Self-Adjusting Profit Sharing Ratios for Mushārakah Financing

By Dr. Volker Nienhaus

Abstract

Islamic economists have propagated contractual arrangements for a sharing of profits between capital providers and entrepreneurs and the bearing of losses by the capital providers (mudārabah, mushārakah) as the “true” Islamic alternative to interest-based debt financing. But this ideal is very difficult to implement in a world with distinct information asymmetries, self-interested market players, adverse selection problems, and debt-like Shariah compliant financing techniques with more predictable and less risky financing alternatives. Wrong profit expectations at the beginning of a profit and loss sharing contract can adversely affect the return on the invested capital. The standards of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has come up with a number of possible corrections for expectation errors, but they all require a consensus of all contracting parties on a modification of the initial agreement. Since the purpose of re-negotiations is a re-distribution of profit shares from one party to another party, a consensus among self-oriented actors is not very likely. The proposal of a self-adjusting profit sharing ratio obviates the need for discretionary re-negotiations. It uses elements from AAOIFI standards to structure a contractual arrangement that maintains a distribution pattern which was initially agreed upon by the contracting parties. It does so by an automatic adjustment of the profit sharing ratio whenever new information on the expected profit becomes available. This reduces the impact of information asymmetries and reduces the risk of adverse selection, and the formula for the profit sharing ratio can be calibrated such that a risk aversion of the financier is factored in.