This contract in its general form is the pillar of Islamic finance in that it is primarily based on profit-and-loss sharing (PLS). It has the flexibility that enables it to be used for a wide variety of economic activities, from industry (as equity participation), to construction (as civil partnerships and installment sales), to farming (as Mozara’ah), to plantation (as Mosa’qaat), and finally to trade (as Mudarabah).
In this contract, the Islamic bank supplies part of the capital required to establish a new joint-stock company or to purchase shares in an existing company…
The project has to be both economically and socially justified and in accordance with the country’s general economic priorities. The bank’s participation will be contingent on its 48 receiving satisfactory results from its initial studies of the proposed project. Such investigations will include the following :
(1)Economic considerations: The effects of the project have to be directed toward increased employment, a reduction in general price levels, a more equitable distribution of income and wealth, an increase in general social welfare, and the creation of secondary and downstream industries. The bank will also consider such things as total outlay and the proportion of that taken up by fixed and variable costs. Average and marginal costs at different capacity levels are important aspects. An efficiency – equity trade-off has to be made and compared with other countries, without losing sight of social considerations.
(2) Technical considerations: There will include the best mode of operation in light of the available infrastructure, skills, machinery, and equipment; the location of the project and any special incentives for investing in the region; the rules and regulations governing its operations; and a host of other considerations that directly and/or indirectly affect the feasibility of the project. A timetable for both physical progress and expenses at different stages of the implementation process is vitally important.
(3) Financial Study and Forecasts: These are often being undertaken in parallel with economic considerations and are mostly concerned with whether the project is useful and viable from the standpoint of the rate of return on capital and profitability. Data needed here include all production costs, domestic and foreign demand, foreign exchange rates, and the tariffs imposed by the importing countries…
Risk has to be taken into consideration in any investment decision-making process. The client would definitely be happier when risk is low but the proportionate rate of return is high. High risk is considered to be a deterrent as far as investors are concerned. But what happens when the project is both viable and badly needed, but the risks involved are high? The state-owned Islamic bank has the central role to play here. The potential investor’s expected rate of return has to take into account the risk factor by compensating the risk-premium of the investor. Our recommendation in such cases would be to increase the relative profit share of the investor to that of the bank. Once these matters have been agreed, a timetable has to be drawn up for the operation of the project at various stages and arrangements put in place for close and regular supervision to ensure that the project is on schedule, both physically and financially.
Source: Prof. Iraj Toutounchian, Thoughts from Iraj Toutounchian’s Islamic Money & Banking: Narrated by Camille Paldi. Republished with permission.
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