ISLAMIC BANKS AND A THEORY OF OPTIMAL PROFIT SHARING

Author(s): ABU N.M. WAHID

Source: Islamic Studies, Vol. 24, No. 3 (Autumn 1985), pp. 389-396
Published by: Islamic Research Institute, International Islamic University, Islamabad
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ISLAMIC BANKS AND A THEORY OF
OPTIMAL PROFIT SHARING

ABU N.M. WAHID

INTRODUCTION

Islam, as a complete code of life encourages all sorts of business

activities and other attempts to achieve material well-being. Of course,
these attempts have to be based on the principles of 'shariah'. Allah says
in the holy Qur'an:
"And when the Prayer
Is finished, then may ye
Disperse through the land,
And seek of the Bounty
Of God: and celebrate
The praises of God
Often (and without stint):
That ye may prosper." (62 :10)

Banking is an inseparable part of modern business life everywhere

in the world. Bank deals inmoney as a link between the savers and the
investors. This business, as we see today, originated and developed in the
West and spread all over theWorld along with its positive dynamic role
as well as the vice associated with the institution of interestwhich is clearly
a means of exploitation. As a predetermined fixed return on money lent
interest is unfair both to the borrower and to the lender of themoney. It

is unfair to the borrower, because he may not earn enough by the use of
the money to pay the interest. It is unfair to the lender if the profit

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 390
A.N.M. WAHID

earnedby theborrowerisquite out of proportiontowhat he paysby way

of interest. Interest is a form of *Riba' which is strictly unlawful in
Islam. The Qur'an reads:

But God hath permitted trade

And forbiddenusuary (Riba).
(2:275)

On the basis of this, and other Quranic injunctions on usuary, Muslims

have started the practice of Islamic Banking on the principle of profit and
loss sharing rather than on pre-determined rate of interest.

to say, Islamic Banks have been successfully and profit

Needless
ably operating for more than a decade and Muslim countries are now de

monstrating a trend of switching over to the Islamic Banking system from

the conventional one. This trend demands a more rigorous research from
theMuslim scholars and economists to develop a complete model of bank
behaviour under Islamic setup.

The chief purpose of this paper is to give a theoretical underpinning

of the process of optimal profit-sharing by an Islamic Bank with itsbusiness
counterparts.

The paper has been divided into five sections. The next section deals
with some general considerations and gives a background of the main
theme of the paper, section III provides a mathematical formulation of the
distribution of profit among the different partners of banking business in
Islam; section IV throws some light on the optimal allocation of profit
among them and finally, the last section concludes the paper with some
suggestions for further research.

II

THEORETICAL BACKGROUND

An Islamic Bank, as a neoclassical business firm uses some inputs

like:equitycapital1and borrowedfundsintheformof deposits. Deposits
can be of various typessuchas : (i) demanddeposits, (ii) profit-sharing
accounts, (iii) corporate stocks, (iv) commercial bank certificates,

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ISLAMIC BANKS 391

(v) central deposit certificates etc.2 It produces outputs like : (i) indexa
tionof depositsand advancesby the rateof inflation;(ii) servicecharge;
(iii) investmentauctioning, (iv) mark-up/hire-purchase/leasing; (v)
murabahah and bay'mu'ajjal, (vi) time-multiple counter loans; (vii)
financing on the basis of normal rate of return etc.3

Islamic Bank has another neoclassical characteristic which refers

to its rational allocation of funds among competing investment proposals
varyingdegreesofrisk and uncertainty. It ishowever,endured
involving
with an additional feature i.e. its profit motive attitude can never override
the Islamic code of moral and ethical values.

Ill

MATHEMATICAL FORMULATION OF PROFIT

DISTRIBUTION

in order to conduct business, need a certain mini

Islamic Banks
mum amount of capital. This capital (A) comes from two main sources :
equitycapital(E); and second,creationofdeposits(D) fromthesavers.
first,
Thus, the total asset of the bank can be expressed as :

= E + . ;
A 1=1,2,,.,m.

Ifm types of deposits are created at the rate of remunerations R then it

follows that ^iD=D,
Let ai denote the proportion of the total funds (A) obtained through the
issuance of the ith. deposit type then,

E*?aiA
or, A ? E +
r
A5a, 1
or, E = A -
Ll
?aTJ
out of this total fund bank keeps a portion as reserve requirement and
allocates the rest among alternative investment proposals with mutually
agreeable share of profits with the borrowing-investors.
Let theinvestible
fundbe represented
byPj withgrossexpectedrate
of Then balance sheetconstraintis givenby : 51* ? 1;
profitTj^- -
and gross expected rate of return on total fund is :Tr
^Ej-jc
Bank after paying return to depositors and shares to the enterpreneurs
:
keep the rest i.e. bank's equity return rate is

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392 ARM WAHID

for the IslamicBank where,

This is thebasic profitidentity

*9 : thegross rateof profitfor thejth. project;

f?i : the% of profitgoes to thedepositors;
t>j : the% of profitgoes to theborrowers;
<3j : the% of profitgoes to theequityholders.

Under similar fashion, the identity for loss can be formulated. It

is however, assumed here, that investment projects on the average do not
incur loss.

IV

MECHANISM OF OPTIMAL SHARING OF PROFITS

Under Islamic Banking system, there are three main partners of

business. They are; the depositors (savers), the equity holders (bank) and
the borrowers (investors). Therefore, the profit4 made out of the business
should be shared in some just and equitable manner among them. This
is the basic principle of profit-sharing in Islamic Banking. The mechanism
of sharing the profit in a just and optimal manner is accomplished in the
following paragraphs.

the supplyof loanablefunds

The scheduleS infigure1 represents
by banks as an increasing function of gross expected rate of profit. The
vertical line D represents demand for such funds by borrowing-investors
which is determined by some exogenous factors such as : political stability,
future expectations abcut business, government's export and import
policies, marketing and transportation facilities etc.

DETERMINATION OF THE GROSS RATE OF PROFIT

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ISLAMIC BANKS
393

Figure 1.

The intersection of thesetwo schedulesdeterminestheequilibrium

gross rateofprofit,say it is it* The shareof thedepositorson thisprofit
isdetermined by the supplyof savingsby depositorsand thedemand for
savingsby thebankswithTr*as a ceiling.5 The supplyof savingsisagain
positivelyrelatedwith thereturn. But thedemand forsavingsby banks
isa deriveddemandbased on thedemandforbank loansby theborrowing
investors and thus it is vertical. Figure 2 determines depositors9 rate of
return (R).

Determination of the Depositors' Rate of Return on Savings

c
u
3

-? ? ? ? ?
Ceiling

Amount of Savings
Figure. %

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 394 A.N.M. WAHID

Once thedepositorsget theirshareRffout of thegrossprofitrate

it*, the leftover (ir *?R*) is to be distributed between the borrowers and
the bank itself. Bank's optimal rate of profit is determined in figure 3.6
Say it is q*. Then the borrowers.

Determination of bank's Optimal Rate of Proift

4J
hq)

Bank's total profit

Figure 3

share
p*
is the residua! i.e. tr*?R*?-q*. This can be found from
p*
figure 4.

Determination of the Borrowers' Share of Profit

4J q)
h 4J
<4-4 Cd
o U

i.

Figure 4

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 ISLAMIC BANKS 395

Since the entire amount of profit is distributed among the partners.

~ R* +
Then,^* q* -f-p* H 100%. This is the profitexhaustion
of theIslamicBank. The profitexhaustioncan be shownwith the
identity
help of a pie chart in figure5.

Pie Chart of Profit Exhaustion

Figure 5
The relative size of the areas in the pie depends on the mutually
three partners on the basis of Islamic
agreed principle reached by the
moral and ethical values.

CONCLUSION AND RECOMMENDATION FOR

FURTHER RESEARCH

This paper can be considered as a very rudimentary attempt towards

Islamic framework.
formulating a partial model of bank behaviour under
The main focusof thepaper ison theprocessof optimal profit sharing.
Its scope is very much limited.

Further research work can and should be done to extend themodel

to determine the optimal scale of operation under the same setting. This

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 396 A. N.M. WAHID

model does not take into account the risks and uncertainties under which
banks are operating.

The most important point the future researchers should pay atten
tion, is to incorporate themoral and ethical aspects of Islamic values into
concrete mathematical formulation.

Theorising bank bahaviour on a priori basis is, however, not an

easy task. It strongly requires the support of empirical findings because
most of the issues raised here are empirical rather than theoretical.

NOTES

1. Equity capital is the contributionof theowners of thebank.

2. For detail please see Iqbal and Khan A SurveyCh. 2, pp. 17-19.
3. For detail, Ibid., p. 35.
4. Purposefully,sharingof loss is omitted here, with the understanding thatnor
mally banking business does not incur loss.
5. The reason for,fto be the ceiling, is that, it is the gross rate of profit.
average
This is to be shared among all the partners. Depositors, as one of the three par
tners can get less than the rate *or at best * Under
any circumstances it cannot
exceed the ceiling.
6. This is a Laffer typeof curvewhich was originally developed to determine the
optimal tax rate for a country^

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