Profit and Loss Sharing is Explained
S J Tubrazy
The basic and foremost characteristic of Islamic financing is that, instead of a fixed rate of interest, it is based on profit and loss sharing. It has already discussed the horrible results produced by the debt‑based economy. Realizing the evils brought by this system, many economists, even of the Western World are now advocating in favour of an equity based financial arrangement. To quote James Robertson again:
“Why was the process of issuing new money into economy (i.e. credit creation) been delegated by governments to the banks, allowing them to profit from issuing it in the form of interest bearing loans to their customers? Should governments not issue it directly themselves, as a component of a citizen’s income”?
“Would it be desirable and possible to limit the role of interest more drastically than that, for example by converting debt into equity throughout the economy? This would be in line with Islamic teaching, and with earlier Christian teaching, that usury is sin. Although the practical complications would make this a goal for the longer term, there are strong arguments for exploring it, the extent to which economic life worldwide now depends on ever rising debt, the danger of economic collapse this entails, and the economic power now enjoyed by those who make money out of money rather than out of risk bearing participation in useful enterprises.’
John Tomlinson is an Oxford based Canadian economist. Having studied the effect of debt on the economies of developed and less developed countries, he set up and is the Chairman of Oxford Research and Development Corporation Limited which explores the use of equity instruments and the development of equity markets for areas of finance currently served by debt. In his book “Honest Money” he has strongly recommended the conversion of debt into equity. His following conclusions merit consideration for those who are adamant on maintaining status quo in the financial system:
“Converting debt to equity is not a panacea for all economic ills. It can, however, produce many positive benefits. These benefits will not necessarily follow automatically from conversion. Concentrated effort will be required to ensure they do. Without conversion they will not happen at all.
Not the least of these benefits will be those brought to the banking community itself. The banking and monetary system will not collapse. Nor should there ever need to be the threat of collapse again. Owners of banks will find the value of their shares underpinned as liabilities disappear from balance sheets and are replaced by assets of a specific value. Each and every depositor will be able simultaneously to withdraw his or her total deposits.
Demand for the bank’s current or cheque account services will not diminish. Longer term depositors will now have to pay for storage, it will be a less attractive option than exchange, so the velocity with which money moves from bank to market‑place to bank again, from one account to another, is likely to increase. There will be a continuous flow of money available for new equity investment.
The market‑place in general will also receive benefits. Conversion will also cause the value of money to stabilize. Savings can then retain their value. Prices need only vary according to the supply and demand of the product being priced. Measurements of exchange value made by different people at different times can be validly compared. The unit of money will once more be a valid unit of measurement of exchange value. The field of economics can become a science.
Many of the distortions which now exist in our individual frames of reference will be corrected. For instance, an investment which took an investor, ten, fifteen or twenty years to recoup used to be considered sound. Now, too often the maximum period envisaged is five years; even three. This short‑term view has precluded many useful businesses from being created. The re‑establishment of stable money and the emphasis on security which will be required within equity investment programme will encourage people to take a longer view. More businesses will then be considered viable and the number of new jobs can increase dramatically.
Existing savers will also be protected. The conversion to equity will eliminate the possibility of collapse for individual banks and for the system as a whole. Savings will not disappear. The nature of savings will change from just units of money to units, of money and shares. The exchange value of both the shares and the money will have to be re‑assessed. But they will have value. If no action is taken and the system collapses, they may end up having no value.
The changes proposed will also free many from the enslavement of debt. Both nations and individuals can regain their dignity. They will be free to make their own choices. No longer will managers have to face the choice between paying interest and dis-employing some or not paying interest and dis employing all.
Nor shall we need to experience the stresses caused by current economic and business cycles. There will be a steady flow of money into investments. New investment opportunities will continually be sought as a home for both individual saving and business profits. Both will wish to avoid storage charges.
Growth will be dependent upon the continuing development of new ideas and new productive capacity. Growth will no longer be dependent upon the creation of new debt. Economic expansion will depend upon the positive flow of new savings and new profits.
Re‑establishing the integrity of money will eliminate at least one of the causes of human conflict. Money will no longer secretly steal from those who save, those on fixed income and those who enter long‑term contracts. .
Further, it can lead to a greater premium being placed on personal integrity. The character traits of honest, honourable and forthright behaviour will ‘be in demand. Investors’ security will depend on them. Recognition of the degree of interdependence in an equity oriented market‑place can lead to more consideration of the needs of others, and, ultimately, to a more caring and, compassionate society.
Of course, life is never roses all the way. Many mistakes will be made. When new paths are trodden, the way is sometimes uncertain. Some will find it difficult to break the habitual patterns of thought which govern behaviour in a debt‑oriented society. No doubt some readers will have already experienced this.
Some will be hard‑pressed when the actual exchange value of their investments becomes apparent. Yet, the conversion process can be controlled. Collapse cannot.
The case of honest money is a compelling one. Honest money is not a thief. It does not steal from the thrifty. It is not socially divisive. It does not promote economic and business cycles, creating unemployment. On the contrary, it encourages thrift. It promotes sustainable economic growth. It rewards merit. It demands integrity.
These were worthwhile goals. They can be achieved. What is needed now is the will to make them happen.”
Michael Rowbotham has commented on the above‑quoted book of Tomlinson as follows:
“One of the most unusual and original contributions to the monetary debate. John Tomlinson is a former merchant banker and presents a powerful case against the debt‑based money system; his solution is highly creative and shows the scope for thought outside the normal parameters of monetary reform. The work is currently being incorporated by Nova University in America as part of their master degree in economics.
Philip Moore, in his recent study of Islamic Finance, observes as follows:
“Although this long term shift from a bond‑based to an equity based financial system accords in many respects with Islamic economic principles, it is a trend which is by no means confined to the Islamic world and which is increasingly being championed globally. The resurgence in Islamic finance worldwide is seen by some simply as a reflection of the global economy’s discernible transition from bond‑based to equity‑based finance.
Mr. Abbas Mirakhor and Mohsin H. Khan, both,economists of the Research Department of the International Monetary Fund (IMF) have studied in detail the implications of an interest‑free Islamic banking, and while discussing the profit and loss system they have observed:
“As shown in a recent paper by Khan (1985) this system of investment deposits is quite closely related to proposals aimed at transforming the traditional banking system to an equity basis made frequently in a number of countries, including the United States.”
Peter Warburton has also preferred an equity‑based financial system and has discussed the theories of Fisher, Minsky, J.Presley and P.Mills in this, respect.
The equity‑based banking is not something proposed by the Islamic circles alone. It is being suggested also by some non‑Muslim economists on purely economic grounds. The injustice, instability and business shocks created by the present debt‑based financial system have themselves compelled them to think about an equity‑based system that has more potential to bring about distributive justice and stability. In an equity based banking the depositors are expected to gain much more than they are receiving today in the form of interest which often becomes negative in real terms by the inflation caused mainly by the expansion of the debt‑based money. It will divert the flow of wealth towards the common people and in turn will encourage savings and bring a gradual and balanced prosperity.