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Islamic venture capital as a solution for economic coordination failures in the

Arab world

Article  in  International Journal of Islamic Marketing and Branding · June 2015

DOI: 10.1504/IJIMB.2015.071780

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142 Int. J. Islamic Marketing and Branding, Vol. 1, No. 2, 2015

Islamic venture capital as a solution for economic

coordination failures in the Arab world

Mohamed Fawzy Omran

College of Business and Finance,
Qatar University,
P.O. Box: 2713, Doha, Qatar
Email: mfomran@qu.edu.qa

Abstract: The underdevelopment in many Arab countries presents many

expansion opportunities for Islamic finance. Islamic economics aim at
achieving economic justice ‘Adal Allah’ and fair distribution ‘Musawah’. It is
argued that these objectives cannot be achieved unless an active role is taken
by Islamic financial institutions. Risk sharing principles underlying Islamic
finance should be extended to the very early stages of start-ups (planning and
legal stages). The Islamic world is blessed by having wealth seeking Sharia
compliant investments on one hand, and on the other hand, many young and
educated people who are looking for finance to start up their lives. This is a
clear example of an economic coordination failure where a medium had to
exist to bridge the gap between these two groups. A new function for Islamic
financial institutions is suggested which is to identify coordination failures and
to take an active role in addressing these coordination failures.

Keywords: Islamic finance; entrepreneurship; venture capital; economic

coordination failures.

Reference to this paper should be made as follows: Omran, M.F. (2015)

‘Islamic venture capital as a solution for economic coordination failures
in the Arab world’, Int. J. Islamic Marketing and Branding, Vol. 1, No. 2,
pp.142–148.

Biographical notes: Mohamed Fawzy Omran is a Professor of Finance at the

College of Business and Economics at Qatar University (AACSB accredited).
He received his PhD degree from the University of Strathclyde (UK) in 1997
and his Chartered Financial Analyst (CFA) designation from the USA in 2001.
He has published in some of the well-respected refereed international journals
such as the Statistician (Journal of the Royal Statistical Society), the Quarterly
Review of Economics and Finance (Elsevier) and Advances in Econometrics
(Emerald). Prior to his appointment at Qatar University, he was the Director of
the Executive MBA program at Nile University (NU) in Cairo.

This paper is a revised and expanded version of a paper entitled ‘Islamic

venture capital as a solution for economic coordination failures in the MENA
Region’ presented at Fifth Global Islamic Marketing Conference, Kuala
Lumpur, Malaysia, 22–24 April 2014.

Copyright © 2015 Inderscience Enterprises Ltd.

 Islamic venture capital as a solution for economic coordination failures 143

1 Introduction

Islamic finance has witnessed a big rise in popularity. Global Islamic assets hit
$1.3 trillion in 2011, a 150% increase over five years (Reuters, 2012). Islamic financial
institutions managed to attract non-Muslims to deal with them since Islamic finance is
seen as less open to the casino gambling activities that have characterised traditional
finance and led in the opinion of many to the credit crunch of 2008 (Brunnermeier,
2009). Brunnermeier (2009) identifies two trends that led to the financial crisis of the
2008. First, repackaging risk and selling it by banks to other investors. The second is
financing long-term assets using short term maturity instruments. These risky alternatives
that are available and heavily used in traditional finance are not allowed in Islamic
finance. The basic principle underlying Islamic finance is the risk sharing between the
Islamic financial intuitions and their clients. Accordingly, risk trading and hedging that
could offload the risky part of the Islamic financial institution is not allowed. However,
Islamic finance is facing three problems. First, many regard Islamic financial institutions
as no different from traditional institutions. The general misunderstanding is that only
different terminology distinguishes between Islamic and traditional approaches to
finance. Secondly, most evidence indicates that projects financed by Islamic financial
institutions tend to be of short term nature and in similar activities to those activities
usually financed by traditional financial institutions. The third problem is the inability to
create and develop enough financial products that can accommodate the influx of
deposits directed at Islamic banks.
The objective of the current paper is to try to shed some lights on the third problem
related to the creation of Sharia compliant products that can accommodate the massive
growth in deposits at Islamic banks. The paper suggests that the problems faced by many
Arab countries are due to economic coordination failures. On one hand, plenty of finance
is available for Sharia compliant projects, and on the other hand massive numbers of
well-educated youth that are looking for opportunities but do not know where to start.
Entrepreneurial spirit is essential in transferring a country out of the poverty trap. Sachs
(2005) defines poverty trap to be the inability of a developing nation of climbing the first
step in the economic development ladder. Poverty trap happens when generation after
generation submit to the idea of the impossibility of moving out of it. Entrepreneurial
spirit is about adding value and creating wealth when an entrepreneur believes s/he can
make a difference by pursuing and harvesting an idea. One major problem facing young
entrepreneurs is to find a financier who believes in the feasibility of their ideas and being
ready to invest in their potential growth. Figure 1 suggests that the right media for
preserving the natural resources of the Arab/Islamic world is to develop the Muslims’
worlds by encouraging venture capital (VC) and entrepreneurial spirit. A role that
traditional banks including Islamic banks are not suited to do in their current
organisational structure.
The figure describes how natural resources such as gas and oil can help start the pool
of finance available for venture capitalists and entrepreneurs. The finance can be
channelled into the highly educated populations that will pay back into the pool of
finance available for future entrepreneurs. The figure shows how sustainable
development can be achieved away from the natural resources which are bound to vanish
in the long-term.
144 M.F. Omran

Figure 1 Suggested media: VC NOT traditional banking

Natural
resources
(gas and
oil)

Highly
educated
Plenty of young
Venture capital
Islamic population
and
finance eager for
entrepreneurial
available employment

VC and private equity firms in the USA provide finance to small unproven start-ups that
will find it difficult to raise funds in capital markets or through other financial channels
due to their yet unproven record. Venture capitalists assume a high risk by investing in
small high risk companies and therefore they retain significant ownership control of the
start-ups which. Siddiqui (2010) states that “today’s Muslim country Islamic finance hubs
are missing two vital aspects: addressing ‘have nots’ (micro-finance), and deploying the
funds of ‘haves’ into Islamic VC funds.”1 The money is there for entrepreneurs who can
prove the worthiness of their ideas and more importantly the compliance of their ideas to
Sharia. Islamic entrepreneurs face double hurdles when compared to entrepreneurs
seeking finance from traditional banks. Islamic entrepreneurs have to prove the feasibility
and compliance while entrepreneurs seeking finance from traditional banks have to prove
feasibility only. One extra hurdle is the jungle of bureaucratic laws that characterise the
economic and business environment of many Arab and Muslim countries.
It is argued in the current paper that Islamic banks play a passive role where they
stand ready to finance. However, this passive role may not be enough to move many out
of poverty. Islamic Economics is more about social justice which is only achieved by
moving many out of the poverty trap. This can only be achieved if Islamic banks take a
more active role in reaching out to young entrepreneurs. Islamic banks need to apply the
concept of risk-profit sharing in all steps starting from the idea generation step instead of
their current role which is confined only to the financing.
This paper is organised as follows. Section 1 is the introduction. Section 2 reviews the
basic differences between Islamic and traditional finance. Section 3 reviews the
coordination failure problems faced by Arab countries. The bureaucratic challenges faced
by many Arab countries are considered by the paper as risks that should be shared
between entrepreneurs and Islamic banks. Section 4 concludes this paper.

2 Islamic finance and economics

Islamic laws ‘Shariah’ prohibits interest ‘Riba’ and gambling ‘Maysir’ (see Omran, 2009,
2011). Traditional banks that use interest in its dealings with depositors and borrowers
are forbidden in Islam. Islamic economics aim at achieving economic justice ‘Adal
Allah’ and fair distribution ‘Musawah’. Critics of Islamic finance have long argued that
 Islamic venture capital as a solution for economic coordination failures 145

the concept of charging interest is the same under Islamic finance except for the fact that
it is hidden under different terminology. For example, Islamic finance uses ‘Murabaha’
under which the bank buys an asset and sells it to the client at a higher price. Critics say
that the higher selling price is an indirect way of charging interest.
According to Islamic finance, murabaha must be genuine with the full intention of
giving and taking delivery. Under murabaha, the Islamic financial institution is facing the
risk of the time value of money if the client is not performing due to circumstances that
are outside his/her control. The Islamic financial institution cannot confiscate the
underlying asset or charge penalties for late payments since the Islamic financial
institution is a partner in the process and the difficulties are outside the controls of either
party. In this case, there is an extra genuine risk that is not faced by traditional banks.
Also, Sharia prohibits the Islamic financial institutions from selling the debt created by
the murabaha. Accordingly, the differences between fixed interest dealings of
conventional banks and profit/loss sharing of Islamic banks are genuine and not subtle.
However, the above facts are not known to many who think that the differences are just
in the terminology used. The borrower under Islamic finance rules must not bear all
failures due to economic misfortune; the financial institution must share the cost of
failure. Accordingly, excessive uncertainty is not entirely transferred to the borrower
since the lender has a share in it. Also, unproductive speculation is not allowed. This
means that the financial institution cannot get rid of its exposure under murabaha by
selling its obligations to a speculator through derivative contracts. This speculation is
considered maysir (gambling) and totally forbidden as it is considered an unearned
income. Money is not allowed to earn money but can be used as a premium of exchange
that can be invested in real assets. The speculator in the case of a derivative contract is
buying the debt cheaply hoping that the borrower would respect the terms of the deal and
therefore the speculator would make net profit. The traditional bank sells the debt
payments and/or interest schedules at a discount to the speculator to transfer the
uncertainty of the borrower’s possible failure. In this case, the conventional bank has
transferred all risk to the speculator and basically waked out of the deal with fixed sure
profits.
Profit sharing under murabaha has three major economic benefits. First, there is more
incentive for the financial institution to thoroughly study the projects since the institution
is partner in it. This will increase economic efficiency. Loans offered by conventional
banks have usually the underlying asset as a guarantee. The bank can always reposes the
asset in the case of the borrower facing difficulty in meeting the promised payments. The
subprime mortgage crisis in the USA and Europe in 2008 was a result of the banks
extending credits to those who cannot afford it. Each bank thought that the underlying
property was enough guarantee. This could have been the case if the number of failures
were limited. However, the number of failures turned out to be too many for the system
to handle which led to the collapse of property values. Islamic finance places market
failures and economic difficulties on the shoulders of the borrowers and lenders.
Therefore, there are more incentives for Islamic financial institutions to pay more
attention to the kind of projects they get involved with. This in process will improve the
overall economic efficiency of the society.
The second economic benefit of Islamic finance is that profit sharing and the
prohibition of maysir (gambling). The objective is to achieve fair distribution ‘Musawah’
of wealth. Derivatives trading involve two parties, one promising to buy an asset at an
146 M.F. Omran

agreed upon price and the other part promising to sell that asset at the agreed price. Most
of derivatives contracts are settled in cash without the underlying asset changing hands.
One person’s loss is the other person’s gain. This is a way of a random wealth
distribution since the gain has been paid by the loss of the other party. However, this is
considered unearned income on unproductive activity. Under Islamic finance, there is
more equitable wealth distribution that is related to the risk of the projects. In other
words, it discourages excessive speculation without the intention of the assets changing
hands. For example, it is acceptable under Islamic finance that a trader buys a certain
asset with the hope to resell it in the future at a higher price. In this case, the trader is
facing real risk that s/he may loose and it is the kind of speculation that is allowed under
Islamic finance.
The third economic benefit is the emphasis of Islamic finance on the justice, equality
and fair play. It does not allow for such destructive economic monopolies that would
concentrate wealth in the hands of the few and increase the social gap between the
classes. It was unimaginable to see the major social up-rises in major developed capitals
such as Athens, Madrid, and London in the aftermath of the 2008.
The objective of fair distribution of wealth (musawah) can be achieved through
Islamic entrepreneurship and Islamic microfinance. Entrepreneurs are energetic
individuals with bright and innovative ideas that can change their life and that’s of their
communities to the better. Entrepreneurs take high calculated risks that eventually lead to
higher standards of living for the society. Microfinance also helps in eradicating poverty
since it helps the poor in acquiring much needed finance either to start or to expand their
trade. Microfinance extends credit to those who are considered non-bankable since they
do not have regular income or assets that can guarantee their loans. Islamic microfinance
is similar to Islamic finance in that it emphasises profit and risk sharing. Accordingly, it
will extend and share in the risk of the credit to the non-bankable. Microfinance
empowers people who traditionally were kept out of the financial system. Islamic
microfinance can help people to move out of the poverty trap and encourages
entrepreneurship sprit in the society which could help in achieving long-term economic
growth in developing countries.

3 The challenges of social and economic development

Modern economic development views stress not only on achieving high sustainable
economic growth but also on reduction or elimination of poverty, inequality, and
unemployment. Modern economic development views are exactly what Islamic
economics define as Adal Allah (economic justice) and ‘Musawah’ fair distribution.
Redistribution of growth is an important goal in addressing social inequality. Three
important measures constitute the focus of development, in addition to growth in per
income capita. The three measures relate to poverty reduction, narrowing the inequality
gap, and reducing unemployment. Little development has been achieved if the three
measures indicate lack of progress. An increase in average per capita income with no
progress on the three measures indicates that few have benefited from the economic
development.
Modern theories of development look at economic underdevelopment as coordination
failure problems (see Mankiw, 2008). Coordination failure results when different
stakeholders fail to reach at a better equilibrium due to their actions being interrelated and
 Islamic venture capital as a solution for economic coordination failures 147

the fact that each stakeholder gain depends on the reaction of different stakeholders. It
can be strongly argued that the success stories of many developing countries were based
on how successful their governments were at identifying coordination failures and how
successful they were at creating the right recipe for solving these failures. As a matter of
fact that is the new function suggested in the current paper for Islamic finance to carry
out in order to achieve Adal Allah and Musawah. It is not enough for Islamic financial
institutions to stand ready to finance projects that are feasible and Sharia compliant. They
have to take a more active role in:
1 suggesting projects
2 encouraging young people to take on these projects
3 educating them on some of the aspects they are lacking
4 offering legal and accountants help on how to get the project started.
Islamic financial institutions will be full partners from the very early stage of the project
and not only get involved with the financing part of it. Eventually, all these tasks will be
far bigger than any one financial institution and that will lead to the birth of new Islamic
economic organisations that can handle different aspects suggested. The growth will
provide opportunities for Islamic economics to become more of a reality. Still the
objective should always be on solving coordination failure where one side has the money
looking for Sharia compliant investments and on the other hand young people looking for
a chance in life. Arab countries will never realise its potential as long as its legislation,
labour laws, and business procedures are bureaucratic and complicated. For example, the
coordination failure in the case of Egypt is in its long established bureaucracy, ambiguous
regulations and corruption. It is time for the state to stop the centralised decision-making
process dating from the 1950s and simplify its procedures for its youth to take initiative
and for Islamic banks to expand.

4 Conclusions

Islamic finance has been witnessing massive growth rates since the credit crunch and the
global recession of the 2008. Islamic finance is seen as less prone to the economic
troubles that faced the global capitalist markets as a result of excessive speculation in the
repackaging of financial assets. There are two sides, one side (Islamic banks) that are on
the receiving end of billions in deposits without enough Sharia eligible investment
opportunities. The other side is the Arab youth that are educated and desperate to find a
chance in life. New function suggested in the current paper for Islamic finance to carry
out in order to achieve Adal Allah and Musawah. It is argued that it is not enough for
Islamic banks to stand ready to finance projects that are feasible and Sharia compliant.
Islamic banks have to take a more active role in:
1 suggesting projects
2 encouraging young people to take on these projects
3 educating them on some of the aspects they are lacking
4 offering legal and accounting help on how to get the projects started.
 148 M.F. Omran

Islamic financial institutions will be full partners from the very early stage of the project
and not only get involved with the financing part of it.

References
Brunnermeier, M.K. (2009) ‘Deciphering the liquidity and credit crunch 2007–2008’, Journal of
Economic Perspectives, Vol. 23, No. 1, pp.77–100.
Mankiw, N. (2008) ‘New Keynesian economics: the concise encyclopedia of economics’, Library
of Economics and Liberty [online]
http://www.econlib.org/library/Enc/NewKeynesianEconomics.html (accessed 4 May 2014).
Omran, M.F. (2009) ‘Examining the effects of Islamic beliefs and teachings on the valuation of
financial institutions in the United Arab Emirates’, Review of Middle East Economics and
Finance, Vol. 5, No. 1, Article 4, pp.1–8.
Omran, M.F. (2011) ‘The valuation premium of the common stocks of Islamic financial
institutions’, Journal of Business Valuation and Economic Loss Analysis, Vol. 6, No. 1,
Article 1, pp.1–15.
Reuters (2012) [online] http://www.reuters.com/article/2012/03/29/islamic-finance-growth-
idUSL6E8ET3KE20120329 (accessed 21 October 2012).
Sachs, J. (2005) The End of Poverty: Economic Possibilities for Our Time, Penguin Books,
New York.
Siddiqui, R. (2010) Missing Link in Islamic Finance Hubs: Islamic Venture Capital [online]
http://halalfocus.net/missing-link-in-islamic-finance-hubs-islamic-venture-capital/ (accessed
4 May 2014).

Notes
1 VC stands for venture capital.

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