Profit and Loss Sharing System v. the Interest System

Profit and Loss Sharing System v. the Interest System

Introduction

Many capitalist countries around the world have adopted the interest-based economic system. The Islamic religion prohibits riba in all its forms. Riba not only refers to usury, which is excessive interest charged on loans, but it also refers to other forms of interest on loans. Some of the Muslims who support and use the conventional banking system claim that interest is not a form of riba. However, a careful analysis of the Quran reveals otherwise. Although many Muslims know this, they continue to exercise different forms of riba. Most economies, even in Islamic countries have become secularized. It has become increasingly hard for Muslims to do business in any other way because they have to depend on the conventional banking system. They are therefore forced to compromise on their beliefs, because they use conventional banks which charge interest on loans, and which pay interest on deposits. Some countries and economies have made the effort of adopting the profit and loss sharing system, which is an interest free system. Although faced with many challenges, this system is more acceptable in the Islamic faith, as it follows the rules set in the holy book, Quran. It is in line with the Islamic legal system of shari’a. Both the interest based system and the profit and loss sharing system have their advantages. However, the profit and loss sharing system is a more efficient in allocating available liquid funds in the economy.

Discussion

The profit and loss sharing is an arrangement that is based on contract between two or more transacting parties. This system enables the parties to pull their resources together, and invest in a project, after which they share the profit or loss realized from the project. This means that the people depositing their money in the bank are not only the banks’ clients, but they also act as shareholders since they have some ownership. The parties involved in the transaction share the risk equitably, depending on the level of participation between the parties. The party providing the finance or the money does not benefit from any interest. Since the investors do not benefit from any interest, the banks and other financial institutions have to find ways to encourage more investors. The mudaraba and musharaka enables the depositors to share in the profits made by the bank. The system is a just way of serving the people because the borrower only needs to repay the amount that he or she had borrowed. In some cases, borrowers repay the money, and they contribute gratuity for the services they have received. It uses a return bearing instead of contracts based on interest.

The interest-based system is not an efficient method of allocating funds in the economy because it tends to rely more on the Keynesian principles and theory. According to the Keynesian theory, the marginal efficiency of investment and the demand and supply for money are vital components to consider when lending money. Most financial institutions finance a project if the marginal efficiency of investment is equal to or greater than the interest rate. The supply and demand of money affects the interest rate. Most of the interest-based systems follow this principle. Lenders cannot finance a project if it does not meet this condition (Ahmad). Lenders offer loans to people that meet the specified condition, and they do not consider the quality, suitability, and profitability of their projects.

The interest-based system is selective and tends to practice favoritism in allocating funds. It treats large corporations and medium enterprises differently. It gives priority to large corporations and it provides them with better borrowing terms (Ahmad). Banks in this system lend to the people they know well or to public enterprises. It does not consider how the different corporations will use the allocated funds. In some cases, banks have incurred huge losses after they gave priority to public institutions, which ended up failing or shutting down. It is therefore important for lenders to consider the quality and profitability of the project, before lending money to an institution. The interest-based system is more concerned with the credit worthiness of an institution. This locks out many individuals and small corporations with viable and profitable projects.

The smaller corporations find it difficult and challenging to get finances from the formal interest based systems such as banks, and they end up seeking financial help from informal interest based institutions such as loan sharks, where they pay very high interests. Even when the conventional banks have allocated some funds to go towards financing small scale and medium scale ventures, the banks put in credit ceilings, cumbersome formalities, and heavy guarantees, which end up discouraging borrowers. When these banks do allocate some funds to the small enterprises, they do not give them enough money to complete and initiate their projects. This has often led to the failure of some of the projects because the money is not usually enough for their business to grow.

Financial Tools

Mudaraba and musharaka are two ways of earning profit while avoiding interest. In mudaraba arrangement, one of the involved parties provides the needed finance capital, and the other party provides the human capital, to perform the economic activity. Mudaraba arrangement is often applied on short-term basis. The entrepreneur utilizes the capital he has received from the investors, and he gives them a pre-specified share of the revenues. He keeps the remaining share as part of the reward for his efforts. This is based on the personal confidence, efficiency, dedication, honesty, and work ethic of the entrepreneur. In case the investment or business venture fails, the investors incur the loss. The entrepreneur’s loss is the time, effort and labor that he spent on the venture.

In musharaka arrangement, partners use their financial capital needed to undertake the economic activity. Partners use the musharaka arrangement on long-term basis. The partners share the profits according to a pre-agreed ratio, but they share the losses according to their proportion of the capital (Hassan and Lewis 51). Since musharaka arrangement is a partnership, all the partners have the right to manage the affairs of the venture. However, this is not mandatory, as the partners can agree to select one or a few members to handle the company’s affairs or the business project. In this arrangement, members have unlimited, and equal partnership. When all the members decide to work together on the project, the decision made by one member is seen as collective agreement. Each member acts as an agent of the other members, or as a guarantor of the other partners.

The profit and loss sharing system increases the number of different investment projects. Other than the mudaraba and musharaka, Islamic banks have developed other financial instruments that comply with sharia. Most Islamic banks have adopted murabaha, because it ensures that they profit from the transaction. The bank agrees to buy the asset from a third party and resells the asset to the client (Hassan and Lewis 52). The concept involves the bank buying the items needed by the entrepreneur, marking up the items, and then handing them to the entrepreneur. The banks mark-up the items with the price of its compensation. The entrepreneur then pays the loan and the mark-up price. Unlike the interest charged at conventional banks, the Islamic banks do not penalize the clients for any late payments, and the mark up price does not increase in value, regardless of the time passed. The markup price represents the services that the bank conducts on behalf of the client. Moreover, the mark up is not based on money lending, but it is based on delayed payment (Hafez 91). This system ensures that the banks are fair and just towards their clients.

Banks can also choose to use ijara, which is the equivalent of a lease in conventional terms. Under this system, a bank buys an asset, which it then leases to its clients at a fee. The bank maintains the responsibility of insuring the asset and making sure that it is maintained properly. The bank can renegotiate the terms of the lease with the client at agreed intervals. This gives the bank a chance to avoid incurring risks because the bank renegotiates the price according to the market rates. Under the ijara wa iqtina arrangement, the client can decide to purchase the asset after the rental period (Hassan and Lewis 52). In ijara, the investors utilize the funds by purchasing a durable asset, which they utilize rather than consume. That means that the leased asset should not be perishable or consumable. The client must use the asset for the purpose it was intended, and he has to follow the provisions in the contract. The client should also benefit from utilizing the asset, in more ways than what is included in the contract. This is because the asset provides a way for the client to pay the agreed lease amount and realize some profits from using the asset. At the end of the lease period, and in the absence of ijara wa iqtina, the client must return the asset to the bank in a good form. The client must pay for any negligence on his part (Iqbal 109-113).

Banks use istisna, where they transact a commodity before they see it. The client requests a manufacturer to manufacture a specific product at an agreed price. Any of the parties involved in the transaction can cancel the order before the work begins. The manufacturer has a moral obligation to manufacture the product once all the parties agree on the terms. The manufacturer has to ensure that the product meets the specification agreed on by all parties to ensure that the client does not retract (Iqbal 117). Another financial tool used in profit and loss system is salaam. Salaam is most often practiced in agricultural economies. The concept of salaam involves the seller, Muslam ilaih, supplying some products, Moslem fih, to the buyer, Rabb-US-Salam, at a future date in exchange for an advance price, ra’sul-mal, which the buyer pays on the spot. In agricultural economies, the bank makes the transactions with the farmers because they expect the farmers to have a harvest at a specific time.

Sukuk is the most recent introduction in Islamic banking. It serves and benefits those who are looking for alternatives to interest-based banking. Most investors interested in financial markets are wary of trading in conventional markets, because the markets associate in the trading of unlawful products such as alcohol. Bond issuance is an accepted way of investing. However, most of the bond trading involves payment and receiving of interest. The sukuk is structured in a different way, in that the investment market bases the bond issue on the exchange of an approved asset, such as infrastructure. All the assets have to comply with sharia law (Hassan and Lewis 53). For instance, investors cannot base their assets on a casino because it involves gambling. Most Islamic governments and corporations use sukuk as a means of financing.

The concept of profit and loss sharing encourages the lenders to find more ways to invest in profitable ventures so that they can avoid incurring any losses. It is a way of allocating the liquid assets available in the economy, as the lenders find ways of investing the assets. Conventional banks are concerned about profitability and loan defaulters. They charge interest to ensure that they remain profitable. The banks remain profitable so long as the borrower keeps paying the interest. This is not a just way of serving people because it continues to depress them financially. The conventional banking system does not consider the financial situation of the entrepreneurs, and will require them to pay interest even during financial and economic difficulties. Islamic financial institutions depend on the returns of their physical investments. Their profitability depends on the real rate of return.

Risk Management

Profit and loss sharing systems have a better way of managing risk, and they provide better financial stability. Investors are cautious and more selective concerning their investment projects, and this reduces the financial risk and chances of incurring losses. Many countries around the world suffered during the financial crisis that began in 2007. This was especially the case in most interest-based economies. The profit and loss sharing system ensures that both the person providing the capital and the person receiving it share the risks. The lenders consider the borrower’s financial state during periods of economic crisis. The rate and state of payment are flexible, and lender adjusts them according to the economic situation. Borrowers pay smaller amounts of their loans during hard economic times. The same concept does not apply in interest-based system. There is poor risk management in interest-based system.

Partnership and Trust

The profit and loss sharing system encourages partnership between the parties. It encourages the lenders to build a long-term relationship with the borrowers. The lenders are able to advice the borrowers concerning profitable ventures, and the financial economy. This is generally good for the economy because it ensures that businesses remain profitable. There is less financial risk and implications during periods of economic meltdown. In interest-based system, the borrower bears a larger part of the risk involved. This is different in the profit and loss sharing system, where the lender incurs the risk. Although this may mean a loss to the lender, it ensures accountability and responsibility on the part of the lender. The lender is more cautious and makes better investment decision because he or she does not want to incur any losses. Lenders are more careful about where they invest their client’s money. It also eliminates any chance of greed on the lender’s part. In most conventional banks, the lenders are more concerned about profits and some are greedy for more money. They look for risky ways of investing so that they can make more money. The profit and loss system eliminates this option.

Better use of money

The concept of Islamic banking and the profit and loss sharing mechanism ensures that borrowers use the money they borrow for their intended purposes. This instills accountability on the borrowers’ part. It ensures that the borrower will use the money for business, which will enable him to repay the money. The banks follow the entrepreneur’s business to ensure that it is in operation and that it is realizing some profits. In conventional banking, borrowers are sometimes tempted to use money for other reasons, other than the ones they had indicated when they were applying for the loans. In most situations, banks do not follow the borrowers, since they are mostly concerned about the loan and interest repayments. The borrowers can use the money in whatever means they choose, so long as they find ways of paying the interest. This has led to an increasing number of loan defaulters, and it has led to huge losses for the banks since they have to write off some of the loans.

Economic Development

The profit and loss sharing system is one of the most effective ways of ensuring economic development. This is because it provides loans to profitable projects, despite a person’s financial status. Banks are more interested in the quality of the proposed project in terms of profitability, and the integrity of the client, rather than the securities that the client can provide (Hafez 90). The bank does not deny a person with a profitable project a chance to pursue the project because it will share in the profits. Most conventional banks are concerned with short-term profitability. In most cases, they do not give loans to people with projects that seem to have a long gestation period. Conventional banks often depend on the client’s record of accomplishment in deposits and loan repayments, before deciding to give the person a loan. This does not happen in the profit and loss sharing system. This means that Islamic banks tend to encourage and support more entrepreneurial development than conventional banks (Hafez 90).

Conclusion

The profit and loss sharing system utilizes many financial tools, which helps it to allocate liquid assets effectively. These financial tools include salaam, istisna, ijarah, murabaha, mudaraba, and musharaka. These financial tools comply with the Islamic legal system of shariah law. They are not based on interest, and they are fair and just to the clients. The financial tools ensure effective allocation by investing the funds in many different projects. The interest-based system is not as effective as the profit and loss sharing system. Not only does it exploit the people by charging interest, but is also risky, and it does not have an effective way of allocating liquid funds. The main goal of the interest based system is to make a profit by charging the clients interest. The profit and loss sharing system is a good way to grow the economy because it assists people with profitable projects. The interest-based system is prejudiced because it tends to favor wealthy individuals and large corporations. On the other hand, the profit and loss sharing system ensures that it allocates the funds to all the people in need irrespective of their credit-worthiness or status in society. These factors make the profit and loss system the most efficient way of allocating the liquid funds in an economy.

Works Cited:

Ahmad, Y. Abdel-Rahman. The Economic Rationale of Riba (Interest) Prohibition in Islam.

Hafez, Kai. The Islamic World and the West: An Introduction to Political Cultures and International Relations. The Netherlands: BRILL, 2000. Print

Hassan, Kabir and Mervyn Lewis. Handbook of Islamic Banking. United Kingdom: Edward Elgar Publishing, 2007. Print

Iqbal, Jaquir. Islamic Financial Management. New Delhi, India: Global Vision Publishing Ho, 2009. Print

Sugema, Iman and Toni, Bakhtiar. “Interest versus Profit-Loss Sharing Credit Contract: Efficiency and Welfare Implications.” International Research Journal 45 (2010): 58-68

Last Completed Projects

Are you looking for a similar paper or any other quality academic essay? Then look no further. Our research paper writing service is what you require. Our team of experienced writers is on standby to deliver to you an original paper as per your specified instructions with zero plagiarism guaranteed. This is the perfect way you can prepare your own unique academic paper and score the grades you deserve.

Use the order calculator below and get started! Contact our live support team for any assistance or inquiry.

[order_calculator]