Loss-sharing is not sine qua non for Islamic finance

Loss-sharing is not sine qua non for Islamic finance

By Afzalul Haq, head of Islamic banking, Bank Asia Available at: http://ae.zawya.com/story/ZAWYA20120403111641/

There remains a misconception amongst the masses that Islamic finance is essentially a system that shares the profit or the loss. In fact this is not the reality. Islamic finance involves different modes, out of which a few are profit sharing and/or profit and loss sharing. There are many other modes, where the question of sharing profit or bearing loss does not arise.

Even these, however, are rich in their respective virtues. Each of the modes of Islamic finance has got its own distinct characteristics in respect of modus operandi and principles. So whenever there is a contract (between two or more parties) under Islamic finance, none can insist on any party sharing profit or bearing loss unless the specific mode itself qualifies for such a provision. It is the mode of agreement that determines whether the contract can stipulate the provision of profit and loss sharing or not.

Of course, there are modes where profit sharing is applicable. Sharing profit may even be a mandatory condition in some specific cases (mudaraba and musharaka, for example). There are modes where the loss sharing ratio is applicable. In some modes, loss sharing is not only applicable but also inherent, and the very ratio of loss sharing is pre-determined and also constrained by divine law (musharaka, for example).

There are also other modes, where the question of profit or loss is a matter of only a single party (murabaha and musawama, for example). In hire purchase and leasing, or ijara, there is no provision of sharing of profit or loss of the business of the lessee or hirer or the gradual purchaser. So there may be no sharing of either profit or loss.

A clear understanding of the consequences of an agreement under Islamic finance or banking norms is essential to understand where profit sharing is applicable and where it is not. There is no straight-cut formula for reaching an inference as to which of the different Islamic modes are better. The “betterness” depends, among other things, on the circumstances and the degree of risk the parties concerned are ready to bear.

Islamic finance and banking has been referred to as an emerging alternative to conventional banking and finance. Its growth rate for past few years has been tremendous. We must admit that the very virtue which attracts an entrepreneur (borrower) and which prominently differentiates Islamic finance from the conventional one, is usually referred to as the “profit-loss-sharing” character of the former.

As a conspicuous distinction, this virtue ranks among the top ones in the list of salient features of Islamic finance. But the beauty of Islamic finance originates from the root – the absence of interest or riba. The charging of interest has no place in Islamic finance and banking, except as being prohibited. The Quran and the Hadith contain very strong warnings against involvement in interest. So the essence of Islamic finance is that it must be free from interest. It is the basic and fundamental stipulation.

For attaining validity under Shariah, a business need not essentially be profit sharing or profit and loss sharing. Interest free finance is typically called Islamic finance. Interest is at the root of how we determine whether a particular transaction is compliant or not with Shariah.

All other features or characteristics of any particular transaction are in fact co-opted from the field where that particular type of transaction is actually adopted. Such a classification of types may be for the purpose of detection of a transaction as bai or trade, lease or rental, loan or quard and so on. No matter that nowadays all of these transactions are adopted as an element of Islamic banking and finance, obviously keeping them away or free from interest.

If any Islamic bank, for any reason whatsoever, offers loan or quard to anybody, the essential element encompassing the quard mode of transaction must be followed in its modus operandi. If a bank adopts any sort of bai or trade in its banking purview, the norms of bai or trade as outlined in the relevant texts of Shariah must be followed meticulously. For this purpose, we must also identify the specific type of that particular bai or trade.

Similarly, a partnership business, if adopted by an Islamic bank or finance company, must follow the Shariah norms of such businesses. As every transaction needs to conform to its own features, the norms or modus operandi of that very category of the transaction must be known to the professionals and other stakeholders concerned.

It is a common inference that each type of transaction, in general, has got its own and inherent features, be it Islamic or otherwise. Let us cite a very practical and generalized example. We can classify shopping into two broad types. One is fixed price trade and the other as bargaining or trade by negotiation between buyer and seller. In the former case, the shop may tag each product with its price. In a restaurant, there is a price quoted against each item on the menu. The customer must pay the quoted price. S/he can either purchase at the quoted price or look for any an alternative seller or product. But s/he cannot negotiate or bargain for a lower price.

The latter type is usually conducted through a process of negotiation. As a rule, the seller will ask for a higher price, whereas the client would desire to buy at the least possible price. The market forces of demand and supply will bring equilibrium to enable the transaction.

The two types of transactions are, therefore, seen as completely different according to their respective natures. There is no question of sharing profit or loss in either case. What does Islamic finance say of these transactions?

Shariah sees no harm in these transactions, except if they relate to haram items like pork or wine, which is a different issue. The objective or motive of the transaction is also a different issue. Our discussion here is limited to the mode of operation of the transaction, assuming all other factors are compliant.

In such a case, for a transaction to be termed as Islamic, it need not be based on sharing of profit or loss. In other words, an Islamic transaction may be conducted on the basis of profit-loss-sharing or not.

Every transaction or each group of transactions or the mode of operations is guided by the terms of its specific category or origin. These characteristics may contain a stipulation of profit sharing or profit and loss sharing. In a bai or trading agreement there may be a provision to sell goods at profit, declared or undeclared; sell at cost or even at a loss. One can sell either for cash or on credit or on installment basis. Each type of the contract is usually independent.

A transaction of a specific mode need not comply with any other characteristic meant for any other mode.

Of these, only the variable return based mudaraba and musharaka transactions are profit-sharing and profit and loss sharing, respectively. In mudaraba, the owner of the fund and the mudarib, or manager of fund, share the profit according to a pre-agreed ratio. A loss is borne by the owner of the fund alone.

In case of musharaka, both or all parties concerned provide capital, share profit according to the pre-agreed ratio and also the loss according to their capital ratios.

But all other modes, such as bai-murabaha or ijara, are fixed-return based transactions where the beauty lies in them being asset-backed. Exclusive financial transaction (of money only) does not suffice such a business; there must be a real transaction (of an asset or goods and/or services).

Obviously no question of profit or loss sharing arises therein. For murabaha, most essential characteristics are taking the possession or ownership of the goods by the seller first and disclosure of cost price and the markup distinctly. For musawama transaction the stipulation of attaining ownership and possession like the former or murabaha is essential; but musawama does not insist on declaring the cost price, unlike murabaha. This is why musawama is not a trust sale. Thus it is also unlike murabaha.

For leasing, the asset is to be in the form of a non-fungible (an asset that can be utilized more than once and service thereof can be separated from the asset itself. For example, a car being non-fungible can be used more than once; but its CNG or fuel as a fungible item cannot.) It also requires existence of the item having an income-generating capacity. For bai salam, full payment of price in advance by the buyer at a time is an essential element, whereas payment at a time is not essential for istisna. The subject of istisna is always a thing which needs manufacturing, while salam can be conducted on anything, no matter whether it needs manufacturing or not.

Nowhere in the above is there is any question of sharing in the loss or profit of the venture.

Similarly in the bond market of Islamic finance, sukuk may also be based on a fixed return based asset or a variable return based one. Both are compliant and can be floated keeping their respective characters intact. If it is based on leasing projects where fixation of the rental is a precondition, profit loss sharing may be irrelevant.

So Islamic finance must not be understood as limited or constraint to any specific profit loss sharing mode only. Islamic finance and banking must be learnt in totality. Let’s learn Islamic finance and try to disseminate its true spirit in the right way, so that no one can misuse it in the name of Islam.


Dubai Creek, UAE

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