INTERVIEW - More equity funding seen as banks look beyond tawarruq

KUALA LUMPUR (Reuters) - Islamic banks are expected to move more deeply into riskier, equity-based financing as they seek alternatives to controversial debt mechanisms like the tawarruq, a prominent sharia scholar said on Monday.

Sharia banks have been reluctant to adopt equity models like the mudaraba to avoid taking on more risk, but there is growing pressure for the industry to reduce its reliance on debt instruments.

The slow shift towards more risk-sharing structures is also expected to expose investors to greater uncertainty, with returns on investments based on performance rather than guarantees.

"Banks must be ready to take extra risks, do extra jobs, expand their role rather than just provide credit," Mohamad Akram Laldin told Reuters ahead of the Reuters Islamic banking summit from Feb 15-18.

"Now the emphasis is on real economic activities, rather than some sort of artificial arrangement that is being done," said Akram, who advises HSBC's Islamic banking arm and Malaysia's central bank, which oversees the world's largest Islamic bond market.

He estimated that less than a tenth of Islamic financing worldwide is currently equity-based.

Some sharia scholars see equity financing as a purer form of Islamic finance, as opposed to some debt instruments which have been compared to interest-based lending.

Under mudaraba, a bank will provide capital for a project while the entrepreneur will manage the deal. Profits are split according to a pre-determined ratio and the bank will bear any monetary losses that arise.

Takaful, or Islamic insurance, and third-party guarantees can be used to mitigate Islamic banks' risks in equity structures, Akram said.

Some Islamic banks in the Middle East are extending equity-type financing by setting up construction companies that build and sell property rather than giving straight financing to builders to develop projects, he said.

Islamic bankers have been under pressure to use more equity structures after an influential group of clerics questioned the use of the popular tawarruq munazzam financing instrument.

The OIC Fiqh Academy said last April tawarruq munazzam was a "deception" which contained usury, calling into question deals in a market estimated to be worth over $100 billion.

Tawarruq, the mechanism used to execute commodity murabaha transactions, involves the sale of an asset to a purchaser with deferred payment terms. The purchaser then sells the asset to a third party to get funds.

Tawarruq munazzam is similar although the transactions are executed through banks.

"From the Islamic law perspective, (commodity murabaha) is allowed but that is not the ideal," said Akram. "It does not really help in creating real economic activities. Basically you are giving cash."

But tawarruq would still be used for now as the industry's heavy reliance on the structure means that "many banks will close down" without it, he said.

Scholars are now pressing for the application of tawarruq mundhabit, where banks are required to follow the structure's guidelines, Akram said.

(Editing by Kim Coghill)

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