Islamic Finance

Islamic Finance: Theory and Practice
"Risk sharing in Islamic finance - an analysis of issues with special reference to Pakistan", a Doctoral Thesis submitted in fulfilment of the requirements for the award of Ph.D. by the Department of Economics, Loughborough University, United Kingdom, September - 1996, Supervisor: John R. Presley

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Tariqullah Khan

Chapter 1 - Introduction
Chapter 2 - Islamic Finance in Theory: Evolution and Economics of Profit Sharing
Chapter 3 - Islamic Finance in Theory: Evolution and Economics of Mark-Up
Chapter 4 - Islamic Finance in Practice: Relative Significance of Profit-Loss Sharing and Mark-Up in Islamic Banking
Chapter 5 - Islamic Finance in Practice: Market Performance of Profit-Loss-Sharing with Special Reference to the Pakistani Modaraba Companies
Chapter 6 - Profit-Loss Sharing in Retrospect: Firm Level Considerations
Chapter 7 - Profit-Loss Sharing in Retrospect: Open Economy Considerations with Special Reference to Pakistan
Chapter 8 - Towards A Contractual Model of Profit-Loss-Sharing
Chapter 9 - Conclusions and Implications


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.

The central conclusion of the study is that the mark-up and PLS mechanisms have their own merits and weaknesses. The merit of the mark-up 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.


I have undertaken this research while working at the Islamic Research and Training Institute, the Islamic Development Bank. Without an opportunity to work at these institutions I will not have been able to complete the work. My foremost gratitude goes to my institutions for providing me the opportunity to work as a researcher. Among many people who have contributed to the progress of this research in different ways, the following deserve special mentioning: John R. Presley, my research supervisor, whose initiative, encouragement and guidance made it possible for me to present my work in the present form, my colleagues Monzer Kahf and Boulem Ben Djilali with whom I worked on beneficial joint papers, M. Fahim Khan, who motivated me to register for a research degree and encouraged me in pursuing it, M. Nejjatullah Siddiqi who helped me in focusing on the issues pursued in this research, Nevzat Yalcintas, Korkut Ozal, Munawar Iqbal, Hasmet Basar, Sami Homoud, Ausaf Ahmad, Abdallah Gul, Hussain Kamel Fahmi, M. A. Zarqa, M. Ali Al Qari, Leyachi Feddad, Mahmoud Gulaid, and Osman Babikir from whose comments and observations I benefited. To all these wonderful friends, I owe my sincere gratitude. Views, interpretations, and omissions and errors are my sole responsibility.

Tariqullah Khan