What can we learn from a widow in Indonesia about equity-based Islamic banking products?

Bloomberg has an interesting article on the potential for the Islamic finance market in Indonesia that starts with the story of one woman who received financing for her small business from PT Bank Muamalat Indonesia:

Hanifah took out a Shariah-compliant loan from PT Bank Muamalat Indonesia after her husband’s death to help finance a store on the ground floor of a shophouse in Serang, two hours’ drive west of Jakarta. While she doesn’t pay any interest, borrowers like Hanifah typically must give the bank 40 percent of their profit plus part of the principal each month.

“When times are good, I pay more on my loan than most people,” said Hanifah, whose monthly take is about 50 million rupiah ($5,189). “But I won’t have to worry when times are bad. I don’t have to pay anything when I’m not turning a profit.”

Besides being a nice story about a widow who has been able to successfully build a store to provide her with income, it shows the potential benefit from the Islamic banking product she uses, which sounds like either a musharaka or mudaraba.  Without knowing for sure, I would guess it is a mudaraba, although the bank offers both forms of financing. 

In a mudaraba, the bank provides the capital (acting as rabb al-mal) and the woman runs her store (as mudarib), with a pre-agreed split of profits (in this case 40% for the bank, 60% for the woman running the store).  If it is a mudaraba, she does not bear any losses, except the loss of her labor running the store.  It is likely that if the business failed, the bank would be able to force the sale of the inventory of the store (and any fixed assets it has) to recoup its investment, but not giving the bank recourse on the woman's other assets. 

For small business owners, this is a form of insurance against the failure of the business, since there is not liability for losses on the part of the business owner.  As a consequence, the bank is going to require greater upside potential (in this case taking 40% of the businesses profits, "When times are good, I pay more on my loan than most people").  However, for this woman at least, this is an acceptable trade-off, "I won't have to worry when times are bad.  I don't have to pay anything when I'm not turning a profit". 

There are several criticisms of Islamic banks using the mudaraba (or musharaka) structure and its applicability as a banking product that are worth remembering:

1. Banks are in the business of credit risk, transforming short-term deposits into long-term financing and (in their banking business at least) are not skilled at making assessments of equity risk;
2. Banks are regulated in terms of acting as judges of credit risk and for the purpose of liquidity transformation (turning short-term assets, deposits, into long-term assets, loans) and providing equity financing does not fit within the standard regulation of banks;
3. Equity-based financing products create an incentive problem since the incentives of the bank and of the entrepreneur may differ, and monitoring is costly;
4. Equity investments are of longer duration (potentially infinite) than loans and it will be more difficult for banks to exit if they need to access liquidity.

 These objections have merit, so perhaps it is useful to look at how they can be overcome (to provide additional opportunities for equity products to be used in Islamic banking, where murabaha, ijara, istisna'a and salam (generally more similar to debt) dominate. 

1. Banks are not traditionally seen as evaluators of business prospects beyond the credit risk they pose to the bank when they take a loan.  This is probably one of the more difficult areas for incorporating equity (or quasi-equity products) into an Islamic bank's product portfolio.  However, where the payments are set up as a percentage of profits plus the gradual reduction in the bank's interest in the business, it is possible for the analysis to be performed more like a credit analysis since the bank is providing financing to generate some target yield (paid out as a share of profits) and to have its investment redeemed over time. 
   
   They do not necessarily have to assess the growth potential of the business, but will instead do more to analyze the probability of default (that the business will not be able to buy out the bank's share, and that the profits generated will be sufficient to pay profits up to the bank's targeted return).  A bank looking at the credit risk of the business will look at the same factors: will the business generate enough revenue to make payments of the interest on the loan (and still remain in business) and will it be able to pay off the loan when it comes due.  The factors that will be analyzed will be the business' historical profitability and the fixed assets (which can be sold if it defaults to recover some of the principal).
   
2. The regulation of banks is predicated primarily on their business as being making interest-based loans to individuals and businesses and may not be flexible enough to allow equity products.  For example, banks in the US are not able to provide equity investment (the reason why Islamic mortgages using equity structures are only offered by non-bank financial institutions). 
   
   In some cases, this is addressed by making changes to the bank regulatory system, while other countries opt to create a separate regulation for Islamic banks (with separate licensing requirements).  The problems of broadening the regulations to allow for more equity products from Islamic banks (particularly if it is not allowed for conventional banks) is that it creates the potential for regulatory arbitrage where conventional banks set up separate Islamic banking subsidiaries or Islamic windows where they conduct the possibly more risky equity financing, while retaining the traditional financing activity in their conventional banking units.  It is always difficult to design banking regulations to neither favor or obstruct Islamic or conventional banks, while not allowing for any differences in the regulation to be used for purposes different from what they were intended. 
   
   
3. The principal-agent problem that occurs makes it harder for a bank to work with equity products than in other areas.  The bank, as principal, wants the business owner to maximize profits while avoiding losses and fully report all the profits when the profit split occurs.  The business owner wants to maximize the profits, because that will increase her income, but is not directly incentivized to avoid losses to the extent that she would if she were fully liable for them (since the bank will take losses under the mudaraba).  There is also an incentive for the business owner to minimize the reported profitability to lower the amount paid out to the bank. 
   
   The second problem--of reporting profits accurately--is the easier to deal with since the bank can require access to information about the inventory, sales, and expenses to check to see if the reported profits are likely to reflect reality (with the assistance of an external auditor).  The bank can require the business prepare financial statements when announcing the profit that is available to split, which can be compared to the other information (inventory, expense invoices, etc) to ensure the profits and losses are accurately measured. 
   
   It is harder to align the incentives between the business owner and the bank in how the business owner manages the business.  No business owner wants to see their business fail, and that provides some discipline, but if the financial losses of the business are absorbed by another party (and the owner loses just her share of future profits) than it may lead to more risky behavior on the part of the business owner, particularly if the business is having difficulties. 
   
   The way banks can mitigate this risk is by again ensuring accurate reporting of the business' revenues, expenses and profits, with the assistance of an external auditor to find signs in advance if a business is having problems, before it becomes more likely that the business owner will pursue more risky business strategies or start shifting revenues out of the business by engaging in business off of the books (to get what income she can while pushing more losses onto the bank).  This is not easy, but there are similar challenges for banks making interest-based loans to businesses, so banks are not necessarily starting from scratch. 
   
4. The equity product described in the Bloomberg article uses the profit-sharing structure, but makes a key modification.  Instead of having an equity investor relationship last forever, the mudaraba is structured to have profit payments be made with a buy-out of the bank's share in the mudaraba [1].  This diminishes the bank's share according to a planned schedule with a targeted end date, similar to a loan.  The end date for the financing is likely to be contingent upon the profits of the business (where the buy out amount is done only where there are profits from the business, although it may be possible to separate out the two components and have the buy-out transaction done every period, but profit payments only made where there are profits.

These are just a few thoughts that came to mind when reading about the widow in Indonesia who uses Islamic banking products to mitigate her risks from her business not generating profits.  There are many more aspects that are involved in looking at how Islamic banks can incorporate equity products into their financing offering.  I hope this will provide a starting point for thinking about how Islamic banks can use equity products alongside their other products, and how it can benefit their customers.  

[1] I am assuming it is a mudaraba contract, it may have been a musharaka, where there was a contribution made either in cash or in kind at the outset.  Then it would be a diminishing musharaka, which is more commonly used.  There are Shari'ah issues with a diminishing mudaraba (as noted in the Vogel & Hayes book section on mudaraba).  The issues are 1) if the principal payments are accumulated to buy out the mudaraba at maturity, it may not be Shari'ah-compliant to specify this purchase in advance; 2) If each payment goes to buy out a share of the mudaraba, it is not clear how the price can be determined at each time; and 3) if the principal payments are used to buy out a share of the mudaraba which is reconstituted each period, it may not be possible to specify that the mudaraba shall be reconstituted in advance.