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Risk and profit sharing in Islamic and conventional finance

It says: mr. Admir Mesković

The most important feature of Islamic banking is the prohibition of interest. In order to completely avoid interest, the Islamic economy has at its disposal a number of models and transactions, the oldest and most original of which are based on the division of profit and loss, that is, the division of risk. These models tend to avoid debt-based financing and use partnership and equity-based financing, similar to venture capital funds.

Profit-loss sharing (PLS) models dominate the theoretical literature on Islamic banking and finance. Generally speaking, these models involve a contractual arrangement between two or more parties, which allows them to pool their funds to invest in a project for profit. Most Islamic economists mention two main ways of financing in this sense, which are mudareba and mushareka.

The prohibition of interest implies that Islamic banking promotes the sharing of risk between the provider of funds (the investor) and the beneficiary of the funds (the entrepreneur). On the contrary, within conventional banking, the investor (owner of savings) is guaranteed a predetermined interest rate. Because the nature of this world is uncertain, the results of any project are not known with certainty ex ante, so there is always some risk.

In conventional banking, all this risk is borne by the entrepreneur. Regardless of whether the project succeeds and brings a profit or not, the savings owner counts on a predetermined return. In Islamic economics, this type of distribution is not allowed. In Islamic banking, both the investor and the entrepreneur share the results of the project in a fair way. In case of profit, both share it in pre-agreed proportions. In the case of mudareba, all financial loss is borne by the investor while the entrepreneur has a loss in terms of wasted work.

Theory and practice

In the early years of the development of Islamic finance, the prevailing belief was that conventional banking would primarily be replaced by the above-mentioned profit and loss sharing models, but this did not happen in practice. Therefore, although the relevant literature still emphasizes the mentioned models as the main characteristics of Islamic finance, in practice Islamic financial institutions avoid them. Several authors have written about the fact that Islamic banks have mainly turned to murabahah, which offers low risk and the possibility of high and fast returns. Vogel and Hayes (1998) point out that, although in theory there is a convincing difference between a murabahah and a conventional loan, in practice there is no such difference because banks use different mechanisms to minimize their risk, and in many cases reduce it to zero.

However, a significant part of the blame for the disparity between the theory and practice of Islamic banking lies with the clients. Clients want to practice conventional financial models and transactions for various reasons. They prefer “Islamic” models that are identical to conventional ones. In the case of deposits, the research done in Bosnia and Herzegovina resulted in the knowledge that most clients who want to save in the Islamic way also want their principal and profit to be insured, which is incompatible according to the theory of Islamic banking. Also, legal entities that need funds for a specific project or projects, or simply need capital for further growth, will find it difficult to agree to share profits with someone – even at the cost of bankruptcy of their own company. Islamic banks have to adapt their offer to their clients, who are not ready to partner with banks to the extent required by the theory of Islamic banking.

Necessary changes and “angels”

We can say that it is necessary to change the very theory of Islamic banking and harmonize it with the modern way of doing business. However, the modern way of doing business in more developed countries often implies the sharing of risk and profit, especially when it comes to starting a business. The economies of developed countries rely heavily on the stock market, while the economies of Islamic countries rely on debt. As a result, startups in the West can count on significant support from venture capital funds, which in principle represent men’s investing. That same woman in an area where Muslims live represents an unsuccessful financing mechanism.

A woman and a debt are not, in principle, direct competitors, as one might think at first. Long before a startup company can borrow large amounts of money from a bank or raise large amounts of money through an IPO, alternative sources of funding are needed. This is where “angel investors” and venture capital investments come into play. A hundred years ago, most venture capital came from just a few wealthy families like the Rockefellers. Today, investors who want to participate in venture capital investments often do so through venture capital funds. That makes a lot of sense – banks are in favor of debt-based financing, and funds are based on risk and profit sharing. We have “Rockefellers” in Islamic countries today, but their priorities are questionable

e to the countries of the Western Balkans. Geographical proximity, low labor costs and an educated workforce were singled out as the greatest advantages of the countries of the Western Balkans for attracting foreign investments, but the panelists also emphasized cultural similarities and connections between people as advantages when deciding to invest. The panelists singled out the metal and wood industry and the energy sector as the most interesting sectors for investment in BiH and the countries of the region. It was also said that Bosnia and Herzegovina needs the support of the government through various reforms that will facilitate the administration, improve the education system, and influence the increase in wages for workers.

In cooperation with the USAID Sustainable Tourism Development Project in Bosnia and Herzegovina, the panel “The Power of Tourism in Stimulating Economic Growth” was organized. The panelists talked about the best international practices and considered local initiatives for starting investments in tourism, growth and development, and industry in BiH with the aim of positioning the country as a globally competitive tourist destination. The panelists emphasized regional cooperation when it comes to the tourism sector, but also the importance of regional destination branding, which is important not only for the tourism sector but also for other branches of the industry. The panelists at the session talked about Bosnia and Herzegovina as the most exciting destination to visit and invest in.

The role of public-private partnership and knowledge transfer in the private and public sector was the topic of the third panel on the second day of the 11th Sarajevo Business Forum. When it comes to Bosnia and Herzegovina, opportunities for public-private partnerships can be seen in all industrial sectors, and the greatest potential for establishing public-private partnerships can be seen in the energy and health sectors, where state-owned companies continue to dominate. It was also emphasized that cooperation between the government and the private sector must be established on a “win-win basis”.

At the end of the second day of the 11th Sarajevo Business Forum, the role of Islamic finance in achieving the goals of sustainable development was discussed, and how to use Islamic financing to regulate poverty, social inequality and limited capacities of the government, i.e. everything negative that affects it and its subjects. It was pointed out that Islamic financing is not exclusively related to Islamic countries, and that it is seen as an important tool when creating synergies between the private and Islamic sectors and development. After this panel, a new educational platform for Islamic finance and sustainable development developed by UNDP IICPSD and the Islamic Development Bank was presented.

As part of the 11th Sarajevo Business Forum, a round table was organized on the topic of strengthening economic cooperation between Bosnia and Herzegovina and Bahrain, and a business conversation with representatives from Malaysia resulted in a signed memorandum on cooperation in the field of business and mutual support.

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