Modes of Financing
Islamic banking operates through the two major methods of financing: equity based profit-and-loss-sharing (PLS) and debt-based sale-lease transactions (DST).[532] While the first mode is designed to stimulate a cooperative/participatory approach to financing, the second contemplates purchasing and reselling or leasing assets with a marked-up price and a fixed-return.[533] PLS is the most Shari’ah-approved financing mechanism comprising Musharakah and Mudarabah on which contemporary Islamic economics is fundamentally rooted.[534]
Musharakah and Mudarabah typically refer to partnerships or joint ventures (between the bank and the client) in which the bank and the client agreed to launch different projects and share profits based on their mutually agreed proportion.[535] Losses are also shared between the parties in accordance with the ratio of their respective capitals.
That is ‘only the party providing financial capital in a mudaraba bears all the losses’.[536] Since the bank usually provides the capital to develop entrepreneurial projects, it is the bank which has to consume all the resulting losses that makes this mode risky and less attractive. In DST, debts are created via, inter alia, Ijara and Murabaha.[537] Ijara transaction involves the bank purchasing an asset and then leasing this to the client on a fixed-term return and a condition that the bank will retain the ownership until the full payment has been made by the client.[538]In the Murabaha[539] transaction the bank first finances the purchase of the goods or asset on behalf of the client and then resells it to him/her (the client) by adding a cost-plus price with a fixed return to be paid over a definite time-frame. Hence, there are two transactions involved in the process: the first transaction is made between the bank and the third party from whom the bank purchases, and the second one is between the bank and the client. The whole process is conducted based on an agreement (the pre agreed promise of the client) that the client will buy the same asset from the bank.[540]
One of the distinguished characteristics of PLS (as compared to DST) is that only the profits are distributed in a mutually agreed proportion and the loss is exclusively borne by the financier as mentioned which is what makes the transaction risky. In DST, the payment methods and rate are fixed in advance which ensures a profitable return and is therefore less risky and attractive. While its limited use is accepted by some Islamic scholars,[541] others raise serious objections as it contradicts the fundamental principles of Islamic finance.[542]
B.
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