Self-Adjusting Profit Sharing Ratios for Musharakah Financing

Banks avoid participatory financing due to serious information asymmetries, adverse selection and moral hazard problems resulting in negative impacts for the return on capital provided. Even financing instruments with a participatory legal form such as musharakah sukuk have been stripped of their risk sharing substance and become functional equivalents of interestbearing bonds. Several authors have addressed these issues, but some proposals are applicable only for (listed) joint stock companies, while others imply Shariah compliance issues. To overcome these limitations, a “self-adjusting profit sharing ratio” is proposed, based on building blocks found in AAOIFI Shariah standards for musharakah financing and musharakah sukuk. These building blocks allow a (surprisingly) wide range of discretionary adjustments of participatory contracts, provided the contracting parties come to an agreement in re-negotiations of the contractual terms. This requires an agreement on a fair distribution of profits. What the parties consider a fair distribution is already known when the contract is initially concluded: It determines the parties’ profit shares based on their profit expectations at this point in time. The AAOIFI building blocks allow the structuring of a formula for the profit sharing ratio, which automatically adjusts to changes in the expected or actual profit. It thus ensures continuously a profit distribution in line with the initially agreed-upon principles of fairness. The formula can be calibrated such that the financing party gets under “normal” circumstances a return in line with a predetermined benchmark (e.g., the market rate of fixed term financings plus a risk mark-up) while the financed party has the advantages of an “insurance” against losses and unrestricted upside gains. Thus, financing instruments or sukuk with new risk/return profiles and some participatory elements could be structured so as to overcome the problems caused by information asymmetries in “pure” PLS financings. © Author