InternationalResearchJournalofFinanceand

EconomicsISSN14502887Issue45(2010)
EuroJournalsPublishing,Inc.2010
http://www.eurojournals.com/finance.htm

InterestVersusProfitLossSharingCreditContract:Effciency
andWelfareImplications
ImanSugema
DepartmentofEconomicsandInternationalCenterforAppliedFinanceand
EconomicsBogorAgriculturalUniversity(IPB),Bogor,Indonesia
ToniBakhtiar
DepartmentofMathematicsandInternationalCenterforAppliedFinanceand
EconomicsBogorAgriculturalUniversity(IPB),Bogor,Indonesia
Email:tonibakhtiar@yahoo.com
Tel/Fax:+622518348903
JaenalEffendi
DepartmentofEconomicsandInternationalCenterforAppliedFinanceand
EconomicsBogorAgriculturalUniversity(IPB),Bogor,Indonesia
Abstract
Inthispaperweattempttoanswerafundamentalquestionofwhetheraprofitloss
sharing (PLS) based banking system can be welfare improving than an interest based
banking system by developing a rigorous theoretical modelling. In the framework of
production technology we firstly show that under production certainty andcompetitive
marketbothPLSandinterestbasedsystems areefficientandjust.However,underan
uncertainsituationduetoaproductivityshock,weprovethatonlythePLSsystemisjust,
sinceitfairlydistributestheriskatindividuallevelamongstlenderandborrower.We
verify ourresultbyquantifying theeffects onincomedistribution forbothlender and
borrower. Two indicators, namely the standard error of distribution and Gini ratio are
considered.WealsoproposeamechanismthatwillimprovetheperformanceofaPLS
systemfromcapitalownersperspectivebyintroducingasocalledriskpoolingbank.We
provethatsuchabankabsorbsalltheriskencounteredbythecapitalownersandthus
maintains their income distribution, and at the same time reduces the risk faced by
borrowers.
Keywords:Profitlosssharing,Islamicbanking,incomedistribution,riskpoolingagent.
JELClassificationCodes:G28,P43,P51

1.Introduction
Thebankingsystemoftheworldisdominatedbyinterestbasedcreditcontractsystem.Thatis,banks
typicallychargetheirdebtorsacertainlevelofinterestrateabovetheprincipalandthenredistributethe
proceedtodepositors.Somepartoftheproceedisofcourseretainedwithinthebanksascompensationfor
intermediary services. Under such a system, banks typically serve as liquidity pool, risk pool, and

intermediaryagent.Asfinancialintermediarybankscanalsoimprovetheefficiencyofallocationof
InternationalResearchJournalofFinanceandEconomicsIssue45(2010)

59

scareresourcenamelycapital,fromfundsurpluspartiestofunddeficitparties.However,thissystemis
relativelynewandmoderninvention.Underagrarianeconomy,creditcontractistraditionallycarried
outthroughaprofitlosssharingsystem(PLS).Thisarrangementcanstillbefoundinruralareain
manypartoftheworlduntilnow(Crane&Leatham,1993).Forinstance,inIndonesiaapeasantcan
borrowmoneytolocalmoneylenderwhichwillberepaidintheharvestingseasonandtheamount
paidwilldependonthefarmyield.Thesystemisthenbroughtintoamodernbankingsystembythe
socalledIslamicbankingsystem.PLSisthoughasacreditsystemthatcomplieswiththeteachingof
Islam.However,oneshouldnotethatthisisnotasystemthatisexclusivelyIslamic.Aspointed
before,wecanfindvariousformofPLSsystemallovertheworldregardlessthecountryisIslamicor
not.
Islamic banking is now an emerging industry. More than fifty countries worldwide have
formally adopted this system, notably the Gulf Cooperation Council (GCC) countries, Pakistan,
MalaysiaandIndonesia.Moreover,somemultinationalbankslikeCitibankandHSBChavealready
developedIslamicdivisionorunits.Rapiddevelopmentoftheindustryisgreatlyvisibleinmany
Muslimcountries.IslamiccompliantassetsworldwidetotalclosetoanestimatedUSD500billionand
havebeengrowingatmorethan10%peryearoverthepast10years.Islamicbanksmarketsharesare
currently12%inMalaysiaand17%inthesixGCCcountries(Standard&Poor's,2008).InIndonesia,
theshareofIslamicbanksincreditmarketiscurrently3%whiletheshareoftheirassetsis2.3%
(BankIndonesia,2009).
This relatively sharp development poses a fundamental question of whether the Islamic
bankingsystemcanbewelfareimprovingascomparedtothemoreconventionalbankingsystem.Ifso,
inwhatareatheimprovementisoffered?Thisisinfactthesubjectofthispaper.Mostofthescholars
ofIslamiceconomics claimthatIslamicbankingis morejustfinancialsystem,seee.g.,(Chapra,
1985).Specifically(Algaoud&Lewis,2007)providecritiques toconventionalfinancialpractices
from the Islamic system point of view. However these claims are generally not accompanied by
rigoroustheoreticalmodeling,exceptthat(Hasan,1985)analyticallyshowsthatPLSfinancingismore
profitable to financiers in the long run than interest financing and (Haque & Mirakhor, 1986)
formulates investment behavior in a profitsharing system as a principalagent problem and
investigatestherelevantissues underconditions ofuncertaintyandmoralhazard.Thelaterpaper
provesthattheassertionofinvestmentdeclinecannotbejustifiedandthat,undercertainconditions,a
profitsharingsystemmayleadtoanincreaseininvestment.
EventhoughthesuperioritiesofPLSschemearerevealed,somedrawbackshavebeenreported.
Asin(Dar&Presley,2000),PLSfeaturesmarginallyinthepracticeofIslamicbankingandfinance,
i.e.,lessthan20%worldwide,meanwhiletheIslamicDevelopmentBank(IDB)hassofarnotused
PLSinitsfinancialbusinessexceptinafewsmallprojects.Recently(Chong&Liu,2009)reportsthat
alargemajorityofIslamicbankfinancinginMalaysiaisstillbasedoninterestmechanism.They
suspectthattherapidgrowthinIslamicbankingislargelydrivenbytheIslamicresurgenceworldwide
ratherthanbytheadvantagesofthePLSparadigm.
We are in the spirit of PLS system reinforcement. Our paper is intended to provide a
mathematicalproofonthejustness ofPLSmechanismas amonetarysysteminasenseoffairly
sharingtheriskbetweenlenderandborrowerunderanuncertaincircumstance.Wefurtherextentthe
effect of the PLSbased credit contract on welfare adjustment and propose a risk pooling agent
mechanismforimprovingtheperformanceofPLSsysteminsupportingcapitalowners'appeal.

2.ProductionTechnology
Consideraoneshotgamesituation.Inthebeginningoftheperiodalleconomicagentsmakedecision
andtheresultofthatdecisionisperfectlyverifiableattheendoftheperiod.Thereisnoasymmetric
informationprobleminvolvedhere.Wearefullyawarethatthisproblemisveryprevalentinthecredit

market.However,itisnottheproblemwewanttoaddressandsolveinthispaper.Theeconomy
consistsoftwogroups:capitalist(whoownscapitalgoodsanddoesnowork)andentrepreneurwho

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ownslaborandrunsafirm.Eachgrouphasarelativelylargepopulation.Everyfirmneedscapital
goodswhichisborrowedfromthecapitalist.Thisgoodsisnonexhaustibleandwillbereturnedin
perfectconditionafterbeingusedbytheentrepreneur.Inotherwordsthereisnoneedtodepreciatethe
valueofthecapitalgoods.Ofcoursethefirmhastopayacertainrentalcostforthatgoods(capital
rent).Becausewewanttodiscussaboutacreditmarket,fromhereinthecapitalgoodsisjustcalledas
capital.
Itisalsoassumedthatbothgroupsareriskneutralagent.Wearefullyawarethatriskaversion
wouldbemoreappropriateassumption.However,aswillbeclearlater,itisnottheissuewewantto
addresscurrently.Riskneutralityisusedtomakeeverythingsimplerinmodelingaswellasnumerical
solution.Onecaneasilyrelaxthisassumptionwithoutgreatdifficultyifheorshewishestoanalyzethe
implicationofriskaversion.Inaddition,itisassumedthatbothcapitalandlaborareindivisible.This
assumptionisneededtolimitthesolutionofthemodelintojusttwopossibilities:thecapitalandlabor
areemployedintheproductionorbotharenotused.Thisseemstobeunrealisticinmimickingthe
creditmarketwherecapitalisdivisiblealmostperfectly(portfolioissue).Likewise,oneunitoflabor
canbedivisibleinawaythatlaboreradjustitseffortormanhouraccordingtoincentivetheyface
(incentiveissue).However,portfolioandincentiveissuesarenotthecasewewanttodiscusshere.
Moreover,eveniftheyaredivisiblethequalitativeconclusionofthesimulationresultremainsthe
samewiththeexpensethatweshouldspentmoreenergytodealwithamorecomplicatedsimulation.
Therefore,thereisnoneedtogointosuchcomplication.
Theproductionfunctionadoptedisaconstantreturntoscaletechnology.Oneachfirm,output
YisafunctionofcapitalKandlaborLsuchthat
(1)
YF(K,L).
BecauseFishomogeneousofdegreeone,i.e.,F(cK,cL)=cF(K,L)foraconstantc,wecan
restate(1)as
Y
K
F

,1.

L
L
Alternatively,
yf(k)

(2)
(3)

wherey:=Y/Landk:=K/L.Weassume,moreover,fisanincreasingconcavefunctionofk,i.e.,
f '0, f''0.
Note that the marginal product of capital (MPK) and its marginal value (MVPK) are,
respectively,givenby
MPKf',
MVPKMPK,
(4)
whereisthepriceofoutputy.Inordertomakethingssimpler,wenormalizethepriceofytounity,
i.e.,=1.Theprofitgainedbytheentrepreneurissimplyyrk=frk,whereintheconventional
creditmarketthepriceofcapitaliscalledinterestrater.ProfitmaximizationleadstoMPKr=0,
whichmeansthatinapurelycompetitivemarket,marginalproductofcapitalshouldbeequaltothe
priceofcapital,i.e.,
(5)
rMPK.
Inotherwords,efficiencyinthiscreditmarketoccursifandonlyifinterestrateequalto
marginalproductofcapital.Aslongasthismarketisefficientthenitisjust.
HowaboutthecreditmarketunderPLSarrangement?Tobeefficientandjust,thepriceof
capitalunderthissystempmustbeequaltoitsmarginalproduct:
(6)
pMPK.
ThiscanbesatisfiedaslongasthePLSsystemoperatesundercompetitivemarket.But,the
problemisthepriceofcapitalisnotquotedasexplicitlyasinterestrate.Itisimplicitlyquotedasa

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61

shareofprofit.Underourproductionfunction,thetotalamountofprofitgiventocreditorisequalto
thesharetimesproductionory,whereistheshare.
Supposethatthereisanoptimumshare*thatcanwarrantefficiencycondition.Theamount
paidtocreditormustequaltothepriceofcapitaltimesthecapitalborrowed,suchthat
*y pk.

Becausey/kistheaverageproductofcapital(APK),itmustbetruethat
*

MPK

(7)
APK
Inotherwords,theefficiencyinthePLSsystemcanholdifandonlyiftheshareisequaltomarginal
productdividedbyaverageproduct.Iftheshareisabovethisoptimallevelthenthecapitalissaidtobe
overpriced.Ifitisbelow,thenthecapitalisunderpriced.IncomparisontoHasan(1985),hestatesthat,
inasystemwhereinterestandPLSmechanismscoexist,theoptimalratioofPLSschemeisprimarily
determinedasafunctionoftheoverallrateofprofitoninvestment,theprevailingrateofinterest,the
degreeofleverage,andtheriskpremiumestimates.Moreprecisely,theoptimalratioofHasan(1985)
isgivenby*=(r+a)/b,whereisthefinancialleverage,i.e.,theratiooffinancier'scontribution
tototalcapital,risrateofinterest,aisriskpremiumfraction,andbrateofprofitontotalinvestment.
Sofarwehaveproventhat,itispossibletofindanoptimallevelofPLSarrangement.This
onlyrequiresthatthepriceofcapitalisequaltoitsmarginalproduct.Inotherwords,ifPLSsystem
operatesundercompetitivemarketthenefficiencyiswarranted.Thusthesystemisjust.
Thereisanimportantimplicationfromtheaboveexplanation:underproductioncertaintyand
competitivemarketthePLSaswellasinterestbasedcreditmarketwillendupwiththesamepriceof
capital.Eitherthepriceisquotedexplicitlyasinterestrateorquotedimplicitlyasthesharedoesnot
matter. Thus bothsystemis effcient andjust.However,the real wordis far fromcertain.Inthe
followingsectionswewillprovethatPLSwillyielddifferentresultscomparedtotheconventional
system.

3.ProductionunderUncertainty
Supposewedefineproductivityshocktobeuncertainanditaffectstheproductionfunctioninaway
suchthat
(8)
Yg()F(K,L).
Thishasastrongimplicationthat"risk"isindependentoflaborandcapital.Itaffectsdirectly
productionfunction,andnotviainput.However,wemayassumethatitaffectseachfirmdifferently.
Alternatively,itseffectoneachfirmisassumedtobearandomprocess.Shocktoeachfirmisnot
correlated.
Aswith(2),wecanrestate(8)as
yg()f(k),

(9)

wherethemeanandthevarianceofg()aregivenby
E[g()],

var[g()]E[g()]2.
Themarginalproductofcapitalisprovidedby
MPKg()f'(k).

(10)

(11)
Withoutlostofgeneralitywemayassumethat =1.Sincetheshocktoeachfirmmaybe
different, the marginal product of each firm may also be different. The shock is assumed to be
observable by both lender and borrower and thus the result is verifiable perfectly by both sides.
However,theshockisunknownexante.Onlythemeanandvariancethatareknownexanteandthe
sameacrossallfirms.Furthermore,weneedtoassumethatbothlenderandborrowerareriskneutral

in a way that only the expected result that affects their decision making. Our purpose is not in
assessing

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theeffectofriskpreferenceondecisionmakingandmarketequilibrium.Riskneutralityisnaturallythe
moststraightforwardintermsofmathematicalsolution.
Firstly,weshallattempttosolvethemarketequilibriumforinterestbasedcreditmarket.Under
competitivemarket,theinterestrateshouldbeequaltoexpectedmarginalproductofcapital.Thus,the
priceofcapitalistheaveragemarginalproduct:
rE[MPK]MPK.
(12)
Thislevelofinterestrateshouldbepaidbyallfirmsirrespectivewhethertheshockaffect
positivelyornegatively.Forthosesufferinganadverseshock,themarketinterestrateisabovethe
marginalproduct.Hencethecapitalisbeingoverpriced.Forthoseenjoyingpositiveshock,thecapital
isunderpriced.
Toseethisproblem,wemaydiscussthreecasesasfollows:(i)neutralshockwhereg()=1,
(ii)adverseshockwhere g()<1,and(iii)positiveshockwhere g()>1.Apositiveshock,by
definition,willincreasethelevelofproductionforacertainlevelofinput.Conversely,theadverse
shocktendstoreduceproduction.
1) In the case that an idiosyncratic shock is neutral, the marginal product of capital
remainsunaffected.Itshouldequaltotheexpectedmarginalproduct,i.e.,
rE[MPK|g()1]MPKr.
Inotherwords,themarginalproductofcapitalisexactlyequaltothemarketinterestrateand
thereforeitisefficient.Underthiscircumstance,themarginalcostofborrowingisexactlyequaltothe
marginalvalueproductofcapital.Thepriceisright.
2)
However, in the case of an adverse idiosyncratic shock, the expected marginal product of
capitalbecomessmallerthantheaveragemarginalproductandhencelessthantheprevailingmarket
interestrate.Themarginalvalueproductofborrowedcapitalisthereforelessthanitsmarginalcost.
Forborrowersexperiencingadverseshocks,thecostofborrowingissimplytooexpensive:
r E[MPK|g()1]MPKr.
3)
Conversely,foraborrowerhavingafavorableshock,theexpectedmarginalvalueproductof
borrowedcapitalishigherthanthemarketinterestrate.Therefore,thepriceofcapitalistoocheap:
r E[MPK|g()1]MPKr.
Basedontheabovediscussion,aninterestratebasedcreditcontractisonlyefficientandjustif
Forfirmsfacinganeutralshockthepriceis
andonlyiftheshockdoesnotaffectthemarginalproductofcapital.Itcannotbeefficientandjustif
pjE[MPKj]f'(k)MPK.
theshockiseitheradverseorfavorablefortheborrower.Itisnotjustfortheborrowerswhenthey
havetopayamarketinterestratethatishigherthanthemarginalvalueproductofborrowedcapital.It
becomesnotfairforthelendersinthecaseoffavorableshock,astheycannotexploittheexcess
marginalvalueproductenjoyedbytheborrower.
To assess this more clearly, we conduct a numerical simulation in the next section.
Qualitativelyitshouldbeclearthatalllendershavethesameincomethatisrk.Thislevelofincomeis
equivalenttothecaseofproductionwithoutuncertainty.Inotherwords,thelendersdonotbearany
risk.Bydefinitionthenetincomefortheborrowersshouldbeyrk.Becausethelevelofydepends
greatlyon g(),thenetincometotheborrowerwillvaryaccordingto 2.Inotherwords,itisthe
borrowerwhobearsalltherisk.
Insummary,itisclearthataninterestbasedcreditmarketcanonlyprovideefficiencyon
averageormarketlevel.Intermsofindividualborrowerandcreditor,marketefficiencycannotbe
warranted.Theproblemisthattheriskisnotbeingequallysharedbetweenborrowerandlender.The
situationbecomessignificantlydifferentifthecreditcontractisarrangedunderaPLSsystem.Under
suchasystem,theriskisdistributedequallyamongstborrowerandlender.Thiscanbeexplainedas
follows.WestartbyderivingajustPLSregime.Bytakinguncertaintyintoaccount,anefficientPLS
regimecanexistifandonlyif
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*y pk ,
whichleadsto

* MPK

(13)
APK
Thatisthesharegiventolendersmustequaltotheaveragemarginalproductdividedbythe
averageofaverageproduct.Notethat:
MPKE[MPK],APKE[APK],
wheretheexpectedmarginalproductandexpectedaverageproductisthesameforeveryborrower.
WhatisdifferentistheactualMPKandAPK,nottheexpectedone.Thustheoptimalshare*isthe
sameforeveryfirm.Inotherwords,*isacommonormarketdrivenshare.
Inordertoprove*istheoptimalshareforeverybody,weneedtoshowthatitisindependent
oftheshocks,i.e.,regardlessofwhethertheshockisneutral,adverse,orfavorable,*isconstantas
definedin(13).Letusseetheproof.
Supposethatjistheoptimalsharethatisappliedtoborrowerj.If j*forallj,then
*iscommonforeveryfirm.Bydefinition,itistruethat
MPK

j
.
j
APKj
(14)
Thatistheoptimumlevelofprofitandlosssharingappliedspecificallytofirmj.However,
equation(14)canberestatedas
g(j)f'(k
f'(k) MPK *.
)
j

g(j)f(k)/
k

f(k)/k

APK

(15)

Thustheoptimalshareisthesameforeveryj.Inotherwords,*isacommonPLSscheme.
However,onemustseeclearlyfrom(15)thepriceofborrowedcapitalisnotthesameforeveryfirm.
Thecapitalisspecificallypricedaccordingtotheactualshockfacedbyborrower,thatis
g(
pjMPKj j
)f'(k).
(16)
(17)
Thismeansthatthepriceofcapitalisequaltothatofintheinterestbasedcreditarrangement.
Onlyinthiscasethatbothsystemsyieldthesamelevelofpriceofcapital.Forthecaseofanadverse
shockwehave
pjg(j)f'(k)MPK.(18)Inotherwordsthepriceis
lessthanaverageprice.Itisalsoeasytoseethatinthecaseofafavorableshock,thepriceofcapital
becomehigher.Thus,thepriceofcapitaliscorrelatedwiththeshock.Theriskissharedbetweenthe
borrowerandlender.ThisinfactthemaindifferencebetweenPLSandtheconventionalcreditmarket.
Becausetheriskisshared,efficiencyisalwayswarrantedbothatindividuallevelandaggregatelevel.
Since,themarginalcostofcapitalisalwaysequaltomarginalvalueproduct,thispricingisefficient
andjust.Attheaggregatelevel,theaveragepricemustequaltoaveragemarginalproductand
thereforeitisalsoefficientattheaggregatelevel.Notethat,theconventionalcreditmarketcan
onlywarrantefficiencyattheaggregatelevel,andnotattheindividual
level.

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4.EffectsonIncomeDistribution
Thediscussionintheprevioussectionhasanimportantimplicationonincomedistributionforboth
lenderandborrower.Theconventionalsystemistypicallyfavorableforlendersastheydonotbearthe
risk.Itisthereforeimperativetoseethatthissystemhasanadverseeffectonincomedistribution
amongsttheborrower.Thosefacingadverseshocksshouldbearallthemisfortune,andthosefacing
favorableshockwillenjoyallthewindfall.Incontras,thePLSsystemprovideabasisforrisksharing.
However,asaconsequencetheincomedistributionamongstlendersisadverselyaffected.
Tofacilitatetheabovementionedconjecture,weshallresorttheanalysistoanumericalsimulation.First,we

YKL.

adoptaCRSCobbDouglasproductiontechnologysuchthat

(19)
Asusualismarginalproductofcapitalaswellastheshareofreturntocapitalowner.Aswill
beclear,thisparticularpropertymakeiteasytocomparedirectlyPLSandconventionalcreditcontract.
Wenormalizebothlaborownedbyborrowerandcapitalownedbylendertoonefortheeaseof
calculation.Wealsoassumethat E[]=1andvar[]= 2 =0.572.Moreover,weset =0.2for
convenience.Onecansetanynumberaslongas<1.
Inthecaseofconventionalcreditsystem,thetotalpaymenttocapitalowneriscalculatedasrk
andthereforethereturntolaborownershouldbeyrk.InthePLSregime,thereturntocapitalowner
issimplytheoptimalshare.
Toassessincomedistribution,weusetwoindicators:thestandarderrorofthedistributionand
theGiniratio.Thelessevenlydistributed,thehigherthestandarderrorandGiniratio.Weassumethat
thepopulationoflenderandborrowerarethesameandlargeenough.Forthepurposeofsimulationthe
population is set to ten thousands. This also means that there are ten thousands idiosyncratic
uncorrelatedshocks.TheresultofthesimulationissummarizedinTable1.
Table1:

Incomedistribution

Productionwithoutuncertainty
Interestbasedcredit
Incometolaborowner
Incometocapitalowner
PLSbasedcredit
Incometolaborowner
Incometocapitalowner
Productionwithuncertainty
Interestbasedcredit
Incometolaborowner
Incometocapitalowner
PLSbasedcredit
Incometolaborowner
Incometocapitalowner

Average

Std.Dev.

Gini

0.8
0.2

0
0

0
0

0.8
0.2

0
0

0
0

0.8
0.2

0.57
0

0.41
0

0.8
0.2

0.46
0.11

0.33
0.33

Asexpected,underproductionwithoutuncertaintyPLSisasefficientasinterestbasedcredit
market.Thetableindicatesthatbothsystemsofferthesameincomestreamtobothlaborandcapital
owners.Theincometolaborowneris0.8perunitoflabor.Theincometocapitalowneris0.2perunit
ofcapital.Inotherwords,thepricesoflaborandcapitalareequaltotheirmarginalvalueproduct.
Moreover,thereisnoproblemofincomedistributionasalleconomicagentshavethesameincome,
depending only whether they are labor or capital owners. A different situation appears when we

introduceuncertaintyontheproductionfunction.Bothsystemsofferthesamelevelaverageincome
only.Howevertherearesomecontraststhatshouldbetakenintoaccount.
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InternationalResearchJournalofFinanceandEconomicsIssue45(2010)
Undertheconventionalcreditmarket,creditorsenjoynovariabilityinincomeasindicatedby
zeroGiniratioandstandarddeviation.Creditorssimplydonotbearanyriskintheproduction.In
contrast,laborownerbearsalltheriskofproductionasthestandarderroroftheirincomeequaltothe
standard errorofthe productivityshock(0.57).This is alsoindicatedbya highGiniratio(0.41)
suggesting a quite high income disparities. Therefore, the conventional system leads to a serious
incomedistributionproblemonthepartoflaborowners.Thissystemissociallylessdesirablefromthe
borrowerspointofview.
UnderaPLSsystem,theaverageincomesarejustthesameasintheconventionalsystem.The
maindifferenceisintheincomedistribution.Therisksaresharedbetweenlaborownersandcapital
owners. Income variation amongst creditors is equal to the share times the standard deviation of
productivityshock().Thestandarderrorofincometothelaborownersissimply(1 )which
shouldbelessthan .Thusthissystemreducestheriskfacedbyborrowersbutatthesametime
increasestheriskfacedbycreditors.Thusthissystemisfavorablefordebtorsbutnotforcreditors.
Thequestioniswhathappensifthetwosystemcompeteinthesamecreditmarket.Notethat
mostofIslamiccountriesadoptthesocalleddualsystemwhereconventionalsystemcompeteheadto
headwiththePLSsystem.WhilethePLSsystemisfavorablefordebtors,itisnotpreferablebycapital
owners.Ifweassumethatcapitalownersareriskaverse,theywouldcertainlyputmorepreferencefor
theconventionalsystem.
Inthefollowingsectionwewillarguethattheanswertothatquestionliesontheintermediated
creditmarketviabanks.Undersuchasystem,capitalownerscanbearnoriskbutatthesametimethe
borrowerscanreducetherisk.Weshalldiscusthislineofargumentveryshortly.

5.IslamicBankasaRiskPoolingAgent
Intheprevioussection,itissuggestedalthoughborrowersmaypreferthePLScreditsystem,risk
aversecreditorswillprefertheconventionalone.Unlessbothsidesareriskneutral,thetwosystemare
indifferent.ThequestionisthereanymechanismthatwillimprovetheperformanceofaPLSsystemso
thatitbecomesmoreattractivetocapitalowner?Yesindeed,providedthatthereisanIslamicbankthat
actsasariskpoolingagentwhichabsorbsalltheriskfacedbycapitalowner.Hereistheproof.
SupposethatthereisanIslamicbankthatislargeenough,saythatcanservetenthousand
borrowers and depositors. This bankoffers a PLS system to the borrowers as well as depositors.
Moreover, the bank does not incur any cost so that all the income collected from borrowers is
distributed to depositors (capital owners). Of course one can easily relax this assumption by
introducingacertainshareofincomethatisretainedwithinthebank.Butthisisverytrivialandwill
notaffectthegeneralconclusion.
Supposethereare n depositorsandeachput K unitsofcapitalinthebank,andthereforethe
totalloanablefundisnK.Thisfundisallocatedevenlytonborrowers.Theproductionfunctionisasin
(9).Moreover,theoptimalprofitandlosssharing*issatisfied.Hence,thebankstotalincomeE[B]
shouldbe
n

E[B]E*g(j

)f(k)

j1
n

* E[g ( j ) f (k )]
j1

n*E[y].

(20)
Notethatonaverage,theincomeextractedperborroweris *E[y].However,eachborrower
paysdifferentamountthatis*yjforborrowerj.Thus,thevarianceofthepaymentshouldbe*22.
Theincomeretainedbyborrowerjisthus(1 *)yjandthevarianceofborrowersincomeis(1

*)22whichislessthan2.Inotherwords,thePLSschemecanreducetheriskfacedbyborrower.

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Howevertheriskisnottransmittedtodepositorsasthebankhasariskpoolingmechanism.Aslongas
nislargeenough,itcanalwaysbewarrantedthatE[g()]=1sothatthetotalincometothebankis
E[B]n*f(k).
(21)
Itisclearthattheriskfactorg()disappearsfrom(21).Itisexactlytheriskpoolingmechanism
inthesensethatadverseandfavorableshockscancelout.Inessence,thebankfacesnoriskatall.This
"riskfree"incomeisthendistributedequallytodepositors.Statisticallyspeaking,depositorsfaceno
risk.Consideringthis,theexistenceofanIslamicbankcanimproveincomedistributiononthepartof
capitalowners.Atthesametime,italsoreduces theriskfacedbyborrowers.This isclearfrom
numericalsimulationpresentedinTable2andwemaycompareitwithTable1.Theaverageincome
ofcapitalownerisstillthesame,butwithzerovariance.Theincomeisevenlydistributed.Thisisin
factoneoftheadvantageofintermediatedIslamiccreditmarket.Now,whatifthebankisoperating
undertheconventionalsystem?Itwillnotimproveincomedistributiononthebothside.Theincome
amongborrowershasavarianceof2,thatofdepositorsiszero.ItcanbesaidthatIslamicbankis
superiorintermsofincomedistributionrelativetotheconventionalone.
Table2:

Incomedistributioninthepresenceofriskpoolingbank

Productionwithuncertainty
Interestbasedcredit
Incometolaborowner
Incometocapitalowner
PLSbasedcredit
Incometolaborowner
Incometocapitalowner

Average

Std.Dev.

Gini

0.8
0.2

0.57
0

0.41
0

0.8
0.2

0.46
0

0.33
0

6.Conclusion
Wehavearguedthatunderproductioncertaintyandcompetitivemarketassumption,PLSbasedas
wellasinterestbasedcreditmarketsareefficientandjustprovidedthatthepriceofcapitalisthesame
as its marginal product. In uncertain circumstance, we have shown that the interestbased credit
contractisonlyefficientandjustforneutralshock.Itisnotjustforborrowersexperiencingadverse
shocks,anditbecomes unfairforlenders inthecaseoffavorableshocks.Generallyspeaking,an
interestbased credit market can only provide efficiency at aggregate level. Conversely, we have
proven that in PLSbased credit market the risk is shared between lender and borrower. Hence,
efficiencyisalwayswarrantedbothatindividualandaggregatelevels.
Oursimulationonincomedistributionshowsthatinconventionalcreditmarket,lendersenjoy
novariabilityofincomeanddonotbearanyrisk.Inthiscase,thereisaquitehighincomedisparity.
WhileinthePLSsystem,incomevariationisdistributed,incomedisparityisreduced,andriskis
shared.
WehavealsoproposedamechanismthatwillimprovetheperformanceofaPLSsystemsuch
thatitbecomesmoreattractivetocapitalownersbyintroducingasocalledriskpoolingbank.We
analyticallyprovethatsuchabankabsorbsalltheriskchallengedbythecapitalowners.
67
InternationalResearchJournalofFinanceandEconomicsIssue45(2010)

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