How To Move From Debt-based To Participatory Modes Of Finance
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.
INTRODUCTION
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 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 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
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.
IJARA
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.
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TAWARRUQ OR COMMODITY MURABAHA
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 the actual purpose is not the sale rather a mechanism is developed to get cash.
PARTICIPATORY MODES
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.
THE RUNNING MUSHARAKA MODE
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 the investment ratio. For the 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.
RUNNING MUZARA’A MODE
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 the 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.
Amjad Bangash is the Chairman of Shari’a Advisory Board of Dar ul Ilm Ltd Trinidad. He is also serving as Head of Shari’a Department of an Islamic banking entity in Oman. He holds a Master’s degree in Islamic Finance, IFQ from CISI UK and is currently pursuing a PhD in Shari’a. He is an expert in Islamic commercial jurisprudence.
PRACTICAL ISSUES IN PARTICIPATORY MODES
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 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.
