THE CAPITAL STRUCTURE OF ISLAMIC BANKS UNDER THE CONTRACTUAL OBLIGATION OF PROFIT SHARING

Talla Al-Deehani, Rifaat Ahmed Abdel Karim and Victor Murinde
Additional contact information
Talla Al-Deehani: Department of Business Administration, University of Kuwait, P.O. Box 5486, Code No. 13055, Kuwait
Rifaat Ahmed Abdel Karim: Accounting and Auditing Organization for Islamic Financial Institutions, P.O. Box 1176, Manama, Bahrain
Victor Murinde: Department of Accounting and Finance, University of Birmingham, Edgbaston, Birmingham B15 2TT, United Kingdom

International Journal of Theoretical and Applied Finance (IJTAF), 1999, vol. 02, issue 03, 243-283

Abstract: Islamic banks are established with the mandate of conducting all their transactions in conformity with Islamic precepts which prohibit, among other things, the receipt and payment of interest. Unlike conventional (non-Islamic) commercial banks, Islamic banks mobilise funds primarily via investment accounts using profit sharing contracts. In this paper, we argue that the concept of financial risk, on which modern capital structure theories are based, is not relevant to Islamic banks. Given the contractual obligation binding the Islamic bank's shareholders and investment account holders to share profits from investments, we propose a theoretical model in which, under certain assumptions, an increase in investment accounts financing enables the Islamic bank to increase both its market value and its shareholders' rates of return at no extra financial risk to the bank. We theoretically demonstrate that such a process leads to an increase in the Islamic bank's market value but does not alter its weighted average cost of capital, i.e. the weighted average cost of capital of the Islamic bank remains constant. The evidence obtained from estimating and testing the model on annual accounts drawn from a sample of 12 Islamic banks lends support to our theoretical predictions, as do the results from counterfactual simulations and sensitivity experiments. Hence, in the context of Islamic banks both our theoretical and empirical results provide a new dimension to the theory of capital structure, which is based on a mixture of only debt and equity financing. In general, viewed against the main competing tenets of the traditional school and the MM standpoint, our results provide an encompassing paradigm on the theory of capital structure.

Keywords: Islamic banks; Profit sharing; Capital structure theories; Cost of capital; JEL classification Code G32; JEL classification Code G21 (search for similar items in EconPapers)
Date: 1999
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Citations: View citations in EconPapers (17)

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DOI: 10.1142/S0219024999000157

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