Profit and loss sharing


Profit and Loss Sharing and Musharakah . Other sources include sukuk and direct equity investment as types of PLS.
The profits and losses shared in PLS are those of a business enterprise or person which/who has obtained capital from the Islamic bank/financial institution. As financing is repaid, the provider of capital collects some agreed upon percentage of the profits along with the principal of the financing. Unlike a conventional bank, there is no fixed rate of interest collected along with the principal of the loan. Also unlike conventional banking, the PLS bank acts as a capital partner serving as an intermediary between the depositor on one side and the entrepreneur/borrower on the other. The intention is to promote "the concept of participation in a transaction backed by real assets, utilizing the funds at risk on a profit-and-loss-sharing basis".
Profit-and-loss-sharing is one of "two basic categories" of Islamic financing, the other being "debt-based contracts" 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". While early promoters of Islamic banking hoped PLS would be the primary mode of Islamic finance, use of fixed return financing now far exceeds that of PLS in the Islamic financing industry.

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, supplemented by a number of fixed-return models mark-up, leasing, cash advances for the purchase of agricultural produce and cash advances for the manufacture of assets, etc. In practice, the fixed-return models in particular murabaha model have become the bank's favourites, 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.

Mudarabah

Mudarabah or "Sharing the profit and loss with venture capital", is a partnership or trust financing contract where one partner, gives money to another 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.
Muslims believe that the Islamic prophet Muhammad's wife Khadija used a Mudaraba contract with Muhammad in Muhammad's trading expeditions in northern Arabia Khadija providing the capital and Muhammad providing the labour/entrepreneurship.
Mudaraba contracts are used in inter-bank lending. The borrowing and lending banks negotiate the PLS ratio and contracts may be as short as overnight and as long as one year.
Mudarabah contracts may be restricted or unrestricted.
They may also be first tier ortwo tier.
A variation of two-tier 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, 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 has dubbed this `Islamic moral hazard` in which the banks are able `to privatise the profits and socialize the losses`.
Another critic, 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 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 much more power over whether and by how much the investment is profitable or a failure.

Musharakah

Musharakah is a joint enterprise in which all the partners share the profit or loss of the joint venture. The two parties that contribute capital to a business divide the net profit and loss on a pro rata basis. Some scholarly definitions of it include: “Agreement for association on the condition that the capital and its benefit be common between two or more persons”, “An agreement between two or more persons to carry out a particular business with the view of sharing profits by joint investment”, “A contract between two persons who launch a business of financial enterprise to make profit”.
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. 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.
Musharaka is used in business transactions and often to finance a major purchase. Islamic banks lend their money to companies by issuing floating rate interest loans, where the floating rate is pegged to the company's rate of return and serves as the bank's profit on the loan. Once the principal amount of the loan is repaid, the contract is concluded
Other sources distinguish between Shirkat al Aqd and Shirkat al Milk, although they disagree over whether they are forms of "diminishing musharaka" or not.

Permanent Musharaka

Investor/partners receive a share of profit on a pro-rata basis.
Musharaka can be either a "consecutive partnership" or "declining balance partnership".
If default occurs, both the bank and the borrower receive a proportion of the proceeds from the sale of the property based on each party's current equity. Banks using this partnership including the American Finance House, and Dubai Islamic Bank.
Diminishing Partnership is particularly popular way of structuring an Islamic mortgage for financing homes/real estate and resembles a residential mortgage. The Islamic financier buys the house on behalf of the other "partner", the ultimate buyer who then pays the financier monthly installments combining the amounts for
  1. rent and
  2. buyout payment
until payment is complete. Thus, a diminishing Musharaka partnership actually consists of a musharakah partnership contract and two other Islamic contracts usually ijarah and bay’.
In theory, a diminishing Musharaka for home purchase differs from a conventional mortgage in that it charges not interest on a loan, but `rent` based on comparable homes in the area. But as one critic complained, some
"ostensibly Islamic Banks do not even make a pretense of attempting to disguise the role of market interest rates in a `diminishing musharaka`, and... the `rental` rate is directly derived from conventional interest rates and not from any imputed `fair market rent`".
El-Gamal gives as an example the Islamic Bank of Britain's explanation that its 'rental rates' are benchmarked to commercial interest rate "such as Libor plus a further profit margin", rather than being derived from the prevailing rental levels of equivalent units in the neighborhood. The Meezan Bank of Pakistan is careful to use the term "profit rate" but it is based on KIBOR.
According to Takao Moriguchi, musharakah mutanaqisa is fairly common in Malaysia, but questions about its shariah compliance mean it is "not so prevailing in Gulf Cooperation Council countries such as Saudi Arabia, Kuwait, the United Arab Emirates, Qatar, Bahrain, and Oman".

Differences

According to Mufti Taqi Usmani, a mudarabah arrangement differs from the musharakah in several ways:
Profit and loss sharing has been called "the main justification" for, or even "the very purpose" of the Islamic finance and banking movement" and the "basic and foremost characteristic of Islamic financing".
One proponent, Taqi Usmani, envisioned it transforming economies by
Usmani notes that some non-Muslim economists have supported development of equity markets in "areas of finance currently served by debt".

Lack of use

While it was originally envisioned, as "the basis of a riba-free banking", 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.
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. Another source found that PLS techniques were no longer "a core principle of Islamic banking" in Saudi Arabia and Egypt. In Malaysia, another study found the share of musharaka financing declined from 1.4% in 2000 to 0.2% in 2006.
In his book, An Introduction to Islamic Finance, Usmani bemoans the fact that there are no "visible efforts" to reverse this direction of Islamic banking,
The fact, however, remains that the Islamic banks should have advanced towards musharakah in gradual phases.... Unfortunately, the Islamic banks have overlooked this basic requirement of Islamic banking and there are no visible efforts to progress towards this transaction even in a gradual manner, even on a selective basis.

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".
(At least one scholar M.S. Khattab has questioned the basis in Islamic law for the two-tier mudarabah system, saying there are no instances where the mudharib passed funds onto another mudharib.

Explanations for lack

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", and their "consequence-insensitive" way of thinking, assuming that "ample supply" of PLS "instruments will create their own demand", consumer disinterest notwithstanding. Faleel Jamaldeen describes the decline in the use of PLS as a natural growing process, where profit and loss sharing was replaced by other contracts because PLS modes "were no longer sufficient to meet industry demands for project financing, home financing, liquidity management and other products".
;Moral Hazard
On the liability side, Feisal Khan argues there is a "long established consensus" that debt finance is superior to equity investment because of the "information asymmetry" between the financier/investor and borrower/entrepreneur the financier/investor needing to accurately determine the credit-worthiness of the borrower/entrepreneur seeking credit/investment,. Determining credit-worthiness is both time-consuming and expensive, and debt contracts with substantial collateral minimize its risk of not having information or enough of it. In the words of Al-Azhar rector Muhammad Sayyid Tantawy, "Silent partnerships follow the conditions stipulated by the partners. We now live in a time of great dishonesty, and if we do not specify a fixed profit for the investor, his partner will devour his wealth."
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 determining levels of profit. 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.
Higher levels of corruption and a larger unofficial/underground economy where revenues are not reported, indicate poorer and harder-to-find credit information for financiers/investors. There are several indicators this is a problem in Muslim majority countries But even in the more developed United States, the market for venture capital varies from around $30 billion to $60 billion compared to "several trillion dollar" market for corporate financing.
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." 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.
;Other explanations
Other explanations have been offered as to why use of PLS instruments has declined to almost negligible proportions:

Sudan

Between 1998 and 2002 musharkaka made up 29.8% of financing in Sudan and mudaraba 4.6%, thanks in at least part to pressure from the Islamic government. Critics complain that the banking industry in that country was not following the spirit of Islamic banking spirit as investment was directed in the banks' "major shareholder and the members of the board of directors".

Kuwait

In Kuwait the Kuwait Finance House is the second largest bank and was exempt from some banking regulations such that it could invest in property and rims outright and participate directly in musharaka financing of corporations and "generally act more like a holding company than a bank". Nonetheless as of 2010 78.4% of its assets were in murabahah, ijara and other non-PLS sources.

Pakistan

The Islamic Republic of Pakistan officially promotes Islamic banking for example by prohibiting the startup of conventional non-Islamic banks. Among its Islamic banking programmes is establishing "musharaka pools" for Islamic banks using its export refinance scheme. Instead of lending money to banks at a rate of 6.5% for them to lend to exporting firms at 8%, it uses a musharaka pool where instead of being charged 8%, firms seeking export credit are "charged the financing banks average profit rate based on the rate earned on financing offered to ten `blue-chip` bank corporate clients". However, critic Feisal Khan complains, despite "rigamarole" of detailed instructions for setting up the pool and profit rate, in the end the rate is capped by the State Bank at "the rate declared by the State under its Export finance scheme".
Another use of musharaka in Pakistan is by one of the largest Islamic banks which has attempted to remedy a major problem of Islamic banking namely providing lines of credit for the working needs of client firms. This it does with a musharaka "Islamic running finance facility". Since the workhorses of Islamic finance are product-based vehicles such as murabaha, which expire once the product has been financed, they do not provide steady funding a line of credit for firms to draw on. The Islamic running finance facility does. The bank contributes its investment to the firm as a partner by covering the "firms net position at the end of the day". "Profit is accrued to the bank daily on its net contribution using the Karachi Interbank Offered Rate plus a bank-set margin as the pricing basis". However according to critic Feisal Khan, this is an Islamic partnership in name only and no different than a "conventional line of credit on a daily product basis".

Islamic Development Bank

Between 1976 and 2004 only about 9% of the financial transactions of the Islamic Development Bank were in PLS, increasing to 11.3% in 2006-7. This is despite the fact that the IDB is a not a multilateral development agency, not a for-profit, commercial bank.

United States

In the United States the Islamic banking industry is a much smaller share of the banking industry than in Muslim majority countries, but is involved in `diminishing musharaka` to finance home purchases. As in other countries the rent portion of the musharaka is based on the prevailing mortgage interest rate rather than the prevailing rental rate. One journalist found costs for this financing are "much higher" than conventional ones because of higher closing costs Referring to the higher costs of Islamic finance, one banker quotes an unnamed mortgage broker as stating, "The price for getting into heaven is about 50 basis points".

Citations

Books and journal articles