Paper Title: Islamic Finance Involvement in Supply Chain of Financed Assets: A Library Research and Systematic Literature Review
Author: Zubair Ahmed, Dr. Mohd Adib Ismail, Dr. Lokhman Hakim Osman, Assoc. Prof. Zizah Che Senik
Publisher: Turkish Journal of Islamic Economics, 9(2), 49 – 71.
This paper is a novel attempt to analyze the involvement of Islamic financial institutions in supply chain of financed assets. It argues that since Islamic bank has to have ownership and possession of the asset besides undertaking risk of the asset in trade and lease contracts, Islamic bank has to engage more intently in supply chain than the conventional bank.
Conventional bank simply provides a monetary loan, which in some cases is provided for the purchase of an asset and in some cases, it does not involve purchase of an asset. However, conventional bank has no concern with the asset, its usability and its ownership related risks.
On the other hand, Islamic bank has to ensure that it has ownership and possession of the asset before it can sell or provide the asset on lease to the client. In Murabaha, the asset is soon sold to the client usually on deferred payment basis after the purchase. However, in Ijarah and Diminishing Musharakah contracts, the asset ownership risk is borne for a longer duration.
Nevertheless, in order to mitigate its risk, Islamic bank locks the credit price in deferred payment sale and rental schedule in lease based financing by obtaining unilateral undertaking from the client which is legally binding on the client.
Even though there is a reasonable business case for doing that, it effectively makes the Islamic financing as secure as conventional for the financier. Since only constructive possession is taken and client is made agent in facilitating the purchase of asset for the Islamic bank in the first leg of transaction in Murabaha, the apparent distinctive engagement of Islamic bank in supply chain merely becomes ceremonial at best.
In Salam and Istisna contracts as well, the client is made agent to sell the asset. Furthermore, by taking Takaful for the asset and adding its cost in the price and rent of the financed asset, the cash flows and effective risk taking become very much similar to conventional banking.
That is why, Islamic banking receives the criticism of being similar to conventional banking in final outcome and economic effect. Nonetheless, Shari’ah compliance is a different matter. Pioneer scholars who have developed Shari’ah compliant product structures also have suggested to use equity based modes of financing which are more distinct in their structure, risk sharing and cash flow commitments.
Since the product structures to finance particular financial needs are limited in Islamic finance, it can even become a hurdle to provide financing to financially distressed firms who do not have need for asset acquisition, but for managing their financing needs in working capital management.
Even though Salam and Istisna financing provide solution for working capital finance, their share in overall financing is very minimal and these modes are only used to finance relatively more stable corporations.
In Pakistan, Islamic banks have much less ratio of total financing provided to agriculture and SMEs as compared to the conventional banks. On the other hand, Islamic banks provide greater proportion of financing to corporates as compared to conventional banks. Hence, conventional banks are financially inclusive to a much greater cross section of commercial enterprises as compared to Islamic banks.
With limited outreach and product variety, Islamic banks are relatively less effective in checking market concentration and supply chain bottlenecks if they occur.
Looking at the predominant use of debt based modes of financing with an average cost of finance which exceeds the cost of financing from conventional banks, it is hard to concede that Islamic banks are doing any better in facilitating supply chain management issues than conventional banks.
Case in point is huge circular debt in energy sector of Pakistan. Issuance of more Sukuk and debt based modes of financing has not and cannot help in managing liquidity any better than conventional banks.
There is fixed cost of repayment commitment with the difference in nature of payoffs, i.e. credit price or rents replacing explicit interest payment. However, cash flow commitment is fixed and rather more challenging with relatively higher average cost of finance in Islamic banking in Pakistan currently.
Having said that, this paper is a welcome research in this area to explore involvement of Islamic bank in the supply chain, both currently and in future. It also proposes distinct structures in Islamic finance which can enable more involved engagement of Islamic bank in the supply chain. By integrating social finance structures, such as Waqf with equity based modes of financing, the paper sheds light on how integrated finance can be more inclusive as well as egalitarian. In future research, the authors may like to explore potential of Islamic banking in value based intermediation and global value chains.