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Risk, Return, and Profit-Loss Shared Lending under a Zero-Interest Financial System

Author

Listed:
  • KHALED, SHAFI A.

    (Metropolitan State University)

Abstract

Owing to its unique nature, writing a profit-loss shared lending (PLSL) contract for a Zero-Interest Financial System (ZIFS) bank is a challenge. Like venture capitalists and stock owners, a PLS lender faces some of the same risks as the borrower. However, as a lender and not as an investor (as opposed to the classical definition), it does not share in any increment or loss in the value of equity. While the share of profit going to capital may be constant, the absolute amount going to the lending bank is likely to diminish over a fixed period of time until the loan is paid. In economies where attempts to float a PLSL contract is strong, it is made worse by an abundance of adverse selection (AS) and moral hazard (MH) factors: lack of knowledge and training, errors in planning and projection, tardiness in identifying and reacting to problems, limitations of oversight, nepotism, favoritism, corruption, falsification, legal loopholes, tendency to cut corners, etc. So, despite its obvious benefits PLSL contracts are finding it difficult to take root and become established as a standard financing arrangement. This is vitiated by internal competition posed by mark-up financing. Pivotal to a viable PLSL contract, relevant equations incorporating AS and MH and related explicit and implicit costs are identified. Then risk-adjusted return to ZIFS bank, capital’s share of profit, absolute income accruable to banks and relevant first order conditions are derived.

Suggested Citation

  • Khaled, Shafi A., 2018. "Risk, Return, and Profit-Loss Shared Lending under a Zero-Interest Financial System," Islamic Economic Studies, The Islamic Research and Training Institute (IRTI), vol. 26, pages 1-30.
  • Handle: RePEc:ris:isecst:0171
    as

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    References listed on IDEAS

    as
    1. Ahmad, Ausaf & Khan, Tariqullah & Iqbal, Munawar, 1998. "Challenges Facing Islamic Banking (Occasional Paper)," Occasional Papers 1998, The Islamic Research and Teaching Institute (IRTI).
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    3. Khaled, Shafi A. & Khandker, A.Wahhab, 2017. "Determination of Mark-Up Rate under Zero-Interest Financial System: A Microeconomic Approach," Islamic Economic Studies, The Islamic Research and Training Institute (IRTI), vol. 25, pages 15-34.
    4. George A. Akerlof, 1970. "The Market for "Lemons": Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 84(3), pages 488-500.
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    More about this item

    Keywords

    Mushārakah; Muḍārabah; PLS; ZIFS; Islamic Banking;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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