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Is Islamic Finance a Profit and Loss Sharing system?

Is Islamic Finance a Profit and Loss Sharing system?

By Nizar Alshubaily | November 09, 2018

Here are a few quotes one easily finds:

 “We see here that there is even a guarantor used to ensure that the bank does not lose money on the deal in the event that the Beneficiary defaults. So much for profit-sharing.”

“In its intended form, Islamic banking as advocated by the Prophet would be close to venture capital…”

“No need to repeat the Quranic verses here but the essence of Quranic injunctions is that debt should be interest free or non-profit transaction. If you want to engage in profitable transactions, do trade which entails taking equity stake.” 

“In Islamic finance, interest-bearing contracts are replaced by a return-bearing contract, which often takes the form of partnerships.”

“The Islamic financial system is equity-based, and without any debt: deposits in the banks are not guaranteed the face value of their deposits, because the returns depend on the profits and losses of the bank.”

“Islam supports the view that Muslims do not act as nominal creditors in any investment, but as partners in the business (that is essentially an equity-based financing).”

“Islamic finance requires that finance is provided on the principle of profit and loss sharing.”

None of the above is true.

Sadly, we see such statements in so many articles, books, research, and manuals on Islamic Finance.

So allow me to make it clear from the outset my view by quoting from a great recent book, “Al-Hikam Al-Ribawiya” by Dr. Mansoor Al-Ghamdi, Associate Professor of Fiqh at King Abdulaziz University in Jeddah, in which he states quite clearly and unambiguously: 

“Even though the revelation of the prohibition of Riba took place in the community of The Prophet (pbuh), He did not order the cancellation of commercial debt transactions, and no reports of him (pbuh) ordering the people to enter into Musharakah instead of commercial Mudayanah, even though He was careful to close doors and stop any tricks that lead to prohibitions. In fact, it is proven in The Quran the permissibility to enter into Mudayanah either through Bai’ or Salam…And this clear permissibility shows that The Prophet (pbuh) and the group of Sahaba did not understand that the prohibition of Riba favoured Musharakah over Mudayanah.” Translated and Abridged by me.

Here, Musharakah refers to Equity and Mudayanah refers to Debt.

It is not clear to me the reasons why some observers and writers on Islamic Finance believe otherwise. Perhaps it’s a wish to see Islamic Finance as completely different from the Riba based Conventional banking system. One can see perhaps traces in some of these statements from the famous Shariah Maxim: “Al-Ghunm Bil Ghurm or Al-Kharaj Bil Daman”, basically meaning “No Risk, No Return”, or “Return comes from Risk (Guarantee or Liability).”

In 2016, Dr. Zubair Hasan, Professor Emeritus of Islamic Economics and Finance at the International Centre for Education in Islamic Finance (INCEIF), Kuala Lumpur, Malaysia, wrote a paper on the subject of risk-sharing and offers some explanation of the possible reasons why: 

“However, early Islamic scholars swayed by some distinctive features of the participatory models regrettably put a rather restrictive interpretation on the maxim deriving a ‘no risk, no gain’ precept which, they thought, made risk-sharing the exclusive principle of Islamic finance. The fact is that the maxim covers both sorts of contracts. The choice of one or other category is discretionary; no preference whatsoever is indicated. Interestingly, the proponents of the ‘no risk, no gain’ precept accept this reality without realising that the acceptance conflicts with the ‘sole principle’ tag they stick to risk-sharing; it becomes irrelevant, rather misleading. Instead, the proponents of the precept continue to parade their exclusivist approach without any let up. Their insistence on sharing of risk being the absolute and paradigmatic imperative of the Islamic financial system remains unrelenting.” Risk-Sharing: The Sole Basis of Islamic Finance? Time For A Serious Rethink (2016)

And here we see the reality: "the maxim covers both sorts of contracts", and "no preference whatsoever is indicated."

Nowhere in history or Shariah do we see any evidence of this favouritism to Musharakah over Mudayanah. One would simply have a very difficult time finding any clear statement in any of the classic Fiqh or Hadith books making this preference. Neither would one find it in The Quran.

Just pick up any old classic Fiqh book, and you will usually find the same situation; the books dedicated to Sales and Rents (Mudayanah) outnumber in their pages anything written on Partnerships (Musharakah or Mudarabah).

I do not know of any of the various Islamic Financial institutions that serve the Islamic Banking industry as ever having issued a statement regarding any preferences. Not AAOIFI, nor CIBAFI, IFSB, IIFM, IIRA, not even the OIC International Islamic Fiqh Academy.

I do not know of any mainstream scholars who serve as Shariah board members in Islamic Banks as having ever claimed such a preference. Many scholars have official websites, have published books, and even have YouTube lectures. I do not recall that any claim of preference in Shariah has ever been made in any of these sources. And I certainly do not recall any claiming Islamic Finance as an Equity based financial system. Of course some scholars have expressed concerns that Debt products may not be administered or structured properly, or that their magnitude has become too large, and thus favoured that Islamic banks seek more Mudarabah or Musharaka opportunities, but not any exclusivity to Musharakah or even outright preference. 

Dr. Zubair Hasan, tackled this issue of preference of Musharakah versus Mudayanah in an earlier paper:

“Islam does allow a time value to money as part of the price in deferred payment contracts based on murābaḥah (cost plus an agreed fixed margin financing mode). Deferred payment sales involving mark-ups are debt-based transactions. We are not aware of any juridical preference between contracts involving profit sharing on the one hand and those stipulating predetermined returns on the other if both meet the stipulated Sharīʿah requirements.” Risk Sharing Versus Risk Transfer in Islamic Finance: A Critical Appraisal (2015).

And this is very important for people to understand and fully embrace: “Any Juridical Preference.” So many observers and students of Islamic Finance believe there is such a preference in Shariah and continue to speak of it in that manner. 

But perhaps it’s a matter of definition as to what constitutes risk sharing and profit and loss. Perhaps some of the proponents do not actually mean Equity as in Musharakah. Perhaps they also mean taking risks on owning the goods as well. 

It seems some observers do in fact mean purely equity or profit and loss as in only Musharakah, or at least a strong preference to Musharakah (Equity) transactions. While others seem to mean something else entirely.

In looking at a number of websites of Islamic Banks, there seems to be some banks that use the term risk sharing and Profit and Loss sharing. However, upon closer examination, it becomes clear that’s not what they mean. They in fact include Mudayanah products as part of this risk-sharing system due to ownership of goods sold to customer. Their websites are full of information on Consumer Finance.

Here’s an example from Dubai Islamic Bank website:

“Islamic banking is also the first where a customer, whether individual or corporate isn’t just a customer, but is a partner with the bank or owner of goods or assets. This means they share the risks, as well as the profits of such a partnership or ownership. And this unique arrangement is done in accordance with the laws of Sharia, which ensure complete transparency at all times.

Islamic banking therefore offers a portfolio of innovative, Sharia-compliant financial models that formalise this unique arrangement between customers and the bank. These are Murabaha, Musharaka, Mudaraba, Istisna, Salam and Ijara, to name a few.”

At first you may be driven to believe they mean risk-sharing as in Profit and Loss, or Partnership (Equity), given they use such words as “partner” “share the risks”, “partnership”. However, when you read it again, you would not be mistaken that in fact what they mean is that the bank is not simply a lender of money, but a seller of goods and assets to the customer, as such, the bank in fact takes the risk of ownership of the assets, regardless of how momentary it may be. And they clearly name a number of Mudayanah (Debt) products such as Murabaha and Salam as part of this definition.

Are they correct in making this statement? Well yes, if you define risk-sharing in that manner, and that’s exactly what happened in Kuala Lumpur.

In 2012, a roundtable discussion held in Kuala Lumpur, Malaysia by the International Shari'ah Research Academy for Islamic Finance (ISRA), the Islamic Research and Training Institute (IRTI) and Durham University, stated exactly that in what became known as The Kuala Lumpur Declaration:

“The Shari’ah emphasises risk sharing as a salient characteristic of Islamic financial transactions. This is not only exemplified in equity-based contracts, like musharakah and mudarabah, but even in exchange contracts, such as sales and leasing, whereby risk is shared by virtue of possession.”

And there it is: “whereby risk is shared by virtue of possession”. Without this statement, the declaration would have been factually incorrect and probably would not have been released.

So now, the Profit and Loss system is better designated as a Risk Sharing system. However, with one very important addition: namely, that exchange contracts that include Debt (Mudayanah) are part of the risk sharing system.

This is far different from the “exclusively” Equity based system we heard before.

So it would seem there are some that have used the maxim of “no risk, no gain” well known in Islamic Finance as somehow meaning a type of risk sharing that is equivalent to both Financier and Borrower sharing some sort of Equity risk together. The simple reality is that this maxim relates to taking some risk on ownership of the product in some cases as The Kuala Lumpur Declaration made quite clear.

Of course, if one would spend time thinking about it one would discover very quickly that it couldn’t be the type of equity or profit and loss sharing system being publicised by some.

Consumer Finance is by nature about consumption, which means nothing remains to take a market risk on and share in any profits or losses. If you buy furniture, or clothes as a consumer, these of course are “consumed” by using them over time. A financier can only sell you the items on deferred payment or instalments, or at best rent them to you. He can’t enter into a commercial joint venture resembling Musharakah on the goods, as they are for consumption, since there won’t be anything left to sell in the market after usage, they will have been fully depreciated.

The trouble with all these terms: Equity, Partnership, Risk-Sharing, and Profit and Loss, is that they are really being used too liberally and with disagreements over definition as well as preference. In my opinion, this is not a very good publicity for the industry; it will only confuse potential customers and future students of Islamic Finance. 

This was not an article about the definition or differences between risk sharing, risk transfer, risk shifting, or risk taking. Nor was it about whether Equity or Debt is better for society in avoiding financial crises. I leave these issues to Economists.

This was simply about whether Shariah makes any preferences between the two forms of Equity and Debt.

It does not.

Having said that, I found this paragraph on the economy very eloquent, so I leave the last word again to Dr. Mansoor Al-Ghamdi from his book ‘Al-Hikam Al-Ribawiya”:

“The reality is that a preference between Musharakah and Mudayanah is like a preference between Hearing and Seeing, or between Eating and Drinking, or between Speech and Writing, each accomplishes a purpose, need, and benefit, that the other cannot, and it would be an economic mistake to build an economic system on one and ignore the other, and Allah Knows Best.” Translation by me.


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10 Comments

Ibrahim Ludwick 3 weeks ago
Jamaa Network

How about we take a look at some of the hadith about debt:

The Prophet (Sal Allaahu Alaiyhi wa Sallam) used to say in his prayer:

“Allaahumma inni a’oodhi bika min al-ma’tham wa’l-maghram (O Allaah, I seek refuge with You from sin and heavy debt).” Someone said to him: “How often you seek refuge from heavy debt!” He said: “When a man gets into debt, he speak and tells lies, and he makes a promise and breaks it.” (Bukhaari and Muslim).

Muhammad ibn Jahsh said: ‘We were sitting with the Messenger of Allaah (Sal Allaahu Alaiyhi wa Sallam) when he raised his head towards the sky, then he put his palm on his forehead and said: “Subhaan-Allaah! What a strict issue has been revealed to me!” We remained silent and were afraid. The following morning I asked him,

“O Messenger of Allaah, what is this strict issue that has been revealed?” He said, “By the One in Whose hand is my soul, if a man were killed in battle for the sake of Allaah, then brought back to life, then killed and brought back to life again, then killed, and he owed a debt, he would not enter Paradise until his debt was paid off.” (Hasan -al-Nasaa’i).

The Prophet (Sal Allaahu Alaiyhi wa Sallam) said:

“Whoever asks people for money when he has what is sufficient for him is only asking for more of the embers of Hell.” They asked him, “O Messenger of Allaah, what is sufficient so that he does not have to ask for more?” He said: “Having enough to eat lunch and dinner.” (Abu Dawud- Saheeh).

So what about home loans? What about loans for cars? Really, no preference whatsoever in the sharia?

The Prophet (Sal Allaahu Alaiyhi wa Sallam) refrained from offering the funeral prayer for someone who had died owing two dinars, until Abu Qataadah (a Sahaabi) promised to pay it off for him. When he saw him the following day he said,

“I have paid it off.” The Prophet said: “Now his skin has become cool for him.” (Hasan-Ahmad)

And what did the sahaba have to say about it?

Umar ibn al-Khattaab said: Beware of debt, for it starts with worry and it ends with war. (Maalik in al-Muwatta).

This is exactly the dynamic we see in the world today, that a system of increasing debt is subject to contagion. To be sure, interest worsens the situation, but it also brings it more quickly to a head- an Islamic imitation of this system is simply less efficient and renders those who practice it deficient in both the dunya and akhira.

To be sure, there is a role to be played by debt, but to say that there is no preference is willful ignorance. It's telling that you had to search for very recent quotations in defense of your position. (edited)


Banker, Writer, Volunteer

السلام عليكم ورحمة الله وبركاته

Brother Ibrahim

Thank you so much for your comments, and I’m very sorry you disagree.

However, I understand the confusion, it’s one of comparing debt vs. No debt with Debt vs. Equity, which is the subject of the article, and is different from the first and has no juridical preference.

The references you make are well known but do not serve as a juridical ruling on the preference between debt and equity in commercial transactions.

Some of those who even wrote papers on the subject have admitted that their views on debt are not based on Shariah rulings but their personal views derived from their understanding of Maqasid Al-Shariah.

May I also add certain historical facts from the period, where Al-Zubair bin Al-Awwam رضي الله عنه refused to accept money on Amanah and instead insisted it was a debt lest it gets lost.

And of course I am sure you’re aware that The Prophet ﷺ died with debt to a Jew and his shield held as collateral. The debt was in the form of a deferred payment sale, a Mudayanah transaction.

Neither of these events would create a juridical preference of Mudayanah over Musharakah for example.

Neither would inferring that since Mudayanah is permissible from verse 2:282, the longest verse in The Quran and called Ayat Al-Mudayanah compared with verse 24 of Surat Saad which is negative on partnerships that there is a juridical preference for Mudayanah over Musharakah.

It would be wrong to assume that Musharakah is all benefit, versus Mudayanah as all corruption, this would be a misunderstanding.

In summary, there is no evidence whatsoever from history, nor have I seen this in your comments for any juridical preference of Equity over Debt in commercial transactions.

I’m sure you didn’t mean your last comment, and it was done in haste, as I’m certain you realise I know well my subject matter and know what I’m talking about.

However, if not, no problem, no hard feelings, and we can agree to disagree.

جزاك الله خير


Jamaa Network

Thank you for your response.
The Prophet's, sal Allahu alaihi wa salam, giving either a shield or armor to the Jew as collateral more than covered the debt in such an event as non-payment due to unforeseen illness. Al Zubair bin Al-Awwam's position also makes sense insofar as he was apparently concerned with the trust mixing with his own wealth. By extension, these principles would never lead to an increasing system wide preference for debt and susceptibility to contagion, whereas your conclusion, which is actually derived from sources other than both the evidences and purposes (maqasid) of the sharia, would.
I would never, ever suggest that debt is by any means haram- undoubtedly it has an important role, which is why there are clear guidelines for dealing with it. But it is clearly something to be avoided wherever possible. The methods of finance favored by the first generations of Muslims are more viable in an environment of tight kinship networks, and are much more difficult to deploy in the impersonal context of modern finance.
You are doubling down on your position, so I would also double down on mine. I'm glad you refer back to Book of Allah, because this usually clarifies things.
But referring to Surah Saad and the word الْخُلَطَاءِ , and suggesting that this word has any particular relation to financing models is disingenuous, and is the kind of intellectual trickery used by recent scholars to justify the label "Islamic" on what appears to be a fairly close copy of the modern, interest based financial system.
Classical scholars never attempted such representations, probably because
1) there was no major financial incentive to misrepresent interpretation of scripture, as is the case with modern push to dupe Muslims into integrating into the hegemonic global financial system and2) because knowledge of tafsir was so widespread, that someone would instantly discredit themselves by attempting to read entirely new meanings into ayat.
قَالَ رَسُولُ اللَّهِ صلى الله عليه وسلم ‏ "‏ مَنْ قَالَ فِي الْقُرْآنِ بِرَأْيِهِ فَأَصَابَ فَقَدْ أَخْطَأ
Meaning roughly, who interprets the Quran according to opinion, is wrong even if he is right. Can you bring any evidence from hadith, the sahaba, or recognized tafasir that supports that this ayah is referring to musharakah financing model?
Then you conclude that all of the clear evidence for preference against debt would not apply in commercial transaction specifically.
This would then be a claim that there is a specific exception to a general rule, with no evidence of such, not even a nod to qiyas?
In summary, your project appears to be to increase the efficiency of the Islamic finance system in the creation of a comprehensive, debt based, economic system, which is actually quite antithetical to the purposes of the sharia.
There is no sense on "agreeing to disagree" on an issue like using some clever mental tricks from the colonial and neo-colonial era to abolish principles of Islamic scholarship that have been established for centuries.
Debt financing is totally acceptable, but having shared interest is clearly preferable- not just because the sahaba preferred it, but because having a mutual interest closes the door to all kinds of potential abuse. Ibn Taymiyyah even concluded that musharaka is clearly preferable to wage labor for the same reason!
Please, if you want to refute the work of generations of classical scholars, be prepared to do so by engaging with their work, rather than just citing the work of a few recent scholars.
If, as you say, that nowhere in history is a preference shown in the sharia for risk sharing, why did you dedicate an article to refuting the principle?


Banker, Writer, Volunteer

Salaam brother Ibrahim

Once again I'm sorry you seem to misunderstand my words. Please don't make accusations, it's unbecoming for a Muslim to accuse his brother.

I'm sorry you are unfamiliar with the terminology and process in Islamic Finance and how modern transactions derive their permissibility from The Quran, The Sunnah, and Ijma.

I've invented nothing, it's all well known and well documented and agreed by all scholars today who are inheritors of our past scholars. If you read any of my articles, I always refer to past scholars, but today's scholars are the same as they summarise that too, so there is nothing in what you have accused me of.

I write articles, that's why, and when I see a myth, I work to correct it. Please don't accuse me of using verses to interpret, this is already done by our scholars and I just simply transfer.

so I'll make this short and simple, here's the AAOIFI Shariah standards written by our top scholars, and you will see in it at the back of each standard The Shariah Basis. Look up Salam and see the use of verse 282, and look up Sharikat and see the use of verse 24 Saad.

In addition, another article from a scholar on verse 24 and a discussion of modern companies.

http://www.iefpedia.com/english/wp-conte...

https://almunajjid.com/2801

If for some reason you have a different understanding of Shariah and do not trust our modern scholars, I can't really help you with that.

I wish you well brother.


Saad Al-Harran 3 weeks ago
Retired, Retired senior lecturer, University Brunei

After almost three decades of applied research and publications the first book on (Islamic
Finance: Partnership Financing by Saad Abdul Sattar Al-Harran, Pelanduk Publications, Malaysia, 1993 followed by another book entitled: Islamic marketing Strategy: Eradicating Rural Poverty in Malaysia, 1994 which we (some of my students at IIUM and I ) build a model of Musharakah
Financing for the Malaysia Fishman to ease their suffering of this fishman and none were implemented. And lastly, before I left IIUM, Malaysia, I organized an international workshop on Partnership (Musharakah) Financing: Concept and Case Studies which was held in Malaysia 23-24 April 1996 to demonstrate that Islamic banks should be a risk sharing system with no risk no gain. But the reality is harsh to accept in that Islamic banks are no different than commercial banks. The practice of the majority of Islamic banks has shown a widespread preference for Murabahah (trade financing) and a lesser degree of mudarabah financing. In contrast, Musharakah (partnership) financing has generally been avoided on the mistaken presumption that it is an economically non-viable (high-risk) instrument. Sadly, adopting such a strategy results in no profound benefit being brought to a large number of societies where Islamic banks operate. You can also read "Arab Law Quarterly: Volume 14, Part 3, 1999. "Islamic Partnership Financing: Concept & Case Studies: Edited by Saad Al-Harran, Kluwer Law International, The Netherlands. It is sad to say that Islamic Banks has failed to bring changes in a real socio-economic status of Muslim Ummah. Regrettably, many social ills such as youth unemployment, poverty, and hunger have become out of controls in these nations without any practical solutions from Islamic banks on the horizon or other government development agencies to tackles these problems. That lead me to write a book entitled: Current Issues in Islamic Banking and Finance by Dr. Saad Al-Harran (www.xlibris.com) in 2008 in which I allocated one chapter entitled: Islamic Finance with Social Responsibility. (edited)


Jamaa Network

Allah reward you (edited)


Robert Hannah 3 weeks ago
N/A

Your article confirms what I suspected when I looked through scholarly material on the supposed Islamic requirement for risk sharing, and did not see any sound basis for the idea from fundamental sources. It would appear to be a subsequent scholarly construction. What is your concept of mudayanah, and how does it differ (if at all) from regular commercial interest bearing debt? (edited)


Banker, Writer, Volunteer

Hello again Robert and thank you for your comments.

Mudayanah is basically any contract that creates an obligation on a party, such as Leasing, Deferred or Instalment Sales.

Another form is a loan (Qard) however, this one is principal only.

From a financial point of view, meaning the obligation itself there would be no difference, the borrower or buyer in both cases is obligated to pay the agreed amount at a particular date.

In interest bearing debt, it was money that was lent, and the margin on top is the interest. In addition, lateness in payment increases the interest. This is Riba and is Forbidden.

In a sale, the seller may place a margin on the sale price for the deferral but can’t charge further if buyer delays payment.

Financially they seem the same. However, Shariah is in the “HOW” and not the “How Much”.

Here’s an example: two individuals, starting with the same amount, trading it for the same period of time, and ending with the same amount of return or profit.

It would look the same, until you learn that one made the profit on trading stocks whilst the other on trading illegal narcotics.

Surely you can see and agree, the Judge would not look upon the financial results to determine whether a crime has occurred but upon HOW the financial result of the second person was achieved.

Now, if your question is Why is one deemed legal and the other not , then that’s a big subject and would require reading the book I mentioned in my article on Riba.

All the best (edited)


Muhammad Altalib 2 weeks ago
King's College London

That’s all good for physical asset backed transactions, but what about transactions where the asset may not be physical such as student loans which finances education. Is there any chance for mudayyana in this situation? (edited)


Banker, Writer, Volunteer

Salaam brother Muhammad

Yes there is in fact.

In the UAE, student loans in a Shariah compliant manner are done under a Service Ijarah Contract.

Here’s a link to such a service offering:

https://www.adcb.com/islamicbanking/fina...

And here’s the Fatwa also on the product:

https://www.adcb.com/Images/2013_English...

I hope these are helpful.

And thank you so much for your comments. (edited)