Islamic Financial institutions are increasing at a faster rate in the world. Islamic financial institutions are based on the principals of Islam, which strictly prohibits the use to riba "interest." To avoid the use of riba in the Islamic transactions the financial institutions have developed Islamic methods that are in accordance to Islam like the "profit and loss sharing methods" therefore in the Islamic banking the riba will be under taken by the PLS methods. There was a belief that Islamic banks avoid riba and use PLS and opt for partnerships and equity based financing but on the other hand the reality is different. They are using debt financing along with PLS methods apart from the literature giving a different perspective. (Mohammad Omar Farooq 2007)
There are three different forms of an organization can undertake
- Sole trader
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Raising financing for partnership is different in contemporary methods while raising finance under Islamic principals is different therefore under the Islamic manner the partnership raise finance from the following sources: -
- Equity financing - which include private and public corporations.
- Venture Capital partnership- including the entrepreneur.
It is very important to understand that which form or business organization is common and least common in countries, this is influenced many factors like the regulation and the location, culture and factors like literacy rate of that particular country. Therefore as an example lets take USA where the least common form is partnership.
The following table shows the distribution of business forms in USA from Statistical Abstracts of the United States, 2004-2005.
From the polls conducted by international magazines in USA the following information was concluded: -
- 59% of the individuals believed that partnership was a bad source for running a business while 39% believed it was a good source.
- 60% of the individuals claimed that personal conflicts constitute partnership as being bad source for running business.
- 59% individuals have a strong mindset that partnership does not live up to the expectations of one and other.
- 53% of the individuals were of the opinion that with one leader, companies do well.
Apart from this polling another International magazine conducted a survey of 500 partnership businesses and found that the partners knew each other before engaging in the partnership business. (Sherman 2000).
According to the Islamic Scholar Imam Malik viewpoint "the liquidity of capital is not a condition for the validity of Musharakah."
When partners bring capital, which is not liquid, it creates problem in equity partnership.
"Imam Abu Hanifah and Imam Ahmad are of the view that no contribution in kind is acceptable in a Musharakah."
According to Mufti Muhammad Taqi Usmani, "the rules of financing in both musharakah and mudaraba are similar".
Some basic features of Musharakah according to Mufti Taqi Usmani: -
- In musharikah financing is the sharing of asset in the ratio of financing.
- The extend of loss incurred by an investor or financier is according to his ratio of investment.
According to the opinion of clients and customers, there is no signicant difference in the practice based of fixed rate financing in the Islamic Institutions compared to conventional methods. (Usmani Taqi 2001)
The partners have the freedom to determine the profit ratio while the partner who is not involved in the management should be allocated the ratio just according to his investment portion. This is linked to the agency problem which the partners hide information from each other and when one partner is not responsible and takes duties assigned to him for granted.
It is generally believed that Islamic institutions use equity financing and avoid debt financing by using PLS modes but in practiced these institutions are not properly engaged in the using of PLS methods. Every method had pros and cons so need to changes is very essential. According to the International Association of Islamic Banks, PLS covered less than 20 percent of investments made by Islamic banks world-wide (1996 figures).
Musharikah is heart of Islamic finance as it is one of the key solutions for Islamic institutions, which are facing problems using PLS methods where the notion of sharing in risk and return between investors and entrepreneurs finds its natural passage.
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There are various reasons why businesses do not prefer PLS modes. According to Iqbal and Molyneus, following are the key reasons: -
- Only diminishing musharikah enables the entrepreneur to become the sole owner of the project.
- It is very essential to keep track of the records.
- Due to moral and asymmetric information problems, the bank only prefers fixed rate of return.
Musharikah is of the key instruments that enables Islamic ideology to become reality in the practice of banking but we cannot deny that the use and implementation of musharikah is not without problems due to lack of government support and regulations and secondly due to the nature of environment.
PLS modes are not present in the Islamic ideology. Several explanations support this conception.
- PLS methods are linked to agency problem
- It is very difficult for the Islamic banks to offer less risky rate of financing as compared to conventional.
- There is no secondary market for the Islamic financial institutions.
Banks are not emphasizing to financing small firms via musharikah because there are increased transactional cost, socio political pressure and lack of security.