comparison between a conventionally financed firm and a profit sharing firm

Name: Mohammad Kashif Choudhury

Research Supervisor: Dr. A.F.M Ataur Rahman

A Comparison

between a

Profit Sharing

Firm and a

Conventionally

Financed Firm

January 17

2014

A Profit and Loss Sharing Firm 1

“The last verse to be revealed was on riba and the Prophet, peace be upon him, passed away

without explaining it to us; so give up not only riba but ribah [i.e. whatever is doubtful].” Umar Ibn al-

Khattab, Second Caliph of Islam


Acknowledgment

I would like to begin by declaring my gratitude and humbleness to Almighty Allah

Subhanahu wa ta’ala for giving me an opportunity to conduct a research like this and

persevere till the end. It is my great honor to have been able to look into a subject matter

that I feel is seldom visited in the field. For this I would like to next thank Dr. A.F.M Ataur

Rahman for being an insightful, patient and wise research advisor to me during this process.

His Grasp of the subject matter at hand and his holistic approach to understanding and

analyzing the issues helped me formulate the ideas of my research and put them to writing.

His book also helped me immensely during my research and was responsible for many of

the ideas in the paper. Lastly, I would like to thank my friends, family and acquaintances

who helped me gain insight into the subject matter and helped me see things from various

perspectives. In a way, their thoughts and feedback was behind the motivation for this

research as well as its direction.


Abstract

This research paper looks at the operations of a firm that finances itself by a method of profit sharing

(PLS) instead of conventional debt financing. The motivation behind this research came about from a

need to study the viability and effects of an alternative system of financing for companies. This was

due to two main reasons, the first of which was a need to find a workable alternative to a system of

financing which is now a monopoly and has been found time and time again to cause severe crises.

Secondly, it came from a need to study a practice which has been thought of as vile and distasteful by

philosophers as well as religions throughout the ages. In particular Islam forbade the practice of

interest and usury. Practices which we now find to be unavoidable when conducting any economic

activity. The paper starts with describing the system of Profit and Loss Sharing financing using

appropriate examples. Then the advantages are discussed followed by a case study that analyzes the

effects of a shift to the PLS method from a conventional debt financing one. The resultant effects are

analyzed and concluding remarks are formulated.


Contents

INTRODUCTION .............................................................................................................................................. 5

LITERATURE REVIEW ................................................................................................................................. 9

THEOLOGICAL STANDPOINT .......................................................................................................................... 9

PHILOSOPHICAL & THEORETICAL STANDPOINT ....................................................................................... 18

METHODOLOGY ............................................................................................................................................ 32

DATA ................................................................................................................................................................. 33

OVERVIEW OF PROFIT AND LOSS SHARING SYSTEM (PLS) ...................................................... 35

ADVANTAGES OF PLS SYSTEM OVER THE CONVENTIONAL SYSTEM ................................... 37

CASE STUDY ................................................................................................................................................... 50

FINDINGS OF THE CASE STUDY ............................................................................................................. 56

CONCLUDING REMARKS ........................................................................................................................... 60

FURTHER RESEARCH TOPICS ................................................................................................................. 61

BIBLIOGRAPHY ............................................................................................................................................. 62


Introduction

The core of this particular research revolves around the concept of profit sharing in

financing a firm's operations in place of interest based financing or what is known as

conventional sources of financing. The effects of introducing such a system in place of the

conventional, interest based system is going to be examined, both at the firm level (micro

level) with some extensions of the effects on the broader economic level (macro level).

The Profit Sharing Arrangement/ Profit and Loss Sharing method referred to as PLS from

here on out can be defined as a financing method where the investor and the firm

(borrower) shares in the profits from the venture and any losses according to their share of

investment. In other words, each entity in the investment process gets the same proportion

of return from his investment from a particular project and has to share in the losses equally.

There are various differences and nuances that accompany the profit sharing method of

financing when compared to interest based financing. These range from differences in the

mechanics of the process to differences in the implications on the economy. These will be

discussed throughout the course of this paper.

But, it should be pointed out from the outset that while this research paper will be guided

by the directions of the Almighty and his Messenger pbuh, and contain various excerpts

from the Quran and the Hadith, it will at the same time look into the realities and

practicalities of the present financial landscape and try to put forward an alternate financial

structure and methods which firms can use to finance their operations. The advantages of

this alternative system in mitigating most of the problems of the current financial system

will also be stated and elaborated upon.

Nor is the financing methods of Shariah compliant banks and other institutions, their

effectiveness and validity a concern of this research. This paper's sole aim is to design the

most basic of profit sharing systems devoid of most of the financial complexities that are

inherent in today’s market and examine them in the context of the present socioeconomic

status quo.

Conventional, interest based financing has come under tremendous scrutiny and criticism in

the last 5 or so years because of the implosion of the U.S financial system and its

widespread affects all across the globe. It has also caused various socioeconomic problems


in developing countries like Bangladesh. The “interest based system” has numerous flaws

and pitfalls that are inherent in its nature. This however should not be taken to be a new

realization. Great thinkers from Aristotle to Jeremy Bentham and economists as

distinguished as Adam Smith to John Maynard Keynes have grappled with this issue for ages.

That is, the issue of usury and by extension interest. Further, religions such as Islam,

Christianity, and Judaism have condemned the practice in their respective Holy Books. In

Islam for example, Allah SWT says, “Those who eat Ribâ (usury) will not stand (on the Day of

Resurrection) except like the standing of a person beaten by Shaitân (Satan) leading him to

insanity. That is because they say: "Trading is only like Ribâ (usury)," whereas Allâh has

permitted trading and forbidden Ribâ (usury). So whosoever receives an admonition from his

Lord and stops eating Ribâ (usury) shall not be punished for the past; his case is for Allâh (to

judge); but whoever returns [to Ribâ (usury)], such are the dwellers of the Fire - they will

abide therein.” (Al Quran: 2:275). This is one of many excerpts in the Quran where Usury is

forbidden in the strictest of terms with the promise of severe torment in the afterlife for

those who choose to ignore it.

Then a question arises of why a seemingly harmless transaction between two willing parties

has been looked upon with disgust from philosophers to God himself. This particular

question is a humbling one because it makes us realize that there are issues that us humans

cannot fully grasp and hence have to look up for guidance from a higher being or at least a

more intellectually endowed creation if one is so inclined. However, this system of loans on

ex ante, fixed returns on principle (interest) has become so ingrained into the financial and

economic fabric of our society that many now argue the validity of the prohibitions on it

that have been applied throughout the ages.

One of the most common rebuttals on the prohibition among Muslims according to the

observation of this researcher is that “modern day” interest is not what was prohibited in

the Quran because it is not usurious (usurious meaning at excessive rates). However, the

Quran in reality does not make any distinction between low and excessive rates of interest

and defines any predetermined increase in principle to fall under the purview of usury. This

is confirmed by the consensus of the Ulama as well as specialists of Islamic Fiqh as

mentioned in the literature review. It is not clear whether this is a causal effect of the

widespread nature of interest based finance and a lack of alternatives or a learned judgment

call on the part of those who claim it. Whatever it may be a statement of Umar ibn al-


Khattab, the second Caliph of Islam where he said “The last verse to be revealed was on riba

and the Prophet, peace be on him, was taken without elaborating it to us; so give up not

only riba but also ribah [whatever raises doubts in the mind about its rightfulness] (Ibn

Majah, op. Cit.,). This statement makes it clear that any transaction that seems remotely

akin to usury should be avoided.

In addition, for Muslims who believe that they have to stand before Allah SWT on the Day of

Judgment to account for their deeds then it should be in their best interests to avoid this

practice. Regarding this an analogy is in order. Suppose you are on a boat with an

uncomfortable seat, then you will not jump into the water to avoid that. You will think of

the cold water and the inconvenience of getting wet. However, if that same boat is on fire,

then you will jump and the last thing on your mind will be the fact that the water is cold.

You will be preoccupied with escaping from the scene as fast as possible. The latter situation

should befall a Muslim when he studies his religion and realizes the grave consequences of

the practice of usurious transactions and jump into the water. He will not give a thought to

the fact that the water is cold (that is, there is not sound alternative to conventional

financing). If enough of the Ummah start doing this there will be an emergence of

alternative forms of finance because after all, as Plato once said, necessity is the mother of

invention. However, for someone who is not concerned about the consequences and

chooses the path of least resistance, he will be in the boat with uncomfortable seating. He

will not jump in because the water is too cold (there is no sound alternative).

Another rationale of Muslims in defense of usury that is common today is that the

alternatives in the form of “Islamic Banks” are not sufficiently differentiated from

conventional banks to be of consideration. As mentioned earlier this is a discussion for

another paper and is not the purpose of this research. However, it must be noted that a lack

of an alternative does not validate a certain practice. In other words suppose Practice A is

forbidden and an alternative is formulated to take its place in the form of Practice B. But

later on, Practice B is found to be forbidden as well. This revelation does not validate

Practice A in any way as many claim in the case of conventional banks.

Also, adherents of Islam should note the following Hadith narrated by Abu Hurayrah where

the Prophet Mohammad PBUH said, “There will come a day when everyone will deal in Riba

or at the very least be touched by its dust”. One has to wonder if he had foreseen a day such

as this when he made this claim because it seems interest and usurious practices are


unavoidable in this day and age from the biggest investment houses to the most destitute

households just scraping by and living from meal to meal. A system that has historically

been responsible for perpetrating injustice and inequality in society is now the very

definition of growth and prosperity across the world.

In designing a system which adheres to the ethos of Islam and avoids interest a lot of

fundamental concepts in finance have to be changed in order to facilitate it. For example

the very question of whether banks as we know it would exist. This is because in a non

interest based system, economic agents deal between themselves and the middleman

becomes less important. This would also mean that large investments would be harder to

come by but the aim of an Islamic system would not be to achieve the highest possible

growth but to achieve economic equality and socioeconomic harmony. This is not to say

that Islam discourages enterprise. Rather, it encourages it as long as it adds value to the

economy and the risks are shared equitably among all the parties involved.

Another issue would be that the ease with which loans are made using a market rate of

interest in a conventional system would be somewhat lost in an interest free profit sharing

system. This would lead to lower economies of scale than the present system and higher

costs in some cases. Again, these would have to be dealt with in time and is not the subject

of this paper. However, through the course of this research it will be observed that the

advantages of a Profit and Loss Sharing System (PLS) will far outweigh the costs and will lead

to a more stable economic system which will in turn lead to the betterment of the

socioeconomic order.

The main premise of this paper revolves around the question of what would happen if firms

financed their operations by the Profit and Loss Sharing Method (PLS) instead of the

conventional method of financing. As such the effects the system would have on different

variables related to the operations of the firm such as the profit to the firm and investor,

taxes paid falls within the scope of this paper. The relevant discussions will take place both

from a theoretical as well as practical perspective.

The paper is organized such that a theoretical discussion about both the systems is

conducted, followed by a generic numerical example of the differences between a

conventional and PLS system. Following this, a case study on Beximco Pharmaceuticals is

presented followed by an analysis of the differences between the two systems and the

findings from the case study.


Literature Review

The motivation for this research came about from a need to understand the theoretical basis

of usury and modern day interest and its theological as well as historical underpinnings.

Specifically the issue of why this seemingly harmless phenomenon of lending money in return

for a fixed surplus was condemned in every major religion as well as by some great thinkers

across the ages. What is it about this seemingly mundane and “fair” transaction between

two apparently “willing” parties that would incur the wrath of God in the Abrahamic texts as

well as the condemnation by thinkers as great as Plato, Aristotle, John Maynard Keynes and

others?

This research aims to explore the current system of financing and its inherent flaws in the

modern setting. Following this, an attempt is made to explore the implications of a firm

financing its operations using a PLS (Profit and Loss Sharing) method of financing.

Due to a dearth of material covering the exact differences between these financing methods,

the literature review consists of the theological and philosophical background of usury and

interest throughout the ages up to modern times.

The literature review for this research will be segregated into two parts. The first part is

going to be a literature review from a religious and theological standpoint and the second is

going to be a literature review from a philosophical and theoretical standpoint.

This is necessary because in order to understand the concept of usury and its implications in

modern times fully, a holistic approach has to be taken.

Theological Standpoint

Some notable excerpts are quoted from the Holy Quran. The reason for quoting the holy

book of the Muslims are two.

Firstly, due to the researcher being an adherent of Islam, he would be most immersed and

interested in the teachings of this text and secondly, it is widely observed to be the case that

Muslims are the particular group who to this day take all forms of interest, not just

excessive ones to fall under the category of usury and Riba.


Some notable excerpts are quoted from the Quran

“Who is he that will loan to Allah a beautiful loan, which Allah will double unto his credit and

multiply many times? It is Allah that giveth (you) Want or plenty, and to Him shall be your

return..” (Al Quran: 2:245)

“Those who eat Ribâ (usury) will not stand (on the Day of Resurrection) except like the

standing of a person beaten by Shaitân (Satan) leading him to insanity. That is because they

say: "Trading is only like Ribâ (usury)," whereas Allah has permitted trading and forbidden

Ribâ (usury). So whosoever receives an admonition from his Lord and stops eating Ribâ

(usury) shall not be punished for the past; his case is for Allâh (to judge); but whoever returns

[to Ribâ (usury)], such are the dwellers of the Fire - they will abide therein.” (Al Quran: 2:275)

“Allâh will destroy Ribâ (usury) and will give increase for Sadaqât (deeds of charity, alms, etc.)

And Allâh likes not the disbelievers, sinners.” (Al Quran: 2:276)

“Truly those who believe, and do deeds of righteousness, and perform As-Salât (Iqâmat-as-

Salât), and give Zakât, they will have their reward with their Lord. On them shall be no fear,

nor shall they grieve.” (Al Quran: 2:277)

“O you who believe! Be afraid of Allâh and give up what remains (due to you) from Ribâ

(usury) (from now onward), if you are (really) believers.” (Al Quran: 2:278)

“And if you do not do it, then take a notice of war from Allâh and His Messenger but if you

repent, you shall have your capital sums. Deal not unjustly (by asking more than your capital

sums), and you shall not be dealt with unjustly (by receiving less than your capital sums)” (Al

Quran: 2:279)

“And if the debtor is in a hard time (has no money), then grant him time till it is easy for him

to repay, but if you remit it by way of charity, that is better for you if you did but know.” (Al

Quran: 2:280)


“And be afraid of the Day when you shall be brought back to Allâh. Then every person shall

be paid what he earned, and they shall not be dealt with unjustly.” (Al Quran: 2:281)

“And whatever riba you give so that it may increase in the wealth of the people, it does not

increase with Allah.” (Al Quran: 30:39)

“And because of their charging riba while they were prohibited from it.” (Al Quran: 4:161)

“O those who believe do not eat up riba doubled and redoubled.” (Al Quran: 3:130)

In addition, on the 9th day of Dhul Al Hijjah 10 A.D, the Prophet Mohammad PBUH said the

following during is last sermon to his people.

"O People, listen well to my words, for I do not know whether, after this year, I shall ever be

amongst you again. Therefore listen to what I am saying to you very carefully and take these

words to those who could not be present today.

O People, just as you regard this month, this day, this city as Sacred, so regard the life and

property of every Muslim as a sacred trust. Return the goods entrusted to you to their

rightful owners. Treat others justly so that no one would be unjust to you. Remember that

you will indeed meet your LORD, and that HE will indeed reckon your deeds. God has

forbidden you to take usury (riba), therefore all riba obligation shall henceforth be waived.

Your capital , however, is yours to keep. You will neither inflict nor suffer inequity. God has

judged that there shall be no riba and that all the riba due to `Abbas ibn `Abd al Muttalib

shall henceforth be waived...”

And finally, one of the authentic Hadiths narrated by Abu Hurayrah, “The Prophet, said:

"There will certainly come a time for mankind when everyone will take riba and if he does

not do so, its dust will reach him." (Abu Dawud, Kitab al-Buyu', Bab fi ijtinabi al-shubuhat;

also in Ibn Majah”)

Riba literally means an increase or excess in Islam. This has very broad implications and has

been taken to include modern forms of interest as they exist. Regarding this, Chapra, M.

(2006) writes, “The consensus prevailing among Muslims throughout history has been, and

continues to be, that riba among other things, includes interest. This consensus is clearly


reflected in the unanimous verdict of a number of international conferences of fuqaha

(jurists) which have been held to discuss the question of riba, including the Mu’tamar al- Fiqh

al-Islami held in Paris in 1951 and in Cairo in 1965, and the OIC and Rabitah Fiqh Committee

meetings held in 1985 and 1986 in Cairo and Makkah respectively” Hence, there have been

conferences over that last half a century among Muslim Jurists and scholars that discussed

the rulings on Riba and they concluded unanimously that Riba includes modern day interest.

Riba in Islam is of two types. They are,

a. Riba al-nasi'ah: Nasi'ah comes from the root word Nasa'a which means to postpone or

defer a payment in return for a premium or excess payment, Chapra, M. (2006). This is

taken to refer to the modern of interest on loans where an increase or premium is paid on

the principal borrowed that is fixed ex-ante as part of the condition for the loan. The

prohibition of Riba al-nasi'ah implies that a preset positive return on a loan as reward for

waiting is prohibited in the Shari'ah. This ruling holds whatever the return may be; small or

usurious.

In addition, there are some who claim that the prohibition of interest was only applicable

for consumption loans which were predominant in Riba al-jahiliyyah (pre-islamic days).

However, Chapra, M. (2006) quotes Shaykh Abu Zahrah, one of this most prominent Islamic

scholars of the century as saying “There is absolutely no evidence to support that the riba of

al- Jahiliyyah [pre-Islamic days] was on consumption and not on development loans. In fact

the loans for which a research scholar finds support in history are production loans. The

circumstances of the Arabs, the position of Makkah and the trade of Quraysh, all lend

support to the assertion that the loans were for production and not consumption purposes.

(Abū Zahrah, 1970, pp.53-4.)”

In addition he quotes Professor Abraham Udovitch, Ex-Chairman of the Department of Near

Eastern Studies at Princeton University, as saying “Any assertion that medieval credit was

for consumption only and not for production, is just untenable with reference to the

medieval Near East”( Udovitch, 1970, p.86). Hence, the Quranic verse about remitting the

principal in the event of the borrower’s hardship does not refer to consumption loans. It

refers essentially to interest-based business loans where the borrower had encountered

losses and was unable to repay even the principal, leave alone the interest”.

Thus the argument that Riba entailed only consumption loans is untenable and hence is

applicable for all types of loans; be it for production or for consumption. This is due to the


fact that when the verses of the Quran were revealed, the prevailing interest on loans at

that time were for mostly production purposes.

Moreover, the Quran makes a clear distinction between different types of increases that is

between Riba and trade. This is revealed in the following verse, “Those who eat Ribâ (usury)

will not stand (on the Day of Resurrection) except like the standing of a person beaten by

Shaitân (Satan) leading him to insanity. That is because they say: "Trading is only like Ribâ

(usury)," whereas Allâh has permitted trading and forbidden Ribâ (usury)”. This is also a

rebuttal to those who, in modern times claim that Riba does not cover interest as it is

essential for business and trade to take place.

Chapra, M (2006) further elaborates on this saying, “While in trade an entrepreneur has the

prospect of making a profit, he also faces the risk of incurring a loss. In contrast with this,

interest is predetermined to be positive irrespective of the ultimate outcome of business,

which may be positive or negative depending to a great extent on factors beyond the control

of the entrepreneur”.

This describes the rationale behind the prohibition of Riba in the Quran and the

endorsement of trade. The crux of the matter is that a predetermined premium on a loan

cannot be set because the entrepreneur does not know for certain the final outcome of his

venture. Thus, fixing payment over that would entail basing something definite and certain

on something that is not would violate the notion of social justice.

Regarding this, Imam Razi, one of the most prominent Muslim scholars explored why Riba

was prohibited when the borrower was just going to invest the money in order to earn a

profit. The rationale he came up with was, “While the earning of profit is uncertain, the

payment of interest is predetermined and certain. The profit may or may not be realized.

Hence there can be no doubt that the payment of something definite in return for something

uncertain inflicts a harm (al-Razi, n.d., p. 87)”.

In prohibiting Riba, the Quran restricts the accumulation of wealth without taking the

inherent risks associated with it. Whosoever transgresses on this ruling is promised War

with Allah and His Messenger in the Holy Quran.

Chapra, M. (2006) ends the discussion on Riba al Nasi'ah with the following, “There is, thus,

absolutely no difference of opinion among all schools of Muslim jurisprudence that riba al-

nasi’ah stands for interest and, is haram or prohibited (Al-Jaziri, Vol.2, p.245). The nature of

the prohibition is strict, absolute and unambiguous.(Al-Jaziri, Vol.2, p.24; See Appendix 3)”.


Thus, there is no ambiguity in modern Islamic Fiqh about the fact that the restriction on Riba

al-nasi'ah implies the restriction on modern day interest.

b. Riba al-Fadl: There is another type of Riba that is less explored. This is known as Riba al-

Fadl. While Riba al-Nasi'ah deals with the excess from principal in a loan, Riba al-Fadl entails

a number of aspects of trade that may indirectly or directly lead to Riba. This is because

Islam prohibits Riba but allows trade. However, it has to be kept in mind that the aim of

Islam is absolute social and economic justice and even though trade is allowed, there are

certain restrictions placed on it in order to ensure this. This conforms to a fundamental

maxim of Islamic law that whatever leads to something unlawful is by definition itself

unlawful. Thus, any action or deed that leads to Riba is by definition unlawful in itself.

There are a variety of situations which can lead to Riba al-Fadl and in this regard the Prophet

Mohammad PBUH said, “Leave what creates doubt in your mind in favour of what does not

create doubt” (Cited by Ibn Kathir in his commentary on verse 2:275). This implies that there

may be a number of situations where there can be a risk of transgression to this law and we

are instructed to avoid that which causes doubt in favor of that which does not. In the

beautiful words of Caliph Umar, “Abstain not only from riba but also from ribah”. It is to be

noted that the word ribah comes from the root word rayb which means doubt or suspicion.

In Regards to Riba al-Fadl there may be four broad categories, The first of which according

to Chapra, M. (2006) is, “the exploitation that may take place in trade through the use of

unfair means even though trade is by itself allowed”. This may include acts such as rigging

prices to favor one party. This is considered to be an unfair and socially undesirable act

because it deprives one party of a fair chance while giving another an undue advantage. The

extra resources earned by this action will fall within the purview of Riba al-Fadl.

The second category according to the paper may be “by accepting a reward in return for

making a recommendation in favour of a person”. This seems precariously close to the

definition of a bribe. The person in power, in many cases a bureaucrat works in favor of a

certain party in return for a promised payment. Such money motivated actions will lead to

the same outcome as before in that an undeserving party will benefit from it while another

will lose out. In other words, this will be akin to a zero and in some cases negative sum game.

The extra advantage, monetary or otherwise from this action will therefore again fall under

the purview of Riba al-Fadl.

The third category according to Chapra, M. (2006) is “through barter transactions because of


the difficulty of measuring the counter-values precisely in such transactions. The Prophet,

peace and blessings of God be on him, therefore discouraged barter in a monetized economy

and required that the commodity to be exchanged on the basis of barter be sold against cash

and the proceedings used to buy the needed commodity (Appendix 2, Hadiths C.5, C.6 and

C.7)”.

This implies that due to the difficulty of assessing the value of barter transactions accurately,

there may be it is undesirable to conduct barter transactions in the presence of a common

medium of exchange such as money. Otherwise, there will be scope for injustice which will

in turn lead to Riba al-Fadl.

The fourth and final category of Riba al-Fadl according to the paper deals with the exchange

of like goods. Chapra, M. (2006) writes, “A number of authentic hadiths stipulate that, if the

same genus of commodities is exchanged against each other, then the same quantity and

weight of the commodities (sawa’an bi sawa’in and mithlan bi mithlin or equal for equal and

like for like) should be exchanged hand-to-hand (yadan bi yadin) (Appendix 2, Haidths C.2, C-

4) If the commodities exchanged are different, it does not matter if there is difference in

weight and quantity, provided that the exchange takes place hand to hand. One of the

implications of this requirement is the elimination of the backdoor to riba (which is referred

to in fiqh as sadd al-dhari‘ah). Another implication of these hadiths, as understood by the

fuqaha, is the prohibition of futures transactions in foreign exchange”.

Hence this last category has a number of implications. The first is that the ruling of Riba,

which at its core means excess, applies to goods the same way it does for money. In other

words, if the same sort of good is to be exchanged for one another, it has to be done so at

the exact same amount and it has to be a spot (hand to hand) transaction. The author states

at the end of the passage that this may also apply to futures transactions especially with

regards to foreign exchange. This is because a like good has to be exchanged in the same

amount and it cannot be deferred as it is in a futures transaction. Doing so leaves a scope

for injustice and manipulation in the case of fluctuations.

In conclusion, there the two types, Riba al-nasi'ah and Riba al-Fadl are the two broad

categories of Riba that have been forbidden in the Holy Quran. In regards to the first, it is a

fairly narrow and unambiguous ruling on the prohibition of fixed positive returns on

monetary loans. This establishes justice between the financier and the entrepreneur.

Meanwhile the second type, Riba al-Fadl, is a little more complicated.


With regards to Riba al-Fadl, Chapra, M. (2006) writes, “This is the ongoing challenge to all

Muslims – to examine their economic practices continually in the light of Islamic teachings

and to eliminate all shades of injustice. This is a more difficult task than eliminating riba al-

nasi’ah. It requires a total commitment and an overall restructuring of the entire economy

within the Islamic framework to ensure justice. This was, and is, the unique contribution of

Islam. While riba al-nasi’ah was well-known in the Jahiliyyah, the concept of riba al-fadl was

introduced by Islam and reflects the stamp of its own unflinching emphasis on socio-

economic justice”.

Thus, eliminating Riba from society not only requires eradicating interest based loans but

also demands a rethinking and inquiry about the practices and actions economic agents take

in their everyday lives. The concept of Riba al-Fadl was something that was introduced by

Islam and its aim is to work towards eliminating the different channels by which the crime of

Riba may be committed. Both types of Riba have to be guarded against and studied in the

context of modern finance and economics in order to ensure an equitable and socially just

society.

As is apparent from the discourse above, the Quran and Sunnah forbid Riba in a manner

that is very strict and unambiguous. There are three important points to be noted here.

Firstly, even though all the verses of the Holy Book are worthy of the same appreciation,

one particular verse should be a special reminder to Muslims. That is where Allah SWT says

the following,

“and if you do not do it, then take a notice of war from Allâh and His Messenger but if you

repent, you shall have your capital sums.”

Here, Allah SWT is making a reference to riba and has promised war on behalf of Himself

and his Messenger on anyone who deals in it. This is a statement that can be considered to

the pinnacle of warning as this promises war with the Almighty himself. The second point of

note regarding this comes from Prophet Mohammad's PBUH last sermon. Muslims should

realize that the last sermon of the last Messenger to ever walk the earth for the benefit of

humanity contained the prohibition of Riba as one of the first topics. Finally, there is a

Hadith that was narrated by Abu Hurayrah where he noted the Messenger PBUH as saying

that

“there will come a day when everyone will deal in Riba or at the very least be touched by its

dust”.


One has to wonder if the Final Messenger PBUH of the Almighty was talking directly to the

Ummah of today. An objective interpretation would certainly suggest that. In light of this, it

is the belief of the researcher that every Muslim has a responsibility to study this subject no

matter what his inclinations.

Some notable excerpts are quoted from the Old Testament

“If thou lend money to any of My people, even to the poor with thee, thou shalt not be to

him as a creditor; neither shall ye lay upon him interest” (Exodus 22:24 (25))

“Take thou no interest of him or increase; but fear thy God; that thy brother may live with

thee.” (Leviticus 25:36)

“Thou shalt not give him thy money upon interest, nor give him thy victuals for increase.”

( Leviticus 25:37)

“Thou shalt not lend upon interest to thy brother: interest of money, interest of victuals,

interest of any thing that is lent upon interest.” (Deuteronomy 23:20 (19))

“Unto a foreigner thou mayest lend upon interest; but unto thy brother thou shalt not lend

upon interest; that the LORD thy God may bless thee in all that thou puttest thy hand unto,

in the land whither thou goest in to possess it.” (Deuteronomy 23:21 (20)

“that hath withdrawn his hand from the poor, that hath not received interest nor increase,

hath executed Mine ordinances, hath walked in My statutes; he shall not die for the iniquity

of his father, he shall surely live.” (Ezekiel 18:17)

“He that putteth not out his money on interest, nor taketh a bribe against the innocent. He

that doeth these things shall never be moved.” ( Psalm 15:5)

Some notable texts are quoted from the New Testament

"Thou oughtest therefore to have put my money to the exchangers, and then at my coming I

should have received mine own with usury." (Matthew 25:27)

"Well then, you should have put my money on deposit with the bankers, so that when I

returned I would have received it back with interest.." (Matthew 25:27)

"…Out of thine own mouth will I judge thee, thou wicked servant. Thou knewest that I was

an austere man, taking up that I laid not down, and reaping that I did not sow. Wherefore

then gavest not thou my money into the bank, that at my coming I might have required mine

own with usury?" (Luke 19:22-23)

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"And if you lend to those from whom you expect repayment, what credit is that to you? Even

sinners lend to sinners, expecting to be repaid in full. But love your enemies, do good to them,

and lend to them without expecting to get anything back. Then your reward will be great,

and you will be children of the Most High, because he is kind to the ungrateful and wicked."

(Luke 6:34-35)

"Give, and it will be given to you. A good measure, pressed down, shaken together and

running over, will be poured into your lap. For with the measure you use, it will be measured

to you.” (Luke 6:38)

Philosophical & Theoretical Standpoint

Aristotle

According to Aristotle, “The natural form therefore of acquisition is always and in all cases,

acquisition from fruits and animals. That art . . . has two forms: one which is connected with

the management of the household. Of these two forms the latter is necessary and laudible;

the former is a method which is justly censured, because the gain in which it results is not

naturally made, but is made at the expense of the other man.”

“The most hated sort, and with the greatest reason, is usury, which makes a gain out of

money itself, and not from the natural object of it.”

“For money was intended to be used in exchange, but not to increase at interest.”

“When the use of coin had once been discovered out of barter of necessary articles arose the

other art of wealth-getting, namely, retail trade; which was at first probably a simple matter,

but became more complicated as soon as men learned by experience whence . . the greatest

profit might be made”

Furthermore, “The quality of courage, for example, is not intended to make wealth, but to

inspire confidence; neither is this the aim of the general's or physician's art; but the one aims

at victory and the other health. Nevertheless, some men turn every quality or art into a

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means of getting wealth; this they conceive to be the end and to the promotion of the end

they think all things must contribute.” (Aristotle)

The preceding extracts show that Aristotle considered the increase of money through the

act of lending as an unnatural occurrence that went against the natural order. How must

money increase if it is known not to be able to reproduce was his question. With regards to

the Aristotelian view of Nature, Nitti, G.T. (1997) says, “In any case, in its primary and strict

sense, it is to be seen as a source of movement or rest intrinsic to all corporeal entity. This is

basically the acceptation he adopted in the context of natural philosophy, which we find in

Book II of Physics; there he will define nature “as the principle or cause of movement in that

in which it is primarily, in virtue of itself and not accidentally.” Though Aristotle’s insight was

certainly triggered by the observation of living beings, the philosopher clearly distinguishes

nature from life. Nature is not the same as the self-movement diplayed by animals or plants,

because it concerns non-living beings as well. Aquinas, too, is well aware that the notion of

nature can be framed within a broad context, which embraces also inanimate bodies”.

In view of this, he believed that money as an entity was merely a means to an end and not

an end in itself. He pointed out that if the later was taken to be true, then true happiness

would never be possible because it would cause a decline in society. This would be so

because a craftsman would no longer be concerned with the quality of his product but with

the return it brings him. Aristotle argued that the craftsman would hence deprive himself of

the “good life” and in the process deprive his fellow man of the same. This he argued would

lead to the decline of society and the “good life”, both of which he considered to be part of

the natural order. Hence his statement of interest being on money being unnatural.

Ultimately, Aristotle disliked usury because he said that it decreased the quality of life and

contributed to the disintegration of society. In saying this he explained what considering

money as an end in itself instead of a means to an end would lead to.

Retrospectives: From Usury to Interest

In his article, Persky, J. (2007) writes about the evolution of usury to what we now know to

be interest. He writes “In modern economics, interest is defined as the rental price of money.

But the word has a complex and less than fully resolved etymology. The origins of “interest”

are intimately connected to the changing meaning of “usury. Canon law in the Middle Ages

forbade usury, which was generally interpreted as a loan repayment exceeding the principal


amount. Our modern word “interest” derives from the Medieval Latin interesse”

Right at the beginning of the article, the author lays out the present meaning of interest and

its ancient origins. Usury in olden times meant a loan repayment that exceeded the principal

sum. This in the modern day can be taken as interest on loans and is now interpreted to be

the rental cost of money. The word interest came from the word “interesse” which meant a

penalty for late payment. This word now encompasses the whole of the financial world and

has a rather different connotation. Usury nowadays is taken to be an excessive interest

rates on money lent which sometimes amounts to 1000 percent annualized per annum.

Some legislatures restrict this sort of lending.

The great economist Adam Smith realized the importance of limits to interest rates as stated

by Persky, J. (2007), “Here is a sketch of the bare facts: Through the first four editions of the

Wealth of Nations, Adam Smith supported state-imposed caps on the rate of interest. Much

to the chagrin of many of his followers then and since, Smith thought 5 percent was just

about enough for any borrower in Great Britain to pay on a loan.1 In 1787, writing from the

estates of the Russian Count Potempkin in the backwater of Zadobrast near Krichev in

Belarus, Jeremy Bentham penned his Defence of Usury as a series of letters.2 From the

remote periphery of the expanding industrial revolution, Bentham claimed a place for usury

in Smith’s own system of economic liberties. In doing so, he explicitly sought to convince

Adam Smith to give up his support for interest rate limits. But the last edition of the Wealth

of Nations to appear in Smith’s lifetime, in 1789, left the usury passages unchanged. ”

Even though Smith was an adamant supporter of free markets as well as free will, he

believed that interest rates left on its own would be exploitative and hence it would need to

be controlled by the state. He had a heated discourse with Jeremy Bentham, one of his

disciples in this regard. Bentham's argument was that the limits on usury contradicted

Smith's principles of free markets. He argued that by letting the market determine the rate

of usurious loans, it would end up at an efficient point.

However, Smith did not agree with this till the end and his views on limits on usurious rates

stayed the same throughout all the revisions of his famous book.

Before this, during the 1600s, usury in finance had already started to become mainstream as

stated by this extract from the article “Francis Bacon endorsed a system of state regulation

fixing a lower interest rate (5 percent) for most loans and a higher rate (9 percent) for loans

to merchants in large centers. Some 90 years later, John Locke (1691) does not even consider


seriously the possibility of an objection to interest per se. Instead he wrests only with the

pragmatic issue of where to set the legal rate. A reduction to 4 percent from 6 percent had

been proposed by the mercantilist Josiah Childe and a number of British merchants. For

Locke, the point was clear. The experienced and clever would work their way around the law,

while only widows and orphans would be left lending their money at the lower legal rate.

Anticipating the core machinery of supply and demand theory, Locke argues that promised

benefits from such a price ceiling would not materialize as the quantity supplied of funds

con- tracted (p. 124)”.

In his essay “Of Usurie”, Francis Bacon wrote that regulation limiting the rates of usury

would be a prudent practice but did not think that usury was to be banned outright. Almost

a century later John Lock took this one step further and wrote that any limits on usury

would be damaging to society. His rational was that if limits were put in place, the only ones

to abide by it would be the widows and orphans while the motivated and clever business

elite would circumvent the limits by ingenious methods and therefore make themselves

exempt from it.

Further, in his book The Wealth of Nations (1776), Adam smith clarified his position on usury

or a return in excess of the principal saying, “[A]s something can every-where be made by

the use of money, something ought every-where to be paid for the use of it.”

By this he meant that as borrowed money could be used to produce products everywhere, it

would also command a premium for its use everywhere. He also supported John Lock's view

that the limits on interest would work towards the benefit of the well endowed and towards

the detriment of the weak saying, “This regulation, instead of preventing, has been found

from experience to increase the evil of usury; the debtor being obliged to pay, not only for

the use of the money, but for the risk which his creditor runs by accepting a compensation

for that use. He is obliged, if one may say so, to insure his creditor from the penalties of

usury.”

However, interestingly even though Smith believed that limits on interest rates would

damage the poor and favor the rich, he still wrote about the need for such a restriction.

More accurately, he endorsed an interest rate limit that would be a little bit above the

market rate saying “This rate ought always to be somewhat above the lowest market price,

or the price which is commonly paid for the use of money by those who can give the most

undoubted security. . .The legal rate, it is to be observed, though it ought to be somewhat


above, ought not to be much above the lowest market rate.”

Smith followed this up with a rational as to why the legal rate of interest should not be too

high. His argument was the following, “eight or ten percent . . . the greater part of the

money which was to be lent would be lent to prodigals and projectors, who alone would be

willing to give this high interest.”

He argued that a high rate of interest would mean that the money would go to the prodigals

(reckless investors) and projectors (speculators) who would be the only ones who would be

able to give such high rates of return. This would in effect, crowd out sober people from

getting financed and it would lead to wasted resources in the economy. Smith showed great

foresight when he said this because we see nowadays that indeed these so called prodigals

and projectors in the form of investment bankers and derivatives traders influence the

interest rates to a great extent by their rent seeking activities. Even though these categories

of agents were of a different nature when Smith was writing the basic mechanics have

stayed the same.

In relation to projectors, Smith further said that “chimerical projectors, the drawers and re-

drawers of circulating bills of exchange, who would employ...money in extravagant

undertakings, which . . . would never repay the expence which they had really cost.”

This prediction stays true to this day as we find speculators all across the world carrying out

activities that are nothing more than arbitrage at its best and rent seeking at its worst.

Adam Smith

In his book, Smith, A. (1776) “The legal rate...ought not be much above the lowest market

rate. If the legal rate of interest in Great Britain, for example, was fixed so high as eight or

ten per cent, the greater part of the money which was to be lent would be lent to prodigals

and projectors [promoters of fraudulent schemes], who alone would be willing to give this

high interest....A great part of the capital of the country would thus be kept out of the hands

which were most likely to make a profitable and advantageous use of it, and thrown into

those which were most likely to waste and destroy it.

When the legal rate of interest, on the contrary is fixed but a very little above the lowest

market rate, sober people are universally preferred, as borrowers, to prodigals and

projectors. The person who lends money gets nearly as much interest from the former as he


dares to take from the latter, and his money is much safer in the hands of the one set of

people than in those of the other. A great part of the capital of the country is thus thrown in

the hands in which it is most likely to be employed with advantage.”

Here Adam Smith is alluding to the fact that if the rate of interest is high then the only

people that will be willing to take up the offer of borrowing would be ones who would earn

the money by dubious means. This is because only by breaking the law and damaging their

fellow man could they afford to pay above average interest rates on their loans. This would

be an inefficient and suboptimal outcome and would cause underutilization as well as

misutilization of resources. This would also prevent people with productive uses for the

capital from access to it. However, time and time again it has been seen that the interest

rates cannot be kept at a sufficiently low level and this leads to the outcome described by

Adam Smith all those years ago.

John Maynard Keynes

According to Keynes, J.M. (1930) “There are changes in other spheres too which we must

expect to come. When the accumulation of wealth is no longer of high social importance,

there will be great changes in the code of morals. We shall be able to rid ourselves of many

of the pseudo-moral principles which have hag-ridden us for two hundred years, by which we

have exalted some of the most distasteful of human qualities into the position of the highest

virtues. We shall be able to afford to dare to assess the money-motive at its true value. The

love of money as a possession -as distinguished from the love of money as a means to the

enjoyments and realities of life -will be recognised for what it is, a somewhat disgusting

morbidity, one of those semi-criminal, semi-pathological propensities which one hands over

with a shudder to the specialists in mental disease. All kinds of social customs and economic

practices, affecting the distribution of wealth and of economic rewards and penalties, which

we now maintain at all costs, however distasteful and unjust they may be in themselves,

because they are tremendously useful in promoting the accumulation of capital, we shall

then be free, at last, to discard”

By this Keynes implies that the financial system at that time operated under some

mechanisms which he deemed to be “semi-criminal, semi-pathological propensities which

one hands over with a shudder to the specialists in mental disease”. This is widely believed

to be Keynes's view on usury that he is expressing in this particular extract. This view is


reinforced by the fact that he mentions the prohibition of usury and its consequences in

some of his other works. In addition, Keynes singles out a very important point which he

believes to be conducive to the widespread prevalence of this practice. That is, he

acknowledges that at that time, some 80 years ago people had started to think of money as

an end in itself and not as a means to an end. This has only exasperated over the course of

the ensuing decades culminating to today. Where money is the end all and be all of

accomplishment and the determinant of status as well as stature. Money has in effect been

separated as an instrument to reach the good life and has turned into the good life in and of

itself.

In addition we also find the following in, Keynes, J.M. (1930) “But beware! The time for all

this is not yet. For at least another hundred years we must pretend to ourselves and to every

one that fair is foul and foul is fair; for foul is useful and fair is not. Avarice and usury and

precaution must be our gods for a little longer still. For only they can lead us out of the

tunnel of economic necessity into daylight.”

Here, Keynes foresaw a future where all the necessities of life would be fulfilled and man

would no longer work as hard as he used to to ensure his survival. This particular extract is

very interesting because Keynes directly says that usury and avarice are the Gods of man in

his economic life. By putting these two traits together, he implies that usury is a

manifestation of avarice. He mentions this in such a way as to convey the disgust with which

he views this. What makes this more fascinating is that this is an economist who is well

versed in the theory of the utility maximizing common man who thinks nothing but to

maximize the returns from the resources he owns.

In addition we also find the following, Keynes, J.M. (1936) “There remains an allied, but

distinct, matter where for centuries, indeed for several millenniums, enlightened opinion held

for certain and obvious a doctrine which the classical school has repudiated as childish, but

which deserves rehabilitation and honour. I mean the doctrine that the rate of interest is not

self-adjusting at a level best suited to the social advantage but constantly tends to rise too

high, so that a wise government is concerned to curb it by statute and custom and even by

invoking the sanctions of the moral law.

Provisions against usury are amongst the most ancient economic practices of which we have

record. The destruction of the inducement to invest by an excessive liquidity-preference was

the outstanding evil, the prime impediment to the growth of wealth, in the ancient and


medieval worlds. And naturally so, since certain of the risks and hazards of economic life

diminish the marginal efficiency of capital whilst others serve to increase the preference for

liquidity. In a world, therefore, which no one reckoned to be safe, it was almost inevitable

that the rate of interest, unless it was curbed by every instrument at the disposal of society,

would rise too high to permit of an adequate inducement to invest.”

Two points stand out from the preceding passage. The first is that here it is evident that

Keynes acknowledges and hence is well versed in the prohibition of interest in theology and

in ancient cultures. This is admirable in someone as scientifically and intellectually inclined

as economists typically think themselves to be. Keynes admits the evils of the practice of

usury and suggests that dismissing the rulings of the forefathers would be unwise. Secondly

and more crucially, Keynes identifies that a rate of interest in market operations is not self-

adjusting and consistently rises too high without government intervention and oversight.

This is crucial because in modern thought a challenge is often formulated that the rate of

interest, if held low does not pertain to the same thing as usury. By this extract we see that

Keynes theorizes that a rate of interest, whatever it may be will inevitably and surely lead to

high rates left to its own devices. It is the belief of the researcher that this suggests Keynes

believed that interest rates led to usurious practices if left unchecked.

In his paper Long, D.S. (1996) discusses about Keynes's views on the subject at length and

gives some interesting insights into the logic behind his words. He also addresses criticisms

of Keynes's view among various economists. He states,

“Keynes agreed with Adarkar that the canonists did not fully understand the difference

between interest on savings by debts and savings by assets. Nonetheless, he raised the

question, "May not Mr. Somerville be right that the social evil of usury, as conceived by the

Canonists was essentially due to the fact that in the circumstances of their time savings

generally went with the creation not of assets but of debts?" Somerville's essay certainly

prompted Keynes to rethink the Scholastics' position.”

In this instance, Keynes's is having a discourse with Somerville who argued that Keynes's

views on savings reflected that of the Canonists and that he did not fathom the interplay

between savings and investments in the economy. Keynes is arguing that the Canonist

doctrine had banned interest because they saw that usurious practices were leading to

promotions of debt rather than a growth in assets. We can see remnants of Keynes's belief

that investment was the driver of the economy and not savings. Idle savings were not


desired and it was only when these savings led to investment that they were useful in the

economy. This is reinforced in the next passage where Keynes's writes,

“I was brought up to believe that the attitude of the Medieval Church to the rate of interest

was inherently absurd, and that the subtle discussions aimed at distinguishing the return on

money-loans from the return to active investment was merely Jesuitical attempts to find a

practical escape from a foolish theory. But I now read these discussions as an honest

intellectual effort to keep separate what the classical theory has inextricably confused

together, namely, the rate of interest and the marginal efficiency of capital. For it now seems

clear that the disquisitions of the schoolmen were directed towards the elucidation of a

formula which should allow the schedule of marginal efficiency of capital to be high, whilst

using rule and custom and the moral law to keep down the rate of interest.”

According to Long, D.S. (1996) in the extract above, Keynes describes admires the

Scholastics' mechanism to keep the marginal efficiency of capital high and discourage idle

savings.

Keynes's defines Marginal Efficiency of Capital as “..being equal to the rate of discount which

would make the present value of the series of annuities given by the returns expected from

the capital asset during its life just equal its supply price" (Keynes, 1936: p. 135).

In other words, the Keynes argues that the Scholastics' argument of maintaining a high

marginal efficiency of capital in order to motivate investment through savings by keeping

the interest rate low by moral law was an elegant solution. In addition, he said claimed that

Classical theory had confused the together the notion of marginal efficiency of capital and

the interest rates. Which he claims was an error not made by the Scholastics. In the modern

context this would entail that projects with the highest rate of return be chosen in order to

maximize return on resources employed.

In addition, Long, D.S. (1996) mentions, “Keynes argued that the soundness of the usury

proscription resided in the Scholastics' effort to reward investment by keeping the marginal

efficiency of capital high and not to reward mere savings by keeping the rate of interest low.

Thus, for Keynes, the beauty of the scholastic teaching resided in the just reward for

investment risk and the denial of a just reward merely for lending out of one's savings. This

fit well with the Keynesian revolution, for it emphasized investment and deemphasized

savings.”

It is evident from the extract above that Keynes preferred the Scholastics' view of


encouraging investment by maintaining a high marginal efficiency of capital and

discouraging savings by keeping the interest rate “morally low”. Although he does not

directly call for the abolishment of interest rates it is clear by the preceding extracts that he

looks down upon this phenomenon and considers it somewhat immoral.

Following Keynes's writings, Bernard Dempsey (1948) pointed out that “.. the Scholastics

taught that marginal profit should equal the rate of interest if a sin against commutative

justice was to be avoided. And Keynes was consistent with the Scholastics, against the

classical theorists, in distinguishing marginal profit from the rate of interest.”

This extract summarizes the previous point nicely. However, Bernard Dempsey held that

Keynes had made some errors in his conclusion. Dempsey stated that

“But though this possibility oí de facto divergence meant that the concepts are distinct, it

may be very misleading to say that the Scholastics labored to keep them separate when

concretely their whole purpose was to keep them together. A high marginal efficiency of

capital meant a true emergent loss to him who relinquished capital goods or the money

means to them. The just price of present money, the rate of interest, was therefore high and

a consistent Scholastic would work to keep it up, and to allocate the benefit to him to whom

in commutative justice it was due, namely, to the one who incurred the emergent loss.

Keynes is right in the distinction which he draws; but the use he makes of it is so different

from the scholastic application that it might readily be the source not only of confusion of

ideas but also of imputation to the Schoolmen of ideas directly contrary to what they held”

Although Dempsey claims that Keynes conclusion may lead to some confusion as to the

Scholastics' views on usury, he maintains that it still held true that the modern acceptance

of usury was the principle reason behind the lack of distributive justice in the economy.

Interestingly, Dempsey went on further to say that the economic system that he observed

was one that was maldistributed and where usury had been institutionalized.

Bernard Dempsey

Bernard Dempsey in his book “Interest and Usury (1948)” (whose introduction was written

by Joseph A. Schumpeter) analyzed interest theory of modern economists such as Knut

Wickseil, Ludwig von Mises, Friedrich von Hayek, Irving Fisher, Joseph Schumpeter, Gunnar

Myrdal, and John Maynard Keynes and examined their writings. Then he looked into the

Scholastic prohibitions of usury and compared the two. His book is a very good reference


point and is well worth discussion. In his book, Dempsey concludes that “The modern

situation to which theorists have applied the concepts of divergence of natural and money

interest, divergences of saving and investment, divergences of income disposition from

tenable patterns by involuntary displacements—all these have a sufficient common ground

with late medieval analysis to warrant the expression, "institutional usury”

According to Long, D.S. (1996), Dempsey studied the concepts of interest rate and usury in

both modern and ancient civilizations and came to the conclusion that the modern status

quo of the economy could be described as institutional usury. He came to this conclusion

after examining three concepts and divergences from them. The three divergences

according to Long, D.S (1996) were, “natural and money interest, savings and investment,

and divergences of income disposition from tenable patterns by involuntary displacements”

The first of the divergences he mentioned was the difference between natural interest and

money interest which he drew from Knut Wicksell's work saying, “For Dempsey, "If goods

did not have the characteristics of producing a greater volume of goods in time, interest as a

production factor would not exist.” Using one's goods to increase one's goods is not usury.

Thus Wicksell's natural rate of interest fit within scholastic possibilities for legitimate profit.

Wicksell stated that the natural rate is "the rate which would be determined by supply and

demand if real capital were lent in kind without the intervention of money."

Further adding, “Each person continues the process of exchange as long as "he continues to

acquire commodities which represent more than the equivalent of the commodities that he

gives in exchange." Insofar as these exchanges will be indirect, which is inevitable, money

will be required. But here the purpose of money is merely to effect the exchange or to serve

as a store of value over time until the exchange is transacted. However, money becomes

something other than this once it "derives a marginal utility and an exchange value against

other commodities." Insofar as money serves either to facilitate exchange or as a store of

value for future exchange, then the usury proscription would not be violated. However, when

money does not express the 'Value relationships" between commodities exchanged, then it

clearly does violate the usury proscription, for it provides the possibility of an income which

was never earned and yet can be used for future gain whether that gain goes to the

individual employing it or to someone else.”

Wicksell seperated the meaning of natural interest and money interest saying that natural

interest entailed the increase in goods that occurred when someone lent physical goods in


kind for the process of production. This did not entail usury as the increase was coming from

real goods invested in production. This was also consistent with the Scholastic's view that

the increase in goods was acceptable as long as the increase was related to real goods that

were the result of enterprise between parties in order to increase value. In other words,

profit.

In the second extract, Wicksell pointed out that because transaction were usually indirect,

money had to be brought in to act as a mediator. This meant that the natural rate of

interest would not always be apparent. He mentioned that money would be neutral as long

as it was just used for exchange and store of value. But as soon as it starts to provide

marginal utility, it ceases to represent the exchange value of commodities and in this an

increase of it institutes usury. He further mentions that this is caused by the generation of

income that was never earned yet is used for further production in the future.

Long, D.S (1996) goes on to say that Dempsey derived the following conclusion from

Wicksell's work, “At this point, Dempsey found the usury teaching applicable. If Wicksell had

adequately explained the modern economic situation, then no emergent loss is possible, and

money violates the purposes it should serve. If money does not so change hands as to

express accurately these value relationships [of physical objects], then the relations

themselves are altered rather than expressed by the money sums paid for them. When

investment is made with funds that have never been income and, before being income, have

never been cost, such a derangement is theoretically inevitable. The problem with this

derangement was that it distorted just distribution.”

Dempsey concludes his logic of this particular divergence by saying that when money does

not reflect the relationships between goods and does not act as solely a medium of

exchange and a store of value then the issue of unearned income arises which has a highly

distorting effect on distributive justice. One of the causes behind this occurrence is that

when the money interest rates are determined by credit institutions, money as an entity

gets separated from the so called real activities in the economy and hence any increase of

this institutes usury.

Another divergence Dempsey mentions is that of Income Disposition from Tenable Patterns

by Involuntary Displacements. This, Dempsey draws from the work of Ludwig von Mises.

Long, D.S (1996) says, " Von Mises divided credit transactions into two types, the first are

those that "impose a sacrifice on that party who performed his part of the bargain before


the other does" through. the "foregoing of immediate power of disposal over the exchanged

good.. This first type of credit transaction is called commodity credit. In this sense, credit

transactions would not be usurious because lucrum cessans could be demonstrated. But

there is also a second class of credit transactions "characterized by the fact that in them the

gain of the party who receives before he pays is balanced by no sacrifice on the part of the

other party." In this second class of credit transactions, referred to as circulation credit, no

sacrifice is made by the issuers of fiduciary media. They could never incur a loss for they have

not given up the power of disposal over any commodity.”

Mises identifies two types of credit related transactions. The first he identifies as commodity

credit which is akin to forgoing consumption today for consumption tomorrow. In other

words this is the situation that would arise if a person sacrificed one apple in order to

consume two apples tomorrow. This sort of credit arrangement involves a sacrifice by the

lender.

The second sort of credit transaction Mises identifies is what he calls circulation credit. This

second type of credit entails no sacrifice on behalf of the lender unlike the case in the

previous credit arrangement. According to Mises, the issuer of the so called fiduciary media

would not have risked anything as he did not surrender the power of disposal to the other

party. In other words, this situation went back to what Wicksell wrote about how money at

one point could stop to represent the exchange value between commodities and start to

have marginal utility of its own. Both points of reasoning lead to the conclusion that when

money as an entity is detached from real commodities, usury may arises.

In addition, von Mises gave two reasons saying how money became detached from real

economic activity. Long, D.S (1996) writes, “His argument had four steps. First, fiduciary

media is issued, i.e. a bank discounts a bill or grants a loan, as an "exchange of a present

good for a future good." This is why fiduciary media is employed. A bank provides a loan (the

present good) in exchange for future goods which the borrower will receive through

employing the present good. But what makes possible the present good? This question gave

rise to the second step in von Mises's argument, "the issuer creates the present good that it

exchanges, the fiduciary media, practically out of nothing." This lead to the third step.

Because fiduciary media is issued practically out of nothing, no "natural limitations" exist for

the quantity of fiduciary media. In truth, the future goods which will be produced are limited,

but no limitations are present in their possibilities for exchange in terms of present goods, as


circulation credit, in the market. And the fourth step is that the issuers of fiduciary media can

"induce an extension of the demand for future goods by reducing the interest demanded to a

rate below the natural rate of interest, that is, below that rate of interest that would be

established by supply and demand if the real capital were lent in natura without the

mediation of money, whereas on the other hand the demand for fiduciary media would be

bound to cease entirely as soon as the rate asked by the bank was raised above the natural

rate." The conclusion is that "the quantity of fiduciary media in circulation has no natural

limits." For von Mises, this was just how the market worked. For Dempsey, this was

institutional usury.”

Mises laid out how when fiat money was created, its amount in circulation could be fixed

arbitrarily with no fundamental basis in the real sector. This would mean that the circulation

of currency as we witness it today would not have any natural limits. Von Mises considered

this to be a byproduct of the market mechanism but Bernard Dempsey thought of this as

institutional usury and thought this was the phenomenon that hindered distributive justice.


Methodology

The objective of the research was to formulate an alternative system of financing, namely a

Profit and Loss Sharing (PLS) system and to show its inherent advantages. As such, the data

gathered as evidence were from observations from various periods in recent times. Namely

in the boom periods of the 1990s and the crashes of 2000 and 2008. Further, a case study

was conducted at the end of the research to show how the operating figures of a typical

firm would be affected by a transition to a PLS method of financing.

Due to the unavailability of established firms that are solely based on the PLS system, a

conventional firm is dealt with and a comparison between the PLS and the conventional

system is made. It is chosen such that it can be a generalized representation of a typical

corporation. This will help make the examples and figures clear and understandable in the

context of the present situation.

The paper started by discussing the disadvantages of the conventional interest based

system followed by a discussion on how the PLS system would help mitigate those

disadvantages to a large extent. This was followed by a section that explained the

mechanics of the PLS system along with some numerical examples. Then a simple example

was formulated to formally demonstrate the differences that would arise between the two

systems in terms of profits for both firms and investors as well as the government through

taxes. Finally a conclusion about the findings and implications was given.

This paper focused solely on the very basics of an alternate system of financing and the

differences that would be observed due to it. It did not address various intricacies such as

changes in incentive structures for firms regarding production and the overall economic

framework that would need to be set up in order to facilitate this system.


Data

Data was gathered from various secondary sources including journals, books, news media

and other publications and were cited where appropriate. Due to the difficulty of finding a

large firm that conducted its operations using solely the PLS method of financing, the data

for the case study was gathered from a large public company in Bangladesh, Beximco

Pharmaceuticals. Both long term as well as short term debt was included in the calculations

in order to get a summarized picture of the differences between the two systems. The data

that was used is presented in tabulated form below.

The data for the case study was gathered from the website of Beximco Pharmaceuticals. The

source destination is http://www.beximco-pharma.com/investor-relations/financial-

reports.html.

Year 2008 2009 2010 2011 2012

Share Holder's Equity (Initial

Equity)

1,259,577,470 1,511,492,560 2,098,065,090 2,517,678,100 3,046,390,500

Liabilities

L/T Borrowings 1,446,600,500 1,924,933,065 1,902,150,733 1,890,074,651 1,469,621,611

S/T Borrowings 1,461,666,227 1,451,326,354 1,639,961,052 1,642,216,008 1,526,449,918

Fully Convertible 5% div. pref. share '09

Long Term- Current Maturity 648,165,841 308,820,056 348,860,443 363,744,181 664,712,728

Creditors and Other Payables

Total Liabilities 3,556,432,568 3,685,079,475 3,890,972,228 3,896,034,840 3,660,784,257

Share Holder's Equity (Initial Equity) 1,259,577,470 1,511,492,560 2,098,065,090 2,517,678,100 3,046,390,500

Profit from Operations 998,794,848 1,001,282,411 1,635,780,192 1,988,479,698 2,207,879,560

Interest

Finance Cost I/S 249,654,298 289,427,992 662,182,384 567,645,757 645,406,575

Total Finance Cost 249,654,298 289,427,992 662,182,384 567,645,758 645,406,575

Tax

Income Tax Expense I/S 168,779,737 242,727,120 309,883,518 479,323,910 590,439,908

Total Income Tax Expense 168,779,737 242,727,120 309,883,518 479,323,910 590,439,908

Profit before Tax 714,121,010 867,467,427 1,361,532,326 1,677,849,252 1,909,829,236


Profit after Tax 545,341,273 624,740,307 1,051,648,808 1,198,525,342 1,319,389,328

Other Comprehensive Income

Tax Rate 23.63% 27.98% 22.76% 28.57% 30.92%

Parameters

Current/Conventional System 2008 2009 2010 2011 2012


Amount Borrowed 3,556,432,568 3,685,079,475 3,890,972,228 3,896,034,840 3,660,784,257

Income Tax Expense I/S 168,779,737 242,727,120 309,883,518 479,323,910 590,439,908

Interest Paid/Finance Cost 249,654,298 289,427,992 662,182,384 567,645,758 645,406,575

Rate of interest 7.02% 7.85% 17.02% 14.57% 17.63%

Profit to Investor (interest) 249,654,298 289,427,992 662,182,384 567,645,758 645,406,575

Profit Sharing

Earnings Before Taxes and Profits 998,794,848 1,001,282,411 1,635,780,192 1,988,479,698 2,207,879,560


Amount Borrowed (external equity) 3,556,432,568 3,685,079,475 3,890,972,228 3,896,034,840 3,660,784,257

Total Equity (Debt+Initial EQ.) 4,816,010,038 5,196,572,035 5,989,037,318 6,413,712,940 6,707,174,757

Debt to Equity Ratio 282.35% 243.80% 185.46% 154.75% 120.17%

Debt to Investment Ratios

Proportion by the Firm 26.15% 29.09% 35.03% 39.25% 45.42%

(Loan)Proportion by the

"Investor"/Equity partner

73.85% 70.91% 64.97% 60.75% 54.58%

Tax Paid 236,061,297 280,170,054 372,302,083 568,064,063 682,584,694

Profit after Tax 762,733,551 721,112,357 1,263,478,109 1,420,415,635 1,525,294,866

Profit to Investor 563,248,502 511,367,172 820,859,509 862,836,995 832,507,820

Profit to Firm 199,485,049 209,745,185 442,618,600 557,578,640 692,787,046


Overview of Profit and Loss Sharing System (PLS)

The current situation as it stands is that firms, big and small, borrow money at a particular

fixed rate of interest to fund their operations. They then subsequently pay off the principal

borrowed at the stipulated rate of interest. This does not depend on the rate at which the

firm profits from that particular investment. For example, the firm borrows 100 taka and

invests it in a project along with 100 taka of his own money (equity). So, it invests 200 taka.

Let’s assume now that it makes a profit of 20 taka, he ends up with a total amount of 220

taka. Now let’s assume that the firm borrowed the amount at a 10% rate of interest. This

means that the firms has to pay back 110 taka to the lender (100*10%)+100. Hence, he is

left with 110 taka, meaning that he has made a net profit of 10 taka by borrowing 100 taka

and using 100 taka of his own. However, now let’s assume that the firm faces a loss of 20

taka from the project and ends up with 180 taka. In this scenario, he still has to pay back the

100 taka with 10 taka as interest.

Conversely, if the firm had made a profit of 200 taka from its 200 taka investment, meaning

it had had a 100% return on its investment and ended up with 400 taka, it would still have

had to pay only 10 taka from the profit to the lender. The lender would still have gotten just

110 taka back and the firm would have gotten to keep the remaining 290 taka and would

have ended up with a profit of 90 taka or a 90 return on investment. The lender/investor in

this case would have no right to share in the abnormal rate of profit.

This particular amount is not related to the gains and losses of the project. In essence, the

return of the lender/investor is not directly related to the "performance" of the project

because his returns have already been guaranteed.

This brings the issue of distributive justice into the picture. Distributive justice is not ensured

in an interest based system. This is because no matter how much profit the firm makes on

the project, the lender gets the same payoff and even if the firm faces losses, the lender has

no obligation to share in the loss and will still be entitled to his principal in addition to the

increase as the rate of interest.

On the other hand, in the Profit and Loss Sharing Method (PLS), the amount returned to the

lender/investor is directly related to the project and not predetermined. This means that

unlike the case above, if the firm had encountered a loss of 10 taka, the lender would also

have had to bear the loss in proportion to the amount he invested. That means that if the


firm made a loss of 20 taka, the firm would have had to bear a loss of (20*(100/200))= 10

taka. This is because as his proportion of investment in the project was 50% (100 taka out of

200 taka), his share of the loss is also 50% or half of 20 taka which is 10 taka. Hence, the firm

and the lender/investor end up bearing the losses from the project in proportion to the

ratio/proportion of their investment.

This is the essence and the basic mechanics of the Profit and Loss Sharing Method. It

stipulates that stakeholders (who are the firm and the investor for the purpose of this

research) share in the profit and losses of a particular project or venture "in proportion" to

the amount of their investment.

In our Holy Book, the Quran, Allah Subhanawataala says “Those who eat Ribâ (usury) will not

stand (on the Day of Resurrection) except like the standing of a person beaten by Shaitân

(Satan) leading him to insanity. That is because they say: "Trading is only like Ribâ (usury),"

whereas Allâh has permitted trading and forbidden Ribâ (usury). So whosoever receives an

admonition from his Lord and stops eating Ribâ (usury) shall not be punished for the past; his

case is for Allâh (to judge); but whoever returns [to Ribâ (usury)], such are the dwellers of the

Fire - they will abide therein.” (Al Quran: 2:275).

Hence, any self-respecting Muslim will have to abide by the prohibition of any and all forms

of riba in which interest is included by the “consensus of the Ulama”.


Advantages of PLS system over the conventional

system

There are numerous differences in between an interest based system of operation and a

profit sharing one. These differences lie in both the fundamentals of the system as well as

the mechanics. These will be discussed in detail in this section.

Ensures Efficient Allocation of Resources

a. Conventional System: In the interest based conventional system, the borrower (firm)

contracts with the lender (bank) to lend him a certain amount of money on the stipulation

that he will pay it back at a later time in addition to a prefixed amount of interest

determined by the bank. The bank fixes this rate after taking a variety of factors into

consideration. These factors include, but are not limited to,

a. the creditworthiness of the borrower

b. the market and book value of the collateral that the firm puts up

c. the riskiness of the project that is going to be undertaken with the money

d. the duration for which the loan is being dispersed

The first point, creditworthiness is the one of greatest interest in the context of this

research. It is defined as the assessment of the likelihood that the borrower will default on

the debt, meaning they will be unable to pay. The main decision criteria for the bank when it

is disbursing the loan is the creditworthiness of the borrower (firm). This term includes a lot

of aspects such as the amount of capital or equity the firm has, the size of its operations, its

payment history, its past profitability, the level of its existing debt and various other factors.

The bank will often times use this as the main criteria for granting the loan to the firm as

well as for setting the rate of interest on the loan. This creates a variety of problems related

to moral hazard as well as adverse selection. These are elaborated on below:

Moral Hazard combined with adverse selection refers to each party acting contrary to the

terms of the contract or to the ethos of an organization in order to gain an unfair advantage

(monetary or otherwise) as well as either the “seller” or the “buyer” having information that

the other party does not have. In the context of a bank financing a firm this may arise from

the fact that the creditworthiness of a big firm is inherently greater than that of a small firm.

The task of the manager of the bank is to select projects that are going to be the most


profitable for the bank and at the same time one in which the default risk (as well as other

related risks) are going to be as low as possible.

Now let’s consider an example; suppose a bank has funds to loan to one of two projects; a

big pharmaceutical firm such as Square approaches it for a project worth 1 Million taka. It is

for building a statue of its founder (hypothetical). The project is going to be of one year and

the bank decides that the rate of interest it will charge is 12%. Now, on the other hand,

suppose that a small firm named Innovative Inc. (hypothetical) applies for a bid to raise

awareness for Solar Home Systems (SHS) in rural areas. However, it has also found a way to

be profitable in this venture through some innovative strategies. It also applies for 1 Million

taka of loan. From the point of view of the bank, lending money to Square Pharmaceuticals

is the better option because according to its (conventional bank's) criteria for judging

creditors, it has stronger standing in all of the decision criteria compared to Innovative Inc.

For example, it has a better credit rating, stronger capital positions, rapport with other

competing banks and so on. So basically square pharmaceuticals is more likely to pay up the

dues when the time comes and hence its project gets financed at a 12% rate of interest for 1

year.

Now a keen observer would point out that the first project by Square Pharmaceuticals which

ended up getting financed does not have any societal benefit associated with it. There is no

cash inflow from this specific project but the bank deems the lender will be able to pay and

hence goes ahead and finances the project. If however, the project of Innovative Inc. had

been financed, it would have had a great number of benefits to the people of the rural areas

by giving them an access to power they had never had before and also, the project itself

would have been profitable. In other words, the repayment of the loan amount with

interest would have been directly associated with the project. In effect, in the conventional

system, the lender is indifferent to the economic and social value that the project creates.

Hence, the project which would have been beneficial to the society and added economic

and social value to it did not get chosen, instead the socially sub optimal option was chosen

and 1 Million taka which could have gone towards enhancing GDP and creating value for a

rural community was wasted on a project that would not be of any value to the economy or

society. It should be noted however that this is an extreme case and it is not suggested that

this sort of situation arises all the time but it is a likely one taking into consideration the

incentive structures of a conventional financial institution and a conventional firm.


Another example comes from the 1990s in the US from Black, W. K. (2005). In this book,

there are numerous examples of how banks misused their capacity to be a middleman by

lending in various dubious and sometimes criminal ways. One of them is the example of

Long Beach Savings; during 1992, savings and loans companies were growing at a rate of 50%

per year. This was phenomenal growth for any industry and more so for an industry

entrusted with making detailed audits of their clients in order to ensure their products (the

loans they gave out) were safe. Most of them were doing this by “cooking their books” and

making extremely risky loans to get short term profit at the risk of long term failure.

The example of Long Beach Savings is given in the book; the firm and many others like it

were giving out loans to high risk borrowers in order to make short term profits and make

the management look good. They could do this because of the disconnect between the

payments of their loans and the project they were investing in as well as the time lag

involved. This is because a buyer of a home does not default on his payments in the first two

years of receiving it but rather does so after a considerable amount of time goes by. And if

the savings and loans companies could give them the loans, they knew that when they

would eventually default on them, the blame would not come on them because of a

concept they believed in called “Diffusion of Responsibility”. By showing high short term

profits, they could artificially improve their performance to the detriment of the borrowers

and the corporation as a whole. Again, this was exasperated by the huge time lags between

the disbursement of the loan and their defaults and the fact that the instrument of interest

to a great extent decouples the project and it’s financing.

Another case cited in the book was that of Charlie Knapp of American Savings who used to

deal in a certain activity known as “Cash for Trash”. This technique was applied by some

savings and loan companies to convert their loss making projects into profitable ones. They

did this in the following way; suppose they had financed a real estate project for 60 Million

dollars and it turned out that it was actually worth 30 Million dollars. The savings and loans

company had effectively incurred a loss of 30 Million dollars. But then they would pick

another real estate company that was just starting out and lend it 80 Million dollars. That

company would in turn use that money to buy up the first, failed project for 78 Million

dollars (keeping 2 Million dollars as a “risk bonus” for committing the fraud). Hence, the

bank had just turned a project that had incurred a loss of 30 Million dollars into one that

made a profit of 18 Million dollars (78 Million-60 Million). They would then repeat this two


or three times to defer the default and make their performance look good on paper.

Under intense competition, a lot of banks followed the examples set by their peers and

started doing such activities. This was back in 1992 when the financial markets were not as

complex as today and this situation and others like it subsequently grew into a massive

problem for the U.S financial system and was central in causing the financial meltdown that

started in 2007 and spread throughout the world because of the level of interconnectedness

of the global financial system in the modern day.

This sort of gross mismanagement or misallocation of resources happens close to home as

well. Recently, some officials of the state run Sonali bank of Bangladesh loaned out

upwards of 2500 crore taka to a little known business conglomerate called Hallmark Group

which the bank officials knew could never pay back the loan. This is a huge amount by any

standards and more so for a small country like Bangladesh.

These references reinforce the argument made earlier in this paper that in a conventional,

interest based system, the incentives line up in such a way that they lead to suboptimal

outcomes due to misallocation of resources. In this system, the managers have incentives to

deviate from safe, prudent and socially responsible practices in favor of risky investments

which sometimes are made even though the managers know full well that they are going to

fail at some point.

b. Profit Sharing System (PLS): The problem of misallocation of resources is mitigated to a

great extent in the Profit and Loss Sharing System (PLS). This happens because the lender's

(bank) returns are directly related to that particular project and there is no scope for

appropriating the proceeds from the loans to any other purpose. Moreover, there has to be

a real contribution made to the firm in order to get financed. This means that all financial

transactions in a PLS system are related to real activities; activities which produce some

tangible good or service that goes towards adding to the economy. This is not the case in a

conventional system. For example, when Square Pharmaceuticals’ project was financed over

Innovative Inc.'s Solar Home System Project in the conventional financing system, the

creditworthiness of the borrower was as important a decision criteria as the merit of the

that particular project. However, in a PLS system the Solar project would be evaluated under

a different set of criteria and the cash flows from that individual project would be evaluated

on a case by case basis. If it was found that the prospects of the project were better than

the competing project from the bigger firm, it would still get financing. This is in large part


due to the fact that the profit or loss of the firm would be directly linked to the profit or loss

of the project.

In addition, there would be no scope for lending to risky clients to boost short term balance

sheet numbers because there is no fixed rate of interest to allow for manipulation. The

manipulation that companies like Long Beach Savings did in the 1990s as well as the recent

examples such as Sonali Bank and Hallmark in Bangladesh would not have been possible

under a system that has the investments linked with the financing. Where the rate of return

is not fixed by a central authority and instead is variable and depends on the merit of

individual projects. This would of course not allow for the kind of explosive growth that the

interest based conventional system has experienced in the last few decades but it remains a

matter of argument if that is desirable or not; and Economists such as F.A Hayek would be of

the opinion that they are not. Is the bust that follows the boom a worthy tradeoff for a few

good years of economic prosperity? How can the benefits of the boom and the damage

from the bust be fully quantified in order to do a cost benefit analysis of the trade off?

The PLS system advocates the stable and steady growth of economies, not a fast growth and

a dip and so on that is the status quo currently. In addition to the aforementioned reasons

for this, another is that the religious basis that the PLS system is based on, The Quran and

the Hadith of the Prophet PBUH do not aim for all out economic races and do not encourage

excesses in anything. The biggest economy is not the purpose of Islam but rather it is the

overall socioeconomic wellbeing of the whole country that is the main concern of Islam. And

hence this system, which is shaped by the ideals of Islam aims to do the same. That is to

ensure economic prosperity and security while at the same time ensuring the efficient

allocation of resources in order to maximize the outputs of the economy.

Mitigates the problem of Overleveraging

a. Conventional System: When firms borrow to invest, the term used for it is leverage. So if

a firm invests in a 1000 taka project and puts 500 taka of its own money in it and borrows

the rest (500 taka) he has in effect invested in the project by leveraging 50%. The money

that it put forward is the equity and the money that it borrowed is the debt. In an interest

based system, debt comes in the form of principal (the loan amount) and a certain amount

on top of that that has to be paid back as interest on the loan. The firm, in theory is

supposed to pay back that additional amount from the profit he makes from the business. It


has to be kept in mind that the lender (the bank) doesn't share in the upside if the firm is to

profit at a rate more than expected. It does however have to share in the downside if the

project ends up losing money. Hence, the bank will try to minimize its risk exposure by

demanding collateral and looking at the history of the firm. Hence, firms with good credit

ratings and adequate amounts of capital (e.g. large firms) can leverage more easily than

smaller ones.

However, there are certain downsides to leveraging from the point of view of a firm. When

a firm borrows money in order to fund its operations and investments, its risk and return

are both magnified. Just as firms can leverage their activities, the investment banks in the

U.S did the same and at alarming levels. This was a major reason for the recent economic

crisis that started with the subprime mortgage crisis in the U.S and later spread to the whole

world. Investment firms such as Merryl Lynch, Bear Sterns, Goldman Sachs and Lehman

Brothers inflated their operations and their profits by leveraging at abnormally high levels.

When Lehman Brothers collapsed into bankruptcy, it was leveraged somewhere around

40:1. Meaning for every 1 dollar of investment it had from its equity, it had 40 dollars’ worth

of debt. This meant that a 2.5% decrease in the value of its overall investments would

render it insolvent.

Economically the interest based system is unsustainable and hence the concept known as

“Business Cycles”. This is because when the economy is experiencing expansion, the interest

rates are low. It is so because of market forces and because the Central Bank artificially sets

it low to “increase investment” (even though the effectiveness of this has often been

questioned, for example in Ahmed, S., Islam, M. E (2006). This in turn gives firms reasons to

invest by borrowing more heavily because it is a shortcut method of expanding very fast. As

F.A Hayek argued in his contributions to the Austrian Business Cycle Theory, an expanding

economy with a fractional banking system will experience a phenomenon called money

creation which will result in the available credit in the economy to exceed the actual money

printed by the Central Bank. This will cause a growing number of investments to be made in

unprofitable ventures as the number of good investments dries out due to demand for them

and the easy availability of credit. Hence, increasing amounts of resources goes towards

unproductive uses and are thus inefficiently allocated. This sort of investment is sometimes

referred to as malinvestment. At some point a correction takes place due to rising inflation,

and the limits of credit creation being reached. At this point a contraction in the money


supply occurs and the market eventually clears but the damage it wreaks is substantial in

the form of defaulted payments, fall in demand from consumers, increased unemployment

and various other economic problems. There are hundreds of empty housing developments

and thousands of acres of land that are laying abandoned and in disrepair in countries like

China, Mexico, United States of America, Argentina, Iceland and many others that are silent

witnesses to this fact. Hence, according to the words of F.A Hayek, “the boom period of the

business cycle sows the seeds for the eventual bust that is inevitable”.

Recent examples of such cases includes Iceland which at the peak of its bubble in the first

quarter of 2008 had borrowed 50 Billion Euros through its three biggest banks. This amount

was almost 6 times the size of its GDP at the time which stood at 8.5 Billion Euros. This sort

of lending allowed Iceland's banks to invest in projects that were almost fully leveraged and

at a huge risk of failure if there were to be any shocks. Icelandic firms and entrepreneurs

leveraged at record levels to invest in foreign firms as well as local ones including in the real

estate sector. After the bust a year or so later, the now abandoned real estate

developments and skyscrapers stand testament to what havoc artificially low interest rates

can wreak through malinvestments.

The main problem lies in the fact that interest rates are the subject of much speculation and

depend largely on the future outlook of the economy. But predicting the future as has been

seen time and time again to be easier said than done. Through a fixed borrowing and

lending rate, the economy is steered by the Central Bank and the financial institutions of the

country in a direction they see fit for the times. This is a very ham fisted and inaccurate

approach and is hardly scientific. This is discussed in detail in the context of Bangladesh by

Ahmed, S., Islam, M. E (2006); So when the economy is booming excessive credit is utilized

in increasingly bad investments and eventually it is followed by a bust (recession).

b. Profit Sharing System: The PLS system would mitigate the risk of firms and banks over

leveraging their finances because the profit or loss of a PLS financing institution depends on

the profit and loss of the individual projects they are financing. Hence, there is no scope for

such a phenomenon. However, the very question of whether a PLS firm can leverage at all

arises because it is after all not taking a loan to conduct its operations and investments,

rather it is taking in equity partners who are going to share in the losses of the firm. So the

firm will only leverage itself and the “bank” will do likewise up to the point where they have

sufficient funds to carry out the investment and lend to the firm as equity partner


respectively.

Unlike in the conventional financing system, the firm shares the upside gains as well as the

downside risks with its investor (the bank). This means that he has to give a proportionate

amount as profit to the bank after the duration of the project and the more he does this

from his own equity, the more profit he will eventually get to retain. This gives the firm an

incentive to “borrow” equity from investors at a moderate rate in order to remain profitable

and maximize his share of the profit. This will be illustrated in detail in the following case

study later in the paper. The onus therefore shifts from leveraging in order to profit to using

more and more equity in order to do so which is inherently more stable, safe and

economically beneficial and equitable.

As explained earlier this would act as an added incentive for the firm not to use external

funds and use its own resources to grow as much as possible. This would lead to responsible

borrowing of funds and would ensure the stability of the firm as well as more controlled and

stable monetary policy by the Central Bank

Incentive Structure (Incentive Compatibility):

a. Conventional System: In the conventional interest based system, the incentives of the

agents often conflict with those of the organization. This leads to what is known as the

agency problem as well as other problems such as moral hazard and adverse selection as

was discussed earlier. In order to safeguard against these a number of mechanisms have

been put in place such as the Basel I, II and III agreements for banks as well as various

regulatory restrictions on firms. However, these still could not prevent the firms as well as

the banks from abusing their resources in search of abnormally high profits that collectively

caused the near implosions of the American economy and had devastating ripple effects

throughout the world. The interest based system of borrowing and lending is inherently

bound to give incentives to agents to misbehave and go against prudent and sound

practices in search of riches. This is because when there is a fixed rate of return that firms

and banks operate under, there is scope for these entities to manipulate their way into

higher profits. Furthermore, this is possible because the economy consists of an almost

incomprehensible number of different economic activities all of which are very hard to be

brought under one interest rate regime or be accommodated for by one unified policy.

Hence, the examples given above of the management of banks giving out high risk loans,


firms leveraging themselves to stratospheric levels and subsequently imploding are bound

to continue under such a system. The cases of Long Beach Savings, Lehman Brothers,

Hallmark of Bangladesh, Cash for Trash transactions of the 1990s are bound to continue

under this system as long as there are incentives for the agents to act as such. The fixed

interest rate mechanism allows the management of both banks and firms to appropriate

resources inefficiently (in the case of the banks) as well as leverage themselves highly for

short term profits (in the case of firms).

The argument here is that if the agents have inbuilt incentives to abuse the system, it will be

almost impossible for the authorities to ward off such behavior because the agents will just

find new workarounds for the new measures taken against such behavior by the authorities

and this is an inherent weakness of the conventional interest based system.

b. Profit and Loss Sharing System (PLS): This is a fundamental advantage of the PLS system

in that it is designed in such a way that incentives of the agents line up in a way that makes

the final outcome economically efficient, optimal and equitable. In other words a lot of the

problems described above that occur In the conventional system are mitigated in a PLS

system.

The main reason for that is the fact that the financing of projects and their returns are

related and so the bank's return on investment depends on the performance of the project

and because payments including that of the principal are not ensured. So the management

will try especially hard to avoid malinvestments. On the other hand the firm will also be

careful of borrowing money because as will be discussed in the mechanics section of this

paper, its profits are going to decrease compared to an interest based system because it has

to share its profits in proportion to the money “borrowed” as additional equity. Whereas in

the conventional system, it just had to pay back the principal borrowed with the interest

and didn't have any obligation to share in the upside with the bank. So the firm will also be

eager to invest more of its own money than “borrow” it from investors.

These as stated earlier will act as built in incentives for banks to avoid malinvestments and

for firms to avoid overleveraging their finances, which are the two of the biggest problems

facing conventional interest based banks and firms at present because of the nature of their

incentive structure which is related to the fixed interest mechanism.


The Mechanics of the Profit Sharing System

In this section, the details of the process of Profit Sharing will be illustrated along with the

relevant tools needed to explain the mechanics of the process. This will allow for better

understanding about the advantages of such a system and how it will impact on the overall

financial system.

Firm A Rate Amount

Firm's Equity

$20,000

Borrows 20.00% $10,000

Total Invested

$30,000

Net inflow after n period

$50,000

EBIT

$20,000

Interest paid

$2,000

EBT ** $18,000

Tax 30% $5,400

Net Income

$12,600

Firm B Rate/Prop. Amount

Firm's Equity

$20,000

Loss

Borrows 33.33% $10,000

Total Invested

$30,000

$30,000

Net inflow after n periods

$50,000

$20,000

EBTP (Earnings Before Tax and Profit) $20,000

-$10,000

Tax 30% $6,000

NA

EBP (Earnigs Before Profit)

$14,000

Profit given out

$4,667

-$10,000

Loss Bourne by investor -$3,333

Net Income of Firm

$9,333 Net Loss of Firm -$6,667


Allocation of Returns (Distribution of Profits) and Payment of Taxes

This particular section will deal with the differences between a firm that finances itself by

conventional methods and one that does so by the profit and loss sharing method (PLS).

This will deal with the numerical workings of the differences between the systems. In order

to demonstrate this, a number of assumptions have to be made. They are,

1. Both firms intend to make investments of $30,000 but only have $20,000 of equity.

They have to source the rest from external sources.

2. In the case study, it is assumed that all the funds are used in one project. Not on a

case by case basis

3. Banks operate under Shariah by utilizing tools such as Mudarabah (describe)

4. In this case study the time value of money is disregarded and project duration is

disregarded as well. All projects are for 1 year

5. Firms discussed only create real goods and services and no speculation takes place

6. The investor will share in the profits in proportion to his investment. However, this

may not be feasible for a firm that has been in operation for some time. In that case,

alternative arrangements have to be made. But for the purposes of this research it is

assumed to be the case.

Following the differences between them, Firm A and Firm B “borrow” the money by

different methods and these are described below:

A. Conventionally Financed Firm (Firm A): This is the firm that finances itself in a

conventional way. It borrows the money from a lender/investor, in this case a bank. The

firm finances itself by borrowing $10,000 from the bank on condition that it pay 20% of the

Principle (borrowed amount) as interest after one year. Hence, as shown in the case study

above, the firm borrows the $10,000 and utilizes another $20,000 of equity and finances a

project worth $30,000.

At the end of the year it achieves at net revenue of $50,000. Hence the firm has made a

profit of $20,000. However, this is not the final profit of the firm because there a two more

steps/calculations that have to be completed. At this stage the profit is known as EBIT

(Earnings Before Interest and Taxes). From this we

a. Deduct Interest Expense: The firm has to deduct the financing cost, which is the interest

expense from the profits, which in this case is $2,000 (20% of $10,000). Hence, after the


deduction, the firm arrives at $18,000 of EBT (Earnings Before Taxes)

The interest expense works to lower the tax obligations of the firm by deducting from the

profits which in turn is going to go towards the calculation of the amount of taxes owed by

the firm. This provides an added incentive to firms to leverage themselves (borrow money)

more than would sometimes be prudent in order to lower their tax obligations. This

particular aspect of the conventional financing system has been discussed in a section above.

This has ramifications both at the firm level as well as the macroeconomic level. At the firm

level this means that a firm might leverage itself at an increased rate in order to reduce their

taxes and hence may increase the risk of insolvency. This was the case for many institutions

during the recent financial crisis. At the macroeconomic level the taxes received by the

government are reduced. A decrease in the tax revenue for the government will mean that

the government itself will have to start borrowing from the banks. This will then cause what

is known as a “crowding out effect” because borrowing by the government, which happens

at a massive scale will dry up funds that would otherwise have been used by the private

sector. There will also be the problem of increased debt servicing obligations for the

government which may further lead to all sorts of negative shocks in the economy both in

terms of fiscal as well as monetary stability.

b. Pay Taxes on the profit: The firm has to pay taxes on its profit to the government at a set

amount. A set percentage of tax is deducted from the EBT (after the deduction of the

interest expense). In the example above, 30% of the EBT (Earnings Before Taxes) is deducted

as taxes to the government. This leaves the firm with a net profit of $12,600. This is the final

profit of the firm and the surplus amount it gained through this investment. Again, to

reiterate, it is assumed here that the investment was for one project only and the duration

of the project was for one year.

Hence the firm earned a profit of $12,600 from its investment of $20,000. This is a return of

63% for the firm given that its equity invested was $20,000 and its net profit after investing

in the project was $12,000.

B. Profit Sharing firm (Firm B): Similarly, Firm B, the profit sharing firm assumed to start

with the same level of equity as the conventional firm ($20,000). However, as mentioned

earlier, its method of sourcing the rest of the amount is going to be different compared to

the conventional firm. The project is going to be of the same amount ($30,000) so the firm

has to “borrow” $10,000 from external sources. It is going to do this by contracting with an


“equity partner” instead of a debtor. This means that the equity partner who in this case is

the investor is going to share in the profit in proportion to the amount he invests.

At the end of the year the project earns a total cash inflow of $50,000. This means the

Earnings Before Taxes and Profit (EBTP) is going to be $20,000 (50,000-30,000) as was the

case in the conventionally financed firm. Now the following adjustments are made before

we arrive at the net profit for the firm.

a. Deduct Tax Expense: The major difference between the conventional system and a PLS

system is that taxes are paid before deducting the payment to the investor (what would

otherwise have been interest expense in the conventional system). Tax rate is assumed to

be the same at 30%. Thus, the taxes paid turn out to be $6,000. In the conventional system

the tax paid was $5,400. This amount increased in this case because taxes were paid before

the earnings from the project were distributed to the investor. This was not the case for the

conventionally financed firm as interest was paid to the investor first and then taxes were

paid on the remaining amount.

Hence after deducting the taxes we arrive at the Earnings Before Distribution (EBD) which

comes out to $14,000.

b. Distribute Profit to investor: The investor is paid according to the proportion of

investment he made in the project. In this case, he contributed 33.33% of the total funds of

the project and hence he will be paid 33.33% of the EBD. This comes out to $4667 (33.33%

of $14,000). This is higher than the fixed rate of interest that was paid to the investor in the

conventional financing system. This is because the investor is paid in accordance to the

returns from the project. Hence he is paid 33.33% of the Net income after taxes (EBD)

instead of being paid 20% interest on the borrowed funds. This has implications in terms of

project selection for the investor (bank) because this means that it will not be able to dictate

the terms such as the interest on loans and will instead have to seek out projects with the

most potential and invest in them. However, as the adjacent panel shows, if the firm had

suffered a loss of $10,000, then the investor would have to share in the losses at the rate of

33.33% (his contribution in proportion to the total investment). That would come out to

$3,333 of lost principal for the investor. This reinforces the fact that this will make the

investor more careful about project selection and will minimize adverse selection problems

and give incentive to the investor to be responsible when lending money.


Case Study

Beximco Pharmaceuticals

Following is a case study of Beximco Pharmaceuticals which is a leading Pharmaceuticals

company in Bangladesh. They are listed in both the Dhaka and Chittagong and London Stock

Exchanges and as such their details are readily available online and are subject to

widespread analysis. Beximco was founded in 1976 and has grown to be one of the largest

pharmaceutical companies in Bangladesh. It specializes in pharmaceutical formulations and

active pharmaceutical ingredients (API). It has more than 500 products that cover a broad

category of types from antibiotics to asthma inhalers. In addition, it is one of the largest

exporters of drugs in Bangladesh with destinations spread out all across the globe.

As is generally the case with case studies related to theoretical formulations such as this a

set of assumptions are necessary in order to go forward. For this particular study, the set of

assumptions are as follows:

1. In the case study, both short term and long term debt is taken. And they are divided

with total funds (Debt/(Stock+Debt) to get the proportion borrowed.

2. In the case study, it is assumed that all the funds are used in one project. In other

words, the firm invests in one project with all its debt and equity.

3. Banks operate under Shariah by utilizing tools such as Mudarabah

4. Profits are shared in proportion to the investment. This applies both to the investor

as well as the firm.

5. In this case study the time value of money is disregarded and project duration is

disregarded as well. All projects are of 1 year in duration.

6. The firm discussed only creates real goods and services and no speculation takes

place.

After accommodating these assumptions, we analyze and compare the following aspects of

Beximco's Operations; that is, we compare the situation as it stands (point a) with the

situation that would hypothetically come about were the firm following an alternative,

Profit and Loss Sharing (PLS) method of financing.

1) Its current method of financing and the variables that follow such as profitability

and payment of taxes.


2) The changes that would occur in its operations and related variables if it adopted an

alternative financing method, in this case the PLS method.

A. Beximco under a Conventional Financing System

a. Profit for the investor (bank): The debt that Beximco incurs comes at a cost. That cost is

the cost of interest payments on the principal borrowed to the investor (in this case the

bank). For example, in 2008, Beximco borrowed 73.85% of its total investments. It borrowed

this fund at a rate of 7.02% (long term and short term rate combined). That means that it

had to pay its loans of a combined 3,556,432,568 taka and a charge equivalent to 7.02% of

this amount as a payment to the investor (bank) for investing in the project. This payment

would have to be made irrespective of what the project that the investor financed earned.

In other words, because the rate of interest as well as the amount that interest is applicable

on is preset, the amount to be paid at the end of the period is also determined beforehand.

In 2007, Beximco earned an after tax operating profit of 545,341,273 taka whereas its

interest payments were 249,654,298 taka. In this year the profits generated by the firm

were sufficient to cover the interest expenses.

So, it follows that in all of the five years covered, Beximco was able to service the debt it

owed to the bank fine because of healthy revenue from its operations. But it should be

mentioned that the payment of interest to the bank was irrespective of the success of the

project and if Beximco had had lower profits from the project or even suffered losses then it

would still have had to pay the outstanding interest on its loans. As mentioned earlier, this

raises some serious issues for the firm as well as the investor who in this case is the bank.

Interest Paid = Preset interest rate x Principal borrowed

The amount of interest paid showed an increasing trend over the five years covered and in

2012 it increased to 645,406,575 taka. It should be noted that over the same period the

Times Interest Earned (TIE) ratio decreased from around 4 in 2008 to around 3.4 in 2012.

This ratio signifies how many times over the company earned an equivalent amount of its

interest expense. So a TIE ratio of 4 in 2008 would signify that in 2008 Beximco earned its

interest obligations four times over.

b. Taxes paid to the government: The taxes paid to the government in case of a

conventional financing system such as the one Beximco (and most other companies)

currently follow, are on the basis of the profit remaining after deducting the preset interest

expense as mentioned earlier. This decreases the amount of taxes that are paid to the


government in proportion to the amount of funds borrowed and the rate at which it is

borrowed. For example, the amount of taxes paid in 2008 by Beximco was 168,779,737 taka.

This came about by the following formula

Taxes Paid by Beximco = (Tax Rate*EBT)

(23.63*714,121,010=168,779,737)

Thus in 2008 the amount of taxes that Beximco paid to the government was 168,779,737

taka. This amount increased to 590,439,908 taka in the year 2012. So in five years the

amount contributed by Beximco to the government exchequer increased by approximately

3.5 times.

However, the government was deprived from taxes of 59,004,827 taka in 2008 due to the

interest expense being paid before taxes. That amounted to the following figure (for 2008)

Taxes Foregone = Interest expense paid before taxes * Tax rate

(249,654,298*23.63%= 59,004,827)

Due to the interest being paid before taxes as interest is a tax deductible expense. This may

give a company like Beximco to take on increased levels of debt and hence leverage itself

more to decrease its tax expense. This might lead to fiscal problems as discussed earlier.

c. Profit for the firm (Beximco): The profit for Beximco was calculated after the payment of

interest to the creditors and taxes to the government. Hence it is the residual amount left

from the investment process. The amount came to 545,341,273 taka in 2008. This is the

amount of profit that the company earned after all its obligations were fulfilled. This

increased to 1,319,389,328 taka in 2012. A comparison of this amount with that in the P.L.S

system will be done later.

B. Beximco under a Profit and Loss Sharing System

a. Profit for the investor (equity partner): Unlike the investor in the conventional system,

the investor in the Profit and Loss Sharing System (P.L.S) acts as an equity partner instead of

a creditor. This has several implications. First, the rate of return or loss for the investor

depends on the cash inflows generated by the project that he is financing. Hence whether

the investor makes a profit or loss in the investment will be dependent on the success of the

project. That is, the rate of return is not fixed ahead of time as it is in the conventional

financing system. Secondly, if the project turns out to be a losing concern then the firm and

the investor will share in the losses in proportion to their investments. That is as Beximco

had invested around 26% of the total funds in 2008, it would bear the losses in proportion


to this amount if the case arose. It would also appropriate the profit from the project in this

proportion. Similarly as the investor had invested around 74% of the funds he will bear any

losses that the project might incur to the tune of this proportion and likewise would

appropriate the profits from the project in this proportion as well.

If Beximco had financed itself using a P.L.S system then the investor's profits would have

been 563,248,502 taka in 2008 as opposed to 249,654,298 taka in the conventional

financing system. The figure in the P.L.S system would be calculated as follows:

Total profit to the investor = (1-t)*(EBTP*Proportion of investment by investor);

This amount would have come to 563,248,502 taka in 2008 and over the course of the next

four years would have increased to 832,507,820 taka. In 2008, the profit to the investor

would have been around 2.26 times greater than it was in the conventional system. The

reason is that the profit would be distributed to the investor according to his share in the

total investment. Following this he would appropriate around 73.85% of the total profits

(after taxes in this case) because his share in the investment was such. However, in the

conventional system he would get a return equivalent to 7.02% of the total amount of funds

borrowed. This amount would be preset by the respective parties.

It should be noted that the proportion invested by the investor decreased throughout the

five years covered and stood at around 54.58% in 2012. Accordingly, his profit for the year

2012 was 832,507,820 taka which was 54.58% of the total profit after taxes for Beximco.

This system would ensure that the investor got returns in proportion to this investment. This

is one of the most crucial tenants of the alternative financing system and this would ensure

that the investor such as banks would evaluate their investments strictly and on many

criteria because their investment success or failure would be directly dependent on the

success of the projects they were financing.

b. Taxes paid to the government: The taxes paid to the government In this system would

differ significantly from the conventional system. This is because even though the tax rate is

the same in both systems, the stages at which the tax rate is applied is different in each. In

the P.L.S system, the taxes are paid on the operational profit of Beximco, what is known in

the conventional system as EBIT (Earnings Before Profits and Taxes). So it follows logically

that this amount in the profit sharing system would be called EBTP (Earnings Before Taxes

and Profits). This happens because in this system there is no separation of debtor and

creditor. Both parties act as equity partners in the business and hence the proceeds are


taxed before it is distributed among the equity partners.

The proceeds for the government from Beximco in 2008 would have been 236,061,297 taka

which was about 1.4 times greater than in the conventional system. This would have

increased to 682,584,694 taka over the course of the next four years. The formula for

calculating this is as follows

Total Taxes = (EBTP*Firm's tax rate) + (Profit earned*Investor's tax rate);

Taxes paid by Beximco = (EBTP*Firm's tax rate);

As the first equation shows, the total taxes paid by the entities. However, for the purposes

of this case study, only the taxes paid by Beximco are covered.

The increased tax revenue at source would benefit the government by enabling it to

effectively conduct fiscal policy in order to foster a stable and growing economy.

c. Profit for the firm (Beximco): The profit for the firm is again the residual amount left over

after obligations such as taxes and investor's share in the profit have been paid. In 2008 this

would have amounted to 199,485,049 taka. This amount would have increased to

692,787,046 taka in 2012. In 2008, the profit to Beximco would have been 36.58% of the

amount that it actually made in the conventional system and in 2012 it would have been

52.51% of what it actually earned.

This discrepancy would arise because in the conventional system, Beximco would have to

pay the preset interest rate on the amount it borrowed. It would then appropriate the

remaining amount. However in the P.L.S system it would have to share in the profits in

proportion to the invested amount.

So, Beximco had to pay the investor (in this case acting as an equity partner) the proportion

of the profit that corresponded to the investor's share in the investment. As the share of the

investor's investment was 73.85% in 2008, Beximco had to pay 73.85% of the profit it

earned at the end of 2008. A similar logic would follow throughout the four remaining years.

Due to the proportional payment to the parties, there would be a disincentive on the part of

Beximco to “leverage” itself by borrowing funds from external sources. This would mitigate

one of the major problems facing the economy these days which is that in the pursuit of

ever increasing scale of business and profit margins firms overleverage themselves and put

the equity of their investors at risk. Similarly, the banks have an incentive to lend as they are

promised a fixed rate of return beforehand which is to be covered even if it means

liquidating the business.


These aspects were covered in detail earlier and is one of the many reasons that a P.L.S

system would be economically as well as societally better as a system of financing.

The Total Profit Equation would be;

Total Profit = (t*EBTP) + (1-t)*(EBP*investor's share) + (1-t)*(EBP*firm's share)


Findings of the Case Study

The findings from Case Study are visualized and presented below.

The findings from the case study are a good representation of that of the paper and hence it

will be used to describe the findings of the research. In the case study the profit for the firm

will be greater in the conventional system than the profit sharing system in this particular

case study. This is because the rate at which Beximco profits means that under a

conventionally financed system, it would have to give up a lower proportion of its profits to

the lending institutions than in the Profit and Loss Sharing System.

Hence, in a PLS system, the firm has to give up profits in proportion to its borrowing. So in

cases where the firm earns a net income, a scenario may arise where the firm borrowed

more than it would have paid interest in the conventional system. In that case the payment

of profit to the investor in the PLS system would be greater than the payment of interest in

the conventional system. These possibilities and their implications were discussed in earlier

sections.

0

200000000

400000000

600000000

800000000

1E+09

1.2E+09

1.4E+09

2008 2009 2010 2011 2012

Figure A: Profit For Firm

Conventional Profit Sharing


The profit for the investor would be higher in the Profit and Loss Sharing System than in the

conventional system. This is because he would receive profits (and share in the losses) in

proportion to his investment. In this particular case that would come out to an amount

greater than the amount it gets in the current system on average.

The implication would be that the investor receives more than what he would have in the

conventional system because he receives payment in proportion to the amount he invested.

In a case where the firm earns profits this would mean that the investor receives payment

that is greater than what he would have received if he lent the money on interest (provided

his share of investment allows for it). This is also a premium for the agreement that the

investor would share in the losses as well in the case the firm was faced with such a

situation.

This would mean that investors and firms would be in close coordination between each

other to ensure the success of a project because both their payoffs as well as principal

depend on it. The selection of projects would be more selective and strict and scope for

malinvestment would be mitigated to a large extent as discussed earlier in the research.

0

100000000

200000000

300000000

400000000

500000000

600000000

700000000

800000000

900000000

1E+09

2008 2009 2010 2011 2012

Figure B: Profit For Investor

Conventional (before tax) Profit Sharing (After Tax)


The Taxes paid by the firm will be higher in the Profit and Loss Sharing System because the

tax would be applicable on income before the distribution of the profits to the investors.

This is because the investors act as equity partners in this case and are not treated as

conventional banks. The implications of this were elaborated in the research.

The ROE for the firm would be lower than in the conventional system because it has to

distribute more of the net income to the investor. This is in line with the rule that each party

bears the burden or reaps the reward in proportion to his share of investment. The return of

equity for the firm would be linked to the firm’s share of investment. Hence, the firm would

try to finance its operations by using increased amounts of equity and less debt. This would

mitigate one of the major reasons behind the recent financial crisis, namely overleveraging.

0

100000000

200000000

300000000

400000000

500000000

600000000

700000000

800000000

2008 2009 2010 2011 2012

Figure C: Taxes Paid


0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

1 2 3 4 5

Figure D: Return On Equity for Firm



These issues have been further discussed previously.

The ROI for the investor would be greater than in the conventional system. The logic behind

this was elaborated on in graph B. The ROI for the investor would also be linked to its share

of investment in the project. This is because a larger share of the investment on the part of

the investor would mean he would receive more of the profit from the venture. This would

also mean that the investor would search out efficient, creative and value adding

investments because increase in profits from the project would directly translate into more

payoff from it. This would also allow the investor to earn a Return on Investment greater

than he would have in the conventional system. This follows from the earlier discussion on

the inherent advantages of the Profit and Loss Sharing (PLS) system.

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

1 2 3 4 5

Figure E: Return On Investment for the Investor



Concluding Remarks

In conclusion, through the course of this research an attempt was made to formulate a

scenario where instead of a fixed ex ante return on loans a system of profit and loss sharing

was used. The subsequent effects of such a change were analyzed in the context of a firm

and the advantages brought on by it to the parties involved were discussed. Subsequently, a

case study was formulated based on Beximco Pharmaceuticals. The aim of this particular

exercise was to demonstrate the effect of a transition from a conventional financing source

to a profit and loss sharing one based on a real, currently operating public company. The key

findings were that the payoffs to the parties would differ from that of the conventional

financing system. This would be dependent largely on the amount of profit or loss that the

firm made during that particular year. In addition, this would have some consequences on

the incentive structure and the decision criteria of both the firm and the investor. The

changes arguably could be thought of as mostly positive ones and would lead to a more

stable and equitable system of allocating resources. Further research has to be conducted in

order to take this system to a level of complexity that is inherent of the conventional,

interest based financial system. This aim of this paper was to merely map the effects of

changing from a conventional financing system to the most basic of profit and loss sharing

systems and its resulting implications.


Further Research Topics

Throughout the course of this research a number of different topics came into light and

would be suitable for further research. Some topics and sub topics are mentioned below.

1. How the rate of time preference derived from the budget constraint and how it

relates to the topic

2. How imperfect credit markets can be used to show the sub optimality of interest

based borrowing

3. An investigation into the interplay between savings and investment that was

explored by Keynes and its place in this analysis

4. The affect of interest based instruments on rent seeking by financial institutions

5. The relationship between the marginal efficiency of capital and interest rates

6. Macroeconomic policy and mechanism changes required for a PLS system to be

established

7. The inability for interest rates to self-adjust and to inevitably reach high levels as

hypothesized by John Maynard Keynes

8. The role of discounting at fixed rates in resource depletion

9. The effects on the discipline of economics in the absence of fixed instruments of

borrowing.


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Lambert.

comparison between a conventionally financed firm and a profit sharing firm

Economy & Finance

profit sharing firm

research paper

system of profit

method of profit sharing

wise research advisor

conventional debt financing

subject matter

pls method