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Islamic Banks and Investment Financing

Author(s): Rajesh K. Aggarwal and Tarik YousefSource: Journal of Money, Credit and Banking, Vol. 32, No. 1 (Feb., 2000), pp. 93-120Published by: Ohio State University PressStable URL: http://www.jstor.org/stable/2601094 .

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RAJESH K. AGGARWALTARIK YOUSEF

IslamicBanksandInvestment inancingIslamic Law prohibitscharging nterest.We study financial nstru-ments used by Islamic banks and find that most are not based onprofit-and-loss sharing (equity) but, instead, are very debtlike innature.We see some bias against providing financing for agricul-ture and industry.Long-term inancing s rarelyoffered to entrepre-neurs. Our model shows that debtlike instrumentsare a rationalresponse by Islamic banks to their contractingenvironments.Asagency problemsbecome more severe, debt becomes the dominantinstrumentof H1nance.We give conditions under which banningdebt increases social welfare as well as conditions under whichbanningdebt decreases social welfare.IN THE LAST TWO DECADES, slamic banks have grown insize and numberaround he world. In this paper,we examine the types of financialcontractsoffered by Islamic banks. We try to understandany departures rom tradi-

tional Islamic principles n the types of contractsoffered. We suggest an economicrationalefor the constraints mposed on Islamic banks and try to determine f theseconstraintsare likely to be social welfare improving.We also examine the types ofprojects n which Islamic banks nvest. In this process we hope to shed some light onthe efficiency of Islamic banks and Islamic economies.Islamic banks operate n over sixty countries,most of them in the Middle East andAsia. In three countries, Iran, Pakistan, and Sudan, the entire banking system hasbeen convertedto Islamic banking. In the other countries, the banking systems arestill dominated by conventional banking institutions operating alongside Islamicbanks. Even so, Islamic banking s the fastest growing segment of the credit marketin Muslim countries hathave Islamic banks: heirmarket harehas risen from 2 per-cent in the late 1970s to about 15 percent oday, as measuredby assets in the bankingsystem (Babai 1995). Even conventionalcommercial banks have started o offer Is-The authors thank Sheri Aggarwal, Hesna Genay, Michael Knetter,Raghu Rajan, Steve Sung, JeffWilliamson, and seminarparticipants t DartmouthCollege, HarvardUniversity,and the Middle EasternEconomic Association Meetings for their helpful comments. Special thanks to two anonymousrefereeswhose comments greatly mproved he exposition of the paper.The authorsalso thankNazim Ali and the

Harvard slamic Finance InformationProject for providing some of the data and Marcia Diefendorf forhelp in preparing he figures.

RAJESH . AGGARWALs associate professor of economics at DartmouthCollege. TARIKYOUSEFSassistantprofessor of economics at GeorgetownUniversity.Journal of Money, Credit,and Banking,Vol. 32, No. 1 (February 000)Copyright2000 by The Ohio State University

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94 : MONEY,CREDIT,AND BANKING

lamic financial contracts. Unlike other commercial banks in the Middle East thatwere eithercreatedby or received extensive support rom governmentsduring he oilbooms of the 1970s and 1980s, Islamic banks are generally the product of privateinitiativeand have appearedpredominantly n non-oil-exporting ountries.Islamic banks are supposed to offer instruments onsistent with the religious be-liefs and culturalcharacteristicsof Muslim societies. According to prevailing nter-pretationsof Islamic Law, financial instrumentsshould emphasize profit-and-losssharing (equity). Interest s prohibited,which seems to exclude debt contracts.Thisis in markedcontrastwith Western inancial nstitutions.Banks in the United States,for example, primarilyoffer debt contracts o firms seeki-ng apital (regulationspro-hibit banks from taking more than a S percent equity position in firms). Banks inGermanyand Japanmake equity investments n firms, but also use debt contracts.Non-Islamic banks operating n Muslim countries are able to offer debt contracts ofirms. Even governmentsof Muslim countries, such as Saudi Arabia,borrowon theinternational apital markets.That SaudiArabiadoes so is fascinatinggiven that theSaudi monarchyderives its legitimacy from upholding Islamic Law and is a majorpromoterof Islamic economics. Nonetheless, Islamic Law prohibitsIslamic banksfrom either receiving or paying interest.We consider two issues. First, do Islamic banks operateaccording o the principleof profit-and-loss haring? f not, why not? Second, is it social welfare improvingtohave a strictban on debt?Who benefits and who loses from such a ban? On the firstissue, our evidence indicates that most of the financing provided by Islamic banksdoes not conform to the principleof profit-and-loss haring.Instead,much of the fi-nancingprovidedby Islamic banks takes the form of debt-like nstruments.On the second issue, proponentsof Islamic bankingarguethat profit-sharing on-tracts (equity) are superior inancial nstruments o debt for a variety of reasons in-cluding the risk-sharingpropertiesof equity (Ebrahimand Safadi 1995). We discusssome of these arguments n section 2. In addition,advocatesof Islamic bankingsuchas Chapra 1992) and Siddiqi (1983) have argued that Islamic banks will promotegrowth in Islamic countries by providing long-term financing to growth-orientedsectors of the economy.Contrary o the expectationsof Islamic banking'sadvocates, we find that Islamicbanks rarely offer long-term financingto entrepreneurs eeking capital. In addition,the majority of Islamic banks' financial transactionsat least initially were directedaway from agricultureand industry and towardretail or trade financing. Further, tappears that much of the "lending"done by Islamic banks is secured, violating alegal prohibitionon collateral.While this evidence does not fully answer the ques-tion about the social welfare propertiesof a ban on debt, it does suggest that theclaimed benefits of Islamic bankingmay be somewhatoverstated.In orderto understandwhy Islamic banks do not operateaccording o the prinici-ple of profit-and-loss haringand to understand he social welfare propertiesof a banon debt, we develop a model of Islamic economies and Islamic banks. Islamic banksoperate mostly in developing economies where financial marketsare characterizedby high degrees of imperfect nformationand rent-seekingbehavior.Data on corrup-



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RAJESHK. AGGARWALAND TARIKYOUSEF : 95

tion and bureaucraticnefficiencyfor Iran, Pakistan,and Egypt suggest that thesecountries have somewhat nefficienteconomies in which there arefairly high levelsof rent seeking and corruption Mauro 1995). Of course, corruptionand inefficiencyare widespread n most developingeconomies,not just Islamic ones. In these coun-tries, many entrepreneursmay be willing to use funds from theirfirms for their ownconsumptionof perquisitesor wasteful, negative-returnnvestments.In such cases,banks providingfinancing face an agency problem.In our model, the agency prob-lem arises fromcontractual ncompleteness,as in the models of Bolton and Scharf-stein (1990) and Hart and Moore (1998). The crucial assumption s that the cashflows (profits)from the entrepreneur's roject arenot verifiableto a court of law. Inthe Bolton andScharfstein 1990) and Hart andMoore (1998) models, this assump-tion rules out the use of outsideprofit-sharing requity contractsas financial nstru-ments as these are based on sharingthe cash flows. In our model, by weakeninganassumptionon the entrepreneur's tility function,we are able to characterizewhenoutside equitycontractswill be optimal financial nstruments or the bank.We find thateconomies characterizedby agency problems will be biased towarddebt financing.As these problemsbecome more severe, we show that debt will be-come the dominant nstrumentof finance.We also show that equityfinancingcanbeoptimal and,in certaincircumstances,a ban on debt can be socialwelfare mproving.We draw connectionsto the literatureon optimalcapital structureand highlight theimportanceof agency problemsand contractual ncompleteness.We argue that theuse of debtlike nstruments s a rationalendogenousresponse on the part of Islamicbanks to the contractingenvironmentsn whichthey operate.Several papers in the literaturehave examined restrictionson the use of debt.Glaeser andScheinkman 1998) examine restrictionson usury andshow that limit-ing the rateof interestcan be social welfare mprovingwhen marketsare ncomplete.In theirmodel,banning nterestaltogetherwouldnot be social welfareimproving,asit can be in ourmodel. In workon Islamic banking,Khan andMirakhor 1987) andKuran 1993) have noted thatadverse selection can result in the use of debtlike in-strumentsby Islamic banks as well.We beginby describing he financialcontractsoffered by Islamicbanks in section1. In section 2, we discuss thepatternsand compositionof creditthat have emergedin Islamic banks.We presentour model in section 3. In section4 we derive optimalcontracts for the bank from the set of profit-sharingor pure equity contracts andcombinationsof debt and equitycontracts,which nest the special case of pure debtcontracts.In section 5, we comparethe contracts rom section 4 and examine socialwelfare implications.Section6 concludes.1. CONTRACTING N CONTEMPORARYSLAMICBANKS

The Islamic legal principlesthat regulate the conduct and contentof commercialtransactionsn Islamic bankingdate back to the early days of Islamin Arabia.TheMuslim scholarsof the MiddleAges made elaborateefforts to establish the funda-



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mentalprinciplesof finance andcommerce.Theseprinciplesaresupposedto governeconomic activity for Muslims today.The most importantof these principles is theprohibitionof riba,any predetermined r fixed return n financialtransactions.Asstated in the Quran:cAllah forbidsribaand permitstrade."While thereis much de-bate aboutthe exact natureof thisprohibitionon riba, here exists a widespreadper-ceptionthat the ban on riba mplies a ban on interest.Because this is the prevailinginterpretation,we follow it in this paper.Alternative"interest-free" inancingtechniques have been developed by Islamicbanks andthe monetaryauthoritiesof severalcountries.The instruments f commer-cial financing have been based on two principles:the profit-and-loss haring (PLS)principleand the markupprinciple. The PLS principleis unanimouslyaccepted inthe Islamic legal and economic literaturesas the cornerstoneof financial transac-tions.According to the PLS principle,the bank mayearn a returnon invested fundsprovidedthatthe bankshares n the risk of theinvestmentand bears a loss if the pro-ject fails. Islamic banksutilize two instrumentsbased on this principle:

* Mudarabahinancing, where the bank provides capital and the entrepreneurcontributeseffort and exercisescomplete control over the business venture. Incase of a loss, thebankearns no returnor a negativereturnon its investmentandthe entrepreneur eceives no compensationfor her effort. In case of a gain, re-turnsare split according o a negotiatedequitypercentage.* Musharakainancing,where the entrepreneur nd the bankjointly supply thecapitaland manage the project.Losses are borne in proportion o the contribu-tion of capital while profitproportionsarenegotiated reely.Both of these instruments an be thought of as equity investments,althoughmu-darabahinancingmay be more akin to a limitedpartnership ndmusharakainanc-ing is closer to a traditional quity stake with rights of control.The markupprinciplehas its historical roots in commercial tradeactivities. Thebank finances the purchase of assets in exchange for a negotiatedprofit margin.

There aretwo widely used instruments n this category:* Murabahainancing,where the bank purchasesan asset on behalf of an entre-preneur.The bankresells the asset to the entrepreneur t a predetermined ricethatcovers the original cost and anadded,negotiatedprofitmargin.Payment smade in the future n lump sum or in installments.Ownershipresides with thebankuntil all paymentsare made.Murabahainancing s the classic instrumentfortradefinancing,dating to ninth-centuryArabia.* Ijara inancing,where the bankpurchases he asset and allows the entrepreneur

to use it for a fixed charge. The ownershipof the asset eitherremains with thebankor is graduallytransferred o the entrepreneurn a rent-to-own contract.Ijara inancing s the traditional ontract or what is known as leasing today.Although markup nstrumentsare widely used, theiracceptabilityunder IslamicLaw is disputed because they can imply a fixed returnon investmentfor the bank.Many Islamic scholarshave taken the position thatmarkup echniques, while per-



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missible, shouldstill be avoidedor restricted Siddiqi1983 and Khan1987). Legally,the fear is that markup inancingmay open a "backdoor"to interest.Economically,observers worrythat markup inancingmay stunteconomic growthby constrainingentrepreneursrom investing in new projects.In sections 4 and5, we show that thiseconomic argumentagainst markup inancing s flawed: markup nstrumentsgener-ally expand the set of projectsthat can be undertaken.Nevertheless,an economiccase can be made against markupnstruments,which we discuss in section 5.We wish to stress that there s a formalequivalencebetween markup inancinganddebt, but the equivalence is not based on the paymentof interest.Following the in-complete contractsand control rights literature Hart and Moore 1998), we arguethat the salientfeatureof debtis that it transferscontrol of an asset to the debtholderin cases of default.This has the effect of forcing the entrepreneuro disgorge cashflows by making regularly scheduled payments to prevent default.What preventsbanks from contractingdirectlyover cash flows, rather hanusingthe indirect nstru-ment of debt?The assumption s thatcash flows may be observableby the partiesbutnot verifiableto a court. We will discuss these assumptions n greaterdetail in sec-tion 3. The criticalfeatureof markupcontracts s that the bank retainsownershipofthe asset andcan seize it in cases of default. UnderPLS contracts, he bank has nosuch direct claim on the asset as it is in partnershipwith the entrepreneur. hus it isthe control rightsover the asset conferredby markup inancing that differentiate tfrom PLS financing.The control rights of markupcontracts are equivalent to thecontrol rightsof debt contracts.One of thebenefitsof markup ontracts elative o standardWesterndebt contrastsis that, n cases of default, here s no ambiguityaboutcontrolof the assets. The bankretains itle to the asset until allpaymentsare made.In most Western ountries,defaulttriggersbankruptcy roceedingsduringwhich the entrepreneur/managerontinuestocontrol he assets(for example,Chapter11 of U.S. bankruptcyaw).Because of thede-lays inducedby formalbankruptcy roceedings n the shift in controlof the assets,bar-gaining problems are introducedthat can significantly decrease the efE1ciency finvestment. nprinciple, heseproblemsare avoidedunderIslamicmarkup ontracts.While therationale or banning nterest s unambiguously ooted in theology, pro-ponents of Islamicbankinghavealso found economic arguments o supporta banoninterest. Many of these argumentsare similar to those put forthin medieval Chris-tianity to restrict usury. Some of the economic rationales for the superiorityofprofit-and-loss haringover the use of interestare describedby the InternationalAs-sociation of Islamic Banks (1995, pp. 3-4):

If interestis replaced by profitsharing, some imbalancesare expected to be reduced.First, the returnon capital will depend on productivity.Allocation of investable fundswill be guidedby the soundnessof the project.Thiswill in effect improve he efficiencyof capital allocation.Second, the creationof money by expandingcredit will be createdonly when thereis a stronglikelihood of a correspondingncreasein the supply of goods and services.In case the enterprise loses, repayment of capital to the bank is diminished by theamountof loss. Thus in the profit-sharingystem,the supply of moneyis not allowed tooverstep the supply of goods and services. This will eventually curbinflationarypres-sures in theeconomy.



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Third, the shift to profit sharingmay increase the volume of investments hat trans-lates into job creation. This is because the interest mechanism makes feasible onlythose projectswhose expected profitsare sufficientlyhigh to cover the interestrateplusadded income. This filters out projects which otherwise would be accepted in theprofit-sharing ystem.Fourth, the new system will also ensure more equitable distribution of wealth.Wealthwould bring more wealth to its owners only when its use has actuallyresulted nthe creationof additionalwealth. This would in time reduce the unjust distributionofwealth which continuedfor decades duringthe interestregime.Fifth, the abolitionof interest,togetherwith the restrictionof forward ransaction, sprescribedby Sharia,will curtailspeculationsmeasurably.But still, there will be a sec-ondarymarket radingcommon stocks and investmentcertificatesbased on profit-shar-ing principles.This will bring sanity back to the marketand allow raising of funds forenterprisesand liquidity to equity holders.Point 1 seems to suggest thatequity investorscare about he qualityof the projectsin which they invest while lenders are indifferent to the quality of the projects towhich they lend. On the other hand, point 3 seems to suggest that lenders constrainthe set of projectsto which they lend to the profitableones. While these points arecontradictory, oint 3 does espouse the commonly held view that lendersrestrictac-cess to capital.Point 1 can also be interpreted s saying that banningdebt will elim-inate conflicts between equityholdersand debtholderssuch as the asset substitutionproblem.We discuss this in section 5. Point 2 suggests thatthere s a macroeconomic

benefit to a ban on interest associated with limiting the amount of liquidity in aneconomy and hence limiting inflationarypressures.This implies that the most im-portanteconomic issue facing developing economies is inflation, ratherthan lowgrowth rates. It is not obvious why restricting he supply of money will not also re-strictthe supply of goods and services. Further, t is likely that eliminatingthe creditchannel of monetarypolicy will prove detrimental n cases of recession, so it is hardto see a clear-cut benefit associated with this point. Point 4 does not obviouslyhold it is not clear why the chargingof interestnecessarily leads to a skewed dis-tributionof wealth, althoughprohibitionson usury clearly adopt this viewpoint. Be-cause this argument s frequentlymade, we discuss it in greaterdetail in section S inthe context of our model. Point S arguesthat banning nterestmay decrease specula-tion, presumablybecause investors borrow on margin and speculate. However, theability to borrowon margingenerally leads to an increase in stock market iquidity,not a decrease as seems to be argued.Another nterpretation f point S is that abol-ishing interest will decrease volatility in the market.However, the relationshipbe-tween liquidity (as created by borrowingon margin) and volatility is unsettled andliquidity often decreases volatility in markets.From this critique of interest-basedbanking, the proponentsof Islamic bankingseem to be arguingthat the primarysocial costs of interest are that it constrains heaccess of entrepreneurso capital (point 3) and that t leads to an unequaldistributionof wealth (point 4). Point 3 implies that debt financing funds fewer projects thandoes equity financing, and there is a social welfare gain when debt is banned. Weargue in section S that a ban on debt may, in certain circumstances, ncrease socialwelfare. However,this gain in social welfare does not come because debt constrains



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the numberof projects undertaken.Debt generallyexpands the set of projects fi-nanced, but thereis a deadweight oss on each project due to the possibility of de-fault and liquidation.In addition,there may be other costs of debt associated withadverse selection, risk shifting,or direct costs of bankruptcy lawyers,court costs).The social welfare gain froma ban on debt comes when these costs arc sufficientlyhigh. Point 4 implies that banningdebt will allowentrepreneurso appropriatemoreof the returns rom their investmentprojects. In section 5 we show that this can betrue, but we also show that banningdebt is not themost efficientway to achieve thisgoal. We canthereforeprovidesome economicrationales or a banon debt, althoughnot quite on the same groundsas proposedby theproponentsof Islamicbanking.Wereiterate,however,that if economic efficiency andincome redistribution re the keyobjectives of Islamic banking, hen there are bettermeans to theseends than a banondebt.In additionto markupandPLS financing, as part of their mission, Islamic banksare encouragedto make charitable oans to individualsor organizations hat needthem in the formof funds or realassets (materials,supplies, etc.). These are termedQardHassanloans, or social or benevolent oans.These loans aremade at no charge,with no interestdue, and with no mark-up.They are clearly negativeNPV invest-ments for Islamicbanks.

2. EVIDENCEON ISLAMICFINANCE

The academicand policy interest n Islamicbankinghas been sparked n partbythe seemingrapidgrowth of theirassets and marketshare in the financialsectorsinMuslim countries,primarily hose in the MiddleEast. Over the lastdecade the assetsof Islamic banksexperiencedan annualgrowthrate of 19 percent.Our calculationsshow that Islamic banks had approximately$100 billion in assets in 1995. Todaymany Islamic banks are among the five largestbanks in their respectivecountries.We caution,however, that there is much speculationabout the size of the Islamicbankingmarketand the variance n estimates is large (The Economist1996).The advocatesof Islamic bankinghave presentedthe rise of Islamic bankingasthe primaryalternative o interest-basedbanking.Two problemsfacing the majorityof Middle Easterneconomiesare low investmentrates and weakfinancial ntermedi-ation structuresWorldBank1995). Islamic banksare supposedto serve the functionof allocating nvestment undsto long-termproductiveprojects.Theyare expectedtofavor small entrepreneurswho do not have access to credit n theconventionalbank-ing system andto extend their inks to ruralregionsthat are oftencut off from formalaccess to urban inancialmarkets. slamic banksmay be an engineof growth n Mus-lim countries.Advocates arguethat PLS financingprovides the vehicle for accom-plishing thesegoals in a fair andefficient manner Chapra1992 and Siddiqi 1983).We find little evidence to support these claims. First, Islamic banks rely muchmore heavily on markup inancingthan on PLS financing. Second, most financingdoes not appear o be long termin nature.Third,the evidence on whetheror not Is-



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lamicbanksprovidefinancing o capital-intensiveectorsof theeconomysuchas in-dustry s mixed atbest.The dataavailableon Islamicbanksaresomewhatlimited. In this study,we usethe most comprehensivedataavailable rom the InternationalAssociationof IslamicBanks, as well as data from annualreportsand other sources.We reportwhat thedatasuggest and we cautionthat our conclusions arenot definitive.Thereseems tobe little reasonto believe thatIslamicbanksoperatemuchdifferentlythanconven-tionalbanks.Egypt'sFaisalIslamicBank(FIBE)provides an interestingcase study.FIBEwasfounded n 1979 andis today thefourth argestIslamic bank n theworldandEgypt'ssixth largestcommercialbank (Kazarian1993 and Ray 1995). ConvertingKazar-ian's (1993) data to constant 1985 Egyptianpounds shows that the total assets ofFIBE grewquiterapidlyfrom 208 million Egyptianpounds in 1979 to 2.75 billionEgyptianpounds in 1985. Thereafter,assets declined and then leveled off in realtermsto 2.05 billionEgyptianpounds n 1990.Ray (1995) shows thatFIBE'smarketshareof totaldepositsincreasedfrom 0.32 percent n 1979 to 7.62 percent n 1984.Marketsharethenremainedroughlyconstantthrough1990. Because Islamicbanksareexcludedfromcompetingwithotherbanksforpublic-sectoroperations, heir m-pactis betterassessedby examiningtheircontribution o private-sector inance.Ray(1995) finds thatFIBE'smarket hareof deposits andfinancings n theprivatesectorfollows thesamepattern rapid nitialgrowth n market hareto 1983 followedby alevelingoff. Webelieve thatEgypt'shigh ratesof inflationhaveled to largenominalgrowthbutlittlerealgrowthforFIBE.Severalotherpoints emerge aboutFIBE from Kazarian's(1993) analysis.First,FIBEhaskepton average35 percentof its assetsoverseas.Second, of theassetskeptdomestically, 46 percenton averagehave been kept at the CentralBank of Egypt.Takentogether,65 percentof FIBE's total assets are not used for financing of do-mesticprojects.Onboththedepositsat thecentralbankand theassetsheldoverseas,FIBE is earninga marketrateof returnon relativelysafe investments.Third,whenlooking atthestockof assetsdeployed fordomesticfinancingof investmentprojects,over90 percentof the financing s markup inancing.FIBEseems to maintaina pol-icy of restrictingPLS financingto 3 percent of totaldomesticallyheld assets.FIBEdoes not appear o be growingrapidly,andit is not investingmost of its assetsin en-trepreneurialrojects.Even whenFIBEdoes providefinancingto such projects,thefinancing s primarilymarkup inancingand notPLS financing.Theconclusionthat the use of markup inancingdominates he use of PLS financ-ing is supportedby datafromotherIslamicbanks. InFigures 1 and 2 we plot theper-centage of new financingthat is markupfinancingand PLS financingfor severallargeIslamicbanks.Forexpositionalease, we have omitted the category of flows tootherfinancing.In addition o the flow of new financingforFIBE,we also plot datafortheJordan slamicBank(JIB) andBankIslamMalaysia(BIM).All threeof thesebankscompetewithconventionalcommercialbanks n theirrespectivecountries.Wealso plot datafor the last decadefor Iranwhose bankingsystem is entirelyIslamic.Except for a few years of netrepayments orFIBE(whichcoincidedwith severe re-



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Flows of MarkupFinancing1 25%75.25% -- - / \ /

0% - . 1 \ i I ; ; . :1g1 1982 1983 r984 198; 1986 1t87 1988 1989| 1990 1991 1992 1993 t934 * FxBE-2s% - | \ | =BIM

| \ | , X Iran-50% / i-75%

-1 oo% -- I

-t 25%-150% l-175%

FIG. . Flows of MarkupFinancing.FIBE=Faisal Islamic Bank of Egypt, JIB=JordanIslamic Bank,BIM=Bank Islam Malaysia, Iran=operationsof the entire Iranianbankingsystem.Flows of financing are calculated by computing the percentage of total new financing allocated tomarkup inancing: Markup(t)-Markup(t-1 ))I(Financing(t)-Financing(t-1)).The variousmarkup nstrumentsused were aggregated o get the percentageof markup inancing.Negative percentages ndicate net repayment o FIBE: (Financing(t)-Financing(t-1 ) < O.Percentagesgreater than lO0 percent (or less than-lO0 percent) indicate net repayment(or net fi-nancing in another category of financing, such as PLS. For example, PLS(t)-PLS(t-1) < 0 andMarkup(t)-Markup(t-1) > Financing(t)-Financing(t-1).Sources:Authors'calculations romAhmad (1987), Kazarian 1993), Pourian 1995), Ray (1995), Saf-fari (1995), Shallah (l990), Bank Negara Malaysia,Annual Reports, 1983-1994.

101



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Flows of PLS Financing45%

35%- \\ /0\

20%- \ / | -+ FIBE\ / _JIBi ^ BIM15%- $, X -Iran

5 % iL*ff4/b\s1g1 1982 1983 1984 1985 1987 1988 1990 1991 1992 1993 194

-5%

-10%

FIG.2. Flows of PLS Financing.FIBE=Faisal Islamic Bank of Egypt, JIB=Jordan Islamic Bank.BIM=Bank IslamMalaysia, Iran=operationsof the entireIranianbankingsystem.Flows of financingare calculatedby computingthe percentageof totalnew financingallocatedto PLSfinancing: PLS(t)-PLS(t-1 ))I(Financing(t)-Financing(t-1 ))The variousPLS instrumentsused were aggregated o get the percentageof PLS financing.Negativepercentages ndicatenet inflows to FIBE andBIM: (Financing(t)-Financing(t-1) < O.Dataare missing for 1986 and 1987 for JIB.Sources: Authors'calculationsfrom Ahmad (1987), Kazarian (1993), Pourian(1995), Ray (1995),Saffari(1995), Shallah(1990), BankNegaraMalaysia,AnnualReports,1983-1994.

102



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cessions in Egypt), markup inancinghas consistentlycomprised more than 50 per-cent of flows of new financing or all of these banks. For BIM, markup inancinghasaveraged95.3 percentof new financingover the period1983-1994. Except for Iran,flows of PLS financinghave consistentlybeen below 10 percent(we are missing ob-servationsfor JIB in 1986 and 1987). Only in Iran s there a significantPLS compo-nent to new flows of financing.But even in Iran, he majorityof financing s based onthe markupprinciple.Kuran 1995a) andNienhaus (1994) also report hat the com-position of markup echniques for otherIslamic banks in mixed financial sectors isconsistently above 90 percent.Panel A of Table 1presentsmore recentevidence from a large cross-section of Is-lamic banks in 1994 and 1995. Roughly 50 percent of the stock of financings isbased on the markupprinciple(eithermurabahar ijara).The use of markup nstru-ments seems to be growing given the datain Figure 1. Panel A also shows that thereis some skewness in the distributionof financing between large and small Islamicbanks. The percentageof average dollarsin murabahainancings s higher than theaveragepercentage,suggesting that largerbanks use murabahainancingmore fre-quently than do smallerbanks. This is consistent with theevidence in Figures 1 and2. The banks in Figures 1 and 2 are some of the largestIslamic banks in the worldandthese banks use more markup inancing than is suggestedby Panel A. Table 1presents data on a representativecross-section of Islamic banks, including manysmall ones. In addition, Figures 1 and 2 represent lows of new financing.Table 1representsstocks of existing financing.Weconclude thatIslamic banks use PLS in-strumentsmuch less frequently hanmarkup nstruments.There is no evidence that Islamic banks are providing significant amounts oflong-term capital to entrepreneurs.Metwally (1992) presents cross-sectional evi-dence from a survey in 1990 of twenty-twoIslamic banks and investmentbanks op-erating in thirteencountries. Using his data, we calculate that, on average, 56.7percent of financingsby nominal value were for maturities asting less than a year.Medium-term one to two years) andlong-term (two to five years) financings aver-aged 0.7 percent and 1.9 percent,respectively. Note that financings do not extendpast five years. Western banks would consider financings of this maturity to bemedium-term.Islamic banks kept, on average, 20.6 percentof their assets as de-posits with other banksand/orcentralbanks. Real estateinvestmentswere 0.66 per-cent of assets andQardHassanor social lending was 0.63 percent.This last point isnoteworthy.Social lending does not seem to happen.Even in theIslamic RepublicofIran, where the state requires banks to allocate specific amounts of QardHassanloans, Pourian(1995, p. 92) notes a steady decline in theirshare of total financingfrom 10.5 percent n 1984 to 4.6 percent n 1993.Kazarian 1993) presents evidence for the two EgyptianIslamic banking institu-tions contrastedwith other Egyptiancommercial banks and investment banks for1979-1990. He findsthat for FIBE, which is comparable o a commercialbank, theratio of long-termfinancing to all financings is a third of that for other Egyptiancommercial banks. For the Islamic Bank for InternationalDevelopment (IBID), anIslamic investmentbank, the ratio of longtermfinancing o all financings s half that



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TABLE 1FINANCINGS BY ISLAMIC BANKS, 1994-95PanelA Financings by Instrument 1994

Percentages Nominal dollars (lOOOs) PercentagesMean Std Dev Mean Std Dev % of mean Mean Std DevTotalAssets 304,809 609,013Murabaha 42.70% 36.04% 132,735 273,094 43.55% 45.10% 35.56Ijara 9.12% 20.84% 16,614 51,281 5.45% 10.66Go 22.98Musharaka 11.39% 19.37% 36,939 170,790 12.12% 16.33% 26.31Mudarabah 8.68% 19.64% 3S,339 159,285 10.61% 6.50% 14.03Other 28.10% 36.77% 86,182 245,443 28.27% 21.40% 34.04Panel B Financings by Sector 1994

Percentages Nominal dollars (lOOOs) PercentagesMean Std Dev Mean Std Dev % of mean Mean Std DevTotalAssets 304,809 609,013Trading 29.29% 28.70% 70,476 174,534 23.12% 23.33% 26.83Agriculture 11.11% 23.36% 49,159 271,111 16.13% 12.24% 23.06Industry 27.85% 29.85% 74,303 138,018 24.38% 24.34% 27.93Services 13.94% 21.24% 55,322 281,323 18.15% 11.77% 17.81Real Estate 5.47% 13.11% 18,242 74,978 5.98% 9.45% 19.03Other 12.33% 16.66% 37,306 118,029 12.24% 18.83% 21.86NorEs: Numberof banks = 82 for 1994. (2) Numberof banks = 86 for 1995. (3) Excludesbanks for which there s missing data. (4) Excludes Bank TSource: Authors'calculations romInternationalAssociation of IslamicBanks (1994, 1995).



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of other Egyptian investment banks. This fact is connected to the dominance ofmarkupfinancing as markup nstruments end to be short term in natureeither byregulation (as in the case of Iran and Pakistan)or by common practice in other Is-lamic banks. PLS financings are typically longer in duration; heir low compositionis underlinedby the small shareof medium-term o long-term inancings.In the caseof Egypt, conventional banks have outperformed Islamic banks in providinglong-termfinancing.The evidence is mixed on whetherIslamic banks nvest in entrepreneurial rojectsin sectors that are typically viewed as growth oriented.Agricultureand industryarepresumably ectors in which entrepreneurial rojectswould have the greatest mpli-cations for growth. Panel B of Table 1 shows that financing s balanced evenly be-tween agriculture/industry nd trade/services. Skewness of the data suggest thatlarge banks provided more financing to agricultureand industry than to trade andservices in 1995. Financing o real estate also seems to have grown in 1995, althoughreal estate financing s still relatively small.However, other evidence suggests that Islamic banks are not extending much fi-nancing to agricultureand industry.Kazarian 1993) finds that commercialbanks inEgypt extended 37 percentof their financing o industryand agriculture n 1979-90,while FIBE allocated only 10 percent. IBID allocated 11 percentto agricultureandindustrycompared o 17 percent for Egypt's other investmentbanks. Saffari (1995)notes that the Central Bank of Iran imposed targets for financing by Iran's highlyregulatedIslamic banking system to various economic sectors. From 1991 to 1993,realized financings to trade and services were more than double the targeted evelswhile those to industry, onstruction,and agriculturewere significantly ess than thetargets.Table 2 provides summarystatistics for Bank Islam Malaysia (BIM) and JordanIslamic Bank (JIB). BIM extended on average 9.7 percent of its new financing tomanufacturing or the period 1983-1994 comparedto 34.1 percent for other com-mercial banks. However, the large standarddeviations do not make this differencestatisticallysignificant.In Jordan,commercialbanks allocated significantlymore fi-nancing to agriculture han did JIB but JIB outperformed ommercialbanks in allo-cating funds to industry.However, Shallah (1990) claims that most of this financingto industry s importfinance for equipmentand supplies rather han projectfinance.There is some evidence that Islamic banks requirecollateral for their financings,apparentlyviolating a widely accepted legal position forbiddingany form of collat-eral in lending transactions.Kazarian 1993) reports n his study of Egypt that FIBEand IBID secured on average 96 percent and 90 percent of their financings,respec-tively, comparedto 60 percent for commercialbanks and 78 percentfor investmentbanks. Thus the great majority of the financing transactionsby Egyptian Islamicbanks are secured by some sort of financial guarantee.However, such a conclusionmust be treatedwith caution, as ownershipundermarkup inancingresides with thebank until all payments are made. Ownershipof the assets by the bank may be re-portedas collateralized ending, in which case the high degree of collateralization smerely an artifactof markup inancing. There is other evidence that Islamic banks



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TABLE 2THE SECTORAL DISTRIBUTION OF FINANCINGS FOR BANK ISLAM MALAYSIA AND COMMERCIAL BANKS INMALAYSIA, 1983-1994 ND JORDAN ISLAMIC BANK AND COMMERCIAL BANKS IN JORDAN, 1984-1991

Bank Islam Malaysia CommercialBanksMean Std Dev Mean Std DevManufacturing 9.69% 54.17% 34.12% 28.09%Commerce 6.31% 15.17% 8.29% 4.91%Housing Loans 24.08% 23.88% 24.58% 44.04%Other 59.92% 38.11% 33.01% 67.57%

Jordan slamic Bank CommercialBanksMean StdDev Mean StdDev

Agriculture 0.47% 0.07% 2.54% 0.36%Industry 30.36% 2.90% 14.53% 0.85%Real Estate 16.99% 0.77% 25.05% 1.48%Transport 7.95% 2.73% 3.41% 0.99%Trade 24.85% 2.33% 24.93% 0.91%Other 19.36% 2.38% 29.55% 2.69%NarEs: (1) Data for Malaysia are in flows.(2) Data for Jordanare stocks of financing.(3) Other or Malaysia includes nonhousingreal estate, agriculture, ransport nd storage, insuranceand business services, and mining andquarrying.(4) Other or Jordan ncludes financing o the service sector and private ndividuals.(5) For JIB, a significantproportion f credit to industry onsists of trade inance for the importof equipmentand stlpplies.Sozerces: Shallah (1990) andAnnual Reports rom Bank NegaraMalaysia, Jordan slalnic Bank, and JordanCentralBank.

are violating the prohibition on collateral. In addition to the purchased or leasedgoods serving as collateral, Islamic banks have been reported o requlreadditionalcollateral depending on the size of the transaction.Kazarian 1993) claims that thesize of this additionalcollateral for Egypt's Islamic banks has ranged between 40and 85 percent of the total funds provided.This seems to suggest that much of thelending done by Islamic banks is overcollateralized.Let us recapitulate he stylized facts that we want to explain; first, the preferenceby Islamic banks for debtlike instrumentsover equity-like instruments; econd, thepreferencefor short-term inancing when using murabahahontracts;third, somepreference or investments n the retail and tradesectors at the expense of agricultureand industry; ourth,the use of collateralwhen providingfunds. The model we pre-sent and analyze in the next three sections explains the stylized facts but does not ad-dress why Islamic banks seem to be more averse to equity and require morecollateral than conventionalbanks. One possible explanation s that Islamic banks

suffer an adverse selection problem they get the entrepreneurs hat have beenturneddown by conventional banks. These entrepreneurs re worse "types" theyare more likely to divert unds and more likely to have high-cost investmentprojects.Conventionalbanks may be more attractive o all types of entrepreneurs imply be-cause they impose fewer nonpecuniary osts such as religious restrictionson entre-preneurs.




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3. THE MODELIn this section, we presenta model of investmentand capitalstructurebased on in-

complete contracts.This model is in somerespects similarto the models of HartandMoore (1998) andBolton and Scharfstein 1990). Onetheoretical nnovationof thispaper s that we allow for outside equitycontracts n addition o debt contracts.At time t = 0, an entrepreneur as an investmentprojectwith randomuncorre-lated cash flows xl andx2 generated n periods 1 and 2. Let xt [0,xH] with cumula-tive distribution unction F(xt) andcontinuousprobabilitydensity functiont(xt).Wemake the standardmonotone hazardrateassumption: hehazardrate (1-F(x))lf(x)is non-increasing n x. The risk-neutral ntrepreneur as no wealth so she needs toraise I dollars to finance the project.In this simple model we assume there is no dis-counting. In principle,the project could be financed throughany type of financialcontract. For example, the project could be financed via an equity investment(profit-sharing) uch as a musharakaor mudarabahcontract.It could be financedthrougha debtlikecontract(markup)such as a murabahaor ijara contract.In thiscontext, it may not be clear what debtmeans given that thereis no discounting.Wedefine debt as fixedpayments due in eitherperiod. These fixedpaymentscan be in-terpretedas coupon payments and principalrepayments.However, the crucial ele-ment of debt is not the payment of interest, but the fixed nature of the payments.Thus, we do not dwell on the explicitrepresentation f interest n this model.We assume the entrepreneur an divertcash flows from theprojecteither throughthe consumptionof perquisitesor throughwasteful spending.As cash flows accrueinitially to theentrepreneur,he can alwaysdivert he proceedsand report ower cashflows to her investor.The investor s not fooled, but becausecash flows are not veri-fiable the investorhasno recourse.The entrepreneur eneratesutility from divertingcash flows but not dollar-for-dollar.The consumption of perquisites is con-strained the entrepreneur annot consumeexactly the bundleshe wants. Diversionis not outright theft, but instead involves spending on negative NPV investmentswhich benefit theentrepreneur lone (see Jensen and Meckling 1976). The entrepre-neur's utility fromdivertingan amounty is u(y) = cy where 0 ' c ' 1. The entre-preneurcan divertcash flows in both periods. Because cashflows are assumed to beunverifiable o a court, there is no way to force the entrepreneur o disgorge theseproceeds.The entrepreneur's tility from a direct cash paymentof y from the firm isv(y) = y. Suchpayments ead to unconstrained pendingby the entrepreneur. here-fore the entrepreneurwould prefer a directcash payment of y from the firm to di-verting an amounty from the firm's cash flows.

The cost of the investmentproject is I, where I is distributed ontinuously on [0,(Exl) + E(x2)]withprobabilitydensityfunctiong(I). The cashflows from the projectareindependentof thecost of the project,so the cost gives no additional nformationaboutthe expectedvalue of the project.Therealized cost of theproject,I, is fully ob-servable to all at date 0. Note that the entrepreneur's roject is always positive ex-pected NPV. From a social welfare perspective, society would be better off if the



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banks offeredcontracts o everyentrepreneur s they all havepositiveNPV projects,even if the bankslose money.In principle, the entrepreneurmay default on a debtpayment.If the entrepreneurdefaults,the bankmay choose to liquidatethe firm'sassets. If the entrepreneur e-faults in the secondperiod,the secondperiod iquidationvalue of the firm s L2.L2 snormalized o zero because we assumethat the firm ends after two periods. The liq-uidation value represents he future value of the investmentproject,which afterthesecond period is zero. If the entrepreneur efaults n the firstperiod, we assumethatthebankcan seize theprojectandliquidate t forL1.No second periodcashflows arethen realized. We assume that E(x2)-L1, the liquidation value of the firm isboundedabove by theexpectedsecond-periodcash flow of thefirm.Therefore iqui-dation is socially less efficient than continuation.This capturesthe idea thateventhough the entrepreneurs the most efficient userof the firm'sassets, the bargainingproblembetweenthe bank and theentrepreneurmay leadto liquidation n the case ofdefault.This assumption mplies thatbankruptcy s costly and introducesa cost ofdebt financing. Our last assumption is that the banks have all of the bargainingpower, or, equivalently, he banksaremonopolybanks.We discuss this assumptionin greaterdetail in section5.4. OPTIMALCONTRACTSFOR THEBANK

In this sectionwe considergeneralcontracts hatbankscan offerto entrepreneurs.Such contractscan be PLS contracts(musharakandmudarabah)r markupcon-tracts(naurabahandijara) n which therearespecifiedfixedrepaymentsorcombi-nations of both. We characterizewhen PLS contracts will dominate the use ofmarkupcontractsandwhen they will be dominated.Markupcontractshave the crit-ical featurewe ascribe to debt:default on a paymenttriggers a shift in controloverthe asset from the entrepreneur to the bank. In a markup contract this istransparent the bank retainsownershipof the asset until all of the paymentsaremade. If a payment s notmade,then thebankliquidates he asset.Fromnow on, werefer to PLScontractsas equityandmarkup ontractsas debt.A generalcontractcanconsistof bothdebt andequity.It will be given by {oc,D1,D2, I), where oc s the amount of equity (the profit share)retainedby the entrepre-neur, 1-oc is the amountof equity given to the bank, D1 is the face value of first-perioddebt, D2 is the face value of second-perioddebt,and I is the amountof fundsprovidedby thebank to the entrepreneur.n principal, he marketvalue of debtmaybe lower than the face value of debtbecause the entrepreneurmay default.Nothingin our analysispreventsone investor from holding debt and another nvestor fromholdingequity.Thus thecontractneed notbe concentratedn a single bank,althoughthatis the way we will refer to the contract.Islamic banks can offer these generalcontacts.These generalcontractsalso nest the special cases of all-equitycontracts,{oc, ), andpuredebtcontracts,{D1, D2,I).The bank will maximize its expectedreturn,E(KB),over the set of possible con-



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tracts subject to inducing the entrepreneuro fulfill her contractualobligations (thatis, not to default or divertcash flows). The bank's problem s:max JwoLlf(xl)dxl + Jwx,(ocD1+ (1 oc)xl + .(x2 (oCD2 ( ) 2)

f(x2)dx2)W(xl)dxl (1)xThe first component f E(KB) s ,(0 Llf(x1)dxl. The bank liquidates the project forL1 f the entrepreneur efaults on first-perioddebt, D1. The entrepreneurwill defaultif the realizationof the first-period ash flow x1 is less thanx1 , where x1 will be de-terminedby the incentive compatibilityand limited liability conditions given below.

If x1 -x1', the entrepreneur does not default and the bank receives D1 +(1-ot)(x1-D1) = oeDl + (1-ot)x1, the first-period debt payment and the equityshare of the excess first period cash flow over the face value of debt. In addition, hebank receives its expected second-periodreturn.If the entrepreneur efaults in thesecond period, the bank receives L2. Because we have normalizedLo = O,this com-ponent drops out of the bank's expected return.The entrepreneur oes not default ifx2-x2', where x2' will be determinedby the conditions given below. If the entre-preneurdoes not default,the bank receives D2 + (1-oc)(x2-D2) = ocD2+ (1-oc)x2,the second-perioddebt payment and the equity share of the excess second-periodcash flow over the face value of debt.The bank'sproblem s subjectto incentive compatibilityand limited liability con-ditions in both periods:

v(ocx)-u(x) (la)x2 xHoc(x1-D1) + JsO cx2 (x2)dx2 + ,(x2,oc(x2-D2) (x2)dx2-cxl ( lb)

X1-D1 ' (lc)

oc(x2-D2) ' CX2 (ld)x2-D2 ' (le)

Condition(la) says that the entrepreneur's tility from paying out the cash proceedsto the equityholdersmust be greaterthan the entrepreneur's tility from diversion.Another way to write this is that oc ' c. The entrepreneurmust be given at least afractionc of the equity, otherwise she will divertcash flows and get a higher utility.Divertingcash flows from equityholdersdoes not constitutedefaultand therefore an-not be prevented.Condition(lb) is the first-period ncentivecompatibilitycondition.If the entrepreneur iverts the first period cash-flow, she gets cx1. If she makes thefirst-perioddebt paymentD1, the entrepreneur ets both her equiHtyhare,oc(xl-D1),and her expected second-periodreturn: (0 CX2X(X2)dX2+x2 (x2-D2)f(X2)dX2-The face value of first-perioddebt and the bank's equity allocationcannotbe so high



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that the entrepreneur ivertsall of the funds, taking into account the entrepreneur'ssecond-period expected return. Condition(lc) is the first-period limited liabilitycondition.This conditioncan also be interpreted s a zero-wealthassumption.If thefirst-periodcash flow is not sufficientlyhigh to meet the debt repayment, he entre-preneurcannot be held liable for the shortfall.She simplyloses control of the firm tothe bank.Further, he entrepreneur annotmake up the shortfallbecauseshe has nowealth with which to do so. In addition,the entrepreneur annot borrowagainst thesecond-periodreturn n orderto make up the shortfall, hatis, the entrepreneur an-notrenegotiate he contract.In the analysisthatfollows, we show thatsecond-perioddebt is not optimal for the bank, so that a bank would never be willing to allow theentrepreneur o borrowagainst the second-periodreturn.Condition (ld) is the sec-ond-period ncentivecompatibilitycondition. The equityallocation to the bank andthe face value of debtcannot be so high that it is optimalfor the entrepreneuro di-vert funds conditional on the realizationof the second-periodcash flow. Condition(le) is the second-period imited liability condition and its interpretation arallelsthat of the first-periodimited liabilitycondition.In orderto simplify the problem andderive the optimalcontracts,we work back-wardfromthe secondperiod.We firstnotethatwe canrestrictattention n the secondperiod to equity contractsbecause, in the second period, an equity contract domi-nates anytype of debtcontract.To see this, let ot = c and D2= O.Then the incentivecompatibilitycondition ( 1d) is satisfiedwithequalityfor anyrealizationof x2 and thelimitedliability condition(le) is clearly met for any realizationof x2. This contractgeneratessecond-periodexpected returnsof (1-c)E(x2) for the bank. Now consideranyalternative ontractwithoc'E (c, 1] andD2' > O.Thenthereexists a cutoffx2' =ot'D2'/(oc'-c) fromcondition (ld) wherefor x2 ' x2', the entrepreneur oes not de-fault anddivert the cash flow. For x2 > x2', the incentivecompatibilitycondition ismet but the entrepreneurarns excess returns that is, this contract s ex post subop-timal for the bank).At x2 = x2', the bank is indifferentbetween the (x = c and D2 -Oand the ot'E (c, 1] and D2' > Ocontracts.For x2 < x2', the incentivecompatibilitycondition is not met so the entrepreneur efaults anddiverts the second-periodcashflow and the bank receives nothing. As the incentivecompatibilitycondition is metwith slackfor x2 > x2', andis not met for x2 < x2', second-perioddebtcontractsaredominated.Further, ny contractwith t2'< c and D2' ' Owill violate (la) and (ld)for any realization of x2 and so is clearly suboptimal.Therefore, optimal second-periodcontractswill be ot*= c, D2 = O.This implies thatx2' = O.Now considerthe firstperiod.We firstverify that ot* = c is the optimalequity por-tion of the contract n the first-periodas well and solve for the optimalfirst-perioddebt level. Note thatD2 - O mplies that the first-periodncentivecompatibilitycon-dition (lb) reduces to ot(xl-D1 +E(x2)) ' cxl. For ot = c and D1 ' E(x2),condition( lb) is satisfiedfor all realizationsof xl . Furthermore,or ot= c andD1 = E(x2),con-dition (lb) will be met withequality for all realizationsof x1. Note, however, hatthelimited liability conditionneed not be met for all realizations of x1. Now considerany alternative ontractwith ot'E (c, 1] and D1' > E(x2).Then there exists a cutoffx1' = ot'(Dl'-E(x2))/(ot'-c) from condition(lb). Forxl > xl', condition(lb) is met



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but the entrepreneur arnsexcess returns.At x1 = x1 , the bank s indifferentbetweenthe ot = c and D1 ' E(x2) and the ot'E (c, 1] and D1 > E(x2) contracts.For E(x2) 'x1 < x1 , condition (lb) is not met so the entrepreneur efaults and the bank receivesL1. In this region, underthe oe= c and D1 = E(x2)contract, he bank earns

D1 + ( 1-C)(X1-D1+E(X2)) ' E(X2)+ ( 1-c)xl > L1 (2)For x1 < E(x2),the entrepreneur efaultsunderboth the D1 = E(x2) and D1 > E(x2)contractsand the bank receives L1.Therefore,any contractwith ot'E (c, 1] and D1> E(x2) is dominatedby the ot = c and D1 = E(x2) contract.This implies that in thefirstperiod, optimal contractswill be characterized y oe*= c and D1 ' E(x2). Con-ditions (la) and (lb) are satisfiedeverywhere.Therefore, he only conditionthatmaynot be satisfied s the limited liability condition (lc) which in turn mplies thatx1' -D1 Forx1 < x1 , the entrepreneur efaults,while for x1 ' x1 the entrepreneur epaysD1 to the bank because the limited liability condition is satisfied.Given the preceding analysis and ot* = c and D2 = O, the bank's optimizationproblemreduces to

max JO Ll (xl )dx+ ( Dl + (1-c)(x1-Dl + E(x2 )))t(xl )dxl (3)The monotone hazardrate ensures quasiconcavityof the bank's objective function.The first-order ondition s

AE(X )B = (F-D1-(1-C)E(x2 ))f (Dl + C(1-F(D1 )), (4)

and the second-order ondition is satisfied as well.We first characterizewhen all-equity contractswill be optimal (that is D1 = O).EvaluatingAE(XB)I8D1 at D1 = O yields a necessary and sufficient condition forall-equitycontracts o be optimal:Ll-(1-c)E(x2) + f(O) ' O (S)

There exists a cutoff level of moral hazardc*E (O, 1) such that for c ' c*, pure eq-uity contracts will be optimal and the bank will only offer pure equity contracts.When c ' c*, the rate of diversion s low. The cutoff c* is given by* _ E(x2 )-Ac - E(x2)+ f(lO) (6)



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Conversely,if c > c*, then D1 = D1 is optimal. Fromequation (4), D1 > O isgiven byLl-Dl-(1-c)E(x2 ) + ( ( ) l )) = 0 . (7)

For c > c* (the rate of diversionis high), debt and equitycontractswill be optimalrelativeto pure equity contractsand the bankwill offer only the combinationof debtand equitycontracts.Finally, n order o see whenD1 = E(x2),we evaluateaE(xB)laDlat D1-E(x2) toget

Lq-E(X2 )-(1-c)E(x2 ) + C(1 F(E(X2 )), O (8)This conditionyields a cutoff for D1 = E(x2)to be optimal:

2E(X2 )-L1

C - 1-F(E(X2 ))2 f (E(X2)For c ' c**, he level of moralhazard s so high that a maximalfirst-perioddebt con-tact, D1 = E(x2), s optimal.There are two points to note aboutthis cutoff.First, thecutoff formaximal debt is higher than thecutoff for any debt,c**> c*. This followsfrom the monotonehazardrate assumption.Second, it may be the case thatc**> 1.In other words, it is possible that maximaldebt may not be optimal for any level of

. . .dlverslon.We can write optimal firstperiod debt contractsaspO for c* ' c

D1 =tD1 forc** >c>c* (10)tE(x2 ) for c ' c**

assuming c**< 1. Figure3 depicts the optimalfirst-perioddebt contractas a func-tion of the rateof diversionc. Using the implicitfunction theoremand themonotonehazardrate propertyyields the following comparative tatics:aD* aD* aD* (11)

The face value of debt, D1, is increasing n the rate of diversionc while the amount



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D1

E(X2) / - D1 (c)

/ l- l

c* c** c

FIG.3. OptimalFirst-PeriodDebt Contractsas a Functionof the Level of Diversion

of outside equity finance 1-oe* = 1-c is clearly decreasing n the rateof diver-sion. This is the sense in which the optimalityof debt as a financial nstrumentde-pends on the level of moral hazard in an economy. The face value of debt isincreasing n the liquidationvalue of the firmas a higherliquidationvalue decreasesthe riskinessof debt due to default.The face value of debt is decreasingin the ex-pectedvalue of the secondperiod cashflow: as the second-periodcash flow becomesmore valuable,the cost of default increasesbecausethe second-periodcash flow isnot realized.We have identifiedthreeregionsof the parameter pace for first-perioddebtcon-tracts.However,we are primarily nterested n two regions:c ' c* so thatD1 = O,and c > c* so thatD1 > O.The firstcorrespondso the useof all-equitycontracts.Wedefine

IE = (1-c)(E(xl) + E(x2)) (12)as the highest-cost project that can be financedunderall-equity finance or profitsharing.The bank'sprofitshare must yield (in expectation)at least the amount offunds providedby the bank.The maximumamountof equitythatcan be given to thebank is 1-c, for then (la) will bind. Because the bank has the bargainingpower,when c ' c* andfor entrepreneurswith costs of investmentI E [O,IE), the optimalcontractis ot*= c, D1 = O, and. D2 = O.The entrepreneur's xpected return scE(xl) + cE(x2).If I > IE,then thebank's return s insufficientrelativeto the invest-ment to induce the bank to provide financing using equity.Equitycontracts workwell when the cost of the project is low or when the rateof diversionis low. Whenthe rateof diversionis high, the agency problemimplies that the project cannotbefundedwith pureequity.In the second region, the optimaldebt andequity contractsareot* = c, D1 > O,and D2 = O-Entrepreneursave anexpectedreturnof



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C X 1 C ( X 1 ) d X 1 |D E C ( X 1 - D 1 E ( X 2 ) ) 8 ( X 1 ) d X 1

= cE(xl ) + c(l-F(D1 ))(E(x2)-D1 ) . (13)We define

IDE = F(D1' )L1 + (1-F(D1' ))(cDl + (1-c)E(x2 ))|D E x11(xl)dxl (14)

as the highest-costprojectthatcan be financedunder the combinationof debt andequity.An entrepreneurwith aprojectthat costs I ' IDEwill haveherprojectfundedwith debtandequity. For I > IDE, heprojectcannot be funded.The project s morelikely to be fundedthe higher the liquidationvalue of the assets, the higher the ex-pectedvalue of the second-periodcash flow, andthe lowerthe rateof diversion.Oneadditionalmplication ollows fromtheoptimalcontracts.As therate of diversion n-creases, a largershareof theprojectwill be fundedwithdebt and less will be fundedwithequity.As moralhazard ncreases,debtbecomes thepredominantnstrumentoffinance.Note, however,that debthas costs as well as benefits.Here the cost of debtcomes from thepossibilityof default.5. A SOCIALWELFARECOMPARISONOF CONTRACTS

In this section,we comparedebtandequitycontracts o pureequitycontractsandwe draw social welfare implications. For c > c*, the level of moralhazard in theeconomy is highenough so thatdebt andequitycontractsexpandthe regionin whichentrepreneurs anget financingrelativeto pureequity.Thebankprefersto offerdebtandequitycontractsas these generatea higherreturn o thebank.Theentrepreneurs,however, prefer pure equity because it allows them to retain more of the pro-ceeds conditionalon thebankfinancing heprojectundereitherpureequity ordebtandequity.Because the bank has the bargainingpower, it will not offerpureequitycontracts.If the level of moralhazard s low, c ' c*, thenpureequitycontractswilldominatethe use of debt and equity. This point is of independent nterestbecauseagency models of capital structure uch as Bolton andScharfstein(1990) andHartand Moore (1998) do not have the use of outside equity as an optimal financialinstrument.We next examine the social welfare implications of the differenttypes of con-tracts.Gross social welfareperprojectfundedunderpureequitycontracts s

GSWE= (1-c) (E(xl ) + E(X2 ) + CE(xl + CE(x2 = E(Xl + E(X2 (15)



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RAJESHK. AGGARWALAND TARIKYOUSEF : 1 15

Gross social welfareper projectfundedunderdebt and equitycontracts sGSWDE= F(D1 )L1+ (1-F(D1 ))(cDl + (1-c)E(x2 ))

+ (1-c)|D* Xlf(Xl )dXl + CE(X1 )

+ c(l-F(D1 ))(E(x2)-D1 ) < E(xl ) + E(x2) . (16)However, the social welfare implicationsare more ambiguousthan this comparisonsuggests because more projects may be funded under the combinationof debt andequity thanunderpure equity.To see this, note thatexpectednet social welfare(priorto time O)underpure equity is

JO (E(x1 + E(x2 )-I)g(I)dI . (17)Expected net social welfare (prior o time O)underdebtand equity is

lo (F(D1 )A + (1-F(D1 ))E(X2 ) + (1-C)|De Xlf(Xl )dXl

+ cE(xl )-I )g(I )dI ( 18)In orderto determinewhetherpureequity or risky debt and equity deliverhighersocial welfare [whether 17) is greater han (18)] we considerthree cases. In the firstcase, c ' c* (therate of diversion s low) which means thatthe bank funds all invest-mentprojectswith costs up to IE withpure equity.Both entrepreneursnd bankspre-fer this outcomeand equity contractsare optimal.In thisregion, a ban on debthas noforce as debt contractsare not used.Figure 4 depicts the second and thirdcases. In Figure4, c > c* (the rate of diver-sion is high) which implies that IDE > IE. In this figure,debt and equity contractsfund more projectsthan do pure equity contracts.Banks will choose to offer onlydebt and equity contracts to entrepreneurs.Net social welfare is given by regionsA+C. The deadweightloss of debt is given by region B, which measuresthe lossdue to the possibilityof default andliquidation rom riskydebt. The second case isthat region C is smaller than regionB. Social welfare is improvedby a banon debt.A ban on debt results n projects n theregion C not beingfunded.However,projectswith costs of investmentup to IE can still be funded withequity. Because C < B, the

value of the projectsforegone is -less han the value lost becausedebt is costly,whichleads to the social welfare gain by a ban on debt.The thirdcase is thatregionC is larger hanregionB. Notonly does the combinationof debt and equityfund more projects han does pure equity,but the additionalncre-ment to socialwelfare from more projects C) outweighsthe deadweight oss of riskydebt (B). Net socialwelfare s A + C.In this case, a ban ondebtreducessocialwelfare.



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GrossSociai Welfare

GSWDE e / / c*, debt and equitycon-tractsexpand the set of projectsthatcan be funded relativeto pure equity contracts.There is an efficiencyloss because for low realizationsof cash flows, entrepreneurswith debt contractswill default and firms will be liquidated, resulting in a dead-weight loss to society. Nevertheless,debt and equity contractscan improvesocialwelfare by allowing some projectsto be undertaken hatwould otherwisenot be.This result s drivenby the assumption hat the level of moralhazard n the economyis high. We believe this assumptionis realistic when thinking about developingcountries.Second, as a corollaryof the previouspoint, for c > c*,debt and equity contractsare more profitablefor banks than are pure equity contracts.Conversely,if bothtypes of contractwere offered to anentrepreneur,hen theentrepreneurwouldpreferthe pure equity corltract o the debt and equity contract.Monopoly and oligopolybanks prefer to offer debt and equity contracts.In the presence of competition,weshould see pureequity contractsbeing offered. As more banks enter Islamic coun-tries, there maybe a shift in the compositionof finance towardequity.Third, as the agency problem becomes more severe (increasing rates of diver-sion), the fractionof debt will rise relativeto the fractionof equity in the composi-tion of finance.This suggests that the high quantityof mark-upcontractsofferedbyIslamic banks is a rational choice given the environmentthey face, one of highmoral hazard.A shift towardequitycan occur if the level of moral hazard n Islamiccountries decreases.Fourth,when looking at the structure f debt and equityfinancing,most financingwill be skewedtoward ow-cost projects.High-cost projects(those that requiremorecapital) are unlikelyto get funded.Thisis consistentwithsome bias on the partof Is-lamic banks to lend to companies engaged in trade and commerce as opposed toagriculture, ndustry,or real estate.The latter are potentiallymore capital intensivethan the former.Even though the assets are more intangible n the case of tradeandcommerce,projectsare more likely to be funded given the higher potentialreturns.Fifth, debt contractswill be shortterm in natureandequity contractswill be long



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term.We view this as consistentwith the fact thatIslamicbanksseem to lend shorttermprimarily. slamicbanksalso requirea high degreeof collateralfor theirloans.This maybe becauseIslamicbanksface a veryhighlevel of moralhazard.Thismay,however,simply be an artifactof the fact thatthe bankowns the asset in a markupcontractuntil all of thepaymentsaremade, andso the loan is reportedon thebank'sbalancesheet as collateralized.6. IMPLICATIONS ND CONCLUSION

We study the set of optimalfinancialinstruments or banks(specificallyIslamicbanks)operating n environments haracterized y agencyproblemsandincompletecontracts.We show thatoutsideprofitsharingor equitycontractscan be optimal fi-nancialinstruments ven when contractsareincompletewith respect to cash flows.However,the optimalityand use of equity contracts will decrease as the level ofagency problemsincreaseswithin an economy,anddebt contractswill become thedominant ormof finance.Wedrawseveral mplicationsfromouranalysis forIslamicbanking.First,the ob-servation hat,forreasonable evels of moralhazard,debtandequitycontractsdom-inate pureequitycontracts roma bank'sperspectiveaccordswell with the fact thatIslamicbankshavechosen markup ontractsas theirpreferredmechanismof financ-ing investment.Second, when debt and equity contractscan be used, debt will beshortterm n nature.Therefore,we canrationalize hepreferenceof Islamicbanks tolend shortterm.Third,bankswill generallypreferlower-cost investmentprojects.Thismayexplain theprevalenceof markupcontractsusedto financetradeandcom-merce: the cost of investmentprojectsmay be lowerin these sectorsthanin agricul-tureandindustryor real estate.Fourth, n orderto obtainfinancingfor more costlyprojects,entrepreneurswill need to show thattheirpropensityfor diversion is low.Theuse of collateralsuggests thatIslamicbanksseek outentrepreneurswho are un-likely to be seriousmoralhazardrisks.Seekingadditionalcollateral,althoughcom-pletelyrational,contradicts he spiritof Islamicbanking.GiventhatIslamicbanksstructure heirlending to be mostly shorttermandquiteheavily secured, we conclude that Islamic banks face severe agency problems intheir attemptsto provide funds to entrepreneurs.Heightenedcompetition amongbanksmightgeneratemoreprofit-sharing ontractsas borrowersareable to chooseamong the varioustypes of contractson offer fromthe differenttypes of banks,butwe haveyet to see this in thedata.Furthermore,t is notclearthatIslamicbankswillprovidemore competitionto conventionalcommercialbanks in Muslim countries.Ourevidence suggests thatIslamicbanksareniche providersof capital,andwithinthatniche do not operatemuchdifferently romconventionalbanks.These resultshave implicationsfor the literatureon religiousnorms andeconom-ics. Kuran(1983, l995a, l995b) arguesthat the principalshortcomingof Islamiceconomicsis that t does notproperlyaccountfor theimpactof economicincentives.In short,religiousnormsareunlikelyto changehumanbehaviorwhen fundamental



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RAJESHK. AGGARWALANDTARIKYOUSEF : 119

economic considerationssuch as wealth maximizationare present. Our results sug-gest that economic incentives are shaping the structureof Islamic banking more sothan are religious norms. The key economic restrictionof Islamic Law is the ban oninterest. While the religious basis for this restriction s a concern with income in-equality and unequal access to capital, there is an economic case for the ban on theuse of interest. The inefficiencies necessary to justify the ban on interest primarilyhave to do with incentives and bargainingpower.These inefficienciescan also lead tQsocial welfare reductions rom a ban on interest.A betterappreciation f these ineffi-ciencies would lead to better policy prescriptions or Muslim countriesand perhapsreconcile the expectationsof Islamic banking'sadvocateswith the reality of Islamicbanking today, a point also made by Kuran 199Sa). Muslim countriescurrentlydonot seem to be in a situation n which a ban on interest ncreasessocial welfare.We conclude from our analysis that althoughIslamic banks are or should be basedon the profit-and-loss haringprinciple, given the economic environments n whichthey operate, using only this type of financing may not be possible. Moral hazardproblems suggest the need for some sort of debtlike instrument.The use of markupcontracts s a rationalresponse to informationalproblems.Thus we feel the informa-tional environmentwill be a more importantdeterminant f the evolution of bankingand growth n Muslim countries hanwill attempts o impose financialsystems based

., . . . .Onspec1ncre ilglOUSr1nc1pes.LITERATURECITEDAhmad, Ausaf. Developmentand Problems of Islamic Banks. Jeddah:Islamic DevelopmentBank, 1987.Babai, Don. Arab Banker'sAssociation of NorthAmerica Newsletter. 12 ( 1995), 1.Bolton, Patrick,and David Scharfstein."ATheory of PredationBased on Agency Problems nFinancialContracting." mericanEconomic Review 80 (March 1990), 93-106.Chapra,M. Umer. Islam and the Economic Challenge. Leicester: The Islamic Foundation,

1992.Ebrahim,MuhammedS., and Akram Safadi. "BehavioralNorms in the Islamic Doctrine ofEconomics: A Comment." Journal of Economic Behavior and Organization 27 (June1995), 151-57.Economist, The. "IslamicFinance:Turning he Prophet'sProfits."The EconomistNewspaper(August 24, 1996), 58-9.Glaeser, EdwardL., and Jose Scheinkman. "Neithera Borrowernor a Lender Be: An Eco-nomic Analysis of InterestRestrictionsand Usury Laws."Journalof Law and Economics41 (April 1998),1-36.Hart,Oliver,andJohnMoore. "Defaultand Renegotiation:A Dynamic Model of Debt."Quar-terly Journalof Economics 113 (February1998), 1-41.InternationalAssociation of Islamic Banks. Directoryof Islamic Banks and Financial Institu-tions: 1994.Jeddah: AIB, 1994.

. Directoryof Islamic Banks and Fiszancial nstitutions:1995. Jeddah: AIB, 1995.Jensen, Michael, and William Meckling. "Theoryof the Firm:ManagerialBehavior,AgencyCosts, and Ownership Structure."Journal of Financial Economics 3 (October 1976),305-60.



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Kazarian,Elias G. Islamic versusTraditionalBanking:FinancialInnovation n Egypt.Boul-der:WestviewPress, 1993.Khan,Mohsin S., and AbbasMirakhor.TheoreticalStudies in IslamicBankingand Finance.Houston:The Institute or Research n IslamicStudies, 1987.. "IslamicBanking:Experiences in the IslamicRepublicof IranandPakistan."Eco-nomicDevelopmentand CulturalChange 38 (January1990), 353-75.Khan,ShahrukhR. Profitand Loss Sharing:An IslamicExperiment n Financeand Banking.Oxford:OxfordUniversityPress, 1987.Kuran,Timur."BehavioralNorms in theIslamicDoctrineof Economics:A Critique." ournalof EconomicBehavior and Organization4 (December 1983), 353-79.

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Markets,edited by RodneyWilson,pp. 100-28. London:Routledge, 1990.Siddiqi,MuhammadN. Issues in IslamicBanking.Leicester:The IslamicFoundation,1983.WorldBank. Claiming the Future:ChoosingProsperity n theMiddleEast and NorthAfrica.Washington:TheWorldBank, 1995.

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