An analysis of risk sharing in Islamic finance with reference to Pakistan

The Islamic law prohibits charging and paying of interest but allows earning profits on the basis of participation in the market. This legal injunction has motivated the establishment and successful operation of a number of Islamic financial institutions. The emergence and rise of these institutions is an important academic and practical development of our time. The theory of Islamic finance evolved on the basis of profit and loss sharing (PLS) principle underlying participatory Islamic financial contracts. However, the practice of Islamic finance does not conform to the theory and overwhelmingly relies on the mark-up principle which underlies deferred trade. The PLS is in striking contrast to the interest mechanism, but the mark-up is not. The present research inquires the causes underlying the negligence of the mark-up mechanism at the time when the theory was developing. Looking at the preferences of users and suppliers of funds, the causes of the overwhelming use of mark-up in the practices of Islamic finance are also analyzed. Pakistan has remained at the forefront of financial Islamization. The research also draws on this practical experience with a view to explore how the market rewards risk. The study also analyzes the prospects of financial Islamization in a real world scenario in which most Muslim countries rely substantially on foreign financial resources. Thq central conclusion of the study is that the mark-up and PLS mechanisms have their own merits and weaknesses. The merit of the markup is that it facilitates the acquisition of assets. The merit of the PLS is that it links financiers' interests with the outcome of projects. The study concentrates on the analysis of the inherent characteristics of the PLS and mark-up as parent principles of Islamic finance rather than the institutional environment in which these are practiced. It implies that given the market environment, the strength of Islamic finance lies in the integration of the prime merits of mark-up and PLS and in developing a comprehensive set of Islamic financial instruments.