Islamic finance has grown rapidly over the last several years, in terms both of the volume of lending and of the range of financial products that are available at institutional and retail levels. The main characteristic of these financial instruments is that they are compliant with the shari’a – the Islamic legal system.1 Since the Islamic financial system differs in important ways from the conventional interest-based lending system, there is a need to devote more attention to the particular issues raised by Islamic finance. This chapter discusses some key insights from an agency theory perspective, and illustrates how the insights from this literature can be employed to provide a framework for the design of
Islamic financial contracts and control mechanisms for the regulation of Islamic financial institutions. The agency theory concepts of incentives, outcome uncertainty, risk and information systems are particularly germane to the discussion of compensation and control problems in Islamic financial contracting.2
The main difference between an Islamic or interest-free banking system and the conventional interest-based banking system is that, under the latter, the interest rate is either fixed in advance or is a simple linear function of some other benchmark rate, whereas, in the former, the profits and losses on a physical investment are shared between the creditor and the borrower according to a formula that reflects their respective levels of participation.
In Islamic finance, interest-bearing contracts are replaced by a return-bearing contract, which often takes the form of partnerships. Islamic banks provide savers with financial instruments that are akin to equity called mudaraba and musharaka (discussed below). In these lending arrangements, profits are shared between the investors and the bank on a predetermined basis.3 The profit-and-loss sharing concept implies a direct concern with regard to the profitability of the physical investment on the part of the creditor
(the Islamic bank). Needless to say, the conventional bank is also concerned about the profitability of the project, because of concerns about potential default on the loan.
However, the conventional bank puts the emphasis on receiving the interest payments according to some set time intervals and, so long as this condition is being met, the bank’s own profitability is not directly affected by whether the project has a particularly high or a rather low rate of return. In contrast to the interest-based system, the Islamic bank has to focus on the return on the physical investment, because its own profitability is directly linked to the real rate of return.
The direct links between the payment to the creditor and the profitability of the investment project is of considerable importance to the entrepreneur. Most importantly, profitsharing contracts have superior properties for risk management, because the payment the entrepreneur has to make to the creditor is reduced in bad states of nature. Also, if the entrepreneur experiences temporary debt-servicing difficulties in the interest-based system, say, on account of a short-run adverse demand shock, there is the risk of a magnification effect; that is, his credit channels might dry up because of lenders overreacting
to the bad news. This is due to the fact that the bank’s own profitability is not affected by the fluctuating fortunes of the client’s investment, except only when there is a regime change from regular interest payments to a default problem. In other words, interest payments are due irrespective of profitability of the physical investment, and the conventional bank experiences a change in its fortunes only when there are debt-servicing difficulties.
But a temporary cash-flow problem of the entrepreneur, and just a few delayed payments, might be seen to be a regime change, which could blow up into a ‘sudden stop’ in lending.