about

providing sufcient return to depositors. Against this background, Islamic banks should make a paradigm

shift, changing its role from nancial intermediaries to real entrepreneurs while at the same time manage

risk efciently besides minimizing the imbalance between the management and control.

3.4. L4 Resource allocation & agency theory

The evolution ofnancial intermediation theories has deviated from the traditional beliefs on existence

and practices ofnancial intermediaries in the nancial markets as well as its roles in the nancial system.

The emergence of Islamic banks in the early 1980s, has signicantly contributed to the nancial system

landscape overtime. Earlier studies in the area ofnancial intermediation theories focus mainly on the

permissible scope of activities for Islamic banks and other Islamic depository nancial intermediation.

These activities are determined by the regulations dictating the abolishment of interest rate in the

nancial system (Chapra, 1985; Chapra and Ahmed, 2002; Kurshid, 2000; Sidiqqi, 1983). Later studies

focus on contemporary issues such as the design ofnancial contracts and Islamic banking models (Archer

et al., 1999).5 The form of the mudarabah contract used by Islamic banks for mobilizing and managing

investors' fund may be seen as involving a complex agency problem. Among others are; rst, the

non-pecuniary benets where the managers of a bank are likely to consume beyond those which a sole

owner would consume; second, the problem of adverse selection arising from the use of debt nancing

under limited liability of shareholders, given that there is an incentive to the latter; andthird, the issue of

information asymmetry, in which the principal cannot observe the actions of the agents. These issues

justify the existence and roles of Islamic banks as nancial intermediaries, in channeling funds among the

economics agents. The basic concept is that funds mobilization and utilization are on the same basis of

prot sharing among the depositors, the bank, and the entrepreneur (Greuning and Iqbal, 2007). A typical

Islamic bank will perform the functions ofnancial intermediation through screening protable projects

and monitoring the performance of projects on behalf of investors who deposit their funds in the bank.

In addition, PLS contracts are inherently susceptible to agency problems as entrepreneurs do not have

the incentive to fully dedicate effort. They tend to report less prot in contrast to the self-nancing owner

manager (Dar and Presley, 2000). This view is based on the fact that capital providers (be it IAH orshareholders) will withdraw their deposits if they are rewarded lower than their expected returns. In

addition, the capital providers hesitate to invest on PLS basis as they are afraid to loose initial capital. The

shareholders claim on residual income (prot), whereas, capital provider put an emphasis on the

productivity of capital and, hence unwilling to bear any losses suffered in production. Consequently, the

reservation to bear risk by the capital provider and the shareholders' inclination to exclude others from

sharing prots, answers why PLS contracts are less favorable by both the Islamic bank and its clients.

Furthermore, a very limited secondary market for trading in Islamic nancial instruments, particularly the

mudaraba and musharakah contracts, prevents the Islamic banks to effectively mobilize its nancial

resources.

Taken together from all four level of NIE mentioned earlier, both the Islamic banks and clients have to

change their mind sets for the PLS contracts to be well-accepted. The government has to play a role in

5 SeeArcher et al. (1999)on the accounting regulation of Islamic banks, consider the contractual bases on which Islamic banks operate

from the perspective of agency theory (principalagent and principalprincipal) and transaction cost economics (contractual forms and

government structures).

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educating the society of the venture capital concept, willing to share prot & loss together viamudarabah

investment account from the liability-side of the banks' balance sheet. The Islamic banks also have to not

only focus on prot maximization via debt-based contract or mark-up pricing nancing, but should try on

equity based-nancing. In summary, for the society and Islamic banks to give space for PLS contracts to

develop, of course L2, L3, and L4 of NIE altogether needs to be tied together and improved. One initial step

to progress is by changing the role of Islamic bank from nancial intermediaries to purely genuine

entrepreneurs.

4. Proposed model: Islamic banks as entrepreneurs

4.1. Entrepreneurship: An Islamic perspective

Before we dwell into how Islamic banks should act as entrepreneurs, let us comprehend the status and

denition of entrepreneurship from Islamic perspective. The Holy Qur'an and the traditions of the Prophet

Muhammad (pbuh) explicitly praise entrepreneurship and commend moral entrepreneurial activity;

But Allah hath permitted trade (bai) and forbidden usury (riba)(2:275)

The economic transaction of buying and selling for prot (bai) implies the existence of the

entrepreneur. Entrepreneurship is widely dened as an economic activity in creating new business

ventures. The term entrepreneur is to describe the risk associated with a business decision due to

uncertainty (Cantillon, 1730). It also can be described as an agent who unites all means of production and

applies new knowledge and expertise to add value to the original products ( Say, 1816). Entrepreneurship

is not merely a means to create employment opportunities and maximize economic returns; it is rather a

development alternative with great potential to contribute to the well-being of individuals, communities

and nations. Taken together, this study denes entrepreneurship in banking as the role of an Islamic bank,

which acts as an agent that combines and manages all means of information and technology know-how to

add value to the original capital invested (be it from asset- or liability-side of the Islamic bank). It seemsthat from this explanation the existing Islamic banks fulll the basic denition of entrepreneur, but only by

focusing on the sale type contracts; the Islamic banks fail to fully add value to the capital invested. One of

the alternatives to aggressively add value to the capital invested is by venturing into PLS contracts.

A strand of studies discusses the importance of entrepreneurship as a viable developmental method

(Chapra, 2000; Siddiqi, 1978& Kahf, 1978). The emphasis of the Islamic value system and moral code of

conduct includes the need for the development and application of Islamic economics that would facilitate

the realization of an Islamic economic model. The aim is to achieve a state of human well-being based on

spiritual and socio economic foundation for well-being in the hereafter. As shown by the Islamic

entrepreneurship model in Fig. 2, the absolute objective is to achieve al-falah (human well-being). In

essence, it starts from two different dimensions; economics and religion. So, how do Islamic banks de ne

other roles and position themselves? First, does it mean that its role is just to collect and distribute fund

i.e. nancial intermediary: taking deposits and channel to investors? Secondly, does it mean that as an

entrepreneur, the Islamic bank is better able to generate higher prot; hence benet the depositors and

shareholders on the liability-side? Thirdly, does it mean that as an entrepreneur, the Islamic bank would

have made a better decision making on capital allocation in its Asset Liability Management (ALM) i.e.

Islamic banks act as entrepreneur, which involves decision-making and distribute prot between

mudharib(asset-side) and investors (liability-side)?

In general, Islam has a positive attitude to entrepreneurship and the rights of ownership. The

uniqueness of the Islamic code of business ethics contributes to a positive economic activity in the form of

cost effectiveness and organization competence (Wilson, 2006). The basic questions on the motives and

incentives in entrepreneurship should be clearly claried, since entrepreneur ventures into the businesses

for various reasons, among others are to earn prot, to build a social status and to be creative. Islamendorses entrepreneurship regardless of its being opportunistic or prot driven as long as it stands on

moral and ethical grounds and conrms with the Islamic code of conduct. The moral dimension of Islamic

entrepreneurship is evidenced by the strict guidelines set by Islam to regulate prot accumulation by

prohibiting dishonesty, greed, exploitation and monopoly. Thus, Islam encourages entrepreneurs to be

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involved only in morally accepted and socially desirable productive business activities. Hence, the most

important motives associated with Islamic entrepreneurship are religious and altruistic motives. It is a

means of participating in the development of Muslimummah. Hence, entrepreneurship is viewed from a

larger perspective in playing an altruistic role that goes beyond satisfying an entrepreneur's immediate

needs and personal interest. The pursuit of self-interest(Smith, 1776) and self-centered wealth creation

(Say, 1816; Schumpeter, 1934) are not the primary motives behind Islamic entrepreneurial activity.

Altruistic motives override personal considerations and self-interest shall be realized as a natural outcome

of advancing the society's common welfare. Islam urges entrepreneurs to include rewards/incentives in

the hereafter as well the satisfaction and potentially high return on his investment in this life. This

promotes the spirit of cooperation and spread socio-economic justice among ummah. Islam mainly usesmoral incentives without failing to account for the material rewards. In developing a model on

entrepreneurship, the most notable issues to take into account are cultural and institutional components.

The various elements in Islamic culture/teachings/guidelines need to be integrated with institutions in

order for a model to work well.

Fig. 2.An Islamic entrepreneur model. Source:Kayed and Hassan (2010)andKayed (2006).

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Several challenges faced by entrepreneurs including nancial resources, government regulations and

social attitudes that often discourage risk-taking (Sage, 1993). Generally, nancial resource is identied as

a major obstacle for entrepreneurs to venture into a business. This could be due to several reasons as the

high risk and administrative costs involved, and the lack of reliable information on the projects

undertaken; therefore leads the nancier to require entrepreneurs to have substantial collateral. In

addition, a pre-determined interest charges on the borrowed/nanced principal burden the entrepreneur,

particularly the small and medium enterprise (SME). The commitment to repay the loan and the

associated interest is inescapable, regardless of the future yield from the projects undertaken.

Islam urges Muslims to invest in business activities that are moral, productive and socially desirable as

an alternative to derive income from the extra money owned. Thus, the comprehensiveness of the Islamic

nancial system accommodates such situations by allowing the investor to have a share in the business

venture through a partnership arrangement with the potential entrepreneur who does not have the

nancial resources to start his business. The musharaka and mudarabah principles ensure that the

potential entrepreneur will not start a business disadvantageously, with a heavy interest burden added to

the initial borrowing which has to be repaid regardless of the outcome of business venture. Islam argues

that capital is the portion of wealth for productive activities while money is a measure of value and a

means of exchange, not a commodity for speculation. Money remains potential capital until it is investedin productive economic activity as factors of input (including land, labor and entrepreneurship). Thus

Islamic banking plays a crucial role in economic development by transforming money into capital through

the act and the process of entrepreneurship.

4.2. Islamic banks as entrepreneur

In Islamic banking models, interest-based contracts are replaced by a return-based contract, which

often takes the form of partnerships. Islamic banks offer nancial instrumentsmusharakaand mudarabah

as partnership arrangement to play a positive role in advancing the cause of Islamic entrepreneurship.

Islamic banking provides current and potential entrepreneurs with needed halal capital and protectagainst risk by sharing the risk between in the partnership arrangements. The discussion of the

implication ofmusharakahand mudarabahcontracts will be done based on the two divisions ofnancial

intermediation process. First, for borrowing activities, Islamic bank acts as mudharib and depositors as

rabbul mal. On the other hand, for lending activities, Islamic bank acts as rabbul maland entrepreneurs as

mudharib. The implications of borrowing and lending activities differ in signicant ways for Islamic bank.

The roles of Islamic bank as mudharib on the liability-side and as rabbul mal on the asset-side, give a

unique and different implications on these contracts. How? Theoretically, PLS arrangement implies a

direct concern with regard to the protability of the physical investment on the part of Islamic bank as

rabbul mal. The expertise of the bank's team under musharakahwill encourage entrepreneurs to engage in

a more innovative and original business undertakings. In contrast, in conventional practice, bank is

concerned about potential default on the loan.Based onDiamond's (1984)study in the context of Islamic banks' nancing (on the asset-side of the

bank) based on musharakah and mudarabah contracts, entrepreneurs or mudharib must be monitored

because there is an ex-post information asymmetry where capital provider (bank) does not know how

much the return is produced. Only the entrepreneur or mudharib observes the realized output of his

project, so contracts cannot be made contingent on the output. Consequently, a capital provider (bank) is

at a disadvantage because the entrepreneur or mudharib may not honor ex-ante promises to pay unless

there is an incentive to do so. Thus,Diamond (1984)proposes the possibility of relying on a contract that

imposes non-pecuniary penalties on the entrepreneur or mudharib. He believes that the non-pecuniary

penalties would able to solve the contracting problem. However, this contract is costly because such

penalties are imposed in equilibrium and reduced the utility of entrepreneur or mudharib. On the other

hand, if the capital provider (bank) had available information on production technology, then theinformation asymmetry could be overcome by application of this technology, at a cost. He asserts that the

information production technology would be cheaper and more efcient than imposing non-pecuniary

penalties. He refers production of information when the entrepreneur's realized output at a cost, as

monitoring cost.

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In Islamic banking, monitoring and supervision are essential due to asymmetric information. Ahmed

(2000)claims that depositor's preferences for using an Islamic bank may be due to religious or ethical

reasons, while the investors of these banks do not necessarily have this motive. This is also reected in the

xed income-based (murabahah contract). To deal with the slackness and dishonesty of the clients in

mudarabahcontract, a ne is imposed by Islamic bank in cases where arrears repayment arises (Usmani,

1999). With the concept of universal banking, nancing undermusharakahcontract, would mean that the

capital owner has a right to enter into the management and hence has some control over the problems

created by the informational asymmetry. The roles of Islamic bank asmudharibon the liability-side and as

rabbul mal on the asset-side, give a unique and different implications on the borrowing and lending

relations (Aggrawal and Yousef, 2000; Ahmed, 2002). It shows that PLS arrangement in the Islamic

banking models is able to minimize asymmetrical information and reduce transaction costs, through

supervision, monitoring and alignment of incentives.

From the perspective of liability-side of Islamic bank, the structure of Islamic nancial intermediation

can be illustrated based on two concepts; the two-tier mudarabah model and two windows model

(El-Hawary et al., 2006). For the two-tier mudarabah model, the deposits are accepted based on mudarabah

contract (the rst-tier on the liability-side). There are two scenarios, if Islamic bank do not guarantee the

value of deposit or any losses incurred, this prot sharing contract is a form of limited term; non-votingequity. On the other hand, an Islamic bank would also offer demand deposits that yield no returns and are

repayable on demand at par value, and are disclosed as liabilities. The second tier is amudarabahcontract

between Islamic bank as supplier of funds and entrepreneurs seeking funds and sharing prots based on

pre agreed ratio (on the asset-side). Meanwhile, the two-window model assumes that Islamic bank

liabilities are divided into two, demand deposits and investment deposits. The depositors can choose to

deposit the funds as demand deposits which are guaranteed and treated as liabilities by Islamic banks, or

as investment deposits in which the funds are used to nance risk bearing investment projects with the

depositor's full awareness. However, in practice, funds are mainly applied by means of commodities and

asset nancing instruments that avoid interest but not prot sharing, such asmurabahah, salam, istisna',

and ijarah.Iqbal (1998) in his study propose that the structure of Islamic banks can be classied into three.

Firstly, the bank acts as agent (wakeel) to the depositors, in managing funds on behalf of clients on thebasis ofxed commission. The other two structures are distinguished based on the structure of the assets.

The two-tier mudarabah structure views Islamic bank as an investment intermediary. It replaces interest

by prot sharing modes on both liability- and asset-side of the bank. Thus, the structure assumes that all

assets are nanced by prot sharing mode i.e. mudarabah contract. On the other hand, the one-tier

mudarabah structure opts for xed-income modes (e.g. murabahah-cost-plus or mark-up sale; and

ijarah-leasing) in nancing the asset-side.

From the perspective of asset and liability management (ALM) of Islamic bank, the roles of Islamic bank

as mudharib on the liability-side and as rabbul mal on the asset-side, give a unique and different

implications on the borrowing and lending relations (Aggrawal and Yousef, 2000; Ahmed, 2002). For the

asset-side,Tahir (2003)argues that in theory, probability of Islamic banks' assets becoming liquid is more

difcult to ascertain than in conventional banks, due to the different nature of its operations. According tothe ideal Islamic bank theory, prot-loss sharing is the main mechanics, but in practice prot-loss sharing

is rarely being used. The nature ofnancial intermediation, including the function of banking, is different

in the case of Islamic bank. The rst model describes two segments of contractEl-Hawary et al. (2006).

First segment is contracts between the depositors and Islamic bank as mudharib. Second, contracts

between Islamic bank as supplier of funds (capital provider) and entrepreneurs who needed funds to

nance their projects. Thus, these two segments raise different types of issues, i.e. principalagent

relationship. In the second model, bank liabilities are divided into two types of deposits; demand deposits

and investment deposits. The latter are used to nance risk bearing investment projects based on PLS

arrangement. On the other hand, the former will be based on the principle ofal-wadiahandqard al-hasan,

where the deposits are held as assets by the bank for safe keeping purposes.

5. Conclusion

In conclusion, form the NIE context, PLS, in the environment of Islamic banks as nancial intermediaries is

difcult to grow. This is because asnancial intermediaries, Islamic banks are not supposed to take part in the


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management of the PLS nancing, although the risk is high. The spirit of nancial intermediaries is to

intermediate the fund from the surplus unit to decit unit, without taking the real business risk faced by the

decit unit. That is why the sales-based contracts (murabahah,ijarah,istisna' and salam) is favorable in the

current scenario, where Islamic banks play a role ofnancial intermediaries. Unlike sales-based contracts, PLS

nancing exposes the Islamic banks to actualbusiness risk, where banks as capital provider (rabbul mal)

must bear the loss (in mudarabah) or share the loss (in musharakah) in the case of business failure. Hence, for

PLSnancing andmudarabahdeposit to grow, there is an urgent need for the Islamic banks to transform its

role fromnancial intermediaries to genuine entrepreneurs.

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