Compliance Rate of Profit-Loss Sharing and Interest-Based Contracts in Islamic Banking: A Game Theory

Participatory or profit-loss sharing (PLS) contracts in Islamic banking have turned into fixed-return (interest-based) contracts which do not comply with the Sharia. Banks enter mostly into participatory contracts with borrowers, and although they estimate the profit they will receive from the contract, they do not consider the surrounding conditions and factors that could affect the contract’s profitability. Thus, by its nature, a participatory contract is one in which clients receive a bank loan and repay that loan at maturity with the minimum expected profit. In short, the participatory contract turns into a fixed-return contract. Using a game theory model, this study attempts to explain why Islamic banks use mostly fixed-return debt financing and the challenges associated with the effective execution of participatory contracts in the presence of adverse selection and costly state verification. We show a significantly higher compliance rate for Sharia-compliant contracts (i.e. participatory or PLS contracts) than for conventional (fixed-return or interest-based) contracts. Our findings provide evidence for why Islamic banks should reconsider using more participatory contracts which could benefit by increasing access to financing and improving compliance rates.