Participation banks work under the guidelines that prohibit interest-based transactions and avoid all impermissible operations. The funds, which are collected based on the profit-loss sharing model, are used to provide financing to permissible commercial activities. Instead of providing cash directly to the customer, the bank applies the models of supplying/leasing goods and services, and profit-loss partnership models.
In order for a return to be interest, earnings must be determined in advance and the use of money must be paid for. For example, conventional banks collect money from depositors based on a fixed interest rate, the bank then lends the funds to borrowers as cash loans at declared interest rates. On the other hand, in profit-loss sharing model, while the funds are collected there is neither a promise made for income nor a guarantee given for the principal capital.
As for the difference in loans; when providing financing, participation banks do not pay cash directly to the customer. Instead, the bank purchases the commodity at the request of the client and resells it to the client at a mutually agreed profit, either through instalments or a delayed payment. Thus, financing to the client was made in the form of trade, not a loan (cash payment). This is also an ideal financing method as it ensures that the financing is given for a specific purpose and is tied to the real economy, preventing inefficient and speculative allocation of resources. In addition, participation banks do not finance businesses that engage in unlawful activities, such as those who deal with the production and sale of alcoholic beverages or tobacco.