Question

As an industry, Islamic finance and more specifically Islamic banking, has been criticized for neglecting the profit and loss sharing (P.L.S.) model originally intended as its main mode of operation by the theorists of Islamic economics and focusing more on sale-based and lease-based models. Do you think that such a criticism is justified? why or why not?

Answer 1

The profit loss sharing is based on two major modes of financing namely mudaraba & musharaka. The profit loss sharing concept marginally features in the practice of Islamic banking & finance. According to the international association of Islamic banks, PLS covered less than 20% of investments made by Islamic banks located worldwide.

There is lack of PLS concept in the Islamic financing for the following reasons:

• The PLS contracts are inherently vulnerable to agency problems as entrepreneurs have disincentives to put in effort & have incentives for reporting less profit as compared to the self financing owner manager.
• The profit loss sharing contracts also require well defined profit rights to function efficiently which are not properly defined or protected in most Muslim countries.
• They also have to offer relatively less risky modes of financing because they face heavy competition from the conventional banks that are more competitive.
• The shareholders have a restrictive role in management & hence the financial structure of PLS is dichotomous that make them non participatory & also allows a sleeping partnership.
• Fifth, equity financing is not feasible for funding short-term projects due to the ensuing high degree of risk (i.e., the time diversification effect of equity). This makes Islamic banks and other financial institutions rely on some other debt-like modes, especially mark-up to ensure a certain degree of liquidity.
• There is also unfair treatment of taxation which is a major obstacle in the profit sharing. The interest is exempted when the profit is taxed. This legal discrimination & tax evasion makes profit sharing a less reliable tool.
• Seventh, secondary markets for trading in Islamic financial instruments, particularly Mudaraba and Musharaka, are non-existent. Consequently, they have so far failed to effectively mobilize financial resources.

Hence all the above mentioned imbalances needs to be removed in order to increase the appeal for the profit sharing concept.