Islamic corporate financing: does it promote profit and loss sharing?

Abstract

Islamic financing instruments can be categorised into profit and loss/risk sharing and non‐participatory instruments. Although profit and loss sharing instruments such as musharakah are widely accepted as the ideal form of Islamic financing, prior studies suggest that alternative instruments such as murabahah are preferred by Islamic banks. Nevertheless, prior studies did not explore factors that influence the use of Islamic financing among non‐financial firms. Our study fills this gap and contributes new knowledge in several ways. First, we find no evidence of widespread use of Islamic financing instruments across non‐financial firms. This is because the instruments are mostly used by less profitable firms with higher leverage (i.e. risky firms). Second, we find that profit and loss sharing instruments are hardly used, whilst the use of murabahah is dominant. Consistent with the prediction of moral‐hazard‐risk avoidance theory, further analysis suggests that users with a lower asset base (to serve as collateral) are associated with murabahah financing. Third, we present a critical discourse on the contentious nature of murabahah as practised. The economic significance and ethical issues associated with murabahah as practised should trigger serious efforts to steer Islamic corporate financing towards risk‐sharing more than the controversial rent‐seeking practice.