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Islamic Banking and Finance

New Perspectives on Profit Sharing and Risk

Edited by Munawar Iqbal and David T. Llewellyn

Islamic Banking and Finance discusses Islamic financial theory and practice, and focuses on the opportunities offered by Islamic finance as an alternative method of financial intermediation. Key features of profit-sharing (as opposed to debt-based) contracts are highlighted, and the ways in which they can facilitate improved efficiency and stability of a financial system are explored.
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Chapter 3: Incentive-compatible profit-sharing contracts: a theoretical treatment

Habib Ahmed


Iqbal 01 chaps 9/11/01 3:08 pm Page 40 3. Incentive-compatible profit-sharing contracts: a theoretical treatment Habib Ahmed* 1. INTRODUCTION With the inception of Islamic banking practices in the mid-1970s academic discourses on the subject highlighted the profit-sharing features of Islamic financing. It was believed that Islamic banking would take the form of the twotier mu∂arabah model. Experience, however, shows that there are some inherent problems in applying profit-sharing modes of financing (mu∂arabah and musharakah). The problems in the application of the profit-sharing model in practice led to the use of other financial instruments. Mark-up financing (muraba˙ah) became the dominant mode of financing in Islamic banks (Iqbal et al., 1998; Khan, 1995). Studies exploring this phenomenon identify the moral hazard problem in profit-sharing modes of financing as the main cause of its unpopularity. Though an Islamic economy cannot be a ‘pure profit-sharing’ economy, there is an aspiration among the proponents of Islamic banking to have a balanced mix between mark-up and profit-sharing modes of financing (Jarhi al-, 1999). The success of the use of profit-sharing modes of financing, however, will depend on the resolution of the problems of asymmetric information associated with their use. A financial system constitutes a series of contracts that resolve the conflicting interests of different parties by addressing incentive problems. Though much has been written on the nature and implications of profit-sharing modes of financing, discussions on contracts that can be used in these transactions are scant.1 This chapter is a contribution to...

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