Banking Expert View

A Far More Interesting Reality

A major persistent myth about Islamic Finance is that it is a profit and loss sharing system.

I have seen this statement being repeated in many places: on TV, in social media, books, conferences, magazines, and newspapers. I have even had it mentioned to me in discussions.

This narrative pervades large areas of basic searches on the Internet. The usual story that seems to be told is that Islamic Finance is all about profit and loss sharing, but somehow Islamic Banks are utilizing less risky methods that whilst approved by scholars do not represent the true spirit of Islam.

I assume that what they mean, is that Islamic Finance is a type of equity participation between parties where both share in the profits or losses of a particular endeavor. Of course any business transaction involves the possibility of profit or loss, but what is meant here is basically equity-based type financing.

Or perhaps what is meant is that Islamic Finance in its origins in the past was essentially a profit and loss sharing system. Some perhaps believe that in the early period of Islam, transactions in society were all on an equity basis; and that over time, this was corrupted and new forms were invented replicating conventional banking.

This of course is an incorrect view.

I have no idea how this belief has arisen, or why so many people seem to hold this view. I can only guess that perhaps individuals have not spent enough time reading the literature on Islamic Finance (or perhaps the wrong literature). Or maybe they want Islamic Finance to be so different than Conventional Finance, which they view with suspicion. Or perhaps they simply haven’t read far enough in an article or a book. In the below examples, what I quoted was a small part usually appearing at the beginning of an article. If one reads the rest, one would surely see there are many methods of financing other than profit and loss sharing:

Profit and Loss Sharing, also called PLS or “participatory” banking is a method of finance used by Islamic financial or Shariah-complaint institutions to comply with the religious prohibition on interest on loans that many Muslims subscribe to.”  WIKIPEDIA

Profit and loss sharing (PLS) financing is a form of partnership, where partners share profits and losses on the basis of their capital share and effort. Unlike conventional finance, there is no guaranteed rate of return. 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). The justification for the PLS financier’s share in profit is their effort and the risk they carry, because their profit would have been impossible without the investment. If the investment makes a loss, their money is lost.” International Financial Law Review

Take a look at this paragraph from “an Introduction to Islamic Finance” by Mufti Muhammad Taqi Usmani:

“It is obvious that exclusion of interest from financial activities does not necessarily mean that the financier cannot earn a profit. If financing is meant for a commercial purpose, it can be based on the concept of profit and loss sharing.”

The problem is that this appears on page 7 of a great introductory book that is 169 pages long. Had the reader taken the time to read further, he would have seen that Islamic Finance is not an essentially a profit and loss sharing concept. Certainly, this view of Sharia-compliant business transactions was not prevalent in the classic literature. Quite the contrary, the classic literature points to a complex history filled with disagreements.

This view seems to be a product of the rise of modern day Islamic Finance. But it has become very popular and pervasive.

Islamic Finance, or Sharia-compliant business transactions were never only in the form of profit and loss sharing. There were numerous forms known throughout history in a variety of different names and rules, and they are well described both in classic literature and in modern Islamic banking.

The Arabian Peninsula like other regions in the world throughout history, had known commercial dealings between individuals, groups, and tribes. Such names as Qirad, Musaqaat, Muzaraah, Musharakah, Mudaraba, and Ijara, etc. were common at that time. These commercial dealings (in addition to other non-commercial relationships) are known in Arabic as “Muamalat”, meaning “dealings” or “arrangements”.

Islam did not invent these types of transactions. Islam modified, fine-tuned, prohibited some aspects, required certain disclosures, and clarified the responsibilities and rights of some of the participants. Basically, Islam became the Regulator of the market. Sharia, as understood by the early Muslims was meant to create a level playing field in the market, to ensure fair trading, and to protect the weak. Essentially, to establish “Economic Justice”. Over time a new area of legal inquiry took shape called “Fiqh Al-Muamalat” or simply “understanding arrangements”. Whilst this also deals with relationships between individuals as in family, we are concerned here with the commercial aspects only. There is a wealth of classical literature on the subject, contained in great books such as: Al-Muwatta by Imam Malik (8th Century), Al-Udda by Al-Maqdasi (13th Century), or Umdat Al-Salik by Al-Misri (14th Century).

My favorite is “Bidayat Al-Mujtahid wa Nihayat Al-Muqtasid” by Ibn Rushd (12th Century) known in its English translation as “The Distinguished Jurist’s Primer”. The book is a tour de force of Islamic Jurisprudence, comparing the different schools of thought. A couple of quotes would suffice to give the reader a flavor of Islamic transactions and names given to each; names that are still used today by Islamic Banks. These quotes should remove any idea that Islamic Finance was originally a profit and loss (equity) sharing system.

“ Each transaction between two individuals is an exchange, either of corporeal property for corporeal property, or of corporeal property for a corresponding liability, or of a liability for another liability. Each one of these three is either delayed or immediate . . . Delay from both sides is not permitted by consensus either in corporeal property or in liabilities . . .”

“The names of these sales are derived from the condition of the goods being exchanged and the form of the contract of sale itself…When a currency is exchanged for a currency the sale is called sarf; when a currency is exchanged for a priced commodity the transaction is sale proper (bay) . . . When corporeal property is exchanged for a liability, the sale is called salam . . . If it is made with a stated profit (mark-up) it is called murabaha…”

We can also look at en example from Umdat Al-Salik (14th Century) now translated into English with the title of “Reliance of the Traveller – A Classic Manual of Islamic Sacred Law”. This section discusses Ijara (Rent):

“Lexically, rent (Ijara) is a name for the rental fee. In Sacred Law (i.e. Sharia) it means to take possession of a utility or service for payment under certain conditions. It has four integrals…A rental agreement is only valid between two persons entitled to conduct sales.”

There is no end to examples like the above in classic literature. I give these examples to show the level of discussion of the variety of commercial transactions and the conditions necessary for them to be compliant with Sharia. Nowhere to be seen in these books is any indication that Sharia demands a profit and loss form of business dealings.

Islamic Banks today use much of the same terminology and rules as then.

I believe that a combination of factors are influencing people’s views and sustaining the myth that Islamic Finance is a profit and loss sharing system: A lack of knowledge of the history of commercial transactions in the Arabian Peninsula and the subsequent Islamic Period, a lack of knowledge of the details of Sharia in general and specifically Fiqh Al-Muamalat, and lastly, a suspicion of all banking. This produces a wish to separate Sharia Compliant finance from its conventional counterpart and recreates the history of Islamic commerce.

I would recommend any reader interested in this subject to simply read freely available literature on the Internet as well as watch the many available videos on YouTube on Fiqh Al-Muamalat by for example such scholars as Sheikhs Al-Ruhaili or Al-Khathlan who have series of lessons. I understand that for some many of these sources are in Arabic but there is still plenty enough that is in English.

It’s very important that this erroneous view of Islamic commercial transactions and Islamic Finance is corrected. Otherwise, the potential exists that Muslims will have a higher level of mistrust of Islamic banking, which in turn would limit its growth.

Islamic Finance is NOT a profit and loss sharing system, and it NEVER was. It is a regulated system that has evolved in an effort to establish economic justice for humanity. But in its imperfection, its many forms, its disagreements between schools of thought, its multitude of names, its complex set of rules, and especially in the wonderful personalities of its classical scholars, it is truly a far more interesting reality.