Does Islamic Finance Operate With Pure Profit and Loss Sharing?

Islam, being a complete way of life and a code of conduct deals with every walk of human life. It gives directives in social life, marital life, political life, governance, war and peace as well as internal and external affairs.

The Economy is always considered a backbone of any society. Flourishing business plays a vital role in raising the social status of an individual and the community as it ultimately strengthens the economy of any country. Islam has given clear guidelines for financial dealings too. The principles hinge on the concept of “Not to harm and not to be harmed.”

Islamic banks and Sukuk are currently based on contracts that formally match what is required by Shariah law. But some scholars argue that the way they operate is not based on Islamic profit and loss sharing.

A buyer of a sukuk, for example, expects to receive an assured yield comparable to an interest-bearing bond. Owners of bank deposits expect capital certainty comparable to deposits in a conventional bank. Islamic banks channel most of their lending through shariah compliant methods that do not involve participating in enterprise risk. Therefore a number of scholars observe that most Islamic finance is not different in substance from conventional finance.

How do Islamic banks manage risk?

A pure Islamic bank would share risks, profits and losses with its customers. The ethical code underlying shariah does not seek to abolish risk. However,  it recognizes that business enterprise is desirable but is inherently risky. Therefore banks need to manage risks to keep them below undesirable levels.

Islamic banks also need to ensure their risk management does not involve purely speculative risk taking, which is prohibited under Shariah . As you will see, conventional investment banks can appear to be betting on exchange rate changes or on the prices of financial assets.

Islamic Methods To Managing Risk

Islamic banks can use some of the methods available to conventional banks. To minimize risk of default they can investigate and monitor the businesses they finance. In fact, profit and loss sharing might create an additional reason for monitoring the enterprise. However, Islamic banks face particular challenges in risk management. Some instruments that conventional banks use are not available. This include conventional financial derivatives.

You will learn that a financial derivative is an instrument whose value is determined by another financial instrument. This directly contravenes the principle of materiality . Materiality means finance must be tied to real economic activity. Shariah compliant derivative markets have not yet been developed.

As you can see, Islamic finance is based on ethical principles including sharing risks, profit and loss sharing based on real activities.

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