Profit and Loss Sharing (PLS) Modes of Financing in Islamic Financial Institutions

Hiba Drizane & Husam-Aldin Al-Malkawi

 

Introduction

Islamic Financial Institutions (IFIs) first came into existence in the Arab countries during the late 1970s and mid-1980s. Later, IFIs began spreading globally and played a vital role in funding economic activities, as well as promoting and stabilizing the country’s payment system. IFIs differ from their conventional counterparts in the treatment and sharing of risk. They provide financial services that are compliant to Islamic law (Shari’a) which prohibits Gharar (excessive risk or uncertainty) and the use of Riba (usury).

Riba (interest) is the unlawful increase of money on principal (Al-Qur’an; 2:275-281). According to Islamic scholars, money is a medium of exchange, not a commodity which can be bought or sold. Gharar, on the other hand, refers to uncertainty or risk and was defined by the Muslim scholar Ibn Taymiyyah as the unknown destiny. 

 

Modes of Financing in Islamic Financial Institutions

Shari’a compliant financial products of IFIs may be classified into two main categories; profit-and-loss sharing (equity-based modes), and non-profit-and-loss sharing (debt-based modes). In debt-based modes, the price is fixed; and any increase is classified as riba.

The two main products in profit-and-loss sharing (PLS) modes of financing are Musharakah and Mudarabah. Musharakah is an active joint venture, while Mudarabah is a silent joint venture. On the other hand, non-profit-and-loss sharing products include bai’ bithammanajil (BBA) i.e., deferred payment, Murabaha (cost plus profit), ijarah (leasing contract), Al-IjarahThumma Al-Bai’ (AITAB), Al-Ijarah Muntahia Bittamleek which is owning the asset after the end of contract, Bai’ As-Salam (deferred delivery or pre-paid sale), Bai’ Al-Istisna’ (manufacturing sale), Bai’ Al-Istijrar (supply Sale), and Qard Hasan (Benevolent Loan) where the borrower repays the principal only.

 

PLS Modes of Financing: Musharakah and Mudarabah

Musharakah from the Arabic word “shirka” means sharing. According to a Hadith Qudsi (Divine Revelation reported by Prophet Muhammad (Peace Be Upon Him): Allah the Exalted says: “I am the third of the two partners so long one does not cheat the other, and when he cheats, I withdraw myself”. Musharakah is a partnership between two or more parties in which all of them contribute towards the capital, all have the right to participate in management, and they all share loss and profit according to the pre-agreed ratio or ratio of contribution. Further, this sharing of profit and loss should be covered by high transparency and disclosure.

When investors enter an interest-free investment, maximizing returns becomes their main goal, and hence, maximizes the other party’s return through the use of PLS Islamic modes of finance. One aspect of Musharakah is known as diminishing Musharaka, which is a partnership between a client and the IFI usually for buying an asset. The client provides a percentage of the fund and the IFI provides a bigger percentage. The client then pays the bank’s percentage as instalments over a period of time. The ownership of the client increases and diminishes for the IFI or the bank until the client pays his share in full and completely owns the asset.

Mudarabah is the other type of equity-based financing and basically a short-term partnership. Mudrabah is an agreement between two parties: the capital provider (rabbulmal) and the provider of managerial expertise (mudarib). The agreement determines the ratio of profit sharing (e.g 70:30), while the loss is only borne by rabbulmal since the mudarib loses his effort, except in case of mudarib negligence, where he bears the full risk.

There are two types of Mudarabah contract, namely; restricted Mudarabah, in which rabbulmal specifies the place and kind of investment, and unrestricted Mudarabah in which the mudarib has the freedom to decide the type and nature of the investment.

 

Key Challenges

Since implementation, Islamic modes of finance as a whole have faced various challenges. Liquidity risk management is one of the key challenges faced by IFIs. This is due to the unavailability of short-term Islamic money markets and weakness of the liquidity structure.

It has been argued that the inequality between equity and debt in IFIs places them in an unfavourable position. Such inequality arises from the usage of PLS in which profits are taxable while interests are exempted. Un-developed primary markets and the absence of a secondary market in IFIs, in addition to the shortage in non-interested instruments, form serious obstacles for IFIs.  It is maintained that in profit-and-loss sharing Mudarabah, the capital provider always bears risk unless there is negligence from mudarib. Here there is a fear of cheating or gharar due to an unethical mudarib which may cause losses. Further, IFIs must secure their capital against deceit or mismanagement, and take high-value collaterals such as asset. However, IFIs partners (clients) may not be able to afford such collateral.

Furthermore, it has been shown that the size of IFIs’ assets and capital are relatively small. This, in turn, reduces their efficiency and may cause failure in managing risk and interior control, and may lead to discrepancies in the practice as distinct from theory, especially in the case of PLS modes of financing such as Musharakah and Mudarabah.

 

Recommendations

Improvement is essential to enhancing the productivity of IFIs. Therefore, some areas call for immediate improvement. One of the main challenges facing IFIs is their inability to compete with their conventional counterparts due to size and capital limitations. Although IFIs have recorded a growth of 10-12 % over the past decade, economists believe that such growth rate still needs significant improvement. The obvious recommendation in this regard is that IFIs need to expand in size and increase their capital holdings in order to be able to compete with conventional banks. Assets and capital expansion would also serve IFIs well in solving their liquidity risks, as banks capital serves as a cushion against potential losses.

 Further, in Mudarabah financing, the provider of the capital bears most of the losses. This increases the moral hazard of the Mudarib, who may be encouraged to take on additional risk to maximize earnings. It is therefore recommended that IFIs should improve their risk management practices by monitoring the Mudarib’s activities and holding him liable to a percentage in the event of losses.

There is almost a general consensus that IFIs need to expand the range of their financial products and to be more innovative in order to meet the rapid development in the financial markets and to suit customers that refrain from using conventional banks’ products for religious reasons. A brief 2015 report by The World Bank stated that only 14% of the world’s 1.7 billion Muslim use Islamic banks services. This has been attributed to the lack of diversification and concentration on selected economic sectors and the lack of competitiveness of IFIs. Therefore, it is highly recommended that IFIs concentrate on offering fee-based contracts like Joalah, kafalah and wakalah that could strengthen Islamic financial services functionality and provide IFIs with an additional source of liquidity.

Furthermore, risk-sharing in Musharakah and Mudarabah are considered ideal modes of financing for IFIs. However, these instruments account for only about 10 percent of assets, while a large proportion of assets come from deferred sales contracts (Murabahah). Therefore, it is recommended that IFIs should diversify their assets side composition by giving more attention to PLS sharing instruments.

 

 

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