Challenges of implementing profit and loss sharing (PLS) financing in Islamic Banking.
Introduction
Despite of the momentous evolution of Islamic banking industry in the recent years, the
insignificant implementation of the Profit-sharing (PLS) financing (Musharakah &
Mudarabah) by the Islamic banks has prompted many uncertainties at the essence of Islamic
banking industry. The current practice of Islamic banks towards their financing activities are
basically based on debt-based financing instruments such as BBA, Murabahah and Ijarah, and
these products dominated all other kinds of Islamic financing.
Some proponents of Islamic banking pointed out that the dominance of fixed income modes of
financing is very critical (Chapra 1985, p.171 and Siddiqi 1983, p.139). They argued that using
fixed income instruments do not represent the true essence of Islamic banking principles, but
it only confirms the status quo of Islamic banks.
One of the main characteristics of Islamic finance that distinguishes it from the conventional
financing is that Islamic banks comply with Shari’ah law (Islamic law). Islamic law strictly
prohibits the use of riba (interest) and gharar (uncertainty) and Qur’an (2: 275–76) clearly
mentions that dealing with riba is ‘sinful’. However, Islam gives the ummah various
alternatives for engaging businesses i.e. ‘profit-loss sharing’ (PLS) financial transactions. PLS
promotes to increase the level of businesses among the society (ummah) that latter sparks the
rise of wealth of Muslims.
Islamic banks offer financial products which comply with Islamic principles. As of the first
quarter of 2017, equity-based financing or PLS contracts accounted for less than 5 percent of
the total financing of Islamic banks. In contrast, debt-based financing combined more than 70
percent in the same period (Suzuki & Miah, 2018). This manifests that Islamic banks are
reluctant to participate in equity based or PLS financing.
1
Many scholars have provided different explanations for the tendency of Islamic banks to avoid
PLS financing. Some scholars stated that the purpose of using debt-based financing is that
Islamic banks are risk averse and equity-based financing is riskier than debt-based financing.
For instance, Profit and loss sharing financing (Mudarabah/Musharakah) involve the risk of
asymmetric information wherein the entrepreneur has much better information than the Islamic
bank as the Islamic bank acts as a silent partner. Hence, this one of the reasons why Islamic
banks do not prefer to undertake PLS financing. In addition, Islamic banks can encounter
difficulties to monitor the entrepreneur ( Mudarib) to ensure whether the Mudarib is using the
fund as the interest of both parties.
Objectives
The objectives of this study are to identify obstacles and challenges surrounding to the
implementation of profit and loss sharing (PLS) financing in Islamic banks. The paper also
discusses some arguments of Muslim scholars about the negligence of PLS among Islamic
banks
Methodology
The methodology uses in this paper is to critically analyse the current literature review of profit
and loss sharing financing in Islamic financial institutions to find out the constraints of PLS
financing. PLS financing is widely discussed by Islamic economists to figure out the reasons
behind the reluctance of Islamic banks to implement it. As Islamic economists argue that
Islamic banks are based on taking risk and reward proportionally, they carry out many
researches to find a way to convince Islamic banks to adopt equity-based finance.
Profit and loss sharing financing in the theory of Islamic banking
Since Islam prohibits interest earnings from financial deal, it does not mean that the financier
is incapable to generate profit. In order the investor to confirm financial gains on the principal
amount is definitely associates with risk undertaken on the investment (Siddiqui, 1987).
2
Although there are various types of Islamic finance to avoid interest (riba), Musharakah,
Mudarabah and Murabaha are modes that can be replaceable for Riba. Musharakah is based
on on profit-loss sharing partnership that undertakes risk and reward proportionally. Albeit
certain financial banks are reluctant to practice such a form of financial instrument for risk
aversion, Musharaka is so far regarded as one of the most accurate methods of finance that
Shari’ah approved. The validity of Musharaka instrument is based on the Qur’an, the Hadith,
and the Muslim jurists Ijma (consensus). The Qur’anic verses that usually referred to
partnership share include (Al-Nisa: 12), (ArRum: 28).
Many Islamic economic experts and scholars have demonstrated the significance of profit-loss
sharing mode in Islamic financing. Ahmed (2006) argued, there is equivalent substitute of
financing mode for Musharaka and Mudarabah and suggested to practice such instrument.
Mentioning the important position profit-loss sharing financing, Chapra (2007) stated that
socioeconomic benefits and exclusion of Riba may not be clearly comprehensible without
profit-loss sharing instrument in the Islamic financing. In the consensus of Muslim scholars
about the issue prohibition of Riba and implementing profit-loss sharing was the basic
proposition in the system of the Islamic Banking (Personal & Archive, 2017).
Current status of profit and loss sharing financing by Islamic Banks
The current practice of Islamic banks across the world reveals that the majorities of financing
activities are not based on equity, but it is a form of debt-based instruments. According to
(Asutay, 2007), Islamic banks constantly seek for profitable financing with less risky such as
murabahah rather than of musharakah and nudarabah. In addition, Islamic scholar Omar Farooq
pointed out this phenomenon as murabaha syndrome since the Islamic Banking and Financial
Institutions excessively use debt-based financing as their products. It is quite evident from the
3
following data that the application of Musharakah and Mudarabaha are very low compared to
Murabaha financing in Malaysian Islamic banks.
Mode of financing Volume
Murabaha 227,643.2
Mudarabah 80,421.2
Musharakah 54,419.5
Source: Islamic Financial Services Board (IFSB), Malaysia
As we can see from the above table, Murabaha which also known as debt-based financing has
the highest volume than Mudarabah and Musharakah. Although scholars emphasize its
importance, Islamic banks are not practicing it intensively. Therefore, (Rahim & Rahman,
2007) argued that this kind of financing is not helping the growth of economy as the business
people cannot get enough financing to invest in various business sectors.
References
Asutay, M. (2007). Conceptualisation of the second best solution in overcoming the social
failure of Islamic banking and finance : examining the overpowering of Homoislamicus
by Homoeconomicus. Journal of Economic and Management, 15(2), 167–195.
Retrieved from http://dro.dur.ac.uk/4531/
Personal, M., & Archive, R. (2017). Munich Personal RePEc Archive Evolution of Islamic
Economics : A critical analysis. (71911).
Rahim, A., & Rahman, A. (2007). Islamic Microfinance: A Missing Component in Islamic
Banking. 2, 38–53.
Siddiqui, M. N. (1987). No Title. Partnership and Profit-Sharing In Islamic Law. Leicester,
UK: The Islamic Foundation.
Suzuki, Y., & Miah, M. D. (2018). Dilemmas and Challenges in Islamic Finance. In
Dilemmas and Challenges in Islamic Finance. https://doi.org/10.1201/9781315105673
