IS IT BAD TO PREFER DEBT OVER EQUITY?

Dr Anas Zarka, a pioneering Islamic economist, reacted to a recent report published in The Economist, entitled ‘Why the World is Addicted to Debt’ (The Economist, May 17, 2015) by asserting that the marginal utility of more debt to an addictive debtor increases, the more indebted he becomes. Dr Usamah Othman, of King Fahd University of Petroleum and Minerals, was however quick to rebut by arguing that the utility theory was not an adequate premise to explain the behaviour of an addictive person, as the addiction violates the fundamental assumption of rationality.

Actually, the whole notion of addiction to debt is subject to psychological, behavioural and linguistic scrutiny. In fact, it may very well be the case that The Economist chose a completely wrong word for individuals’ and corporates’ preference for debt. A vast majority of economic players (individuals, businesses and governments) borrow because they find it more beneficial to do so as compared with other alternatives like the sale of equity. As a number of studies have suggested that owners of successful businesses tend to prefer debt over equity to preserve their residual claims on the future profit streams. In most cases, an owner of a business, who is not sure about the outcome of the business in terms of its success or failure, will be open to partnerships or raising capital in the form of equity. This is an example of the well-known adverse selection problem. Moral hazard problems associated with share contracts (of which equity is an example) are also well documented.

On an individual level, the purchase of a house with the help of borrowed money is the preferred choice of almost everyone because the individuals wish to benefit over a long period from appreciation of value of the property. This behaviour is certainly rational, and calling it addictive or irrational is not consistent with the empirical evidence on psychological behaviour of individuals and corporate strategy of businesses.

Islamic economists have for long shown their preference for equity, i.e, profit loss sharing, with a severe criticism of debt. Now they have started receiving support from many Western thinkers who, in the wake of the recent financial crisis, have started highlighting ills of debt-driven economies. There is a definite merit in criticism of the huge budget deficits most of the governments of the world are running. However, it is still fair to ask if it is bad to prefer debt over equity.

Islam does not deem debt impermissible altogether, although interest-based lending and borrowing is strictly prohibited. It has introduced mechanisms on the supply side and moral persuasion on the demand side to discourage dealing in debt. The biggest hurdle to the issuance of debt on the supply side is an almost impossible restructuring of debt in the event of default, as Islam strictly prohibits imposition of default penalty.

Although in the modern practice of Islamic banking and finance, contemporary Shari’a opinion has evolved in favour of conditional imposition of default penalty, the new stance on the treatment of default (i.e., imposition of default penalty) is bound to dilute Islamic preference for equity over debt.

An ever-increasing issuance of sukuk by sovereigns and corporates alludes to the influence of debt-based financing. Approved as a quasi-equity type of instrument by the regulatory bodies like Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), sukuk have nevertheless emerged as debt instruments in the contemporary practice of Islamic banking and finance. One does not have to dig deep to find out the actual practice of Islamic banking and finance remains debt-based from the front (retail) to the back office treasury operations. Given this, it is hard to argue that Islamic banking and finance is more stable than its conventional counterpart. Although there are some studies showing anecdotal evidence in favour of stability of Islamic banking, but this could be just incidental. There is a definite need to scrutinise methodologies of such studies.

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