A New Proposal for the Profit Distribution System of the Participation Banking

Abstract

Purpose: The trust in participation banks depends largely on authentic dependence on Sharia, legal financial instruments and fair yet transparent distribution among account owners and banks. Taking into account the economic Islamic principles and those of mudarabah agreement, this study aims to identify problematic areas pertaining to profit sharing in addition to revealing opportunities leading to the improvement of the profit distribution system while developing a new profit distribution system proposal. Design/methodology/approach: This study proposes two hypotheses (H). H1: There are partial deviations between the profit considered to be legal according to the economic principles of Islam and the practice of participation banking. H2: There are partial deviations or loss of right in practice between the mudarabah contract concluded among owners of participation account and participation banks. In-depth interview technique and review of the literature including legislation were used to determine the parameters affecting the distributed profit. The collected data was tested through comparison with the theoretical framework of the mudarabah contract. Findings: There are two separate fund pools used in participation banks, including equity and participation accounts. Managers’ selection of pools set according to their personal goals related to balance sheet profit management may cause profit to pass between participation accounts and equity. Many issues negatively affect the distributed profits. For example, incomes from funding commissions, reserve requirements and idle funds, although they originate from participation accounts, are recorded in the bank’s income. In addition, the bank does not return the profit initially recorded in its own account to participation pools, whether or not profit. Research limitations/implications: The interviewed officials were cautious to avoid a negative perception of the sector. This made it difficult to determine the real situation of applications decided with initiative in profit distribution. Although the authorization documents have partially been published, it is still difficult to access most licensed documents. There is no independent audit report made considering the interest-free banking principles regarding the profit distribution system of participation banking. The scarcity of the literature on the subject is another limitation. The research does not cause any harm to the reputation of participation banks. Practical implications: Adopting a single-pool system in line with the global practices will end the shift of right between pools while ensuring a fair and transparent system. In this system, the bank equities, other shareholders’ funds and participation accounts are collected and operated in a single pool. The pool profit and loss are distributed as per the shares in the pool. The profit per each participation account is distributed based on the share of each participation account in the pool and profit-sharing ratio. Social implications: Participation banking is expected to support the real economy by means of production, leasing, merchandising based on certain religious, ethical and contractual principles. Bringing funds of conservatives, that does not go to conventional banks for avoiding of interest, in the economy is expected to provide new sources to reduce the foreign dependency for the economy and to supply a financial alternative for the conservatives who stay away from interest-based economic activities. However, if this will represent an alternative to debt-based systems, then products, contracts, business processes and legislations driven according to interest-free banking principles should be developed. Originality/value: This study introduces and analyzes a new proposal of the profit distribution system of participation banking. A similar methodology is used in interest-free banking on a global scale, especially in Malaysia, and is compatible with the profit distribution decisions in AAOIFI’s depositor accounts. However, this methodology is considered to be new as far as participation banking is concerned. The implementation of this new methodology will eliminate several problems identified in the profit distribution system of participation banks. This research provides an academic contribution to the participation banking profit distribution system and represents a reference material on the subject.