Profit and Loss Sharing

The organizing principle of Islamic finance: a provider of capital is entitled to a return only if it shares in the risk of loss, in contrast to interest, which guarantees the lender a return regardless of outcome. The two profit-and-loss-sharing contracts are Mudarabah (one party provides capital, the other management, profit shared by ratio, financial loss borne by the capital provider) and Musharakah (all parties provide capital and share profit by ratio and loss by capital share).

Sale- and lease-based contracts like Murabaha and Ijarah are accepted alternatives but are considered second-best to genuine profit and loss sharing by many scholars.

Profit and loss sharing is the ideal that Islamic finance was founded on in the 1960s and 1970s, and the gap between that ideal and the industry's actual product mix is the source of much of its internal criticism. In theory an Islamic bank would take deposits on Mudarabah, invest them in Musharakah ventures with businesses, and pass through real profit and real loss. In practice, by most estimates well over 80% of Islamic financing worldwide is Murabaha, Ijarah, and other sale- or lease-based debt-like contracts, because they are easier to price, document, and enforce and because customers and regulators expect fixed obligations.

Scholars accept those contracts as valid, but many describe them as a concession rather than the goal. For U.S. consumers the principle matters in three ways. It is the clearest test of whether a product is genuinely Islamic: does the financier stand to lose if the asset loses value or is destroyed? In diminishing Musharakah home financing the answer is partially yes, since the provider co-owns the house.

It explains why halal savings accounts in the U.S. pay little or nothing: without a true profit-sharing deposit, which FDIC rules complicate, there is no risk to compensate. And it points to where profit and loss sharing is fully available to Americans: equity investing. A screened stock portfolio or halal fund is Musharakah in its purest modern form, which is why scholars generally regard halal equity investing as more squarely within the spirit of the law than any financing product.