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Profit sharing, interest and related theoretical assumptions in Islamic finance- an overview.

To be Islamic defensible, the banking system must avoid Riba. Therefore, much of the
literature on Islamic banking theory was born out of the impression that the money and
banking industry would have worked if the law had removed interest. The Islamic bank
literature shows two different and distinct characteristics of thought. The literature
developed in the Middle East, mainly in Arabic, concerns the functioning of a single
bank and has adopted a micro methodology. On the other hand, the literature developed
in the Indian subcontinent, mainly in English, has generally adopted a macro
methodology and has dealt with the development of an interest-free banking system that
addresses issues such as the nature and functions of money in a country. Islamic
economy, function, objectives and instruments of monetary policy in an interest-free
framework, etc. In this section, the theoretical foundations of Islamic banks will be
briefly reviewed.
Modern commercial banking activity is based on the creditor-debtor relationship in the
middle of the depositors and bank, on the one hand and between the debtor and the bank
on the other. Interest is viewed as the price of credit replicating the opportunity cost of
money. Islamic view about loan (qard) is that it should be given or taken; free of charge
to meet any possibility and creditor should not take any benefit from the borrower. When
money is borrowed on the basis of interest, more often than not, it ends up in some kind
of injustice.
The Islamic principle in these kinds of transactions is that “deal not unjustly, and ye
shall not be dealt with unjustly” (al- Qur’an, 2:279). Hence, commercial banking in an
Islamic framework could not be based on the creditor-debtor relationship.
The other Islamic principle within the substances of monetary transactions is
that there's no reward without risk. This principle is appropriate both to labour and
capital. As no payment is allowed to labour unless it is applied to work, no reward for
capital should be allowed unless it is exposed to business risks.
Financial intermediation in an Islamic framework could happen using these two
principles. Accordingly, Islamic financial relationships are participatory in nature. It has
been proposed by several philosophers that money-making banking in an interest-free
system which is to be organised on the basis of principle of profit-sharing which is
referred in the Islamic legal system as mudarba.
The principle of mudarba might be explained by an easy illustration. Suppose there are
two persons, one of them has capital but no special skills in trade, while the other has
been bestowed with some special insight and dexterity in the matters of trade but
possesses no capital. These two persons can cooperate in any one of the following two ways:

1. The trader can borrow money from the owner of the capital and invest in his trade.
The owner of the capital will recover his capital and an additional amount calculated
on the basis of a fixed rate called interest rate as compensation for the refusal of
liquidity. This is debt financing. Generally, the loan will be granted for a fixed period.
The credit of the creditor for the repayment of the principal and the payment of the
interest becomes practicable only after the expiry of this period. This is independent
of whether or not the trader made a profit using the borrowed money. In the event of a
loss, the borrower must pay the principal amount of the loan, as well as the interest
earned on his resources. This is viewed by Islam as an unfair transaction.
 2. The other possibility is that the two people cooperate with each other, not on the basis
of the creditor-debtor, but on the basis of a partnership and cooperation in which the
owner of the capital will provide his capital and the other party will implement the
skills and management. . The owner of the capital will not be involved in the real and
daily functioning of the companies, but will be free to establish some conditions that
he deems necessary to ensure the best use of his funds. After the expiry of the period
which may be the termination of the contract or until the moment when the benefits of
the operation are obtained, the owner of the capital will recover his principal amount
together with a profit share. The ratio, in which the total profit of the enterprise is
distributed between the capital owner and the manager of the enterprise, has to be
determined and mutually agreed at the time of the contract before the beginning of the
project. In the event of loss, the provider of the capital shall bear all the loss and the
principal will be reduced by the amount of the loss. In a way, it is the possibility of
the loss which makes the capital owner entitled for a share in the profit of the
enterprise. This is in essence the principle of mudarba.

The Islamic legality of mudarba is based on the Sunnah as it was reported that mudarba was
practiced in the city of Medina and elsewhere during the time of the Prophet (as) and was not
frowned upon.
The creditor-debtor relationship is considered unfair because it gives the creditor more
influence than the debtor. The creditor's interests are protected at the debtor's expense. On the
contrary, the mudarba agreement is based on justice, as it guarantees an equal position for
both parties to the agreement.
There could be at least three reasons to consider that the mudarba relationship is more just
than the creditor-debtor relationship.
First, both sides have the same position in determining the relationship in which profits will
be shared with each other.
Secondly, the treatment of both parties in currency in the event of a loss in which if the
capital provider suffers a reduction in its principal amount, the worker or manager in the
transfer contract is deprived of the remuneration for his work, time and effort.
Third, both parties are treated equally in the event of a breach of the agreement. If the worker
or manager violates any of the conditions established or if he does not work hard or is
decisive in causing losses to the company due to negligence or bad management; you will
have to take responsibility for the safe return of the total amount in question. If, on the other
hand, the capital provider violates any of the stipulated conditions (for example, withdraws
its funds before the deadline, or the documents do not provide partial or total funds at the
promised time, etc.), you must pay to the worker or manager a compensation equivalent to
what he would have earned in a similar job.
It has been suggested that the move is the idea of reorganizing banking activities within an
interest-free framework. This can be achieved by entering into a two-tier shift agreement
which can be explained as follows:
The first tier of the transfer agreement is between banks, therefore compliant depositors
deposit their money into the bank's investment account and share the revenue with it. In this
structure, the depositors are the capital providers and the bank acts as fund manager.
The second level of the transfer agreement is between the bank and entrepreneurs
seeking financing from the bank provided that the profits of their activities are shared
between them and the bank in a previously mutually agreed proportion, but the loss is
borne by the sole financial. In this case, the bank works because the capital provider and,
therefore, the entrepreneur works because the administrator. In the event that there is
more than one lender of the same project, or a project is jointly financed by multiple
banks, the profits will be distributed in a previously determined agreed proportion, but
the losses will be distributed in the proportion in which different lenders have invested
their capital. . There may also be a partnership agreement (sharikah) between the bank in
which the contracting parties must share the loss in the proportion in which they must
invest their capital, but the profits will be shared in the agreed proportion determined in
advance.
The principle of moving as a basis for monetary intermediation within the Islamic
economy can be obtained as a feasible substitute to the interest-free banking sector. The
creditor does not gather interest at a fixed rate in this system, but contributes in
commercial risk and contributes in profits. So, within the Islamic banking system, the
cost of capital is not zero, as some people misguidedly believe that it is corresponding to
the zero interest rate. The only difference between the Islamic banking sector and the
interest-based banking sector in this regard is that the cost of capital in the interest-based
banking sector is communicated in terms of a pre-set fixed rate, while in the Islamic
banking sector it is communicated as a ratio of earnings. Some writers have even
suggested that the percentage of profit sharing in an Islamic economy could perform the
same functions as the interest rate in a capitalist economy. Therefore, the profit-sharing
relationship could function as an allocation device, as well as a control variable.
Islamic banks are recognized with an order to conduct all their transactions in accordance
with Islamic precepts which prohibit, among other things, the receipt and payment of interest.
Unlike conventional (non-Islamic) commercial banks, Islamic banks mainly mobilize funds
through investment accounts through profit-sharing contracts. In this document, we argue that
the concept of financial risk, on which modern theories of capital structure are based, is not
relevant for Islamic banks. Given the prescribed obligation that indulges the shareholders of
the Islamic bank and the holders of investment accounts to share the profits of the
investments, we propose a theoretical model in which, based on certain hypotheses, an
increase in the financing of investment accounts allows the Islamic bank to increase both the
market value and the rates of return of the shareholders without further financial risks for the
bank. Theoretically we demonstrate that this process leads to an increase in the market value
of the Islamic bank but does not alter its biased average cost of capital, i.e. the biased average
cost of capital of the Islamic bank leftovers relentless. The evidence obtained by estimating
and testing the model in annual accounts obtained from a sample of 12 Islamic banks
supports our theoretical predictions, as well as the results of counterfactual simulations and
sensitivity experiments. Therefore, in the context of Islamic banks, our theoretical and
empirical results provide a new dimension to the capital structure theory, which is based only
on a combination of debt and equity financing. Overall, given the main competitive principles
of the traditional school and the perspective of MM, our results provide a global example for
the theory of capital structure. The practice of Islamic finance differs meaningfully from its
theory. The survey statements the causes of opposition and offers substitute research
methodologies and themes that in the future could simplify the conjunction of repetition with
theoretical objectives, an alteration from the simple execution of the standards of validity to
the accomplishment of the purposes of Islamic law.
In an Islamic system, banks, according to Allah's mandate, must ban interest and assumption
and participate directly in profitable and investment operations. Unsubstantiated credit
growth is predictable in an Islamic system and banks cannot pledge and emphasize a
hypothetical process. Credit is founded on real savings. It is not potential to create excess
purchasing power with the hit of the pen. Cash flows originate from the sale of goods and
services and from transit through the banking system for payment or investment purposes.
They do not arise within the banking system and are therefore transmitted to real activity.
Islamic banks do not compete to issue loans to borrowers for the purpose of managing
liabilities resulting from maturity mismatches between assets and liabilities; they participate
only for real investment opportunities; its capitals are reinvested in real assets. Given the
constancy of its financial system and the resistance to currency shocks, suggestive of the
predictable system, an Islamic economic system would experience continued economic
growth and avoid harmful impacts on social justice, since inflation cannot be used for tax
creditors and employees in favour of defaulters and risk-takers.