Profit and loss sharing

The premise underlying PLS is the concept of shirkah (similar to joint venture) in which the partners share in the profit and loss based on their ownership. This premise may be realized through mudarabah, musharaka, or a contract combining both concepts. 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 (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, 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 is a partnership where one party provides the capital while the other provides labor and both share in the profits. The party providing the capital is called the rabb-ul-mal ("silent partner", "financier"), and the party providing labor is called the mudarib ("working partner"). In classical mudaraba, the financier provides 100% of the capital; cases where the capital is provided by both the financier and the working partner result in a joint mudarabah-musharakah contract. 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. • 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. 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. They may also be first tier or two tier. • Most mudarabah contracts are first tier or simple contracts where the depositor/customer deals with the bank and not with entrepreneur using the invested funds. • In two-tier mudarabah the bank serves as an intermediary between the depositor and the entrepreneur being provided financing. Two tier is used when the bank does not have the capacity to serve as the investor or expertise to serve as the fund manager. 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 (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'. 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 is not 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 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 (or more) 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", (Mecelle) "An agreement between two or more persons to carry out a particular business with the view of sharing profits by joint investment" (Ibn Arfa), "A contract between two persons who launch a business of financial enterprise to make profit" (Muhammad Akram Khan). 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 (i.e. issuance of loans). 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 • ''Shirka al'Inan'' is a Musharaka partnership where the partners are only the agent but do not serve as guarantors of the other partner. Other sources distinguish between Shirkat al Aqd (contractual partnership) and Shirkat al Milk (co-ownership), 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. • The period of contract is not specified and the partnership continues for as long as the parties concerned agree for it to continue. • A suitable structure for financing long term projects needing long term financing. Diminishing partnership Musharaka can be either a "consecutive partnership" or "declining balance partnership" (otherwise known as a "diminishing partnership" or "diminishing musharaka"). • In a "consecutive partnership" the partners keep the same level of share in the partnership until the end of the joint venture, unless they withdraw or transfer their shares all together. It's used when a bank invests in "a project, a joint venture, or business activity", but usually in home financing, where the shares of the home are transferred to the customer buying the home. • In a "diminishing partnership" (Musharaka al-Mutanaqisa, also "Diminishing Musharaka") one partner's share diminishes as the other's gradually acquires it until that partner owns the entire share. This mechanism is used to finance a bank customer's purchase, usually (or often) of real estate where the share diminishing is that of the bank, and the partner acquiring 100% is the customer. The partnership starts with a purchase, the customer "starts renting or using the asset and shares profit with (or pays monthly rent to) its partner (the bank) according to an agreed ratio." 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 (as of 2012) including the American Finance House, 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 • rent (or lease payments) and • 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 (leasing by the bank of its share of the asset to the customer) and bay’ (gradual sales of the bank's share to the customer). The Meezan Bank of Pakistan is careful to use the term "profit rate" but it is based on KIBOR (Karachi Interbank Offered [interest] Rate). 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 (GCC) countries such as Saudi Arabia, Kuwait, the United Arab Emirates, Qatar, Bahrain, and Oman". Differences A mudarabah arrangement differs from the musharakah in several ways: ==Promises and challenges==

Profit and loss sharing has been called "the main justification" for, 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". Usmani considers profit and loss sharing the "ideal" Islamic financial instrument and superior to Islamic debt-based financing (such as credit sales). Usmani notes that some non-Muslim economists have supported development of equity markets in "areas of finance currently served by debt" (though they do not support banning interest on loans). Lack of use While it was originally envisioned (at least in mudarabah form), as "the basis of a riba-free banking", Another source (Suliman Hamdan Albalawi, publishing in 2006) 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, 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" (Muhammad Akram Khan), 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 (PLS being 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, (the borrower/entrepreneur having no such burden). 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 [mudarabah] 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. 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." ;Other explanations Other explanations have been offered (and rebutted) as to why use of PLS instruments has declined to almost negligible proportions: • Most Islamic bankers started their careers at conventional banks so they suffer from a "hangover", still thinking of banks "as liquidity/credit providers rather than investment vehicles". • But by 2017 Islamic banking had been in existence for over four decades and "many if not most" Islamic bankers had "served their entire careers" in Islamic financial institutions. • Islamic products have to be approved by banking regulators who deal with the conventional financial world and so must be identical in function to conventional financial products. • But banks in countries whose governments favor Islamic banking over conventional i.e. Malaysia, Pakistan, Sudan, Iran show no more inclination towards Profit and Loss sharing than those in other countries. • According to economist Tarik M. Yousef, long-term financing with profit-and-loss-sharing mechanisms is "far riskier and costlier" than the long term or medium-term lending of the conventional banks. • On the other side of the ledger, their customers/borrowers/clients do not like to give away any "sovereignty in decision making" by taking the bank as a partner • 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. • 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. • 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; • The difficulty in expanding a business financed through mudaraba because of limited opportunities to reinvest retained earnings and/or raise additional funds. ==Industry==

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(s) 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. 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". Islamic Development Bank Between 1976 and 2004, only about 9% of the financial transactions of the Islamic Development Bank (IDB) were in PLS, increasing to 11.3% in 2006-7. This is despite the fact that the IDB is not a multilateral development agency, nor a for-profit, commercial bank. United States In the United States the Islamic banking industry occupies a much smaller share of the banking industry than in Muslim majority countries, but is involved in 'diminishing musharaka' to finance home purchases (along with Murabaha and Ijara). 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 (Patrick O. Healy 2005) 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 (David Loundy) quotes an unnamed mortgage broker as stating, "The price for getting into heaven is about 50 basis points". ==See also==