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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 4: Evidence on agency-contractual problems in mudarabah financing operations by Islamic banks*

Abdel-Fattah A.A. Khalil, Colin Rickwood and Victor Murinde


Iqbal 01 chaps 9/11/01 3:08 pm Page 57 4. Evidence on agency-contractual problems in mu∂arabah financing operations by Islamic banks* Abdel-Fattah A.A. Khalil, Colin Rickwood and Victor Murinde 1. INTRODUCTION Islamic banks have developed specific forms of financial contracts to replace the interest rate mechanism in financial transactions. Invariably, these forms are based on profit/loss-sharing relationships between the supplier of funds, on the one hand, and the entrepreneur, on the other. One of the main forms of these financial contracts is the profit-sharing (hereafter, mu∂arabah) contract. A standard mu∂arabah contract can be described as a contractual relationship between two parties, the financier (rabb al-mal) and the entrepreneur (mu∂arib), who are governed by the Shariºah (the Islamic law) and combine human and financial capital in order to set up a risky but profitable joint invesment project. The contract has a prime role in utilizing funds as well as distributing returns to investment without resort to interest. However, in the context of agency theory, the mu∂arabah contract seems to be inherently characterized by agency problems. In particular, the economic interests of the entrepreneur (the agent) may conflict with those of the Islamic bank (the principal) despite the contractual relationship between the two that requires the former to act in the interest of the latter. Moreover, information asymmetry may exist in the sense that the bank may not be able consistently to monitor the activities of the entrepreneur. * This chapter was completed while A.A. Khalil was...

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