Profit and loss sharing

Profit and Loss Sharing (also called PLS or "participatory" banking is a method of finance used by Islamic financial or Shariah-complaint institutions to comply with the religious prohibition on interest on loans that many Muslims subscribe to. Many sources state there are two varieties of profit and loss sharing used by Islamic banks -- Mudarabah (مضاربة) ("trustee finance contract or passive partnership) and Musharakah (مشاركة or مشركة) (equity participation contract). Other sources include sukuk (also called "Islamic bonds") and direct equity investment (such as purchase of common shares of stock) as types of PLS.

The profits and losses shared in PLS are those of a business enterprise or person which/who has obtained capital from the Islamic bank/financial institution (the terms "debt", "borrow", "loan" and "lender" are not used). As financing is repaid, the provider of capital collects some agreed upon percentage of the profits (or deducts if there are losses) along with the principal of the financing. Unlike a conventional bank, there is no fixed rate of interest collected along with the principal of the loan. Also unlike conventional banking, the PLS bank acts as a capital partner (in the mudarabah form of PLS) serving as an intermediary between the depositor on one side and the entrepreneur/borrower on the other. The intention is to promote "the concept of participation in a transaction backed by real assets, utilizing the funds at risk on a profit-and-loss-sharing basis".

Profit-and-loss-sharing is one of "two basic categories" of Islamic financing, the other being "debt-based contracts" (or "debt-like instruments") such as murabaha, istisna'a, salam and leasing, which involve the "purchase and hire of goods or assets and services on a fixed-return basis". While some (such as Mohammad Najatuallah Siddiqui) hoped PLS would be the primary mode of Islamic finance, use of fixed return financing now far exceeds that of PLS in the Islamic financing industry whose popularity is in decline.

One of the pioneers of Islamic banking, Mohammad Najatuallah Siddiqui, suggested a two-tier model as the basis of a riba-free banking, with mudarabah being the primary mode, supplemented by a number of fixed-return models—mark-up (murabaha), leasing (ijara), cash advances for the purchase of agricultural produce (salam) and cash advances for the manufacture of assets (istisna'), etc. In practice, the fixed-return models -- in particular murabaha model—have become the bank's favourites, as long-term financing with profit-and-loss-sharing mechanisms has turned out to be more risky and costly than the long term or medium-term lending of the conventional banks.

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