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

The Islamic law prohibits charging and paying of interest but allowsearning profits on the basis of participation in the market. This legal injunctionhas motivated the establishment and successful operation of a number ofIslamic financial institutions. The emergence and rise of these institutions isan important academic and practical development of our time. The theory ofIslamic finance evolved on the basis of profit and loss sharing (PLS) principleunderlying participatory Islamic financial contracts. However, the practice ofIslamic finance does not conform to the theory and overwhelmingly relies onthe mark-up principle which underlies deferred trade. The PLS is in strikingcontrast to the interest mechanism, but the mark-up is not.The present research inquires the causes underlying the negligence ofthe mark-up mechanism at the time when the theory was developing. Lookingat the preferences of users and suppliers of funds, the causes of theoverwhelming use of mark-up in the practices of Islamic finance are alsoanalyzed. Pakistan has remained at the forefront of financial Islamization. Theresearch also draws on this practical experience with a view to explore howthe market rewards risk. The study also analyzes the prospects of financialIslamization in a real world scenario in which most Muslim countries relysubstantially on foreign financial resources.Thq central conclusion of the study is that the mark-up and PLSmechanisms have their own merits and weaknesses. The merit of the markupis that it facilitates the acquisition of assets. The merit of the PLS is that itlinks financiers' interests with the outcome of projects. The studyconcentrates on the analysis of the inherent characteristics of the PLS andmark-up as parent principles of Islamic finance rather than the institutionalenvironment in which these are practiced. It implies that given the marketenvironment, the strength of Islamic finance lies in the integration of theprime merits of mark-up and PLS and in developing a comprehensive set ofIslamic financial instruments.