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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 5: Incentive-compatible constraints for Islamic banking: some lessons from Bank Muamalat

Adiwarman A. Karim


Iqbal 02 chap 5 9/11/01 3:09 pm Page 95 5. Incentive-compatible constraints for Islamic banking: some lessons from Bank Muamalat Adiwarman A. Karim 1. INTRODUCTION Presley and Sessions (1994) draw a comparison between a riba contract1 and a mu∂arabah contract under symmetric and asymmetric information. The key assumption is asymmetric information. The manager is assumed to have superior information to investors in two respects: first, having signed a contract with investors, the manager is able to observe the demand or productivity conditions affecting the project before committing to production decisions; and second, he alone observes his personal level of effort. Such asymmetric information is not unusual and, indeed, rationalizes the manager’s involvement in the project. But while the manager’s relative informational expertise suggests that he should be delegated some authority over production decisions, the exploitation of this expertise is problematic. Since effort is private information, the manager cannot be compensated directly for its provision. A revelation problem, therefore, arises with the manager’s preferences over productive inputs only coinciding with those of investors if he personally bears the entire risk of adverse shocks. If the manager is risk-averse then such a policy, while productively efficient, is sub-optimal (see Holstrom and Weiss, 1985). Furthermore, a policy of paying the manager a fixed return independent of the outcome is also inefficient because there is no incentive for him to supply more effort when its marginal product is high. One way out of this dilemma is to design an incentive-compatible contract, which...

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