Profit-Loss Sharing Contract Formation under Zero Interest Financial System

Abdul Khandker and Shafi Khaled

No 6815, EcoMod2014 from EcoMod

Abstract: Under Zero Interest Financial System, Profit Loss Sharing (PLS) contract supposedly is the primary vehicle of incurring debt by a business. However, factually, for various reasons that is not the case as of now. An alternative mode of financing called Mark-up (MU) has stepped in as the favored means. Both the PLS and MU have their pros and cons, some ethical and some practical. A question has arisen as to what extent MU may be opportunistic and actually be bending the rule while nominally adhering to the concept of risk-shared financing modality. No matter how ethically clouded MU transactions may appear to be, a failure to fully appreciate how a PLS contract may be soundly crafted and implemented leaves little option but to depend on MU contract. Arguments have been made why the PLS appears not to be floating sufficiently: Moral Hazard, tax evasion, duration of the loan contract, etc. Of course, one notices how MU has been allowed to cross-over from consumer-goods type loans to loans where a tangible profit flow exists. This has likely reduced the market for PLS loans. Also, when consumption in an economy is trade driven rather than production based, MU is likely to dominate. This is a mathematical model. Using the profit maximizing macroeconomic model of firm, this paper investigates an entrepreneur’s willingness to make a PLS contract under two different situations – first, when PLS is the only mode of financing and second, when both MU and PLS modes of financing are available. It is able to discern what the share rate is likely to be, how it is affected by the duration of the loan, the MU rate, risks borne by the parties, their comparative market power and negotiating aptitude as well as transparency. In the process, we also explore the comparative statics issues that impact a PLS contract.

Keywords: Countries where Islamic Banking is practiced; Finance; Modeling: new developments (search for similar items in EconPapers)
Date: 2014-07-03
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