Why Do Islamic Banks Tend to Avoid Profit and Loss Sharing Arrangements?

Abstract

The twentieth first century has witnessed resurgence in the observance of fundamental Islamic practices around the world. With it’s significant potential and competitive form of financial intermediation, Islamic finance and banking has emerged and experiencing rapid expansion. However, it still faces many problems and challenges relating to Islamic instruments, financial markets, and regulations that must be addressed and resolved. One of the problem is low level participation of the Islamic banks in profit and loss sharing arrangements. This arrangements are unique to Islamic banking and account for its superiority over conventional banking on grounds of ethics and efficiency, but the majority of Islamic banks have limited themselves to less risky trade-financing assets, which tend to be a shorter maturity. This is contradictive with the theoretical models and basic principles of Islamic finance. This paper analyzes why Islamic banks are reluctant to indulge in profit and loss sharing instruments. We present the basic understanding of the concept of Islamic finance and banking. We introduce the theoretical model of balance sheet to compare them to the practices of Islamic banking. We also explore the risk management concept to solve this problem. One of the implication is that the theory and practices differences in Islamic banking have led to increased the perception of riskiness at the institutional and systemic level.

Keywords: Islamic Banks, Profit and Loss Sharing Arrangements, Risk Management

JEL Classification: G00, G20, G21