160 AN INTRODUCTION TO ISLAMIC FINANCE
creates an explicit mapping between the input and remuneration of capital,
so that the manager is left free to choose the individually optimal level of
effort in each state contingent on the specifi ed level of investment. However,
in the case of a mudarabah, an explicit mapping between the remuneration
of capital and the outcome of the project is created. A mudarabah, there-
fore, allows the contract to control directly the manager’s incentive to exert
effort, since this effort affects the relationship between capital investment
and the outcome of the project. Under a mudarabah contract, the manager
is free to choose the individually optimal level of investment in each state of
the economy contingent on his contractually specifi ed level of effort. Presley
and Session’s model concludes that these individually optimal levels corre-
spond to the full - information, productively effi cient levels such that a mean
variance improvement in capital investment is obtained — that is, average
investment is increased whilst ineffi ciently large fl uctuations around this
level are reduced.
With fi nancial intermediation in Islam, the intermediary simply “passes
through” the performance of its assets to the investors/depositors on its
liability side. There is an element of risk sharing present in the contractual
agreement between the fi nancial intermediary and the depositors/investors.
The assets on the asset side of the balance sheet could be in the form of over -
the - counter assets fi nanced by the Islamic bank or direct investments in
marketable securities of Shari’ah - compliant assets; that is, equities or asset -
linked securities. Table 8.6 describes the contractual roles of an Islamic
fi nancial intermediary (IFI). For Islamic banks, there is a greater diversity of
contractual agreements as the bank may be acting as a trustee in one mode
of intermediation and as a “partner” in another. The bank also enters into
a principal/agent model on both sides of the balance sheet. The purpose
of showing different contractual agreements is to show that Islamic banks
have more fi duciary responsibilities which have a direct impact on the gov-
ernance of the fi nancial institution.
Profi t/Loss Sharing
The profi t/loss - sharing concept implies a direct concern for the profi tability
of the physical investment on the part of the creditor (the Islamic bank). The
conventional bank is also concerned about the profi tability of the project,
because of concerns about potential default on the loan. However, the con-
ventional bank puts the emphasis on receiving the interest payments accord-
ing to set time intervals, and so long as this condition is met, the bank’s own
profi tability is not directly affected by whether the project has a particularly
high or a rather low rate of return. In contrast, the Islamic bank has to focus
on the return on the physical investment, because its own profi tability is
directly linked to the real rate of return.
The direct links between the payment to the creditor and the profi tability
of the investment project is of considerable importance to the entrepreneur.
Most importantly, profi t-sharing contracts have superior properties in the