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  • Challenges of Implementing Profit and Loss Sharing (PLS) Financing in Islamic Banking

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    The document discusses challenges with implementing profit and loss sharing (PLS) financing in Islamic banking. While Islamic principles promote PLS to share risks and rewards, currently Islamic banks primarily use debt-based financing like murabaha due to risk aversion. PLS contracts like mudarabah and musharakah involve information asymmetry and monitoring difficulties that make banks reluctant to use them. Studies aim to identify obstacles to PLS use and convince banks to adopt equity-based financing more to help businesses and align with Islamic values. However, data shows PLS volumes remain low at under 5% of financing compared to over 70% for debt-based modes. This reliance on debt raises economic growth concerns.

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    challenges of profit and loss sharing

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    Assignment IIB

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    The document discusses challenges with implementing profit and loss sharing (PLS) financing in Islamic banking. While Islamic principles promote PLS to share risks and rewards, currently Islamic banks primarily use debt-based financing like murabaha due to risk aversion. PLS contracts like mudarabah and musharakah involve information asymmetry and monitoring difficulties that make banks reluctant to use them. Studies aim to identify obstacles to PLS use and convince banks to adopt equity-based financing more to help businesses and align with Islamic values. However, data shows PLS volumes remain low at under 5% of financing compared to over 70% for debt-based modes. This reliance on debt raises economic growth concerns.

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    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
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    Download as docx, pdf, or txt
    61 views4 pages

    Challenges of Implementing Profit and Loss Sharing (PLS) Financing in Islamic Banking

    Uploaded by

    ISMAIL RAGE
    The document discusses challenges with implementing profit and loss sharing (PLS) financing in Islamic banking. While Islamic principles promote PLS to share risks and rewards, currently Islamic banks primarily use debt-based financing like murabaha due to risk aversion. PLS contracts like mudarabah and musharakah involve information asymmetry and monitoring difficulties that make banks reluctant to use them. Studies aim to identify obstacles to PLS use and convince banks to adopt equity-based financing more to help businesses and align with Islamic values. However, data shows PLS volumes remain low at under 5% of financing compared to over 70% for debt-based modes. This reliance on debt raises economic growth concerns.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
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    Download as docx, pdf, or txt
    of 4

    Challenges of implementing profit and loss sharing (PLS) financing in Islamic Banking.

    Introduction

    Despite of the momentous evolution of Islamic banking industry in the recent years, the

    insignificant implementation of the Profit-sharing (PLS) financing (Musharakah &

    Mudarabah) by the Islamic banks has prompted many uncertainties at the essence of Islamic

    banking industry. The current practice of Islamic banks towards their financing activities are

    basically based on debt-based financing instruments such as BBA, Murabahah and Ijarah, and

    these products dominated all other kinds of Islamic financing.

    Some proponents of Islamic banking pointed out that the dominance of fixed income modes of

    financing is very critical (Chapra 1985, p.171 and Siddiqi 1983, p.139). They argued that using

    fixed income instruments do not represent the true essence of Islamic banking principles, but

    it only confirms the status quo of Islamic banks.

    One of the main characteristics of Islamic finance that distinguishes it from the conventional

    financing is that Islamic banks comply with Shari’ah law (Islamic law). Islamic law strictly

    prohibits the use of riba (interest) and gharar (uncertainty) and Qur’an (2: 275–76) clearly

    mentions that dealing with riba is ‘sinful’. However, Islam gives the ummah various

    alternatives for engaging businesses i.e. ‘profit-loss sharing’ (PLS) financial transactions. PLS

    promotes to increase the level of businesses among the society (ummah) that latter sparks the

    rise of wealth of Muslims.

    Islamic banks offer financial products which comply with Islamic principles. As of the first

    quarter of 2017, equity-based financing or PLS contracts accounted for less than 5 percent of

    the total financing of Islamic banks. In contrast, debt-based financing combined more than 70

    percent in the same period (Suzuki & Miah, 2018). This manifests that Islamic banks are

    reluctant to participate in equity based or PLS financing.

    1
    Many scholars have provided different explanations for the tendency of Islamic banks to avoid

    PLS financing. Some scholars stated that the purpose of using debt-based financing is that

    Islamic banks are risk averse and equity-based financing is riskier than debt-based financing.

    For instance, Profit and loss sharing financing (Mudarabah/Musharakah) involve the risk of

    asymmetric information wherein the entrepreneur has much better information than the Islamic

    bank as the Islamic bank acts as a silent partner. Hence, this one of the reasons why Islamic

    banks do not prefer to undertake PLS financing. In addition, Islamic banks can encounter

    difficulties to monitor the entrepreneur ( Mudarib) to ensure whether the Mudarib is using the

    fund as the interest of both parties.

    Objectives

    The objectives of this study are to identify obstacles and challenges surrounding to the

    implementation of profit and loss sharing (PLS) financing in Islamic banks. The paper also

    discusses some arguments of Muslim scholars about the negligence of PLS among Islamic

    banks

    Methodology

    The methodology uses in this paper is to critically analyse the current literature review of profit

    and loss sharing financing in Islamic financial institutions to find out the constraints of PLS

    financing. PLS financing is widely discussed by Islamic economists to figure out the reasons

    behind the reluctance of Islamic banks to implement it. As Islamic economists argue that

    Islamic banks are based on taking risk and reward proportionally, they carry out many

    researches to find a way to convince Islamic banks to adopt equity-based finance.

    Profit and loss sharing financing in the theory of Islamic banking

    Since Islam prohibits interest earnings from financial deal, it does not mean that the financier

    is incapable to generate profit. In order the investor to confirm financial gains on the principal

    amount is definitely associates with risk undertaken on the investment (Siddiqui, 1987).

    2
    Although there are various types of Islamic finance to avoid interest (riba), Musharakah,

    Mudarabah and Murabaha are modes that can be replaceable for Riba. Musharakah is based

    on on profit-loss sharing partnership that undertakes risk and reward proportionally. Albeit

    certain financial banks are reluctant to practice such a form of financial instrument for risk

    aversion, Musharaka is so far regarded as one of the most accurate methods of finance that

    Shari’ah approved. The validity of Musharaka instrument is based on the Qur’an, the Hadith,

    and the Muslim jurists Ijma (consensus). The Qur’anic verses that usually referred to

    partnership share include (Al-Nisa: 12), (ArRum: 28).

    Many Islamic economic experts and scholars have demonstrated the significance of profit-loss

    sharing mode in Islamic financing. Ahmed (2006) argued, there is equivalent substitute of

    financing mode for Musharaka and Mudarabah and suggested to practice such instrument.

    Mentioning the important position profit-loss sharing financing, Chapra (2007) stated that

    socioeconomic benefits and exclusion of Riba may not be clearly comprehensible without

    profit-loss sharing instrument in the Islamic financing. In the consensus of Muslim scholars

    about the issue prohibition of Riba and implementing profit-loss sharing was the basic

    proposition in the system of the Islamic Banking (Personal & Archive, 2017).

    Current status of profit and loss sharing financing by Islamic Banks

    The current practice of Islamic banks across the world reveals that the majorities of financing

    activities are not based on equity, but it is a form of debt-based instruments. According to

    (Asutay, 2007), Islamic banks constantly seek for profitable financing with less risky such as

    murabahah rather than of musharakah and nudarabah. In addition, Islamic scholar Omar Farooq

    pointed out this phenomenon as murabaha syndrome since the Islamic Banking and Financial

    Institutions excessively use debt-based financing as their products. It is quite evident from the

    3
    following data that the application of Musharakah and Mudarabaha are very low compared to

    Murabaha financing in Malaysian Islamic banks.

    Mode of financing Volume

    Murabaha 227,643.2

    Mudarabah 80,421.2

    Musharakah 54,419.5
    Source: Islamic Financial Services Board (IFSB), Malaysia

    As we can see from the above table, Murabaha which also known as debt-based financing has

    the highest volume than Mudarabah and Musharakah. Although scholars emphasize its

    importance, Islamic banks are not practicing it intensively. Therefore, (Rahim & Rahman,

    2007) argued that this kind of financing is not helping the growth of economy as the business

    people cannot get enough financing to invest in various business sectors.

    References

    Asutay, M. (2007). Conceptualisation of the second best solution in overcoming the social

    failure of Islamic banking and finance : examining the overpowering of Homoislamicus

    by Homoeconomicus. Journal of Economic and Management, 15(2), 167–195.

    Retrieved from http://dro.dur.ac.uk/4531/

    Personal, M., & Archive, R. (2017). Munich Personal RePEc Archive Evolution of Islamic

    Economics : A critical analysis. (71911).

    Rahim, A., & Rahman, A. (2007). Islamic Microfinance: A Missing Component in Islamic

    Banking. 2, 38–53.

    Siddiqui, M. N. (1987). No Title. Partnership and Profit-Sharing In Islamic Law. Leicester,

    UK: The Islamic Foundation.

    Suzuki, Y., & Miah, M. D. (2018). Dilemmas and Challenges in Islamic Finance. In

    Dilemmas and Challenges in Islamic Finance. https://doi.org/10.1201/9781315105673

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