MISUNDERSTANDINGS ABOUT ISLAMIC BANKING How to move from debt-based to participatory modes of finance AMJAD BANGASH

One of the most important characteristics
of Islamic finance is that it is based on the
principles of profit and loss sharing (PLS). However,
presently, we see over 90% of financing by Islamic
banks is structured around debt-based modes
like murabaha (deferred sale), ijara (leasing) and
tawarruq etc. Due to this phenomenon, most of the
people see no difference between both systems
due to similar end results. Many Shari’a scholars
initially allowed use of debt-based modes in dire
need and for some transitory period. However,
at present, practically this is not the case. Most Islamic economists view participatory modes of
financing like musharaka, mudaraba, and muzara’a
etc. as authentically Islamic. Having said that, both
Islamic banks and other such financial institutions
and their customers prefer to use debt-based
modes. This begs questions:
• Are the participatory modes or PLS really Islamic?
• If yes, why are even Muslims reluctant to use them?
Murabaha and ijara have in the Islamic history never been used as modes of financing. In the
contemporary practice of Islamic banking and
finance (IBF), they have been reshaped so that
they could be used as modes of financing, subject
to certain conditions. This article explains that
even though the current practice of Islamic banks
of using debt-based instruments has resemblance
with conventional banking instruments, yet it is
different in many respects. Nevertheless, the
article asserts that there is a need to shift from such
modes to the genuinely authentic participatory
modes. The challenge is how to structure them to
make it feasible for Islamic banks and customers to
use them.

Contemporary paper money has no intrinsic
utility. It is only a medium of exchange. Each unit
of money is 100% equal to another unit of the
same denomination. Therefore, there is no room
for making profit through exchange of these units,
inter se, as is the case with interest-based lending.
Profit should be generated when something
having intrinsic utility is sold for money. When a
financier contributes money on the basis of Islamic
instruments it is bound to be converted into the
assets having intrinsic utility. Profits are generated
through the sale of these real assets. This is a very
basic difference between the two systems even if
it provides the same end results as conventional
interest-based lending.
Let us take an example to further explain the
concept at a very basic level. All human beings are
created with in-built desires like they feel hungry
and thirsty, and that they want to look beautiful,
need to earn money to buy goods, etc. However,
there are divine guidelines on how to satisfy these
desires. Islam, and for that matter other religions, have prescribed certain principles how to satisfy
our desires. There are two ways to satisfy desires,
i.e., as per the law or illegally. For example, if a
person is feeling hungry, he may steal a piece of
bread and eat it to satisfy his desire (hunger) or
alternatively use money to buy a piece of bread to
eat. The apparent end result would be the same,
i.e., to satisfy hunger, but one is acceptable and the
other is not. Similar is the case with interest and
trade. In both the cases, there is an excess but trade
is allowed and interest is not allowed since trade
results in overall economic improvement while
interest becomes part of an artificial economy. It
means that it is the underlying transaction that
makes something permissible and not the apparent
end result itself, therefore, we can say it is not just
change of name, as many understand it as such,
rather it has well defined principles which helps to
avoid involvement in interest-bearing transactions
– unethical & immoral practices.

Few of the widely used Islamic modes of financing,
which are the backbone of IBF industry are
explained below.

Murabaha refers to a contract in which an Islamic
bank purchases goods upon the request of a client.
Bank adds defined percentage of profit on the cost
price of the goods, which results into sale price.
Customer pays the sale price either in lump sum
or in installments in future. It looks similar to an
interest-bearing loan where interest is added to
the principal amount and payment is deferred.
However, in reality, it is not the case, since in
murabaha, money is used to buy goods, and the
goods come into the possession and ownership
of bank, which means bank bears the risk before
selling it on to the customer. Since bank becomes an owner and owner has the right to sell its owned
goods at any market price, this is a Shari’a compliant
mode. In murabaha, once price is fixed, it cannot be
changed, which is not the case with interest-based
lending where the rate may change.

It is an alternative to leasing. An Islamic bank upon
the request of customer purchases a leasable asset
and leases it to customer against a defined agreed
rent (installment) for a defined time period. The
bank remains the owner of the asset throughout
the term of lease and bears the risks and expenses
pertaining to ownership of the asset. Now again it has resemblance to conventional leasing where
bank arranges asset to customer who pays
installments. The amount and payment structure of
installment is usually similar to that of a conventional
lease. Moreover, the Islamic bank may also create
mortgage, if legally the asset has to be in the name
of the customer (due to lack of legal framework and
to avoid double taxation). In such an instance, the
bank executes sale agreement with owner of an
asset to attain ownership rights, while keeping the
legal title in the name of customer. Many observers
question the permissibility of such an arrangement.
However, in better structured ijaras, there is a huge
difference between the Islamic and conventional
leases, as in such ijaras Islamic bank is responsible
for the loss of the leased asset (being its owner),
which is not the case with conventional leasing.


It is a kind of mechanism where a customer who
is in need of cash, requests an Islamic bank to
arrange cash for him. Conversely, when an Islamic
bank feels that normal Islamic modes of financing
will not work to get liquidity, the option of
tawarruq or commodity murabaha is used. Under
this mechanism, the customer (i.e., the buyer)
signs an order to purchase, indicating the intent to
purchase the commodities through London Metal
Exchange (or any other commodity exchange)
from a bank (i.e., the seller). The bank then buys
a commodity usually metals. Once, the bank has
completed the purchase from the commodity supplier, it offers to sell the purchased commodity
to the client on murabaha with deferred payment
basis. Post-acceptance, the bank simultaneously
sells these metals on behalf of the client on spot
basis and crediting the proceeds of the sale in
the client’s account. In essence this transaction
generates liquidity for the client. Shari’a allows it
since it is based on the concept of sale, which is
valid if it meets all the elements required for sale.
It is criticised since actual purpose is not the sale
rather a mechanism is developed to get cash.

This paper discusses muzara’a (sharecropping) and
musharaka as examples of participatory modes.

The participatory modes have features of
investment and risk diversification for both the
banks and the customers, which, if implemented
properly, may lead to huge economic growth and
employment generation in the economy. This will
enhance commitment by and cooperation between
both parties to ensure the success of the business.

Under this model, a customer and a bank enter into
a partnership based on musharaka whereby the
bank acts as a sleeping partner while customer acts
as an active partner on the bank’s behalf. The funds
are used in the customer’s operating business, up
to an agreed limit, during a given period (say for one
year) as per agreed sharing ratio while loss is shared
as per investment ratio. For calculation of profit, a
weightage system is defined and agreed between
the parties while reserves from the profits may be
created to avoid losses. The customer is allowed
to invest the funds of other investors (including its
equity holders) in the musharaka pool (which is the
business of the customer). Customer account may
be opened in the bank where a limit is sanctioned
to withdraw and return funds as per the business
cycle. At the end of the tenure, the bank calculates
its investment in the musharaka pool (i.e. the
customer’s business) based on daily balance basis,
i.e., the end of the day outstanding balances (the
balance of funds utilised by the customer at the
end of each day). The formula for this is as follows:

Bank’s Musharaka Investment for the Period (BMIP)
= End of Day Outstanding Balances in Running
Musharaka Account divided by No of Days in the
Musharaka period

As per the rules of musharaka, the equity capital of
the customer in its business is taken as customer’s
investment in the pool (i.e., the customer’s
business. The business is thus considered as a
running business based on running musharaka. At
the end of financial period the customer analyses
the actual earning from the business in a year. If
there is a positive earning in the pool, it is shared
as per agreed ratio and if there is a loss it is also
shared as per the investment ratio.

This model is based on the concept of PLS and both
the bank and customer are actually involved in real
business, which is indeed the best characteristic of
Islamic banking. This mode requires more research
and further scrutiny.

The word muzara’a is derived from the root word
“zara’a” which signifies crop. It has been defined
as a form of partnership between the landlord
and agricultural labour whereby the production
outcomes are shared according to agreed terms.

Muzara’a is defined as a participatory form of
financing between the farmer and financier with
the agreement to share the output in accordance
with a pre-determined ratio.

Due to the participatory nature of muzara’a, the
provider of capital acts as a partner and possesses
every right to closely supervise the activities of the
entity being financed, a practice that is different
from the conventional loan. This mode of financing
will assist the producer to minimise the cost of
capital by not being burdened with a risk that is
beyond his ability. This signifies that whatever
losses incurred during the cultivation period as a
result of natural hazard and the effect of weather
will be shared between both parties. The most
important parties and their roles under muzara’a
can be described as under.

The Islamic bank acting as a partner enters into
a muzara’a contract with a farmer by providing
funds meant for farming activities and share the
crop outcomes based on an agreed proportion. In
addition to the provision of funds for procurement
of seeds and chemicals, it also ensures that other
support services such as efficient transportation
and storage equipment are in place to maximise
profit by reducing wastage. In addition to this,
bank will also regularly monitor the activities of the
farmer and may provide agricultural expertise and
support through its agriculture division. It will also
provide macro and micro economic data related to
the sector and predictions about prices, demand
(marketing expertise) and market dynamics. The
Islamic bank has to do this because the farmer is its
partner; its contract with the farmers is based on
PLS. It has to do all these in order to avoid losing their investment. In such a model the relation
between the financial institution and the farmer
is no more debtor-creditor; it is a partnership.
Partnership requires coordination and cooperation.

The farmer also agrees to enter into muzara’a
contract with the bank by contributing in the form
of labour and/or land and sharing the crop output
based on an agreed proportion. The farmer is
responsible for growing, maintaining the crops and
selling them to customers or industries that use
them as their inputs. The farmer is also required
to provide actual qualitative and quantitative data
on their activities and production, and reports
any problem on time. They have to do this in their
own interest and because the financial institution
is their partner not their creditor. Based on the
above, below is draft structure for execution of
muzara’a transactions.

The Islamic bank enters into muzara’a contract with
the farmer(s) to provide financing for procuring the
necessary inputs and logistics related to agriculture
while the farmers contribute in the form of labour
(and or land). The bank may facilitate the farmers in
providing logistic support to deliver their produce
to the market as and when the produce is ready. The
profit/loss from the sales will then be distributed
between the parties based on an agreed profit and
loss sharing ratio.

There are two common issues:

Islamic banks do not have an expertise to actually
or practically participate in business and or farming
activities of the customer. However, the Islamic
bank can either make the customer or third party
as an agent or can train some of their staff to have
the knowledge, since it is necessary to achieve
maximum profit that is not fixed.

There is a risk factor, however, which many banks
don’t want to assume. The nature of risk in the PLS
modes is different from the plain vanilla credit risk
in the loan contracts.

The recent global financial crisis is a lesson for
the banks to be more involved in PLS investments
rather than financing based interest. Participatory
modes of financing are a viable investment means
for the Islamic banks to get acceptance from
different stakeholders. The customers should
also like it, as their income will rise. Furthermore,
it is beneficial for the economy as participatory
arrangements may reduce inflation, since less
money will be created in the economy. On the
other hand, inflation is inevitable in a financial
system that is based on interest.

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