Profit and loss sharing

Profit and Loss Sharing (also called PLS or "participatory" banking^[1]) is a method of finance used by Islamic financial or Shariah-complaint institutions to comply with the religious prohibition on interest on loans that many Muslims subscribe to. There are two varieties of Profit and Loss Sharing used by Islamic banks -- Mudarabah (مضاربة) and Musharakah (مشاركة or شركة ).^[2]

The profits and losses shared in PLS are those of a business enterprise or person which/who has borrowed money from the Islamic bank/financial institution. As the loan is repaid, the lender collects some agreed upon percentage of the profits (or deducts if there are losses) along with the principal of the loan^{[Note 1]}, unlike a conventional bank which collects some fixed rate of interest along with the principal of the loan.^[3] Also unlike conventional banking, the PLS bank acts as a capital partner (in the mudarabah form of PLS) serving as an intermediary between the depositor on one side and the entrepreneur/borrower on the other.^[4] The intention is to promote "the concept of participation in a transaction backed by real assets, utilising the funds at risk on a profit-and-loss-sharing basis".^[2]

Profit-and-loss-sharing is one of "two basic categories" of Islamic financing,^[2] the other being "debt-based contracts" (or "debt-like instruments")^[5] such as murabaha, istisna'a, salam and leasing, which involve the "purchase and hire of goods or assets and services on a fixed-return basis".^[2] While some (such as Mohammad Najatuallah Siddiqui) hoped PLS would be the primary mode of Islamic finance, fixed return financing now far exceeds PLS in the Islamic financing industry.^[6]

Background

One of the pioneers of Islamic banking, Mohammad Najatuallah Siddiqui, suggested a two-tier model as the basis of a riba-free banking, with mudarabah being the primary mode,^[4] supplemented by a number of fixed-return models—mark-up (murabaha), leasing (ijara), cash advances for the purchase of agricultural produce (salam) and cash advances for the manufacture of assets (istisna'), etc. In practice, the fixed-return models -- in particular murabaha model—have become the bank's favourites,^[6] as long-term financing with profit-and-loss-sharing mechanisms has turned out to be more risky and costly than the long term or medium-term lending of the conventional banks.^[7]

Mudarabah

Mudarabah is a partnership where one partner (rabb-ul-mal) gives money to another (mudarib) for investing in a commercial enterprise. The rabb-ul-mal party provides 100 percent of the capital and the mudarib party provides its specialized knowledge to invest the capital and manage the investment project. Profits generated are shared between the parties according to a pre-agreed ratio. If there is a loss, rabb-ul-mal will lose his capital, and the mudarib party will lose the time and effort invested in the project. The profit is usually shared 50%-50% or 60%-40% for rabb ul mal-mudarib.

Further, Mudaraba is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. Such participatory arrangements between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing the lender to monopolize the economy.

Mudaraba contracts are used in inter-bank lending. The borrowing and lending banks negotitate the PLS ratio and contracts may be as short as overnight and as long as one year.^[8]

Mudarabah contracts may be restricted or unrestricted.

• In an al-mudarabah al-muqayyadah (restricted mudarabah), the rabb-ul-mal may specify a particular business for the mudarib, in which case he shall invest the money in that particular business only.^[9] For the account holder, a restricted mudarabah may authorize the IIFS (institutions offering Islamic financial services) to invest their funds based on mudarabah or agency contracts with certain restrictions as to where, how, and for what purpose these are to be invested.^[10]
• in a al-mudarabah al-mutlaqah (unrestricted mudarabah), the rabb-ul-mal allows the mudarib to undertake whatever business he wishes and so authorizes him to invest the money in any business he deems fit.^[9] For the account holder funds are invested without any restrictions based on mudarabah or wakalah (agency) contracts, and the institution may commingle the investors funds with their own funds and invest them in a pooled portfolio.^[10]

A variation of mudarabah that has caused some complaint is one that replaces Profit and Loss Sharing between depositor and bank with Profit Sharing—the losses being all the problem of the depositors. Instead of both the bank and its depositors being the owners of the capital (rabb al-mal), and the entrepreneur the mudarib, the bank and the entrepreneur are now both mudarib, and if there are any losses after meeting the overhead and operational expenses, they are passed on to depositors. One critic (Ibrahim Warde) has dubbed this `Islamic moral hazard` in which the banks are able `to privatise the profits and socialize the losses`.^[11][12]

Another critic (M.A. Khan), has questioned the mudarabah's underlying rationale of fairness to the mudarib. Rather than fixed interest lending being unfair to the entrepreneur/borrower, Khan asks if it isn't unfair to the rabb al-mal (provider of finance) to "get a return only if the results of investment are profitable", since by providing funds they have done their part to make the investment possible, while the actions of entrepreneur/borrower -- their inspiration, competence, diligence, probity, etc. -- have the power (at least in part) to make the investment profitable or a failure.^[13]

Musharakah

Musharakah is a joint enterprise in which all the partners share the profit or loss of the joint venture.^[14] The two (or more) parties that contribute capital to a business divide the net profit and loss on a pro rata basis.

Musharakah is often used in investment projects, letters of credit, and the purchase or real estate or property. In the case of real estate or property, the bank assesses an imputed rent and will share it as agreed in advance.^[15] All providers of capital are entitled to participate in management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion to respective capital contributions. This concept is distinct from fixed-income investing (i.e. issuance of loans).^[16]

Musharaka is an approach used in business transactions. Islamic banks lend their money to companies by issuing floating rate interest loans. The floating rate of interest is pegged to the company's individual rate of return. Thus, the bank's profit on the loan is equal to a certain percentage of the company's profits. Once the principal amount of the loan is repaid, the profit-sharing arrangement is concluded.^[17]

Differences

According to Mufti Taqi Usmani, a mudarabah arrangement differs from the musharakah in several ways:

• In mudarabah:
  • investment is the sole responsibility of rabb-ul-maal, not all partners.^[18]
  • the rabb-ul-maal has no right to participate in the management which is carried out by the mudarib only.^[18]
  • the loss, if any, is suffered by the rabb-ul-mal only, because the mudarib does not invest anything. His loss is restricted to the fact that his labor has gone in vain and his work has not brought any fruit to him,^[18] unless losses are due to the mudarib's misconduct, negligence, or breach of the terms and conditions of the contract.^[10]
  • all the goods purchased by the mudarib are solely owned by the rabb-ul-maal, and the mudarib can earn his share in the profit only in case he sells the goods profitably. Therefore, he is not entitled to claim his share in the assets themselves, even if their value has increased.^[18]
• In musharakah:
  • unlike mudarabah, investment comes from all the partners^[18]
  • unlike mudarabah, all the partners can participate in the management of the business and can work for it.^[18]
  • all the partners share the loss to the extent of the ratio of their investment^[18]
  • as soon as the partners mix up their capital in a joint pool, all the assets of the musharakah become jointly owned by all of them according to the proportion of their respective investment. Therefore, each one of them can benefit from the appreciation in the value of the assets, even if profit has not accrued through sales.^[18]
• Liability
  • In musharakah all the partners share the financial loss to the extent of the ratio of their investment while in mudarabah the loss, if any, is suffered by the rabb-ul-mal only, because the mudarib does not invest any money. This is considered just because his/her/their time and effort has been in vain and yielded no profit. This principle is subject to a condition that the mudarib has worked with the due diligence required for whatever the business involved is. If there has been negligence or dishonesty, the mudarib is liable for whatever loss was caused by their negligence or misconduct.^[19]
  • The liability of the partners in musharakah is normally unlimited, so that if the liabilities of the business exceed its assets and the business goes in liquidation, all the exceeding liabilities shall be borne pro rata by all the partners. However, if all the partners have agreed that no partner shall incur any debt during the course of business, then whichever partner has incurred a debt on the business in violation of the aforesaid condition shall be liable for that debt. In the case of mudarabah the liability of rabb-ul-maal is limited to his investment, unless he has permitted the mudarib to incur debts on his behalf.^[14][18]
• Appreciation of assets
  • In musharakah, as soon as the partners add their capital together in a joint pool, these assets become jointly owned by all of them according to the proportion of their respective investment. Therefore, each one of them can benefit from the appreciation in the value of the assets, even if profit has not accrued through sales.
  • The case of mudarabah is different. Here all the goods purchased by the mudarib are solely owned by the rabb-ul-maal, and the mudarib can earn his share in the profit only in case he sells the goods profitably. Therefore, he is not entitled to claim his share in the assets themselves, even if their value has increased.^{[9][14][18][20]}

Promises and challenges

Profit and Loss Sharing has been called "the main justification" for,^[5] or even "the very purpose" of the Islamic finance and banking movement"^[21] and the "basic and foremost characteristic of Islamic financing".^[22]

One proponent, Taqi Usmani, envisioned it transforming economies by

• rewarding "honest, honorable and forthright behaviour";
• protecting savers by eliminating the possibility of collapse for individual banks and for banking systems;
• replacing the "stresses" of business and economic cycles with a "steady flow of money into investments";
• ensuring "stable money" which would encourage "people to take a longer view" in looking at return on investment;
• enabling "nations and individuals" to "regain their dignity" as they become free of the "enslavement of debt".^[23]

Usmani notes that some non-Muslim economists^{[Note 2]} have supported development of equity markets in "areas of finance currently served by debt"^[25] (though they do not support banning interest on loans).

While it was originally envisioned (at least in mudarabah form), as "the basis of a riba-free banking",^[4] with fixed-return financial models only filling in as supplements, it is those fixed-return products whose assets-under-management now far exceed those in profit-loss-sharing modes.^[6]

One study from 2000-2006 found PLS financing in the "leading Islamic banks" had declined to only 6.34% of total financing, down from 17.34% in 1994-6. "Debt-based contracts" or "debt-like instruments" were far more popular in the sample. 54.42% of financing was on the basis of murabaha, 16.31% on the basis of ijara and 5.60% on the basis of salam and istisna during 2004-6.^[5][26] Another source (Suliman Hamdan Albalawi) decries the departure of PLS techniques as "a core principle of Islamic banking" in Saudi Arabia and Egypt,^[27] In Malaysia a study found the share of musharaka financing declined from 1.4% in 2000 to 0.2% in 2006.^[28][29]

This "mass-scale adoption" of fixed-return modes of finance by Islamic financial institutions has been criticized by shariah scholars and pioneers of Islamic finance like Mohammad Najatuallah Siddiqui, Mohammad Umer Chapra, Muhammad Taqi Usmani and Khurshid Ahmad who have "argued vehemently that moving away from musharaka and mudaraba would simply defeat the very purpose of the Islamic finance movement".

Explanations

Critics have in turn criticized PLS advocates for remaining "oblivious to the fact" that the reason PLS has not been widely adopted "lies in its inefficiency" (Muhammad Akram Khan),^[21] and their "consequence-insensitive" way of thinking, assuming that "ample supply" of PLS "instruments will create their own demand" (Nawab Haider Naqvi), consumer disinterest notwithstanding.^[30]

Many explanations have been offered as to why use of PLS instruments has declined to almost negligible proportions:

• Islamic financial institutions seek to avoid the "risk of exposure to indeterminate loss".^[5]
• On the other side of the ledger, their customers/borrowers do not like to give away any "sovereignty in decision making" by taking the bank as a partner^[5] which generally means opening their books to the bank and the possibility of bank intervention in day-to-day business matters.^[6]
• Because clients can share losses with banks in a PLS financing, they (the clients) have less financial incentive to avoid losses of risky projects and inefficiency, than they would with conventional or debt-based lending.^[31]
• Competing fixed-return models, in particular the murabaha model, provides "results most similar to the interest-based finance models" depositors and borrowers are familiar with.^[6]
• Regarding the rate of profit and loss sharing -- i.e. the "agreed upon percentage of the profits (or deduction of losses)" the Islamic bank takes from the client -- there is no market to set it or government regulation of it. This leaves open the possibility the bank could exploit the client with excessive rates.^[32][33][32]
• In conventional banking, the banks are able to put all their assets to use and optimize their earnings by borrowing and investing for any length of time including short periods such as a day or so. The rate of interest can be calculated for any period of time. However, the length of time it takes to determine a profit or loss may not be nearly as flexible, and banks may not be able to use PLS for short term investment.^[34]
• PLS is also not suitable or feasible for non-profit projects that need working capital, (in fields like education and health care), since they earn no profit to share.^[5][35]
• The bank's client has a strong incentive to report less profit to the bank than it has actually earned, as it will lose a fraction of that to the bank. As the client knows more about its business, its accounting, its flow of income, etc. than the bank, the business has an informational advantage over the bank.^[5][35] (For example on way a bank can under report its earnings is by depreciating assets at a higher level than actually wear and tear.^[36]) Banks can attempt to compensate with monitoring, spot-checks, reviewing important decisions of the partner business, but this requires "additional staff and technical resources" that competing conventional banks are not burdened with.^[6]
• The property rights in most Muslim countries have not been properly defined. This makes the practice of profit-loss sharing difficult;^[5][35]
• Islamic banks must compete with conventional banks which are firmly established and have centuries of experience. Islamic banks that are still developing their policies and practices, and feel restrained in taking unforeseen risks;^[5][35]
• In some countries interest is accepted a business expenditure and given tax exemption but profit is taxed as income. The clients of the business who obtain funds on a PLS basis have to bear the financial burden in terms of higher taxes, they would not if they obtained the funds on an interest or fixed debt contract basis;^[5][35]
• Secondary markets for Islamic financial products based on PLS are smaller;^[5][35]
• One of the forms of PLS, Mudaraba, provides only limited control rights to shareholders of the bank, and thus denies shareholders a consistent and complementary control system.^[5][35]
• The difficultly in expanding a business financed through mudaraba because of limited opportunities to reinvest retained earnings and/or raise additional funds.^[37]
• The difficulty for the entrepreneur in becoming the sole owner of the project financed through PLS except through diminishing musharaka, which may take a long time.^[37]
• On the liability side, the structure of deposits of the Islamic bank is not sufficiently long-term, and therefore they do not want to get involved in long-term projects.^[37]
• A bank should have a lot of information about the entrepreneurial abilities of the customer before drawing up a PLS contracts. This may not be available or at least easy to find.^[37][38]
• The sharia calls for helping the poor and vulnerable groups such as orphans, widows, pensioners, who seek to preserve capital and generate sources of steady, reliable income insofar as they have any capital to preserve. Conventional Interest bearing savings accounts have provide such conservative investments, PLS has not.^[39]

Reply

Taqi Usmani states that the problems of PLS would be eliminating by banning interest and requiring all banks to be run on a "pure Islamic pattern with careful support from the Central Bank and government."^[40] The danger of dishonesty by borrowers/clients would be solved by

1. requiring every company/corporation to use a credit rating;
2. implementing a "well designed" system of auditing.^[40]

See also

• Islamic banking and finance
• Islamic economical jurisprudence
• Murabaha

References

Notes

Citations

Books and journal articles

• Kepel, Gilles (2002). Jihad: The Trail of Political Islam. Harvard University Press. 
• Khan, Muhammad Akram (2013). What Is Wrong with Islamic Economics?: Analysing the Present State and Future Agenda. Edward Elgar Publishing. Retrieved 26 March 2015. 
• Roy, Olivier (1994). The Failure of Political Islam. Harvard University Press. pp. 132–47. 
• Warde, Ibrahim (2000). Islamic finance in the global economy. Edinburgh: Edinburgh University Press. 
• Usmani, Taqi (1998). An Introduction to Islamic Finance (PDF). Karachi. 
• Usmani, Muhammad Taqi (December 1999). The Historic Judgment on Interest Delivered in the Supreme Court of Pakistan (PDF). Karachi, Pakistan: albalagh.net. 
• Warde, Ibrahim (2000). Islamic finance in the global economy. Edinburgh: Edinburgh University Press.