Is Islamic Finance a Profit and Loss Sharing system?
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.