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20.5.09

Lack of Profit Loss Sharing in Islamic Banking

This piece from Loughborough University provides a critical view on the profit loss sharing mechanism in Islamic finance today (actually the lack of it). Our aim is to further bring a variety of constructive criticsms to the fore, and while this paper was published in 2001 it does provide a starting point for future discussions. Effectively, we seek to explore the chasm between the theory, the principles and the inputs and what happens in practice, in the real-world, effectively what is the actual output of Islamic finance. Nonetheless, the focus is not on what is wrong but what can we do to make it right.

Lack of Profit Loss Sharing in Islamic Banking: Management and Control Imbalances
Humayon A. Dar and John R. Presley
Centre for International, Financial and Economics Research
Department of Economics, Loughborough University

Some excerpts: "An imbalance between management and control rights is attributed as a major cause of lack of Profit Loss Sharing (PLS) in the practice of Islamic finance. Given this dichotomy, the agency problem gets accentuated, which may put the PLS at a disadvantage vis-à-vis other modes of financing. However, there is no theoretical reason to believe that PLS is inherently inefficient. In certain circumstances, this in fact may serve some important economic function."

"Without the types of management and control discussed here, Islamic banks will persist in taking the easy and risk averse route and avoid profit and loss sharing contracts. The incentive to cheat must be eliminated, the desire to withhold information must be negligible and systems must be put in place which allow efficient and open profit and loss share instruments to develop."


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