Profit and loss sharing


Profit and Loss Sharing refers to Sharia-compliant forms of equity financing such as mudarabah and musharakah. These mechanisms comply with the religious prohibition on interest on loans that most Muslims subscribe to. Mudarabah refers to "trustee finance" or passive partnership contract, while Musharakah refers to equity participation contract. 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 categories of Islamic financing, the other being debt like instruments such as murabaha, istisna'a, salam and leasing, which involve the purchase and hire of 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.

Concepts

The premise underlying PLS is the concept of shirkah 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, 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 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, and the party providing labor is called the mudarib. 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, 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 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. For the bank customer they would be held in "Investment Funds" rather than "Investment Accounts".
  • In a al-mudarabah al-mutlaqah, 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. For the account holder funds are invested without any restrictions based on mudarabah or wakalah contracts, and the institution may commingle the investors funds with their own funds and invest them in a pooled portfolio, going to "Investment Accounts" rather than "Investment Funds".
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, 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 is not 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
  • Shirka al'Inan is a Musharaka partnership where the partners are only the agent but do not serve as guarantors of the other partner.
  • *Different shareholders have different rights and are entitled to different profit shares.
  • *Al'Inan is limited a specific undertaking and is more common than Al Mufawada.
  • Mufawada is an "unlimited, unrestricted, and equal partnership".
  • *All participants rank equally in every respect
  • *Partners are both agents and guarantors of other partners.
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.
  • 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".
  • 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" 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 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 its partner 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 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".