Economics of profit in Islamic banking

In Islamic banking profit is the reward of risk. There are both 'equity' and 'debt'-based financing products in use in Islamic banks. The equity-based products comprise Mudaraba and Musharaka. On the other hand, debt-based products comprise Baimurabaha, Baimuajjal, Ijarah, Baisalam, Istisna and Istijrar etc. The Musharakah and Mudarabah are profit-sharing and loss-bearing products. Loss means capital loss, not profit loss. In the case of loss, all the Muslim jurists are unanimous on the point that each partner shall suffer the loss exactly according to the ratio of his investment. Therefore if a partner has invested 40 per cent of the capital, he must suffer 40 per cent of the loss, not more, not less, and any condition to the contrary shall render the contract invalid. There is a complete consensus of jurists on this principle. When a financier contributes money on the basis of these two products, it is bound to be converted into the assets having intrinsic utility. Profit and loss is generated through the sale of these real assets. The nature of the Mudaraba and Musharaka therefore indicates that there is no guarantee of capital in use of these two products. This particular nature of the Mudaraba and Musharaka is a threat to banking. A bank cannot finance in an equal chance of making profit or losing capital because it is, after all, a financial intermediary and is engaged in banking business with depositors' money. Moreover, the deposit is payable on demand so it is protected by a banking safety-net, and besides, banks are under obligation to safeguard depositors' money.
The depositors' money is protected in Islamic banks but there cannot be protection of 'bank money' in the use of Mudaraba and Musharaka products. Suppose to protect the bank money in an alternate way, the partner of Musharaka may be held liable, through contract, for the loss with a view to protecting the bank money as well as sharing the profit only. It may be called profit Musharaka. Such attempt makes the Musharaka parallel to the debt-based products -- Bai-Murabaha and Bai-Muajjal etc. In that case the customers may prefer the debt-based products because these are more advantageous for both the customer and the banker. Debt for the customer is prefixed by the stipulated schedule of repayment. So it is easy to re-pay by the customer and realize by the banker without further calculation.
Islamic banks earn 'Mark-up profit' (Cost plus agreed profit) using the Bai-Murabaha and Bai-Muajjal products. This special type of profit is being earned by the Islamic banking industry only. The terms "Bai-Murabaha" have been derived from Arabic words 'Bai' and 'Ribhun'. The word 'Bai' means purchase and sale and the word 'Ribhun' means an agreed upon profit. Bai-Murabaha means sale on agreed upon profit. Generally there are two parties in buying and selling, the seller and the buyer, where the seller as an ordinary trader purchases the goods from the market, without depending on any order and promise to buy the same from him, and sales those to a buyer for profit. It is an ordinary Bai-Murabaha in which the trader bears uncovered risks and earns 'profit' as a reward of undertaking risks, through bargaining and facing the three business situations i.e., loss, no profit or no loss (breakeven), and profit.
It can be termed as an 'ordinary buying and selling.' In line with the Shariah maxim of "al-kharaj bi-al-daman" or "revenue goes with liability" the seller must bear a certain amount of risk associated with ownership, such as price risk, risk of destruction of asset etc in order to legitimate its return.
If the bank buys first, there appears uncovered risk. There is a possibility that the customers may refuse to receive the goods and banks may suffer loss. A bank, as an intermediary, is not in a position to bear an uncovered risk indeed. Banks have evolved purely as a 'financial intermediary'. The bankers play the role to attract money, keep it in safe custody, and invest/lend it under safety, profitably. A banker has to maintain a balance between income, liquidity and flexibility. While allocating funds they have to be meticulously sensitive about the factors like capital position and rate of profitability of various types of investments/loans, stability of deposit, economic conditions, influence of monetary and fiscal policies, ability and experience of bank's personnel and investment/credit need of the area. So far the bankers try to thrive on a fixed rate of return a portion of which is passed on by them to the depositor. Thus the entire effort of a banker is directed towards money management and it is not geared to act as an entrepreneur, trader, industrialist, contractor or caterer. Hence profit making, using the Ordinary Bai-Murabaha, is impossible in Islamic banking.
Therefore Islamic banks use the 'Bai-Murabaha on Order or Promise' product to avoid the uncovered risk. If there are three parties, the buyer, the seller and the bank as an intermediary trader between the buyer and the seller, where the bank upon receipt of order from the buyer with specification and a prior outstanding promise to buy the goods from the bank, purchases the ordered goods and sells those to the ordering buyer at a cost plus agreed profit, the sale is called "Bai-Murabaha on Order or Promise". Moreover before purchasing the goods by the bank, the banker obtains sufficient collateral/securities along with the Charge Documents properly executed i.e., duly filled in, signed, stamped, verified and witnessed, where necessary. It ensures predetermined positive rate of return which makes the Bai-Murabaha mode like interest-based instruments. In spite of this, it has been argued that the Islamic banks bear risk in the use of 'Bai-Murabaha on Order or Promise' product which legitimates bank's profits in the eyes of Shariah as distinct from prohibited 'riba'. There are three main reasons for such distinction. Firstly, Bai-Murabaha mode is sale rather than outright borrowing and lending transactions. Secondly, since the Shariah does not allow a person to sell what he does not own and possess, the financier takes the risk as soon as he acquire ownership and possession of the goods for sale. Thirdly, it is the price, and not the rate of interest, which is stipulated in the case of these sales transactions, and once the price is fixed it cannot be altered if there is a delay in payment due to unforeseen circumstances.
This has made the Islamic bank 'an intermediary trader' between the bank's client (buyer) and the seller. Al Qur'an says, "Allah has permitted trade and forbidden riba" (2: 275). What actually happens in the process is: Islamic banks deal with money using the Islamic modes of finance. The bank converts 'bank money' into 'commodity' and sells those to the ordering buyer at a mark-up profit under the instalments of re-payment in future. Islamic banking therefore may be called 'money to commodity to money (MCM)' model of banking. It necessarily links financing to real goods, services and projects. Outright lending without the involvement of goods and services may not be possible in the system. Further, it may be called 'asset backed financing system'. Islamic finance in form and legality is asset-backed at the micro-juristic level. It also ensures control of bank over 'money movement' which ultimately contributes to minimize the overdue risk of bank and curb over expansion of credit to both public and private sectors. This may help attain monetary expansion in harmony with the growth of output and, thus help minimize inflationary pressures.
'Mark-up profit' is the reward for converting 'bank money' into 'commodity' and selling them under constructive possession to the promised buyer. Islamic banks bear risk under documentary ownership and constructive possession of goods for a short or fleeting time period. It is 'mark-up profit' that is generated from the adaptation of Shariah principles of buying and selling to Islamic banking. Mark-up profit therefore is neither 'general profit' nor 'riba.' A conventional bank deals in money. It may be called money upon money (MM), which is prohibited 'riba' model of banking.
Islamic banks accept deposits at provisional rates. The final rates are being paid at the end of the year on closing of accounts. In the process, the depositors are 'Saheb-al-Mal' (Owners of Fund) and Islamic banks are 'Mudarib' (Entrepreneur) for doing banking business. The depositors invest money in Islamic bank business and share profit and loss under Mudaraba principle "equity and reward sharing" which provides an opportunity to share the banking risk (Result of non-performing assets) with the depositors. It is called 'Shock Absorption' capacity of the Islamic banks. It indicates that an Islamic bank is not a 'financial intermediary' and it does not maintain 'debtor-creditor' relationship like conventional banks; rather it is an 'intermediary trader' and maintains 'Mudarabah' relationship with its deposit customers. This unique feature of Islamic banks provides an in-built mechanism of risks minimisation and profit maximisation for the industry.
The writer, Dr Mahmood Ahmed, is Executives Vice President, Islami Bank Bangladesh Ltd. E-mail: mahmood.ahmed@islamibankbd.com