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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 7: Choice between debt and equity contracts and asymmetrical information: some empirical evidence

Kazem Sadr and Zamir Iqbal


Iqbal 02 chap 5 9/11/01 3:09 pm Page 139 7. Choice between debt and equity contracts and asymmetrical information: some empirical evidence Kazem Sadr and Zamir Iqbal* 1. INTRODUCTION Although an Islamic financial system offers a combination of both equity- and non-equity-based instruments, the system’s preference for equity contracts often raises concerns regarding its efficiency and stability.1 It has been asserted that prohibition of debt contracts creates an incentive for Islamic banks to concentrate their asset portfolios on low-risk trade financing instruments when faced with asymmetric information.2 This chapter presents empirical evidence based on the last 15 years of data from the Agricultural Bank of Iran (ABI) which demonstrates that reduction in information asymmetry and increased direct participation by the financier led to a preference for equity participation over lower-risk short-term instruments, thus improving efficiency. The conclusions drawn in the chapter are significant for (i) the choice of contract in a world with enhanced information and monitoring, (ii) the importance of high returns to investment in information-gathering and monitoring for reducing information asymmetry and thus improving the efficiency and viability of a financial intermediary operating on Islamic principles, and (iii) optimal portfolio composition of an Islamic bank.3 Section 2 discusses the theoretical foundations of financial intermediation with asymmetric information and its relevance to Islamic finance. Section 3 analyses procedural and policy changes undertaken by the Agricultural Bank of Iran to reduce information asymmetry and its impact on the composition of its portfolio. Finally, a summary of results and conclusion...

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