New Perspectives on Profit Sharing and Risk
Edited by Munawar Iqbal and David T. Llewellyn
Chapter 3: Incentive-compatible profit-sharing contracts: a theoretical treatment
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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