Musharaka

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 most Muslims subscribe to. Many sources state there are two varieties of profit and loss sharing used by Islamic banks – Mudarabah (مضاربة) ('trustee finance' or passive partnership contract) and Musharakah (مشاركة or مشركة) (equity participation contract). Other sources include sukuk (also called 'Islamic bonds') and direct equity investment (such as purchase of common shares of stock) as types of PLS.'ostensibly Islamic Banks do not even make a pretense of attempting to disguise the role of market interest rates in a `diminishing musharaka`, and ... the `rental` rate is directly derived from conventional interest rates and not from any imputed `fair market rent`'.The fact, however, remains that the Islamic banks should have advanced towards musharakah in gradual phases .... Unfortunately, the Islamic banks have overlooked this basic requirement of Islamic banking and there are no visible efforts to progress towards this transaction even in a gradual manner, even on a selective basis.When it comes to the manner in which Islamic securities are offered, the process and rules for such offerings, even in those jurisdictions with special licensing regimes, are, in effect, the same. (For example, the rules governing the listings of Islamic bonds issued by the Securities and Commodities Authority of the United Arab Emirates are almost identical to the rules governing the listing of conventional bonds save for the use of word 'profit' instead of 'interest'. 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 most Muslims subscribe to. Many sources state there are two varieties of profit and loss sharing used by Islamic banks – Mudarabah (مضاربة) ('trustee finance' or passive partnership contract) and Musharakah (مشاركة or مشركة) (equity participation contract). Other sources include sukuk (also called 'Islamic bonds') and direct equity investment (such as purchase of common shares of stock) as types of PLS. The profits and losses shared in PLS are those of a business enterprise or person which/who has obtained capital from the Islamic bank/financial institution (the terms 'debt', 'borrow', 'loan' and 'lender' are not used). As financing is repaid, the provider of capital collects some agreed upon percentage of the profits (or deducts if there are losses) along with the principal of the financing. Unlike a conventional bank, there is no fixed rate of interest collected along with the principal of the loan. Also unlike conventional banking, the PLS bank acts as a capital partner (in the mudarabah form of PLS) serving as an intermediary between the depositor on one side and the entrepreneur/borrower on the other. The intention is to promote 'the concept of participation in a transaction backed by real assets, utilizing the funds at risk on a profit-and-loss-sharing basis'. Profit-and-loss-sharing is one of 'two basic categories' of Islamic financing, the other being 'debt-based contracts' (or 'debt-like instruments') such as murabaha, istisna'a, salam and leasing, which involve the 'purchase and hire of goods or assets and services on a fixed-return basis'. While early promoters of Islamic banking (such as Mohammad Najatuallah Siddiqui) hoped PLS would be the primary mode of Islamic finance, use of fixed return financing now far exceeds that of PLS in the Islamic financing industry. One of the pioneers of Islamic banking, Mohammad Najatuallah Siddiqui, suggested a two-tier model as the basis of a riba-free banking, with mudarabah being the primary mode, supplemented by a number of fixed-return models – mark-up (murabaha), leasing (ijara), cash advances for the purchase of agricultural produce (salam) and cash advances for the manufacture of assets (istisna'), etc. In practice, the fixed-return models – in particular murabaha model – have become the bank's favourites, as long-term financing with profit-and-loss-sharing mechanisms has turned out to be more risky and costly than the long term or medium-term lending of the conventional banks. Mudarabah or 'Sharing the profit and loss with venture capital', is a partnership or trust financing contract (similar to western equivalent of General and Limited Partnership) where one partner (rabb-ul-mal or 'silent partner'/financier), gives money to another (mudarib or 'working partner') for investing in a commercial enterprise. The rabb-ul-mal party provides 100 percent of the capital and the mudarib party provides its specialized knowledge to invest the capital and manage the investment project. Profits generated are shared between the parties according to a pre-agreed ratio. If there is a loss, rabb-ul-mal will lose his capital, and the mudarib party will lose the time and effort invested in the project. The profit is usually shared 50%-50% or 60%-40% for rabb ul mal-mudarib. Further, Mudaraba is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. Such participatory arrangements between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing the lender to monopolize the economy. Muslims believe that the Islamic prophet Muhammad's wife Khadija used a Mudaraba contract with Muhammad in Muhammad's trading expeditions in northern Arabia – Khadija providing the capital and Muhammad providing the labour/entrepreneurship. Mudaraba contracts are used in inter-bank lending. The borrowing and lending banks negotiate the PLS ratio and contracts may be as short as overnight and as long as one year. Mudarabah contracts may be restricted or unrestricted.