Financing Cost and Risk Sharing in Islamic Finance A New Endogenous Approach

This paper suggests a new explanation to the low presence of Profit and Loss Sharing (PLS) contracts in Islamic banks balance sheets. At the opposite of the mainstream literature that explains this trend exclusively by supplies factors as moral hazard and adverse selection, we demonstrate that the banishment of the PLS contracts is due to demands factors, and more specifically, the way used to price the margin profit of the other main contract category: the mark-up contracts. The current pricing practices of Islamic finance institutions lead to double price in the market. We called this situation “artificial adverse selection” and we suggest a new way of calculation to unify the financing cost of those two main categories of contracts. This allows us to restore the condition of their coexistence in the market. The endogenous profit margin we model is a function of the optimal share ratio of the PLS contract and its default probability but also a function of the risk aversion of the ent