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In accordance to the profit-loss sharing principle, Shariah experts promote Mudarabah
and Musharakah to the most important Islamic financial contracts. However, Islamic banks
decide rarely to engage in the Mudarabah and Musharakah investments because they are
burdened with a high level of risk and characterized by pronounced agency problem.
In the Islamic banking practice, the most common contract is Murabahah, which is based
on the cost-plus principle, i.e. banks determine fixed amount (cost + margin), which the client
returns usually in installments, in advance. In this contract type, the bank is not a creditor, but a
vendor of the specific property which the client buys and then pays on deferred. However,
regardless of this fact, the Murabahah contract is far more similar to conventional credit
arrangement than Mudarabah and Musharakah, and, thus, the banks earning is considerably
more certain at the Murabahah contract than at contracts based on the profit-loss sharing.
The absence of fixed obligations of the client to the bank and conditionality of the banks
yield by the funded projects profitability, may encourage clients to invest in risky activities
(high yield, but also high probability of loss), because clients are aware that partial or complete
loss burden would be borne by the bank (moral hazard problem). This problem is caused by the
unequal awareness of the bank and its clients about the risk of funded project (asymmetric
information problem), where clients are far better informed about the scope of work than the
bank as a financier.
Also, in Mudarabah and Musharakah there is the problem of adverse selection because it
is quite possible that some clients who run a profitable project and who regularly pay their
obligations, would prefer another form of Islamic financing, or even opt for the conventional
financing if the Shariah aspect of the business is not important to them.
The reason for this behavior of such customers is their unwillingness to share profits of a
successful project with the financier. Therefore, they prefer debt financing with a obligation to
pay fixed rate on obtained funds. That is not the case with risky and unreliable clients who do not
have the option of borrowing from conventional banks.
The issue of these contracts for Islamic banks is lack of control over the implementation
of the project. Also, the possibility of insurance against loss of these contracts is very limited. If
loss occurs, the bank can not seek from its partner or mudarib to pay its principal and yield nor
activate collateral, unless they acted contrary to the agreement and the principles of Shariah.
However, the Islamic banking scholars consider that high risk of these financial
arrangements can be significantly mitigated due to: 1. stronger linkages between banks and

customers and creating a better business relationship than in the case of conventional financing,
2. knowing the credit history of the potential client and the qualitative project selection,
3. equity investments with the possibility of gradual abandonment of the funded project
(Diminishing Musharakah, without neglecting all its shortages), 3. existence of the legal and
financial infrastructure providing protection to all market participants, without which the Islamic
equity investments will not be attractive enough for Islamic banks.