Articles on Islamic Finance

Risk Sharing versus Risk Shifting in Islamic Banks

Paper Title: Risk Sharing versus Risk Shifting: A Comparative Study of Islamic Banks

Author:        Sunil Khandelwal and Khaled Aljifri

Publisher:    Journal of Islamic Accounting and Business Research, 12(8), 1105 – 1123.   

This paper aims to see which modes of financing are majorly employed by Islamic banks while providing finance to the clients. Authors classify the financing contracts into Risk-sharing versus Risk-shifting. In another sense, this classification could be summarised as debt financing versus equity financing. In debt based modes of financing, the structure of the contract creates debt for the client which the client has to repay.

In Islamic debt based modes of finance, this could take the shape of deferred Murabaha price which has to be paid in the future by the client or rental payments which have to be paid by the client in lease based modes of finance. In Diminishing Musharakah, the client is required to pay rents plus the purchase price of units owned by the banks. Therefore, in debt based modes of finance, even though money loan is not provided, but the structure of the contract results in client becoming liable to pay either the price of assets or rentals on the use of asset.

The authors classify Murabaha, Ijarah and Diminishing Musharakah under risk-shifting contracts. The bank is able to shift the risk through either quick sale of asset as in Murabaha and-or by agreeing payment schedule with the client according to which the client is liable to make rental payments. Since the payment schedule is agreed with the client at the outset through a unilateral binding undertaking, the bank is effectively able to shift the risk for all practical purposes.    

In contrast, in equity based modes of financing, such as in Musharakah and Mudarabah, the risk is shared rather than shifted. Both the partners are exposed to the payoffs. If the partnership earns profit, it is shared as per the pre-agreed profit sharing ratio. If the partnership suffers loss, it is shared as per the capital contribution ratio. That is why, the authors classify Mudarabah and Musharakah as risk-sharing based contracts.

The empirical analysis shows that by and large Islamic banks use risk-shifting contracts. The use of risk-sharing based contracts is quite minimal. The authors do not present the reasons. But, the general reasons cited by practitioners is that this tendency is because of

  • High risk of moral hazard.
  • High risk of adverse selection.
  • High information asymmetries.
  • Lack of transparency and monitoring complexities.
  • High exposure to risk discouraged by BASEL risk weightage mechanism, and which also goes beyond the expectation and tolerance of funding clients, i.e. depositors and shareholders.

Moral hazard implies that the behaviour is different in situations where the client has own capital at risk as compared to situations where the client is only acting as agent. This risk is highest in Mudarabah where the Rabb-ul-Maal (i.e. investing partner) has to bear all financial loss if it occurs and the Mudarib (i.e. working partner) has no responsibility to share in loss.

Information asymmetry and adverse selection imply that the bank will be approached mostly by those clients to obtain equity finance who have greater risk of loss. Profitable enterprises find debt financing cheaper. But, enterprises who are suffering losses and who have expectation to suffer further losses will be attracted towards equity financing. However, bank can only rely on documented information to identify, evaluate and screen clients. Clients know about themselves better than the bank.

If client shows losses, then there is no easy way to ascertain whether the loss occurred due to negligence or because of factors not in the control of the client, such as economic recession, decline in sales due to political instability, lockdowns and so on. 

Finally, the BASEL requirements suggest greater risk weights for equity financing as compared to debt financing. Thus, in meeting capital adequacy requirements, banks generally prefer secured low-risk financing.

All these reasons are cited by the practitioners in explaining that why the use of equity financing is negligible in current practice of Islamic banking. However, with certain covenants, these risk-sharing based contracts can be made more robust. For instance, tier-based profit sharing ratio, excluding certain common expenses to be deductible against revenues and asking client to also contribute capital. In Pakistan, Running Musharakah is one example of using risk-sharing based contracts after introducing certain covenants. Nevertheless, it is also important that such covenants should not become yet another instrument to achieve the same end-result as in debt based mode of financing in terms of cash flows. It is critical to keep the spirit and essence of risk-sharing intact.

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