The role of Islamic financing in entrepreneurship development
Saturday, 23 January 2010
Rasem N. Kayed and M. Kabir Hassan
Although each country is faced with typical obstacles that hamper the development of entrepreneurship, and despite the uniqueness of the problems in their quest to establish businesses there are certain difficulties shared by the vast majority of entrepreneurs. Entry into business is often hindered by the lack of financial resources, government regulations, and social phenomena that often discourage taking risk. However, the procurement of capital to start a business is widely recognised to be a major obstacle in the way of most potential entrepreneurs irrespective of their pace of activities. The validity of this statement is not limited to a particular culture or confined to a certain landscape, although it is more pertinent in the context of developing countries.
Cooperation between potential entrepreneurs and conventional lending financial institutions in Islamic countries is usually held back on the following grounds: Firstly, commercial lending institutions are reluctant to extend their credit to entrepreneurs. This reluctance is largely attributed to the high risk and high administrative cost of lending to small firms where the size of the loan is often too small to be economically viable. However, the real reasons behind such reluctance are believed to be lack of understanding of the nature and the dynamics of SMEs, coupled with lack of qualified bankers when apprising feasibility studies and evaluating and monitoring small business loans.
Some of the conditions imposed by lending institutions such as prior business records showing profitability to guarantee the repayment of the loan are hard to fulfill, especially by new and potential entrepreneurs who do not have established track record. Commercial banks are also hesitant to take a risk in financing new venture as they are not confident enough about its market potential and success.
To protect their investment and ensure the security of the loan, banks require entrepreneurs to come up with substantial collateral, in most cases, the value of which is more than cost of the loan. The inability of the entrepreneur to meet the tough conditions set by commercial banks means that he/she cannot count on the conventional banking system to secure the required start-up capital. This leaves the entrepreneur with the difficult task of trying to find another financing alternative – where excessive interest rate is often charged – or to abandon the dream of becoming an entrepreneur.
Even if the potential entrepreneur was able to satisfy the requirements of the lending institution and proved his/her eligibility for the loan, the entrepreneur would then be held accountable to repay the pre-determined interest charges in addition to the borrowed principal. The high cost of capital needed to undertake the business venture imposes a heavy debt burden on the entrepreneur. The extra cost of finance places the entrepreneur in a difficult position from the start, hence raising the odds against the success of his/her business venture. Furthermore, the commitment to repay the loan and the associated interest is irreversible. Should the venture prove to be a success and the rate of return higher than the ongoing interest rate, fixed arrangements would not then be fair to the lender. On the other hand, if the business activity ends up in failure, the entrepreneur is left to his/her fate, while the lender with the borrower assets as collateral unfairly recovers. This practice is deemed unfair and unjust hence it is explicitly prohibited in Islam.
Secondly, the majority of potential Muslim entrepreneurs do not wish to deal with conventional banks on religious grounds. They consider commercial banks doing conventional banking to be unethical institutions that widen the divide between the wealthy and the needy through their immoral interest (riba)-based financial practices. Scholars surveying this topic frequently overlook this factor despite its significance and immense implications. Thirdly, a sizable portion of Muslim entrepreneurs would prefer sharing rather than bearing the risk associated with new business undertakings
Islamic scholars cogently pointed out that although the current interest in Islamic economics is relatively recent, Islamic economics is not a new paradigm. In fact, the roots of Islamic economics can be traced to the time of the revelation of the Holy Qur’an, some fourteen centuries ago.
The following discussion on the Islamic financial system is limited in its depth and scale to the potential role that Islamic banking is capable of commanding in the development and promotion of a productive Islamic entrepreneurship sector. Islamic Shariah is the set of rules that governs the economic, social, political and cultural aspects of Islamic societies. Qur’an and Sunnah are the main sources of Shariah. The philosophical thinking underlying the principles of the Islamic financial system is the implementation of a financial system (wealth accumulation and wealth distribution) that is fair, just and unbiased towards the rich minority at the expense of the poor majority. The ultimate aim is to spread socio-economic justice amongst Muslims throughout the Islamic world. Although Islamic banking is a core component of the Islamic financial system, it is a common fallacy to identify the Islamic financial system exclusively with Islamic banking and to define the economy as a whole only on the basis of being an “interest free” economy.
The prohibition of interest (riba) in Islamic economics has received much attention. Many Western scholars have suggested that the prohibition of interest is anti-capitalist and an obstacle to the proper functioning of a modern economy and a limiting – if not an impeding – factor to economic development and growth. On the other hand, others have argued that there is no moral or economic justification for charging or receiving interest. Charging interest, they argue, is counterproductive and adds to the burdens of the entrepreneur and an interest-based economy is by no mean an economy that aspires to provide socio-economic justice.
One scholar explored the possible relationship between the prohibition of interest and economic development and concluded that: Firstly, money generated from “rent-seeking activity” such as charging interest creates new but artificial capital which is by no means the life-blood of the markets. He pointed out “The essence of the market is entrepreneurship” and explained that “trade, not banking is the primary function of markets”.
Secondly, the partnership arrangements between the financier and the entrepreneur eliminate the negative effect of banning interest, if any, on the markets. Mudarabah and Musharakah are two Islamic financial instruments used as alternatives to the interest-based arrangements employed by conventional banking. Mudarabah and Musharakah operate under the concept of ‘rate of return’ where the financier and the entrepreneur share the risk, hence they also share the profit/loss generated by the investment according to an agreed upon ratio. This is in contrast to the fixed pre-determined ‘interest rate’ to be paid by the entrepreneur in addition to the borrowed principal regardless of the outcome of the business undertaking.
Thirdly, Islam prohibits paying or receiving any predetermined rate of return on borrowed/lent money. Charging interest (riba) tends to drive the poor into more poverty and create more wealth for the wealthy without doing work or sharing the risk involved in every business undertaking. Riba further creates wealth without actually being the outcome of productive economic activity or as the result of an increase in commodity supply. Islam therefore considers all interest-based financial arrangements to be unfair, unjust and morally unjustifiable and all money generated by such transactions to be unearned money, thus declares riba unlawful. Interestingly, all major religions (Judaism, Christianity and Islam) and other ethical systems such as Buddhism and Hinduism were united in denouncing interest as unethical and immoral practice.
Rasem N. Kayed belongs to the faculty of Arab American University, Palestine and Dr. M. Kabir Hassan to the faculty of University of New Orleans, USA. Kabir Hassan can be reached at e-mail: kabirhassan63@gmail.com
Although each country is faced with typical obstacles that hamper the development of entrepreneurship, and despite the uniqueness of the problems in their quest to establish businesses there are certain difficulties shared by the vast majority of entrepreneurs. Entry into business is often hindered by the lack of financial resources, government regulations, and social phenomena that often discourage taking risk. However, the procurement of capital to start a business is widely recognised to be a major obstacle in the way of most potential entrepreneurs irrespective of their pace of activities. The validity of this statement is not limited to a particular culture or confined to a certain landscape, although it is more pertinent in the context of developing countries.
Cooperation between potential entrepreneurs and conventional lending financial institutions in Islamic countries is usually held back on the following grounds: Firstly, commercial lending institutions are reluctant to extend their credit to entrepreneurs. This reluctance is largely attributed to the high risk and high administrative cost of lending to small firms where the size of the loan is often too small to be economically viable. However, the real reasons behind such reluctance are believed to be lack of understanding of the nature and the dynamics of SMEs, coupled with lack of qualified bankers when apprising feasibility studies and evaluating and monitoring small business loans.
Some of the conditions imposed by lending institutions such as prior business records showing profitability to guarantee the repayment of the loan are hard to fulfill, especially by new and potential entrepreneurs who do not have established track record. Commercial banks are also hesitant to take a risk in financing new venture as they are not confident enough about its market potential and success.
To protect their investment and ensure the security of the loan, banks require entrepreneurs to come up with substantial collateral, in most cases, the value of which is more than cost of the loan. The inability of the entrepreneur to meet the tough conditions set by commercial banks means that he/she cannot count on the conventional banking system to secure the required start-up capital. This leaves the entrepreneur with the difficult task of trying to find another financing alternative – where excessive interest rate is often charged – or to abandon the dream of becoming an entrepreneur.
Even if the potential entrepreneur was able to satisfy the requirements of the lending institution and proved his/her eligibility for the loan, the entrepreneur would then be held accountable to repay the pre-determined interest charges in addition to the borrowed principal. The high cost of capital needed to undertake the business venture imposes a heavy debt burden on the entrepreneur. The extra cost of finance places the entrepreneur in a difficult position from the start, hence raising the odds against the success of his/her business venture. Furthermore, the commitment to repay the loan and the associated interest is irreversible. Should the venture prove to be a success and the rate of return higher than the ongoing interest rate, fixed arrangements would not then be fair to the lender. On the other hand, if the business activity ends up in failure, the entrepreneur is left to his/her fate, while the lender with the borrower assets as collateral unfairly recovers. This practice is deemed unfair and unjust hence it is explicitly prohibited in Islam.
Secondly, the majority of potential Muslim entrepreneurs do not wish to deal with conventional banks on religious grounds. They consider commercial banks doing conventional banking to be unethical institutions that widen the divide between the wealthy and the needy through their immoral interest (riba)-based financial practices. Scholars surveying this topic frequently overlook this factor despite its significance and immense implications. Thirdly, a sizable portion of Muslim entrepreneurs would prefer sharing rather than bearing the risk associated with new business undertakings
Islamic scholars cogently pointed out that although the current interest in Islamic economics is relatively recent, Islamic economics is not a new paradigm. In fact, the roots of Islamic economics can be traced to the time of the revelation of the Holy Qur’an, some fourteen centuries ago.
The following discussion on the Islamic financial system is limited in its depth and scale to the potential role that Islamic banking is capable of commanding in the development and promotion of a productive Islamic entrepreneurship sector. Islamic Shariah is the set of rules that governs the economic, social, political and cultural aspects of Islamic societies. Qur’an and Sunnah are the main sources of Shariah. The philosophical thinking underlying the principles of the Islamic financial system is the implementation of a financial system (wealth accumulation and wealth distribution) that is fair, just and unbiased towards the rich minority at the expense of the poor majority. The ultimate aim is to spread socio-economic justice amongst Muslims throughout the Islamic world. Although Islamic banking is a core component of the Islamic financial system, it is a common fallacy to identify the Islamic financial system exclusively with Islamic banking and to define the economy as a whole only on the basis of being an “interest free” economy.
The prohibition of interest (riba) in Islamic economics has received much attention. Many Western scholars have suggested that the prohibition of interest is anti-capitalist and an obstacle to the proper functioning of a modern economy and a limiting – if not an impeding – factor to economic development and growth. On the other hand, others have argued that there is no moral or economic justification for charging or receiving interest. Charging interest, they argue, is counterproductive and adds to the burdens of the entrepreneur and an interest-based economy is by no mean an economy that aspires to provide socio-economic justice.
One scholar explored the possible relationship between the prohibition of interest and economic development and concluded that: Firstly, money generated from “rent-seeking activity” such as charging interest creates new but artificial capital which is by no means the life-blood of the markets. He pointed out “The essence of the market is entrepreneurship” and explained that “trade, not banking is the primary function of markets”.
Secondly, the partnership arrangements between the financier and the entrepreneur eliminate the negative effect of banning interest, if any, on the markets. Mudarabah and Musharakah are two Islamic financial instruments used as alternatives to the interest-based arrangements employed by conventional banking. Mudarabah and Musharakah operate under the concept of ‘rate of return’ where the financier and the entrepreneur share the risk, hence they also share the profit/loss generated by the investment according to an agreed upon ratio. This is in contrast to the fixed pre-determined ‘interest rate’ to be paid by the entrepreneur in addition to the borrowed principal regardless of the outcome of the business undertaking.
Thirdly, Islam prohibits paying or receiving any predetermined rate of return on borrowed/lent money. Charging interest (riba) tends to drive the poor into more poverty and create more wealth for the wealthy without doing work or sharing the risk involved in every business undertaking. Riba further creates wealth without actually being the outcome of productive economic activity or as the result of an increase in commodity supply. Islam therefore considers all interest-based financial arrangements to be unfair, unjust and morally unjustifiable and all money generated by such transactions to be unearned money, thus declares riba unlawful. Interestingly, all major religions (Judaism, Christianity and Islam) and other ethical systems such as Buddhism and Hinduism were united in denouncing interest as unethical and immoral practice.
Rasem N. Kayed belongs to the faculty of Arab American University, Palestine and Dr. M. Kabir Hassan to the faculty of University of New Orleans, USA. Kabir Hassan can be reached at e-mail: kabirhassan63@gmail.com