Islamic Banking & Finance Page 31-05-2019

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Profit and Loss Sharing (also called PLS or participatory” banking is a method of finance used by Islamic financial or Shariah-complaint institutions to comply with the religious prohibition on interest on loans that most Muslims subscribe to. Many sources state there are two varieties of profit and loss sharing used by Islamic banks – Mudarabah  (“trustee finance” or passive partnership contract and Musharakah (equity participation contract). Other sources include sukuk (also called “Islamic bonds”) and direct equity investment (such as purchase of common shares of stock) 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 (the terms “debt”, “borrow”, “loan” and “lender” are not used). As financing is repaid, the provider of capital collects some agreed upon percentage of the profits (or deducts if there are losses) 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 (in the mudarabah form of PLS) 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” (or “debt-like instruments”) 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”.

The profit and loss sharing scheme prescribed by the Islamic Shariah in joint enterprises intends to achieve a just distribution of gain and liability among the joint partners. Taking the ideals and guidelines propounded by the Shariah and the prevailing conditions into consideration.

First we examine the process generally adopted by Islamic financial institutions for determining the profit sharing ratio in projects financed on joint equity basis. However the discussion here is mainly relevant to adopting the equity basis in financing ventures where the capital is jointly funded by both the financial institution and the client. Thus, the process of determining the profit sharing ratio analyzed is not directly relevant to the ratio adopted for division of profits between the depositors of the institution and the share holders. Although the main thrust of the discussion is centered on joint equity based financing, i.e. musharakah, a major portion of it is also relevant to financing on the basis of mudarabah, where the venture managed by the client is solely funded by the bank.

Here we attempt to suggest alternative bases for profit ratio determination in equity based financing of ventures that could facilitate realization of the socioeconomic goals of Islamic Shariah.

In financing ventures on musharakah and mudarabah, Islamic banks are required to agree on a profit sharing ratio so as to comply with Shariah guidelines. Equity financing of single transactions that are short term in nature involve single exports and imports, financing of produced goods etc, while financing of projects involving production and manufacture could extend over longer terms. In determining the profit sharing ratio in such ventures the bank primarily takes into account the envisaged rate of return on capital, usually also considering factors such as the size of the investment and the period of exposure, i.e. the duration taken for realization of profits or alternatively, liquidation. Usually, ancillary factors such as the nature of risks involved, additional business income that could be generated through other means from the same client and his credit record, too, are also kept in view. It is pertinent to examine the method through which Islamic banks determine the profit sharing ratio in such equity ventures.

Profit and Loss Allocation among Islamic Bank and Client Partner in Equity Financing is done through multiplying the amount of capital sought to be invested by the bank by the appropriate rate of return and by the expected period, arriving at the net return the bank wishes to realize through the venture. The rate could be marginally altered in view of the other factors referred to above, especially in the case of larger exposures, based on negotiation. In the case of smaller exposures, more often than not, the role played by negotiation happens to be minimal. Thereafter, the envisaged return thus calculated is divided by the expected total profit projected for the venture for obtaining the ratio of the bank’s share in the profits. This means that the return sought by the bank is compared with the total profit the venture is expected to yield, and is then reflected as a proportion of it. After the bank has determined the amount of return it wishes to achieve, the remainder of the expected profit, irrespective of its size, is taken as the profit share of the client / joint partner, and the proportion of one to the other is held as the ratio of profit sharing. Since this method fundamentally aims at the bank achieving a predetermined return on the capital invested in the equity venture, it is necessary to scrutinize the level of its appropriateness islamically in joint ventures based on mutual sharing and joint participation. As evident, the period of exposure, usually counted in months, is taken as the most important variable in the determination of the bank’s profit share. Consequently, a venture expected to take a longer term for completion would invariably involve a higher share of profit being allocated to the bank. The other component, i.e. the rate of return, could alter marginally based on the other factors mentioned earlier. Owing to this state of affairs, it is seen that any negotiation with the potential partner on the bank’s capital infusion almost exclusively centers on the monthly rate to be applied, along similar lines as when a conventional banking facility is applied for. The rate of return applied to different types of equity investments is almost always parallel to the corresponding lending rates for similar facilities in conventional banks, and no substantial change is observed to occur in view of the profitability of a venture. This scenario is largely attributed to the competition offered by the conventional side.

It can be feared that potential equity partners would prefer loan capital at relatively low rates of fixed interest to risk capital with a higher demand on potential profits. Thus the interest rate on loan capital extended by conventional banks is taken as the primary basis for determining the rate of return on the risk capital invested in equity ventures, and more often than not, the liability borne by the bank through investing based on a profit and loss sharing platform is not given sufficient room to play an effective role in this process. At the conclusion of the project as expected, the bank succeeds in achieving the return on its capital as dictated by the rate applied. Any additional amount of profit over and above the sum projected initially could only result if the venture succeeds in realizing a higher profit than was anticipated. In this event, by virtue of the share of the bank being fixed as a ratio of the total profit and not as a lump sum or a percentage of the initial capital outlay, the bank would be entitled to a higher return, irrespective of the amount. However, it should be noted that the possibility of earning such a higher return is minimal due to banks entertaining only ventures that lead to a definite return, and incorporation of additional clauses that make the client entitled to any profit earned over and above a stipulated ceiling.

 However In the current method, generally the rate of return on capital is taken as the basis for the calculation of the profit ratio, where the period of the exposure acts as the major variable. The process of determining the profit sharing ratio in joint ventures financed by Islamic banks, therefore, starts from the amount of capital invested by the bank in the venture. Consequently, the process is largely similar to fixing a margin of profit in trading products offered by Islamic banks such as ijarah and murabahah. Reflection of the return sought by the bank as a percentage of the capital ceases only at the final stage of concluding the musharakah/mudarabah contract, at which point the amount is converted into a percentage of the total profit expected and recorded as such in the agreement, principally for the purpose of Shariah compliance. It is observed that due to adopting a mechanism designed to achieve a defined return, the profit share accruing through a venture yielding high profits is not significantly different from that achieved through one that is lower in profits.

Thus, the profitability of the venture would not necessarily bring about a higher return to the bank, usually the major provider of capital, and through it, to the bank’s investors, as the profit share is determined on the basis of a specific amount of profit the bank desires to generate through the project.

This in turn restricts to a large extent a primary role Islamic banks are envisaged to play, viz. facilitating an equitable distribution of wealth among entrepreneurs and principal owners of funds. Consequently, the investors of the bank are generally observed to receive a flat return that does not adequately reward them for the risk capital they had provided, even when the projects funded through their monies realize huge profits. Fundamentally, this could reflect the anomaly arising out of juxtaposing a capital-centered rate of return method within a profit-centered shirkah framework.

In this method, the primary emphasis is placed on the time factor, which is conceived as the fundamental basis for multiplication of the return. However, it could be observed that ideally, the expected period for the realization of profits/ liquidation should not play a role in determining the profit share of any single partner. This is because time, being a factor that affects the venture as a whole and consequently, the interests of both partners, should be regarded as a common element and its impact on the profit sharing ratio overall should be zero.

Thus, there appears no justification for the Islamic bank unilaterally adopting a profit shares calculation mechanism that fundamentally depends on the element of period for fixing its own share of profit exclusively.

A true implementation of equity financing could demand that the element of time be excluded from playing a role in fixing the profit share of one partner to the exclusion of the other. The Shariah principle with regard to distribution of profit both in musharakah and mudarabah is that the profit shares of partners should be fixed as a ratio of the total profit realizable through the venture. It is due to this reason that fixing a lump sum or a ratio related to the capital as the profit share of any partner has been ruled inadmissible. But nobody cares and the process moves on in collaboration with Sharia Scholars, Academicians, Bankers and Regulators.

Hence deciding unilaterally on factors of Profit and Loss sharing regarding applicable rates, amount, time factor and area of investment all needs to be decided mutually in a transparent way through some mechanism approved and monitored by the regulators.

 

Differences between Islamic Remunerative and Conventional Remunerative accounts?

Islamic Remunerative Conventional Remunerative
Contract Funds are accepted under Mudaraba agreement It is a lending Contract
Relationship Relationship between Bank and Customer is that of Partners Relationship is that of Debtor and Creditor
Return Profit rate are not fixed. Profit from Mudaraba Pool is distributed amongst the depositors Rate of return is fixed and guaranteed and depositor gets the return even if the bank suffers losses
Restrictions Funds can only be utilized in sharia compliant financing and investment activities No Shariah based restriction on utilization of funds

 

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