162 AN INTRODUCTION TO ISLAMIC FINANCE
area of risk management, because the payment the entrepreneur has to make
to the creditor is reduced in periods of economic downturn. Also, if the entre-
preneur experiences temporary debt-servicing diffi culties in the interest - based
system, for example, on account of a short - term adverse demand shock, there
is the risk of a magnifi cation effect; that is, credit channels might dry up
because of lenders overreacting to the bad news. This is due to the fact that
the bank’s own profi tability is not affected by the fl uctuating fortunes of the
client’s investment, except when there is a regime change from regular inter-
est payments to a default problem. In other words, interest payments are due
irrespective of the profi tability of the physical investment, and the conventional
bank experiences a change in its fortunes only when there are debt - servicing
diffi culties. However, a temporary cash - fl ow problem for the entrepreneur and
just a few delayed payments might be seen to be a regime change, which could
blow up into a “sudden stop” in lending. In the Islamic model, these tempo-
rary shocks would generate a different response from the bank, because the
lenders receive information on the ups and downs of the client’s business
regularly in order to calculate their share of the profi ts, which provides the
important advantage that the fl ow of information, as indeed the payment
from the borrower to the lender, is more or less on an ongoing basis.
Enhanced Monitoring
Islamic fi nancial contracting encourages banks to focus on the long term
in their relationships with their clients. However, this focus on long - term
relationships in profi t/loss-sharing arrangements means that there might be
higher costs in some areas, particularly with regard to the need for moni-
toring the performance of the entrepreneur. Conventional banks are not
obliged to oversee projects as closely as Islamic banks, because the former
do not act as if they were partners in the physical investment. To the extent
that Islamic banks provide something akin to equity fi nancing as against
debt fi nancing, they need to invest more in managerial skills and expertise
in overseeing different investment projects. This is one reason why there is
a tendency amongst Islamic banks to rely on fi nancial instruments that are
acceptable under Islamic principles but may not have the best risk - sharing
properties, because in some respects they are closer to debt than to equity.
Asset/Liability Management
Theoretically, Islamic banks offer their asset portfolios in the form of risky
open - ended “mutual funds” to investors/depositors. By contrast, banks
in the conventional system fi nance the assets through issuing time-bound
deposit contracts. This practice results in solvency and liquidity risks, since
their asset portfolios and loans entail risky payoffs and/or liquidation costs
prior to maturity, while their deposit contracts are liabilities that are often
payable instantly at par. In contrast, Islamic banks act as agents for inves-
tors/depositors and therefore create a pass - through intermediation between