In any financial system, private investment occurs in two different ways: active investment, where one or more people put their own wealth into a development, manage it themselves and enjoy the fruits of their labor and capital themselves; and reactive investment, where the investor provides the capital and receives a revisit but takes no additional part in the project.  Generally speaking, a passive depositor has three options: one, acquire shares in a company and receive a payment; two, acquire securities and receive interest; three, deposit in a bank and receive interest.  In an Islamic economy, dynamic investment and the first option are permitted while the last two options would be regarded as riba (interest) income and therefore prohibited.  On the capitalist side, he may invest his project with his own capital, by promotion shares in his venture, or by borrowing on interest (from a bank or by issuing bonds/securities).  In an Islamic setting, the first two methods are allowable while the last is not.

Both conservative and Islamic systems allow and encourage active investment, which booty labor and capital from realized earnings.  Both also allow and hearten passive investment in shareholder companies, which too repayment capital from realized earnings in the form of dividends.  In both cases any realized loss is borne by the capital-providers.  But any investment that brings in riba income or financing that involves the payment of riba is prohibited in an Islamic system.  This vegetation the Muslim passive investors who cannot or will not buy shares in a company and Muslim entrepreneurs who do not have their own capital or cannot move up share capital but need seed capital and/or additional funds in a difficult condition.  If not for their religious convictions, they would resort to bonds and securities or predetermined deposits and bank loans.  Since this group of investors and entrepreneurs form a large segment of the Muslim investor-entrepreneur population, it is necessary to address their complexity.  This essay explores the options accessible to this group contained by an Islamic setting.  Participatory Financing explained in the following paragraphs is a system developed to address this special concern of Muslims.  It is based on the ancient concept of mudaraba.

Brief history.

Mudaraba is an earliest form of financing practiced by the Arabs since long before the beginning of Islam.  It suited the Meccan Arabs because of their locality at the cross infrastructure of the earliest trade caravans.  They themselves were merchants moving goods north to Syria in the summer and south to the Yemen in winter.  They took goods from their homeport to sell at their objective, and with the earnings bought other goods and brought them back to sell at home and/or to re-export to another destination.  When a trading procession is planned it was the carry out of the Meccans either to connect it with their own supplies and money or to throw such through agents who did the industry on their behalf.  When a procession returned home and the goods were all sold, the mission was complete and it was time to arrange the ‘balance sheet’ and calculate the profit/loss.

The rules of this example had long been recognized by custom and had been known by the name musharaka. The agents who carried others’ goods and/or money had to give accounts to their principals and declare their share of the profit/loss according to a pre-arranged model.  This too had policy assigned by convention and was known by the name mudaraba. When Muhammad (Peace be upon him) began his visionary mission he did one of three things with observe to the practices of the Arabs:

1) If it occupied the denial of the subsistence or the exclusivity the one Allah associating  anyone with Him he prohibited it outright;

2) If it did not absorb any such accomplishment he did not interfere with it.

3) If some positive or essential perform involved some basics of the first, and if that could be removed, he detached the offending rudiments and allowed the customized version to be practiced.  Mudaraba and musharaka belonged to the second group.

Nabil A. Saleh in his responsible and very readable book, Unlawful Gain and justifiable Profit in Islamic Law (1986), gives complete metaphors of the rules connecting to mudaraba and musharaka, including the differences of attitude in the interpretation of these policy by the later schools of Islamic Law.  A recent (1999) publication by Justice Taqi Usmani is a very helpful input to Islamic finance.  It is useful to students and teachers of Islamic banking and finance on account of the dependable definitions given of the terms and concepts used in the field, and because of the complete explanations and conditions information provided.  It also describes how these concepts are currently implemented, and points out the shortcomings and gives suggestions for improvements.  The others such as murabaha, ijara, salam, istisna are modes of trade which are right now being used as modes of financing.

Islamic financial institutions believe the role of traders and use the modes of trade but remain financiers.  This transmutation is achieved by ‘legal’ credentials and some self-persuasion.  It does not, however, convince many; and the root of the problems faced by Islamic banking and finance today lies in this split individuality.  The theme of this article is: let the financiers be financiers, and the traders and entrepreneurs be traders and entrepreneurs.

Social context: past and present

The Mecca of 1400 years ago was a small city (of possibly a few thousand inhabitants), basically everyone of any consequence was known to everyone else, and the assembling of a trade convoy was a great public occasion that took position twice a year.  The Who’s Who? of the financiers and the agents, their quality and abilities, who took what, what was sold for what value, what was bought for what value and the sale price were all public knowledge.  There was little room for misconduct and the price for it in terms of social banishment was very high.

In the modern world, mainly in large cities, basically everyone is a stranger to his neighbors.  Financial dealings are strictly confidential.  Who has money, who needs it, and to do what are all usually unfamiliar to any other.  But the bank has become privy to this information, counting the amounts, and has recognized itself as an mediator between the owner of funds and the capitalist who needs it.

Actuality today is that there are many capital-holders who wish to receive an income from their capital but have neither the time nor the skills obligatory to embark on a project.  They may variety from simple wage earners who have saved some money, pensioners, widows or orphans who have established a lump sum payment, trusts and institutions with whom some capital has been entrusted, to insurance companies and individuals who have inherited a fortune.  The size of their capital too may vary from hundreds and thousands to millions.  They need to invest their capital in a profitable undertaking, but may not know any entrepreneurs who wish to embark on a project and are looking for financiers. On the other hand, entrepreneurs who have viable project proposals may not recognize those who have the required funds and are disposed to invest in their projects.

This is where, in the context of the present-day, the need arises for a financial intermediary who could bring the investor/financier and the entrepreneur together.  Conventional banks do perform this role very effectively and efficiently.  Capital holders deposit their funds with the bank, and entrepreneurs submit their project proposals to the bank, the bank examinesz.  The bank does not get occupied in the mission; whether the borrower makes a profit or loss he pays the principal and interest on due dates, or the bank has recourse to the collateral.  The bank accepts the depositor’s capital, guarantees its full return, and pays him an interest (or return on his ‘investment’) at a fixed rate, and uses the capital to grant loans to borrowers.  But the interest rate given to the depositor is always minor than the rate the bank charges the borrower, and the difference goes to cover its own expenses and profits.

This seems to work very well if people have no qualms about paying or receiving interest, despite the built-in inequality to both the entrepreneurs and the depositors.

[1]  But some people are beginning to have qualms, and Muslims are prohibited from earning an income in this fashion.

[2]  Islamic banking is a rejoinder to their concern ¾ an substitute method to address the need, minus the injustice.

Islamic banking

Mudaraba is essentially an concurrence between a investor and an entrepreneur — the principals.  However, pleasing account of the up to date social structure and context, the pioneers of Islamic banking brought in an mediator between the principals and fashioned a two-tier mudaraba. This modified form of mudaraba was introduced into conservative profitable banking in the form of profit-and-loss-sharing (PLS) investment accounts and financing arrangements.  The earned profit (which is an undecided and unpredictable return on capital) was to replace the curiosity (a pre-determined fixed return) in the conservative setting. Therefore, except in a few countries where rules were relaxed or special banking laws were enacted, it was not possible to establish and operate Islamic banks in most countries of the world.  In such countries Islamic financial institutions, which did not arrive under deposit bank policy, were introduced.  In both cases, while the deposit/investment side worked on mudaraba basis, mudaraba was only one of several modes used for financing.  Though a favorite one in theory, in practice it became one of the least used.  The most used forms are modes of trade, and this has led to questions of morals and ethics.   In addition, Islamic banks are unable to present all the financing services probable of a commercial bank.

One of the very serious penalty of using modes of trade as modes of financing is that Islamic financial institutions are confined to financing short-term trade, and are unable to finance long-term projects in industries, farming, services, etc.

[4]  The latter are uniformly important, if not more, to any nation except perhaps for some few raw resources exporting countries which import all other foodstuffs.  But this condition too cannot persist for long.  Many, including Dr. Ali Yasseri in a recent (August 2000) article, cry out for a new move toward.  The question is: is there a viable option methodology?   A inclusive new methodology has been developed in a series of three books published in the last few years, and an overview of the salient features of the new approach is given in a recent publication.

The author argues that, “In Islam, there is a clear difference between lending and investing ¾ lending can be done only on the basis of zero interest and capital guarantee, and investing only on the basis of mudaraba.  Conventional banking does not ¾ and need not ¾ make this differentiation.”  But a system catering to Muslims “has to take this into consideration” and “…provide for two sub-systems ¾ one to cater to those who would ‘lend’ and another for those who wish to invest.”  The first sub-system would cater to those who wish to put their money into a bank for safety and transaction convenience; and the bank would provide all current account facilities and short-term loans and advances.   This is explained in a 1995 publication ¾ Interest-free Commercial Banking.  The 1996 publication ¾ Participatory Financing through Investment Banks and Commercial Banks ¾ describes the second sub-system, where both investment and financing are strictly on the basis of mudaraba.    Though the title mentions only banks, the methodology can be used by investment companies as well.  In this article we propose to bring out the salient features of the second sub-system.

[In the present era inflation is an important consideration where money is involved, and this has serious consequences in a riba-free system.  An attempt at dealing with it in the context of banking and finance is presented in the third book: Commercial Banking in the presence of Inflation (1999).]

Participatory financing

The central idea in the concept of mudaraba is that two parties, one with capital and the other with know-how, get together to carry out a scheme.  The financier provides the capital and plays no additional part in the project; specifically, he does not impede in its completing, which is the exclusive region of the entrepreneur.  If the project ends in profit they share the profit in a pre-arranged quantity.  If it results in loss the entire loss is borne by the financier, and the entrepreneur gains no benefit out of his effort, which was his part of the investment.  There are many variations of this simple model but this is the basic concept.  Mudaraba is usually translated as profit-and-loss-sharing but, as far as the financier is concerned, it is in fact profit-sharing-and-loss-absorbing.

In participatory financing, as envisaged in the present discussion, there are three important additions to this basic concept.   One, there are many investors and many entrepreneurs.  Two, an intermediary comes in with whom investors deposit their funds and the intermediary finances projects put forward by entrepreneurs.  In this investors-intermediary-entrepreneurs triangle, the depositor is basically a sleeping partner.  He provides capital and then shares the profit or absorbs the loss.  It is the responsibility of the entrepreneur to present a good proposal, convince the financier that it is viable and profitable, and provides proof that he is able, qualified and practiced to carry out the project successfully.  Three, individual investors and individual entrepreneurs have no direct contact/relationship with each other.  The investor does not know which project is financed by his capital, and the capitalist does not know whose money is financing his project ¾ a pool of funds from quite a few investor’s finances a sequence of projects from several entrepreneurs.  When it comes to profit/loss division too it is the net profit/loss from all the projects that is shared among the investors (and the intermediary).  The individual entrepreneur, however, shares with his financier (the intermediary, in the first instance) the profit/loss from his own project only.

It is apposite at this point to state that in the above scenario, the financiers ¾ both the investors and the mediator ¾ operate purely on the basis of mudaraba while the capitalist is free to choose any mode of practice (such as murabaha, ijara, salam, istisna, etc.) appropriate to his trade, business, industry, agriculture, etc. to run his enterprise.  Thus the proposed method simply avoids the need to devise dubious “financial instruments” which have brought the very concept of Islamic banking and finance into disrepute.  This also nullifies the need for “Shari’a Boards” in these institutions.

The occupation of the intermediary is very important.  He is accountable for identifying good projects for financing as well as for monitoring their growth and ensuring proper accounting and auditing.  But he (the intermediary) plays no part in managing the scheme or in making policy decisions — that is the restricted domain of the industrialist.  The intermediary is a disconnect physical and lawful entity, monarch of both the investors and the entrepreneurs.  But he (she/it) is an equal co-worker in every project he finances so that he has full lawful right to the corporeal and financial assets of all the projects and has full admission to all the books.  This is very significant, and it is here that participatory financing differs from conservative financing practices; in this admiration it differs from the existing practices of Islamic banks too.  This allows the mediator to have a true picture of the health of the projects at all timesOne important feature of participatory financing is that the entrepreneur need not provide security for the financing he receives.  The project itself is the refuge, and the intermediary, being an equal partner in the enterprise, is its guardian.  This should play a very productive role in discovering and increasing new entrepreneurial and other talents in the humanity, especially at the micro level, or else unearthed on account of the unavailability of collateral/sanctuary.

The planned scheme provides for two types of reserves: one called Participatory Financing (PF) stocks and the other PF shares.  These are basically stocks and shares in the intermediary’s PF scheme (which is a compilation of all (or a group of) the projects financed by the intermediary).  PF shares correspond to unit shares because every PF share contains a tiny piece of every scheme in the scheme.  PF stocks roughly communicate to fixed deposits in a bank.[7]  The main disparity between the conformist fixed deposits and the PF stocks is that the come back in the latter is computed from the profit and loss statements of all the projects in the PF scheme (and the profit/loss shared among the participants) at the end of the secretarial period.  Therefore the profit/loss is a realized one, and not an probable or pre-fixed one.  Thus neither assumption, nor indecision, nor riba is concerned in the operation.  But the PF stockholders will have to wait till the end of the secretarial period to collect their proceeds.

The status of every of the three participants in this system is as follows.  The mediator (an investment bank or an investment company) is a investment company with the legal status of a (public) imperfect liability business.  The investor may moreover hold a PF Share or a PF Stock.  The PF shareholders are like commonplace shareholders in the holding company’s PF scheme.  The PF stockholders are like the time-deposit holders in a bank.  Each project is a partnership incomplete accountability company where the industrialist and the holding business are the two partners.  PF shares supply the equity assets for the PF projects, while the PF stocks cater to the short-term cash necessities (which are normally met by loans and advances from commercial banks).

In essence, participatory financing combines features of time deposits, business organizations (partnerships, shareholder companies and holding companies), and unit trusts on the one hand, and equity resources and commercial bank loans and advances on the other.  It makes use of well-known rules and techniques of financing, company laws and secretarial procedures.  That makes it easy to apply, but the combination of all these in one single system within an industrial environment is a new formulation.  That makes it a challenging one, requiring new attitudes and a comprehensive approach.  We will briefly touch on these issues in the next section.

The theory of participatory financing has been fully urbanized and accessible in the book.  The depth of the theory can be gauged from the particulars given in the appendices, one of which is reproduced below (with slight explanatory modifications to suit this article) to help better appreciate the system.

Issues in implementation

The accomplishment of this system requires the cultivation of new attitudes on the part of all the participants.  This is a tall order but is an complete necessity if we are to generate a truly riba-free wealth.  It requires more from each contributor, but it also offers extra both to the human being and to the culture as a whole.  From the investor it requires the full considerate that he/she/it may invite loss and that he will have to linger longer to know the consequences, but it promises a actually riba-free income and perhaps better profits.  From the entrepreneur it requires complete and precise bookkeeping and full revelation of all his/her/its accounts and the sharing of his reward with his financiers, but it provides him with capital without security and the promise that in case there is a loss he will not be required to make it up, provided he had been honest in his dealings and his books will substantiate it.  The mediator is both a financier and an industrialist.  As an industrialist, he too is requisite to be sincere in his contact, and accurate and translucent as to his bookkeeping and accounts.

Bankers are trained to be very cautious, because their first concern is to guarantee the safety of the funds deposited with them.  But in this system they are relieved of that concern because the investors have agreed to take the risk, and therefore if they persist with the banker’s attitude they will miss many opportunities at the investors’ expense.  On the other hand, too much adventurism can bring about low profits or even loss, and that may lead to the loss of customers.  They must have an entrepreneur’s natural talent to spot profitable projects and to avoid bad ones, and should develop it into a professional tool.  The intermediary’s staff will have to be carefully picked and trained to bring out inherent entrepreneurial talent.  Such intermediaries will have ample reward, as they will share in the profits.  It requires a new culture, a culture of entrepreneur-financiers and of professionally run partnership companies.

The system is heavily dependent on proper and accurate bookkeeping, accounting and auditing.  That requires the availability of trained bookkeepers and their wide use, as well as professionally responsible and well-trained accountants and auditors.  They are the bedrock of the system.  The system requires a high level of integrity from these personnel, and it is in the interest of all the participants in the system to respect it.  Substantial investment is necessary in the training of such personnel, and legal protection is necessary to safeguard the independence of the auditors.

The inclusive system accessible in the four books groups the entire range of business actions into three broad categories: at one end is the one-man-owned-and-operated small enterprises, including the ones financed or supported by loans and advances from commercial banks, and at the other end are the large enterprises financed totally by shareholders and managed by professionals.  In between are the proposed participatory-financed enterprises.  The size of the enterprise is an important factor in this categorization, and the type of financing and the type of organization must normally match the size.  Presently in all mounting countries ¾ to which group most of the Muslim economies belong ¾ the allocation is highly skewed towards the slighter end.  To achieve a improved and stable economy, it is needed to bring about a more even allocation.

The mudaraba principle is appropriate to a range of situations, from a simple local two-person business to a multiparty worldwide corporation.  A shareholder company works basically on the mudaraba principle.  But the participatory financing system envisaged in this article aims at the center section of this range. It brings in the mediator, and provides the investors with a unit trust type of speculation opportunity.  The scheme is ideally suitable to medium scale new enterprises.

This can be done as follows.  There are two possibilities.  One, the venture is a organization business and has no debts, and wishes to expand its activities.  In this case, first the present worth of the enterprise (property, equipment, stocks, receivables, etc. including goodwill) must be determined.  This is the capital of the enterprise in monetary terms.  The investment bank/company brings in the necessary additional capital, and both go into a partnership (preferably by establishing a new private limited liability company) as before.  However, in the present instance the original enterprise has two roles, as an entrepreneur and as a financier, while the investment bank/company is only a financier.  Accordingly, when the profit/loss is computed, the financiers (both the enterprise in its role as a financier and the investment bank/company) will first share the profit/loss with the “entrepreneur” on mudaraba terms.  Next, the two financiers will share the financiers’ share between themselves in proportion to their capital contribution.  Finally, the bank/company will credit its share from this project to the bank/company’s PF pool of profit/loss.  The procedure from here on is the same as previously described.

Two, the endeavor is a running business and has debts owing to, say, a commercial bank.  In this case, the investment bank/company will pay up all the debts and go into partnership with the enterprise, as in the first case, with this amount as its capital contribution.[8]

In establishing the new institution of mudaraba-based speculation and finance, using the participatory financing scheme as described above, it is preferable to create with intermediate size running businesses.  This will supply a stable base for the new institute to test the theory and to gain knowledge.

Conclusion

In order to bring about a riba-free economy, the country’s banking system has to be riba-free, its commercial enterprises have to be financed by equity capital, and its investments have to be on a profit and loss sharing basis.  This article has dealt with speculation and financing, and has introduced a mudaraba-based system called participatory financing that takes into account present-day realities.  This is a new institution purposely urbanized to address the concerns of Muslims.  It has no parallel in the conventional financial system, but the individual tools and techniques it uses are ones tested and proved in the conservative setting.  Thus, while re-invention of the wheel has been avoided, proving the viability of the new organization and benefiting from it are challenges specific to Muslims.  It is for the Muslim intellectuals, professionals, investors, entrepreneurs, and other worried individuals, institutions and organizations to take up the confront.

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