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Introduction
The Islamic finance system, especially banking, provides an alternative model that differs from the conventional framework. Precisely, Islamic banking is designed in a manner that interest or riba is not charged. However, such riba-free institutions can participate in legitimate mechanisms and modes of trade, including financing through the Profit Loss Sharing (PLS) theoretical approach. This framework requires banks to look for portfolios and instruments that generate high profits while guaranteeing liquidity if they have to record optimal productivity. While Islamic banking theoretical approaches are anticipated to provide a risk-shared approach, various criticisms have been raised. For example, as an industry, Islamic finance, and more specifically Islamic banking, has neglected the Profit and Loss Sharing (PLS) model originally regarded as its main mode of operation by theorists of Islamic economics. This paper confirms that indeed Islamic banking focuses more on sales-based and lease-centered models, as opposed to the recommended PLS.
Criticism Justification
The available literature on Islamic finance mainly dwells on profit-sharing (Swartz 49). This arrangement entails the establishment of a contract among various parties engaging in transactions with the goal of collectively pulling resources together. Their objective is to invest the resources to generate profits. Losses or profits generated are shared proportionately among the corresponding parties. This approach ensures that no party bears full responsibility or load in case losses are encountered. Echchabi and Azouzi agree with this assertion by noting that almost all models of Islamic financing are based on the musharaka or mudaraba (34). However, Rahman observes that today’s Islamic banks and various investment companies use “mark-ups, leasing, and commissioned manufacturing as the project-financing basis (153). In these approaches, PLS only constitutes a marginal feature in Islamic finance and banking.
Islamic banks have recorded success since the adoption of the PLS theoretical model. However, according to Ayub, while an investigation on Islamic finance literature may suggest that such financial organizations use the PLS model as the basis of their success, this position is contested in practice (76). For instance, Masih asserts that irrespective of the extent of success recorded by banks in the Islamic world, such institutions have failed to faithfully utilize the PLS model as the original theoretical foundation of their operations (1456). The case of Pakistan-specialized banks such as the Mudaraba Companies substantiates this argument. According to Ayub, such companies are structured to operate purely based on the mudaraba or mushtaraka (320). However, they have a negligible amount of investment in the form of musharaka or mudaraba. Indeed, the Islamic Development Bank has only deployed PLS models in small isolated projects (Masih 1456). While these arguments justify the criticisms that Islamic banks have failed to utilize the PLS model as the theoretical framework for their operations, various reasons explain such failure.
First, contractual agreements based on the PLS encounter agency-related demerits. Investors or entrepreneurs require incentives to motivate them to take investment risks. They anticipate marginal compensation of their contribution to an investment or a production process (Rahman 159). Therefore, based on the PLS approach, capitalistic investors hesitate when it comes to investing their resources in line with the PLS theoretical basis. This claim may be justified by the apparent differences in Islamic and conventional investment worldviews. Regarding the available conservative systems, entrepreneurs are interested in optimal income returns in the form of profits while capitalists seek the most favorable profits from the prevailing factors of production, namely, land, labor, and capital. Consequently, they reluctantly share losses encountered in the production process (Rahman 159). This finding reveals the focus of Islamic economics on sales-based and lease-centered approaches, as opposed to the PLS framework. Indeed, entrepreneurs’ reluctance to absorb risks and their tendency to ensure that other parties do not share profits lead to the reduced uptake of the banking model, which is purely based on the PLS.
Secondly, contracts based on the PLS model require well-defined policies, including property rights. However, according to Ayub, most Muslim nations have no distinct or protected property policies (82). Consequently, PLS contracts are unattractive to Islamic financial organizations since they fail to work efficiently to support long-term banking operations. Therefore, according to Salem, Islamic banks need to provide less risky investment approaches and products when compared to the mushtarka or mudaraba (34).
Such a strategic move is important in the wake of the heightened rivalry from conventional banking systems, which are not only well established but also highly competitive in their operations. Banks finance both long-term and short-term projects. However, equity financing under the PLS arrangement is unfeasible in facilitating short-term projects, owing to the need to absorb high risks (Rahman 161). Consequently, Islamic banking and the entire financing system should look for alternatives such as mark-ups in the effort to guarantee liquidity. This strategy supports the need for Islamic economics to focus more on sales and lease-based approaches, as opposed to concentrating purely on the PLS model.
Conclusion
The Islamic financial system, especially the banking sector, has been subjected to heavy criticisms following deviation from recommended the PLS model. Financial institutions have focused more on sales and lease-centered approaches in their operations. The paper not only supported this criticism but also recommended the need to adopt debt-based approaches such as mark-ups to ensure liquidity in Islamic banks. Consequently, such institutions can compete effectively with conventional banks.
Works Cited
Ayub, Muhammad. Understanding Islamic Finance. John Wiley & Sons, 2007.
Echchabi, Abdelghani, and Dhekra Azouzi. “Islamic Banking and Finance in North Africa: An Extensive Review.” Journal of Islamic Banking and Finance, vol. 34, no. 4, 2017, pp. 29-40.
Masih, Mansur. “Islamic Finance and Banking.” Emerging Markets Finance & Trade, vol. 53, no. 7, 2017, pp. 1455-1457.
Rahman, Arshadur. “Islamic Banks and Central Banking.” Bank of England Quarterly Bulletin, vol. 57, no. 3, 2017, pp. 156-169.
Salem, Rania. Risk Management for Islamic Banks. Edinburgh University Press, 2013.
Swartz, Nico. “The Salient Characteristics of Islamic Finance and Banking Law.” Journal of Management, vol. 4, no. 2, 2013, pp. 49-57.
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