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Profit- and loss-sharing partnership: the case of the two-tier mudharaba in Islamic banking

Author

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  • Amine Ben Amar
  • AbdelKader O. El Alaoui

Abstract

Purpose - The purpose of this study is to understand the profit-sharing structure at equilibrium of the two-tier mudharaba contract in a pure Islamic banking system and then in a dual banking system. Design/methodology/approach - This paper aims to better understand the profit-sharing structure at the equilibrium of the two-tier mudharaba. It first assumes a purely Islamic banking system and then introduces a risk-free asset to simulate trade-off opportunities in a dual banking system. Findings - First, by using a model inspired from a neoclassical framework and assuming that the Islamic banks are the only channel for financing the economy, the results suggest that the profit-sharing structure built up by the three parties, the bank, the depositor and the entrepreneur, at the time of signing the Mudharaba contract has to be drawn up in the way that, at the ex post, the remuneration of each necessary production factor, capital and labor, should equal its marginal productivity. Second, the authors relax the hypothesis of a purely Islamic financial system and introduced a risk-free asset in favor of the depositor. Thereby, the authors are able to apprehend the financial balance of the two-tier mudharaba contract by simulating the trade-offs that can occur in a dual banking system. The findings suggest that the profit-sharing structure is not the same whether we are at the level of bank assets (bank–entrepreneur relationship) or liabilities (bank–depositor relationship). For the asset side, an increase (respectively decrease) in the expected profit of the mudharaba implies a decrease (respectively increase) in the share of the bank, whereas an increase (respectively decrease) in the return of the risk-free asset and/or the risk underlying the project implies an increase (respectively decrease) of the bank’s share in the expected profit. Originality/value - Theoretical work that has studied the determinants of the ratio of profit sharing between capitalists and entrepreneurs in the context of mudharaba has omitted that this contract should be assessed at both asset and liability sides of the bank. To overcome this theoretical gap, this paper aims to better understand the structure of profit sharing at the equilibrium of the two-tier mudharaba, while taking into account the contractual specificities between the different stakeholders.

Suggested Citation

  • Amine Ben Amar & AbdelKader O. El Alaoui, 2022. "Profit- and loss-sharing partnership: the case of the two-tier mudharaba in Islamic banking," International Journal of Islamic and Middle Eastern Finance and Management, Emerald Group Publishing Limited, vol. 16(1), pages 81-102, May.
  • Handle: RePEc:eme:imefmp:imefm-12-2020-0630
    DOI: 10.1108/IMEFM-12-2020-0630
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    More about this item

    Keywords

    Two-tier mudharaba; Profit and loss sharing; Dual banking system; Pure Islamic banking system; D31; D86; G21;
    All these keywords.

    JEL classification:

    • D31 - Microeconomics - - Distribution - - - Personal Income and Wealth Distribution
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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