Risk sharing financing of Islamic banks: interest free or interest based?

In theory, profit and loss or risk sharing financing (RSF) is considered as a corner stone of Islamic finance. In practice, however, this feature of Islamic financial products has been argued by many to be negligible. Instead, debt-based instruments, with conventional like features, have overwhelmed the Islamic financial industry. This study applied system GMM in modeling the determinants of RSF, and found that RSF is interest-free. We also found that, surprisingly, RSF is negatively related to the GDP growth. However, this is in accordance with those who argue that entrepreneurs in expectations of good economic conditions would take a fixed-cost financing, and thus reap the benefits of high return, rather than share the profit with banks. Similarly, in expectations of unfavorable economic conditions they would want to share their risk and loss with their financiers. Our results also imply a significantly very strong relationship between risk sharing deposits and RSF. However, the pass-through of these deposits to RSF is economically low and is about 0.40. In other words, only about 35-40% of the risk sharing deposits goes to the risk sharing financing. Thus, for practical implications, our findings suggest that through risk sharing products, Islamic banks can gain their ‘independence’ from the conventional banks and interest rates, the potential for which is enormous. Also, RSF seems to have countercyclical features that could enable policy makers to fight the unfavorable economic conditions through this banking channel.